濱特爾 (PNR) 2004 Q3 法說會逐字稿

My name is Tracy and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Pentair Incorporated Third Quarter 2004 earnings release conference call. All lines have been placed on mute to prevent any background noise. Thank you, Mr. Harrison, you may begin your conference.

Good morning. We appreciate your interest in our conference call today which we discuss Pentair's results for the third quarter 2004. I'm Dave Harrison, and 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. These statements are subject to future risks and uncertainties such as but not limited to the ability to integrate the WICOR acquisition successfully and the risks of expected synergies may not be fully realized or may take longer to realize than expected. In addition, there are economic and market risks. Also, I'd like to refer you to the risks outlined in our 10K as of December 31, 2003 and our news releases. Forward-looking statements remain as of today in the company undertakes no obligation to update publically such statements to reflect subsequent events or circumstances. Actual results could differ materially from anticipated results. I would also like to tell you that we may have a little bit of a problem with our telephone system today, and for some reason if we go -- our call fails, we will try to get back on the call as soon as possible. So with that, I'll turn the program over to Randy Hogan.

Thanks, Dave. Welcome and thanks for joining us for our third quarter conference call. We passed major milestones in the third quarter. Completing both the acquisition of WICOR industries and more recently, in fact right after the close of the quarter, the successful sale of our tools group. Both of which we accomplished several months ahead of schedule. As a result, we swapped the EBIT of our tools business and the challenging dynamics of the tools market for the EBIT of WICOR and the brighter prospects of the water business. All for a net cash outlay of roughly $100 million or about half a years cash flow for us. . With the strategic reposition positioning of Pentair now complete, we turned our attention to integrating the former WICOR businesses building on the strengths of our existing water businesses and capitalizing on the tremendous momentum of our enclosures group.

Our third quarter results demonstrated we continue to perform even while remaking the company. Sales were up 46% with organic sales growth of 11%. Operating income from continuing operations increased 42% or 20% including acquisitions. Third quarter earnings per share from continuing operations totaling 32 cents was a 19% gain. This was our tenth consecutive quarter of year-over-year EPS improvement. Our free cash flow of 74 million for the quarter or 169 million dollars for the first nine months puts us well on the way to achieving our free cash flow goal of $200 million this year.

Our growth initiatives are on track. Margins continue to improve and the integration of former WICOR businesses is proceeding well. Despite the fact that integration costs were higher than benefits in the third quarter and that WICOR's starting margins were somewhat lower than expected, our productivity improvements, supply management activities and ability to achieve price increases more than offset the impact of higher materials costs in the quarter. In water, third quarter sales increased 58% and operating income gained 31% over the third quarter of 2003. Enclosures group sales grew another 24% in the third quarter compared to the previous year period while earnings were up 71%.

Now that the strategic repositioning is complete, we have a tremendous opportunity to continue adding further value for shareholders by driving margins in the expanded water group back toward the goal of 15% while capturing growth opportunities in water and enclosures. Now let's delve into the details a little bit.

In water, sales for the quarter were up 58% compared to last year reflecting both the Ever Pure and WICOR acquisitions. Organic sales increased in the upper single digits reflecting continued double digit growth in our pump markets. Year-over-year sales in our acquired businesses were also up in the double digit percentages in the quarter. Pump revenues in North America benifitted from storm related sales in the southeast during August and September. Water systems, marine, and agriculture pump sales all grew strongly in the quarter as demand in these vertical markets continue to gain momentum. The former WICOR Marine and ag pump lines are a new and welcomed addition to Pentair. Third quarter pool equipment sales, excluding acquisitions, reflected the fact that last year's pool season was late which boosted third quarter sales last year. This year's season was characterized by unfavorable weather conditions in the quarter. So though our pool sales were only up slightly in the third quarter. Sales growth is in the high teens on a year-to-date basis. We expect the fourth quarter to reflect a more normal year-over-year comparison.

Our high end commercial water treatment and filtration sales, the latter of which is served by the ever pure business continue to grow nicely. Offset somewhat by slower growth in residential filtration. Looking at the international markets, European sales without acquisitions and currency translations were up in the mid-single digits even though European market was hampered by a cool, wet summer. Sales in Asia and India continued their rapid growth. Excluding the WICOR and Ever Pure businesses at about $1 million of post acquisition integration expenses in the quarter. Operating margins were 13.6% compared to 13.4% in the same period in 2003. As we announced at our second quarter conference call, we anticipated water group margins would be about 200 basis points lower than free acquisition levels over the next three quarters because the overall margins of the former WICOR businesses are several percentage points lower than those of the existing Pentair water businesses. The integration of the former WICOR businesses got off to a quick start and were progressing well towards our goal of achieving $30 million of cost savings in the first full year of ownership despite increasing material costs. The consolidation of three manufacturing facilities and six distribution or warehousing locations in the U.S. and Europe has been announced or completed. Costs associated with the integration efforts, which are expected to total approximately $5 million in the fourth quarter of 2004 will continue to offset the benefits for the remainder of the year. WICOR acquisition dramatically increased our purchasing power and consolidating the water group spending and materials is expected to deliver considerable savings cushioning the impact of rising raw material prices. Currently we have more than 50 individual supply teams looking at commodity groups including metals, resins, injection molding, circuit boards and packaging as well as travel freights and MRO. These teams are already conducting over 100 supplier meetings and negotiating sessions and the result of these efforts will help improve water group margins in 2005. Recent operations reviews confirmed our beliefs that our people, both Pentair and former WICOR employees, are engaged in moving towards common objectives. Our Pentair management system is being implemented at the acquired operations and initial results from the lean enterprise program are beginning to read out. In short, the execution of our integration plans is proceeding on schedule and in line with our expectations. We'll update you on our progress in this area and future conference calls.

