濱特爾 (PNR) 2006 Q2 法說會逐字稿

Good afternoon.

My name is Marianne, and I will be your conference operator today.

At this time I would like to welcome everyone to the Pentair, Incorporated second quarter conference all. [OPERATOR INSTRUCTIONS].

At this time, I would like to turn the conference over to Mr. Dave Harrison, Chief Financial Officer.

Mr. Harrison, you may begin your conference.

Thank you.

Good morning and thank you for joining us on this call today to discuss our second quarter earnings results.

With me today 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 the risk outlined in our 10(K) as of December 31, 2005, and our news releases.

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.

Welcome to our conference call and thanks for joining us today.

Pentair generated solid results in the second quarter.

We made the most of our market opportunities and generated higher growth in water than in the first quarter of this year.

We enjoyed particularly good growth in pump markets, in our Asian markets, and in the industrial and commercial markets of our technical products group.

Among the highlights for the quarter, earning per share of $0.67 from continuing operations was up 12%.

Net sales of $862 million increased 9%, comprised of 4% organic growth, with the remainder coming from the Thermal Management acquisition.

Organic growth in Water totaled 3.4%, while Technical Products organic growth was 7%.

Our Technical Products group once again achieved a record level of profitability at $39.7 million, and exceeded our goal with operating margins of 15.5%.

The Thermal Management acquisition exceeded its sales, operating income and margin targets for the first six months of the year.

The integration process is going very well and we continue to be enthusiastic about the opportunities ahead of us in this business.

Cash flow totalled $128.5 million, bringing free cash flow for the first half of 2006 to $27.2 million.

We continue to invest to drive growth and establish low-cost country operations.

In the second quarter, costs totaling $7 million continued to run higher than benefits from our investments in additional sales and marketing resources, expanding R & D, implementing a unified business system infrastructure in Europe, and advancing our Faradyne Motors joint venture.

Our supply management initiatives delivered incremental growth savings before inflation of nearly $15 million in the second quarter compared to last year.

Supply management continues to be a key contributor to our operating excellence for us and it is helping us combat the higher impact of inflation.

Our Asian sales were up approximately 30% in local currencies.

We're particularly pleased with sales growth in China and India and our other international markets continue to build momentum.

Now, let's turn to the operating groups.

In the water group, second quarter sales of $606 million were up 3.4% over second quarter 2005.

Effective currency exchange was negligible in the quarter.

Second quarter growth rates were higher than in the first quarter due to stronger sales in North American pump markets and Asian water markets while pool and spa sales in North America and Europe grew slower than expected.

North American pump sales were particularly strong in the commercial, municipal and residential markets.

In fact, our Aurora and STA-RITE operations, which make commercial and residential pump products respectively, achieved quarterly sales records.

We captured new customers in several vertical markets including waste water and fire protection systems, and introduced new products, including control boxes, some variable speed drive pumps and some new end suction pumps, among others.

While pool and spa has been growing double digits for several years, in the second quarter we saw lower single digit growth consisting of higher single digit growth in pool equipment offset by double digit declines in the spa and bath sales.

Sales of pool equipment were somewhat dampened by inventory adjustments at several distributors.

While some slowing could be expected in the effect of an economic downturn, we believe we are positioned well in the pool replacement market, which should moderate any impact.

The pool business continues to see good sales gains from new products introduced over the last year, Particularly from our new electronic controls, self-chlorinator, and high efficiency variable speed pumps.

Filtration growth reflected strong industrial and municipal sales that more than offset weaker sales in residential and OEM markets.

We've entered into a filter supply agreement with Brita products, a wholly owned subsidiary of Clorox.

We're also exploring the joint development of new superior water filtration products for the North American household filtration market with them.

Our Ecolab partnership also continued in the quarter as the launch of the Fresh2O product line rolled out and initial stocking orders were placed.

We received increasing water softener orders as new training and marketing support programs began to take root.

Overall, sales to Ecolab increased strongly year-over-year and sequentially.

Everpure has appointed 500 authorized dealers under its high end residential filtration program and that program is off to a good start.

In food service, Everpure added new distribution and introduced new commercial heater and chiller product lines.

Other filtration products introduced in the quarter included a new product line for recreational vehicles and a new bulk agricultural chemical transfer system.

The international water businesses reported mid-single digit sales growth driven by very strong Asian sales in India and strong pump shipments in Europe.

Delta pumps in Europe established new records, reflecting the early success of our initiatives to gain share in the professional channels and new product success supplemented by solid retail channel gains.

New products in the European business included an energy efficient variable speed pump for residential markets, and a new integrated fire protection system where the pumps, controls, and tanks are installed underground, thereby saving space inside buildings.

We also launched a small cabinet sized water softener for point-of-use applications, targeted at coffee OEMs and service markets.

Globally, we recorded another excellent quarter for code lined pressure vessel business, as our efforts to capture additional share in global desalination projects continue to pay off.

These products are made at our Goa, India facility, which continues to enjoy a high level of quotation activity, much of which specifies Pentair multi-ported high pressure vessels which are a particular competitive strength for us.

We also recently launched a new China commercial solutions initiative which will augment the gains we're seeing in water treatment and pump markets in China.

We recently announced we plan to acquire 70% of a leading Chinese manufacturer of disc filters, valves, pressure tanks and systems used in a water filtration, softening and water treatment systems applications.

This company also has an extensive sales and distribution network that we're particularly pleased to secure.

With this acquisition, we expect to expand our engineering capabilities for commercial and industrial systems initiatives in China, and expand our product offering tailored to China's local market needs.

This transaction, which we expect to close in the third quarter, represents a major step forward in our efforts to rapidly expand the Asian water business.

Operating income for the water group totaled $84 million, down 9% over the same period last year.

Return on sales was 13.9%, down 180 basis points compared to the same period last year.

As expected, profits continued to be effected by the planned investments of approximately $7 million that I mentioned earlier.

Overall water margins were also negatively effected by the margins and some of our successful new products that carry low initial margins.

Also negatively affecting margins were proportionally higher sales in our lower margin markets -- Asia in particular.

Record margins for pump operations benefited from supply management savings, low cost country sourcing activities, pricing and volume.

Unfortunately, these were offset at the water group level by the pool and filtration operations where margins were affected by unfavorable product mix, higher material costs and plant consolidation related inefficiencies.

In Europe, profits were adversary effected by higher material costs, continued investments to move to lower cost production and business system infrastructure.

Operating income in Asia was down sequentially and year-over-year due to reorganization costs in our Australian operations and ongoing Asian growth related investment spending.

For example, in India, we've again increased the number of engineers at our India Center for Design and Research, doubling the number from a year ago.

This is a reflection of our commitment to drive organic growth with new product development.

Finally, inflationary pressures continued during the second quarter with higher raw material costs for plastic, resin, copper, brass and liner board.