Overall, our water group is making excellent progress in integrating the former WICOR businesses. Although the benefits of those integrations activities won't become visible until the associated costs are absorbed, we expect the margins in our water group will rise as we continue to execute our plan in the quarters ahead. Meanwhile, we're pleased that our existing Pentair businesses continued to drive growth and margin improvements.

Pentair's implosions group delivered 24% sales growth in the third quarter, same as in the second quarter. Excluding the impact of favorable foreign exchange, sales improved about 22%. Our implosions business continue to experience excellent growth in all segments benefiting from its targeted vertical market and strengthening economy.

Third quarter sales that are Pentair electronics packaging unit had the strongest growth particularly in telecom. In addition, we realize benefits from the market share gains that we made in all of our primary markets. The three-year downturn in enclosures market has clearly narrowed the competitive field as one of the strongest players in the market today leveraging our position and growing at a record pace. In western Europe, enclosure sales grew despite continued softness in Germany. Eastern Europe and middle Eastern markets were particularly strong. Nearly one-third of the growth came in the form of new customers reflecting share gain above underlying market conditions.

New product development should help to continue to propel the enclosure group sales with several key products announced in the third quarter and new cabinet line under development for release early in Q4. In the data line, the group announced a series of four new cabinets designed for the data networking market as well as what we call the de-bock [phonetic] a distribution point for land and specifically the education market. For general electronics, the group developed a full cabinet line designed for high flexibility and offering seismic and electromagnetic shielding. In addition, the group has recently released several new server cabinets accessory products which are offer to a fast start with major OEMs. The group's efforts to focus resources to medical and security markets are also paying off with key security wins supporting FAA airport upgrades and communications security upgrades.

The medical business expanded with a major program release and medical diagnostic provider and a second half million dollar win for worldwide deployment in the imaging market.

Enclosures group for the quarter was up 71% over the same quarter last year. Margins of 12.8% expanded by 350 basis points over the third quarter of 2003 and 70 basis points sequentially. This marks the 11th straight sequential quarter-over-quarter margin improvement. Last time this group achieved $23 million of operating income in its sales of $210 million and an ROS of 11.1%. The fact that the enclosures group delivered this third quarter performance on almost 30 million of fewer sales is a real testament to the power of our PIMS and supply management programs. The enclosures group continues to demonstrate the benefits of high productivity, sophisticated supply management, strong market positions, carefully targeted new market programs, broad geographic footprint, and savvy leadership team. The momentum the enclosures group and the diversity it brings to our business underscores the value of this group as an integral part of Pentair.

Dave, please address the financial topics now if you would.

Thank you, Randy.

From a financial viewpoint, we are incredibly pleased with the results of the largest transformation in the history of Pentair. When we spoke to you on February 4th of this year, we laid out a strategy to pursue our largest acquisition and at the same time sell our tools business. Our plan was to utilize an $850 million bridge loan with the goal of completing these transactions by year end. We felt it was important to communicate the full strategy in order to maintain the support of our shareholder base. For those of you who believed in the transformation and our ability to make it happen, we thank you for your support and we trust that you are happy with the 50% increase in the value of your investment. The completion of this transformation occurred ahead of schedule and we are now operating in more vibrant and focused company. In addition to the transformational activities, we have continued to positively influence the quality of results you have seen over the last ten quarters. Just to highlight a few of the many improvements, EPS from the continuing operations increased in the third quarter versus last year by 19%, 32 cents versus 27 cents. All the numbers we are reporting today include WICOR for two months of the third quarter and tools has been discontinued. The 32 cents reported for the third quarter is in line with our July 21st guidance and meets the average of our 11 analyst expectations. Most of the upside from the prior year emanated from continued volume improvement and productivity gains.

Return on sales in the third quarter of 10.5% is up 60 basis points from our prior year reported margin including tools and is only 30 basis points below the new continuing operations recording with WICOR. Even though this is neutral to the third and fourth quarters of this year, it serves as immediate evidence of the benefits of our transformation. Pentair's productivity improvement, supply management activities, and ability to achieve price increases more than offset the impact of higher raw material costs in the quarter. As we have stated, we are pleased with the free cash flow from the third quarter at $74 million, bringing the nine months cash flow to $169 million, a $21 million improvement compared to nine months last year. Higher margins coupled with continued improvements in working capital productivity are having a significant impact on our ability to generate consistent, positive cash flows. Our 12-month average EBIT ROIC was 15% at the end of the third quarter. A 140 basis point improvement since the beginning of the year. As we have communicated in previous discussions, this is one of our major goals and we continue to focus on improving productivity in both our balance sheet and income statement. We are continuing to see the impact of margin improvement in our return on invested capital and cash flow.

WICOR is raising our working capital base but we expect to take some $40 million out of working capital in the next two years. Similarly, ROIC will continue to improve as we work to bring our new water group to a higher level of performance. Our gross profit margin in the third quarter increased 140 basis points for the third quarter of last year and is up 210 basis points for nine months. As we indicated in this morning's news release, our third quarter cost of goods sold increased reducing EPS by approximately 3 cents per share for the expensing of fair market value inventory adjustments related to inventory acquired in the Ever Pure and WICOR transactions. Excluding the impacts from fair market inventory valuation adjustments, the increases would have been 210 basis points in the quarter and 230 basis points year-to-date.

At the end of the first half, we mentioned that with the inclusion of WICOR, as of August 2004, our water operating income margins for the rest of the year will be lower by roughly 200 basis points compared to the prior year. In fact, the reported margins were down in water by 230 basis points, however, excluding the impact of the inventory purchase accounting adjustments and integration expenses, margins in the third quarter would only be down 110 basis points. We expect this gap to be at its widest in the fourth quarter of 2004, which will include a full three months of WICOR, which is a more seasonal business than our own water business. WICOR typically experiences its lowest sales in the fourth quarter. The fourth quarter will also be affected by three fewer shipping days than the prior year, which is the offset from the additional days in the first quarter of this year. In 2005, we expect to see the results of our integration process improve margins in the water group.

We continue to see material and overhead inflation in a number of our businesses. Productivity improvements are helping offset cost increases in base materials such as steel and purchase semi-finished products such as motors, and in healthcare, and insurance. We have been selectively raising selling prices to help cover the additional costs on many of our products. Our goal is to continue our past practice of improving our total company margin. SG & A costs were up 160 basis points in the third quarter and 110 basis points year-to-date versus last year. This reflects the cost of pursuing synergies between Pentair and the newly acquired businesses, which include internal and external support for integration planning. Corporate governance talk specifically those related to Sarbanes-Oxley compliance, insurance and external odysseys, also contributed to the higher SG & A.

Interest expenses for the third quarter of 2004 was higher by 5.6 million dollars compared to last year. This is primarily due to the bridge loan required for the financing of the WICOR acquisition. Great cash flow generation over the last year reduced debt so that even with the recent acquisition of Ever Pure and rising interest rates, interest expense would have been the same last year without the WICOR borrowings. Our debt to total capital ratio which ended the quarter at 54% was up from 39% last year end due to the bridge financing associated with the WICOR acquisition. However, taking into consideration the sale of the tool business that took place right at the beginning of the fourth quarter, our debt to total capital fell to 37%. Our continued improvement in cash flow has allowed to us grow through acquisition while maintaining our desired capital structure. A 37% ratio is below our target level of 40% while supporting dividends, seasonal fluctuations, and working capital, a 17% year-to-date organic increase in sales, and eight acquisitions over the last three years. The third quarter 2004 effective income tax rate at 37.5% is 550 basis points higher than the 32% rate last year. The higher rate is due to several factors. Starting with the discontinued status of tools, a higher rate of tax in the WICOR businesses, our increased level of profits, the anticipated higher level and mix of our 2004 U.S. and foreign earnings and the fact that many of our tax savings programs are relatively fixed. Based on our current knowledge of the WICOR tax rate, we expect our overall blended tax rate to be in 2004 to be 35% and a 100 basis point increase in 2005 to 36%. As part of our acquisition strategy, we are pursuing rate reduction opportunities which could improve our effective tax rate.

We continue to make excellent progress and working capital productivity which is now at 33 days. Down another day from this time last year. The productivity of inventories is measured on a 13-month rolling average improved from 58 down from 60 days. All of our businesses are making great progress and inventory management through their PIM activities and we expect continued improvement in inventory days throughout 2004. [inaudible] again saw another improvement in the annual average moving in the current quarter to 52 to 54 days. This difference reflects continued productivity that we have seen in receivable management over the last few years. But water and enclosures saw increases in orders in the third quarter. We continue in the third quarter to show a book-to-bill ratio for both groups over one. Even with the strong sales experienced in the quarter, both groups exited the quarter with strong backlogs.

On a final note, we're still anticipating $200 million of free cash flow this year even while supporting growth in water and enclosures, and raising dividends for the 28 straight years. Now I'll turn the call back over to Randy.

Thanks, Dave.

The strategic repositioning of Pentair has been completed and we now started writing a new chapter in our history of success. We recognize the real work is still before us. As we integrate WICOR and capitalize on the momentum of our encloses group, we will execute our operating initiatives an uphold our commitments to higher performance. We will capture the growth opportunities before us, expanding product lines, and creating new ones by targeting new areas for development. We're aggressively pursuing new channels in market, new geographic areas, and new business platforms. In addition, we will continue to act in the best interest of our shareholders, customers, employees, and suppliers through our values and code of business conduct. In short, we now embarked on a journey to high performance on the strength of two attractive markets, enclosures and water. Looking ahead, our expectations for earnings per share in the fourth quarter are between 30 cents per share and 34 cents per share which results in full year 2004 EPS between $1.32 and $1.36. This is in line with our prior guidance and represents the year-over-year EPS growth of approximately 35%. We still expect 2005 EPS to be in the range of $1.95 to $2.10, an increase of approximately 50% over 2004. So while the strategic repositioning the water led diversified company is complete, the journey really is just getting started.

Thanks for your attention.

I'd now ask the operator to come back on the line and please provide our audience with instructions for the Q & A session.

Your first question comes from the line of Jim Lucas with Janney Montgomery.

Thanks. Good afternoon, guys.

Hi, Jim.

Two questions. One on each segment. One starting with enclosures. Could you expand a little bit more on what you are seeing in Europe as well as the new market penetration, the verticals you are talking about. Then two, on WICOR, could you talk on your initial impressions any positive or negative impressions that you have, what are the biggest surprises you've seen?

Sure. First, on enclosures, in the underlying performance of enclosures, we really had a nice step up in both growth and profitability at all three of our operations, Hoffman, Pentair electronics packaging, Europe and in, fact in Asia as well. In Europe specifically, the growth in a local currency basis was in the mid-teens. And that clearly was higher than what we were seeing in terms of the markets. We had a net addition of about 100 customers that drove that and some benefit from new products as well. We have a nice new business developing in what's called ATTA, advanced telecom computing architecture which we believe we're a leader in a technology base both in the US and in Europe for that. So that's one of the key drivers as well as some nice business with some of the telecom players over there that drove performance. Both of the -- both pep and Europe had very large step ups in margins in the quarter. In terms of WICOR coming in, as we mentioned in the conference call, margins were a little weaker than we expected. That's largely because, you know, in taking eight months to close, there was some, I think, opportunities in supply and pricing that probably went by the boards early in the year. Those are things that we can fix. That's if, if you will, on the negative side. On the positive side, and frankly much more positive than the negative, is the fact that WICOR businesses maintained, if you look at their year-over-year performance in the third quarter, their growth was in the double digits. And I think it's a testament to what a great job the employees did there at keeping their eye on the ball with serving customers and driving their new products and new market opportunities.

Okay. And back on enclosures. You touched on Europe but in terms of the verticals you talk a little about security and medical wins. Are there any other new verticals that you entered into that you can speak to at this point?

Well, the focus that we've been talking about in terms of security, defense and medical continue and we did mention those in the conference call. We continue to make great progress on the data com. I mentioned some of the new products there. And in particular, we've tel developed, and if you will, expanded the range of activity and enclosures when we talk about our accessories for networking and server cabinets. These are things that we didn't make before. And we basically have started from scratch and have some nice intellectual property protection on some of those accessories. And we've got a great take up with a couple of OEMs and we think we can broaden those product lines as well. So those are really built on our data com and networking segment, which I think is looking very promising.

All right. Great. Thanks a lot.

Okay.

Your next question comes from the line of Dan Wang with Lehman brothers.

Good morning. My first question was regarding material costs. I think you were more than offset the higher material costs in the quarter with passing on of higher prices. Was that true for both water and enclosures?

It wasn't just prices, Dan. The -- it was truly in both water and enclosures that we were able to raise price. And in fact, you know, prices are up between 1 1/2 and 2% overall. But material costs was more than offset by a combination of productivity, price, and that's productivity both in terms of overall total cost productivity but also the underlying material cost productivity that we got from our initiative. You know, it was great that we had the big focus on supply management now and particularly integration because we already had the team spooled up to face the raw material price increase head on. And so we were able to be proactive. So we did some avoidance. We did see material inflation higher than price. And higher than what we achieved in price. And the combination of productivity and price increases more than offset the material push.

How about your outlook on going forward? Do you think with material costs continuing to be high, do you think you could get incremental pricing in the quarters ahead?

We certainly have not got all of the benefits of the price increases that we have put in place yet with our numbers. We also have not seen all of the price increases we're going to see. For instance, we buy a lot of motors. Motors are bought on a long-term contract. We're seeing pressure that hasn't yet hit our P & L. And, we've done a very good job, frankly, when we look at metals, you can see 100 to 150% price increases in the marketplace, and we've been able to maintain only about a 50 to 55 increase in our metals which is obviously not something we'd be proud of a year ago but in this market we feel our team's doing a good job. So I think the material inflation pressures are going to remain. In fact they're going to get tougher but I'm expecting better productivity from our supply management group. And a more readout of the price increases.

We feel pretty good that a combination of the price increases as well as productivity, we can maintain or improve the margins.

Okay. And the second question was regarding, you talked about the expensing of fair market value inventory adjustments. Do you expect any additional in the quarters coming up or is that sort of a one-time?

it will impact again in the fourth quarter but because of the turns that we're seeing on the products, the biggest part of it occurred in the third quarter. But we will see some smaller amounts in the fourth quarter.

And lastly, questions regarding enclosures. You talked about you getting market share gains. Now, is that domestically and overseas?

We think it's both. I'd say that when we look at Asia, it's probably not market share. It's probably market growth over there. But clearly in North America and the industrial commercial segments, we are taking share, that's a standard product Hoffman. There's no doubt from our look at the numbers that we're taking share there. We believe we're taking share in Pentair electronics packaging. We have a number of nice programs in telecom. All of that medical business and that security business is brand new for us. So we're taking that out of somebody else's hide. And in Europe, we measure both customers. We don't sell to every quarter in customers we do sell to. Our next gain is the 99 customers in the quarter. So we know that that represents share gain for us.

Okay, great. Thank you very much.

Your next question comes from the line of Michael Snyder with Robert W. Baird.

Good morning, guys.

Hi, Mike.

I wonder first on the organic growth of the water businesses. You stated in the press release that total organic growth as 11%. So it looks like if you exclude Ever Pure and WICOR entirely, the base water water businesses were up 4 to 5%. Is my fath math about right?

Your math's right but the way we look at it is as follows. As I mentioned earlier, we're quite pleased with the organic growth that we're maintaining at WICOR. When you take a look at the base which isn't in our core when we look at organic growth, we also look at our new acquisitions. And when you look at it that way, we look at the organic growth and we're getting WICOR. Some of which, by the way, could have showed up at WICOR, could have showed up at Pentair because some of it's cost. Of the Ever Pure initiatives, which are also as a result of the broader efforts, the number is in the mid, higher single digit percent growth. That's the way we look at it because we don't give our new businesses a buy on organic growth.

Right. That's a fair point. And what was the actual organic growth number as you compute it?

You're about right. If you look at same-store sales.

No --

if you look at it this, you know, we're talking in the sevenish range.

Okay. And you mentioned that the residential products were somewhat weaker in the quarter. Is that weather related or is that just that last quarter was so strong?

Well, the big driver, if you look at, you know, the mid-teens organic growth we have in the water business, same-store in the second quarter versus the fiveish and the third quarter. The biggest difference is the pool business.

Sure.

It's basically had over 20% growth in the second quarter and essentially no growth in the third quarter. That was really, if you will, sales sloshing from the third quarter to the second quarter between the two years. We had a slow start last year and an early start this year. It was a cold, wet winter and -- excuse me, summer in the third quarter in the northeast which meant the distributors were drawing down inventory. That was really the big driver. We did lose some share in the residential filtration business, which is reference I made to residential filtration. We lost some placement that we had a year ago in one of the big boxes, and I believe you know this year.

Okay. And WICOR's double digit organic growth, that's pretty incredible for those businesses. Is there something new or different about that growth rate from prior quarter?

Well, we think they're gaining share. I think particularly in the High Pro-business and Sure Flow business, which are two of their end market focus businesses that sure flow is in part of our filtration and pure fiction group. High Pro is now part of our pump business. And we think the ag market and Marine market and filtration markets of sure flow surge are all sales in those markets are all up because of some new products and because of some very good sales work.

And Dave, we talked in the past about the fact that WICOR because of the sales process really hadn't been aggressive on price this year yet. That was something you guys were going to address. Can you put some numbers around the benefit, and I'm not sure how to do this, but numbers around the benefit of putting in price at WICOR and the fact that this inventory revaluation is going to lapse? It seems like there's almost a double kick here at the margins at WICOR, which you guys will begin to enjoy.

Well, is certainly true that as the selling prices phase in, we're going to see the impact of that and, you know, starting a little bit in the fourth quarter. However, we still do have integration costs that are going into the fourth quarter. So we're looking at numbers that, you know, will be improving as we go forward as you're indicating, and again, we'll see that in 2005.

Mike, the way I look at it is we haven't seen all of the materials we're going to see and the price we're going to get there is going to offset the material inflation. So you know, we're certainly going to shoot for more than that. But our philosophy is basically, anything we can't get and we get passed on by our suppliers, we get a pass on. So that's the strategy we'll use in the price increases to begin with.

Okay. Thanks for the detail.

I wouldn't count it too much as a double. I mean, great if it is a double win, but it I wouldn't plan on it.

Okay. Thanks for the detail.

Your next question comes from the line of David Smith with Smith Barney.

Good morning, guys.

Hi, David.

Hi, Dave.

Can you go over the pricing a little bit more. Just by segment and then maybe also talk about what you're seeing in the water business by group?

In terms of the pricing, we have gotten more price where we have more power. So if you take a look at enclosures, as I mentioned, we're up about 1 and a half to 2% in price overall. That's higher than that in enclosures and a little lower than that in water. If you look at it within not surprisingly enclosures it's on the standard product and our strong brand the product versus the OEM product where we get price. But we also look at it, we do a lot of cost reduction programs even though it's a margin enhancement frequently. Right. So we try to look through that. Even though it is calculated the discipline's solid in terms of calculating price. And in terms of water, the price is basically in the quarter it was the price achieved was highest in the pump business, and, you know, sort of trails down from there. And all those cases, not offsetting material costs. It didn't offset the material costs? In the case of water, price did not offset material costs without additional productivity in the additional material cost savings. We have savings in some areas.

Is that 1.5 to 2% year-over-year for the full nine months?

That's third quarter.

Okay, can you give us a little insight as well into water trends what you are seeing going out in Q4 in '05 maybe? Okay in enclosures, I would say the European outlook in orders are softer than the U.S.

Germany's a very important market to us. The German economy seems soft even though we did grow 15%. And, in terms of water, I think I'd rather not give you specifics on the individual businesses until I understand them more. I mean, we just got the WICOR businesses in, and I want to make sure that we're not giving misdirection on the growth. Suffice it to say that if, too, the U.S. is much stronger than Europe. We see the market in Europe as softer than it was in the first half.

Okay.

For our water businesses. And as I mentioned, the pool business was softer in the third quarter than it was in the second quarter. So you are right, they're not quite as busy as the other business. As I mentioned in the pool business we expected more normal comparison, we expected more normal comparison.

Some growth.

Year-over-year. So I would expect some.

Okay. One last thing. On WICOR and working capital, I guess this comes back to the inventory adjustment, but can you talk a little about the working capital metrics at WICOR and what you are seeing as far as your savings plan goes?

When you look at the numbers from WICOR, they are about where we were in both inventories and receivables three years ago. So there's a significant amount of improvement to get down to the numbers that we're at today specifically with receivables. You know, in terms of the goals that were -- that we basically have set and basically for our base business set a goal of 55 days and they're still above 60. So we have an opportunity there to get that down to where we are today which is really below the 55 level. On the inventory side, we have a significant opportunity there from the standpoint that our goal is really to get somewhere close to 45 to 50 days and they're operating today in the 70, roughly 70 range. So we have an opportunity with their inventories as well as continuing to move ours down toward our goal of 45 to 50 days.

Okay. That's great. Actually, you know one last thing. I don't know if you haven't commented on this but the Franklin Electric lawsuit, is there any impact we should be looking for there?

Well, you know, as they put out in their press release there is a lawsuit between us. And, you know, basically, you know, we've tentatively agreed on a settlement between us and there will be additional information coming out on that. So we think it's moving forward in a positive way for us.

And there's no other supplier that you guys have for those materials?

No. I mean, I let the facts come out as they come out, okay?

Yep, great.

With a lawsuit, I just want to be respectful of the process.

Thanks.

Your next question comes from the line of Joe Quely with Adam Partment [inaudible].

Good morning Randy and David. First, I wonder, can you talk a little about the backlog as how they compare to last year on a year-over-year basis maybe by groups?

Well, when we look at the enclosures business, we're looking at backlogs that are, you know in are the high end, in the double digit range. Up from the prior year. When we look at the numbers for water, I think at this point in time, our backlog basically bring in the comparison that we have in the prior year really has WICOR in this year and it's very difficult to get those numbers squared away for the prior year. Hold on.

Right, right. Okay. And then we had --

are you still there?

Yeah.

Sorry about that noise.

That's all right.

Trying to break no that out and get numbers that we can really relate to. We're still seeing for the total water business on a comparative basis with the prior year, including or excluding the WICOR business. We're still seeing numbers that are pretty positive on the backlog. Though still on the double digit range for the total business. I think it's even more important, you know, in terms of using that number just to use the book to bill ratio, which basically comes out of the last month of the quarter which basically is over one for both of our businesses which means that we're seeing orders coming in quite nicely in, you know, in the current period.

Okay. And second, we had pretty strong pre-cash flow this quarter. What about the outlook for Q4?

Well, you know, we expect that we're going to have at least 2 $200 million for the year. Not for the four quarters, thank you. So I think you can draw a conclusion there that we should have something that's somewhere in the rain range of 30 million plus in the last quarter.

One thing I'd add and I think it's important for all of you who modeled on it. Is as you recall the fourth quarter was a strong quarter for the tools business which isn't part of Pentair anymore. So the fourth quarter as Dave mentioned has fewer days but the fourth quarter will also reflect the water seasonality as opposed to tool seasonality. And as Dave mentioned in his discussion, the WICOR business, the low quarter for WICOR is the fourth quarter. So that said, we're still committed to the $200 million of cash flow and feel good about it.

Okay, great. Thanks. I'll jump back to the queue.

Your next question comes from the line of Deane Dray with Goldman Sachs.

Thank you. Hi, Randy and Dave.

Hey.

A follow up a couple of questions ago was the point you made about WICOR being about three years behind where Pentair was on inventory. That kind of begs the question of pace of improvement. I Trust it's not going to be three years. How should we expect to see those trends improve?

We expect continuing improvement as I mentioned, you know, in my address, over the next couple of years in terms of pulling out the 40 million of working capital. So we're going to be, I think, we've learned a lot of ways of being able to get it out. Our PIMS process is working well on our inventory side. So it's not going to take three years but you don't do it overnight. So we're in the process of basically doing the same kinds of things that we did for the base of their business and we think it's going to be over the next few years pulling inventories down.

Okay.

Don't forget we're still in the process with our improvements on inventory. So we're not there yet on the Pentair side, either.

So you keep extending the finish line.

Exactly.

And then second question is, how long are you going to be able to track WICOR separately as a business. You know, a certain point with integration, will there be that distinction between what was WICOR and get blurred?

We'll do our best to keep them as separate as we can so we can pay people appropriately on incentives. Next year, though that's all going to be blended. When you take a look at the consolidation we're doing, we've got WICOR -- former WICOR businesses moving into former Pentair factories. We've got product lines moving vice versa. So I'd say that next year it's a little more difficult to separate the two. But we do have the baseline so we can measure overall organic the way I talked about it earlier, which is to take their actual sales into last year and add it to our actual sales so we can still measure an organing rate for the businesses overall. And probably by market within the businesses overall because we know where we're putting things for example Sure Flow as I mentioned as part of the filtration and purification business for us. So I think it will get a little fuzzy, but we'll do our best to to continue to keep our disciplines around organic calculations.

The important factor will be to follow the margin improvement from the business. Because that's going to give you an indication of how well it's going from the standpoint of integration as well as continued cash flow we expect to get.

Great. Thank you.

Thanks.

Your next question comes from the line of Dana Walker with Calamar Investments [phonetic].

Hi there.

Hi, Dana.

If 230 bases points was the operating margin drag in Q3 order of magnitude, what are you expecting in y 4, Dave sf

Well it's probably going to be a little bit greater than that because of the fact that the sales numbers won't be as high as Randy mentioned it's going to be our lower quarter of the year. Specifically for the WICOR businesses.

And the last three months of WICOR.

And we'll also have three months, which will make it a little bit larger.

Question two. Can you tuck about -- talk about the pacing of your integration activities and the P & L burden of these integration activities and how your pacing is perhaps progressing at a different level than you might have thought would you have proceeded a few months back?

Yeah. It's not proceeding in a different pace, Dana. You take a look at the inventory valuation that we talked about in the third quarter plus the million dollars of integration costs we talked about in the quarter. And as we mentioned we have about five million coming in the fourth quarter. That's about as we expected it. And we expected us to basically be neutral to maybe even slightly negative in terms of the cost versus the benefits. We expect that to flip over beginning in the first quarter or benefits would be greater. I say we're not really off of where we thought we'd be. As I mentioned, the WICOR margins coming in are a little lower than we thought they'd be. But the growth rate's a little bit better than we thought it'd be. So that, I think, is, I think that's probably how I'd summarize it. I think that's good. One more thing would I add is even with the integration costs, in the third quarter, and also the fourth quarter and also the extra cost of interest that we had during the third quarter for the financing of the business before we sold tools, the WICOR acquisition, the WICOR businesses were still accretive.

Understood. How transparent --

Black zero.

How transparent are your production plant activities or other things that you're doing to your customers and/or the activities in the planner? How much friction are these causing if any?

The general feedback we're getting at this level is that things are going okay with customers. You know, obviously our goal is to minimize the impact so they don't even feel it. And our plans and execution of plan consolidations are geared that way. And which is why you won't see necessarily inventories drop early in our processes. You want to get our cost structure right first. And we'll use inventories to help cushion changes as we go forward. But I'll tell you, you know, we've already closed a couple of the warehouses without any impact on customers. We've just changed over one of our factories to a new IT system seamlessly with no impact on customers. And, you know so that there is a strong focus on keeping it that way. Even one of our more, what I would call sensitive site enclosures which is the closure of the Pentair facility Hydromatic Ashland, Ohio we're actually consolidating with another factory across town in Ashland, Ohio. We felt there might be some customer negativity to that's gone very well, too. So we're clearly sensitive to it and aiming to not disturb the customers and haven't yet.

One final question. Also, focusing on water, can you talk about the scope of either market competitive thematic or new product influences that you see in the business over the remainder part of this year and '05 that might define how well you do?

I think on the -- I'll talk by group. In enclosures, I think we have the momentum on new products. I mention we have a whole new range of cabinets that were launching for the electronics business or launching next month. And we think it's a more cost effective better technology solutions to a number of applications, particularly where shielding is required or seismic capability is required. I mentioned the expansion into new products for the local area network market and also mentioned the accessories. So I think we actually have a great deal of momentum on new products site and enclosures. I think in water, frankly it is a bit of a mixed bag. We continue to have great new products in tools. We have great new products, very interesting things going on in filtration. We just got NSF certification for some of our production in the water treatment that's going to help us in that market. So that's looking very good. I think in the pump arena, we've got more work to do. A new product I think that's one of the benefits WICOR has I think it's a little bit more robust new product activity in pump. That's leaving out High Pro-. High Pro Pump has good product vitality. Something that's beginning to measure in those businesses. One of the other interesting things that we're finding in the cross training of our sales forces between WICOR Pentair is there's a real thirst for the opportunity to cross-sell and cross-brand some of our products. So taking products that WICOR didn't have that Pentair makes and be able to sell it to the WICOR sales force. It looks very promising. But more of a mixed bag. Enclosures looks, I think it's all good and water, some very good things with some others I mentioned we lost some residential filtration business. That's going to continue to affect that business for the next few quarters. And we need to do something that gains some of that business back.

How do you do that?

I think new products and focusing in on costs. Those two things. I think branding, the [inaudible] business was one of the will of the brands. We need to work more closely with our brand partners on the retail side.

If you could only take some of the shielding properties and apply them to the sanctity of this line, we'd have less static. You're in the enclosure business.

No kidding. We apologize for that.

Thank you and good luck.

I think the static may have more to do with the craziness in the telecom business than anything else.

Your next question comes from the line of Ned Armstrong with FBR and company.

Good morning. You just alluded to the opportunity for cross-selling, cross-branding between the WICOR and Pentair companies. When do you see the benefits of that type of project having a material affect on the combined entitys?

I think in a modest way it's going to help in the fourth quarter. I think in particular, there's a number of businesses like the pool business where we see big opportunitys in that regard. Where it won't really hit until pool season comes again, which is, you know, in the March and forward time frame next year. We've already seen some wins, and cross-selling and cross-branding even between Ever Pure and Sure Flow already, which is very interesting. And not a lot of sales yet but we know it's going to yield customer weight. So we're seeing benefits already.

Was that something that you pursued by design or is it just an opportunity that hasn't presented itself very soon?

We had a number of integration teams working before the close of business. And even in the market arena, we could work on products. We couldn't talk about customers. Those are, I would say, a couple of them are serendipitous a couple of pools, I think, although the pool opportunity was clear. The ones of filtration are ones we've been working on for a while. So they were really part of the integration planning.

With respect to the enclosures business, how high do you think margins can go there? We've had just excellent progression over the past several quarters.

I tell you, Mike Schrock upwards of 15%. Mike runs the enclosures business.

Would that be aided by or with a the effect of these new verticals be neutral or aid you in gaining into that 15%?

It's really a mix. One of the interesting things we found out we didn't used to think of some of our OEM businesses as having the opportunity to be much more than a 10% business, but when we looked at base loading for instance Pentair electronics packaging, some of that OEM business, and they are getting a further growth of some of the ATCA business and a security and medical business, I mean, now see where that business can actually be a 12% business. Our standard business should be a 20% business. So that's how we blend it out that way.

Okay, thank you.

Your next question comes from the line of Michael Snyder with Robert W. Baird.

Hi. Just some follow ups. I guess on the sale of tools it looks like it came many before a quarter ahead of what most people are anticipating on their models. I am just wondering, maybe Dave specifically, what is the offset to what should have been probably some savings on interest? Is it raw materials or anything else?

Well, there's -- would it be better just to sort of comment on what we think the interest costs will be in the fourth quarter?

Well, yeah. That would be helpful. I guess what I am asking maybe put in a different way, simply, you've got an additional quarter of interest savings as a result of selling tools earlier than you had been guiding. I'm just wont wondering what the natural law set is because the guidance didn't go off. I'm just wondering if there's more conservative conservatives among raw materials.

To start with, the tools business was discontinued.

Yep.

So there is no offset, inset, whatever you want to call it from the tools business. We're basically doing comparison with last year's continuing operation without tools versus this year, which is continuing with WICOR. So we're looking at, if you want to -- an interest, we're looking at approximately $12 million for the fourth quarter.

Okay, but I guess maybe another way that I can follow up offline if it doesn't make sense. You've been guiding to the fact that you had sold tools around the first of the year, which assumed, presumes that you had more --

those numbers were not in that guidance.

We already -- Dave and the team worked feverishly to get when we announced in the second quarter to get discontinued look at the third and fourth quarter.

Okay.

When we gave the guide guidance, we already assumed the discontinue wags. Then you are allocating some of the debt, so the continuing really, the forecast we gave was not dependent on when tools sold.

Okay.

It was discontinued. That's correct.

Thanks for clarifying that. Secondly, just as far as the fourth quarter guidance goes, you mentioned the $5 million in integration costs you expect.

That's included in the guidance? That's correct.

That;'s included In the guidance.

Finally just on WICOR, you mentioned that you've got three plants to be closed and/or closed in six distribution facilities or warehouses. Can you give us any color as to what that constitutes of the total and what we should expect as we head into fiscal '05?

We're not done. But we're on track. And I'd lake to leave it at that. I prefer to talk to employees about impacts bring talk to anybody else.

Okay. Thank you.

Your next question comes from the line of Mike Hamilton with RBC Dane Roucher

Good afternoon. First of all, could you give your thoughts on where you anticipate R and D spending's going to be?

Well, as you can see it's flat on a percent [inaudible] basis. As we focus on investing more in growth, you can expect us to go up over time. Particularly in the water segment. Enclosures R and D a little hard to measure because a lot of the development we do ends up just going through costs of goods sold because it's application engineering. So rather than breaking into R and D, it typically goes to costs of goods sold even though it is an area we are investing in as we develop some of these new markets. For instance, in the security and defense arena, a lot of those are only in specific business that typically is cost of goods sold. That spending is already up although it doesn't impact the R and D [inaudible] overall. But I would see that over the next two years.

Thanks. How about are we too early to give any thoughts on '05 capital expenditures?

Yeah. We've looked at that, and we're looking at a number that between 60 and 65 million dollars.

That's the first block we will be firming that up over the next our planning cycle is more.

Thanks very much.

There are no further questions at this time.

All right. Thank you very much. Appreciate your attention and the forbearance, I would ask you all to study the numbers and if you have any other questions for clarification to please call us. This is the first quarter that we're showing real results of the new Pentair, and so rather than assume about how things will look, if we could provide clarity, we will. That said, operator, could you please give the directions on the replay?

Yes, sir.

And we'll be out.

Thank you for participating in today's Pentair incorporated third quarter 04 earnings release conference call.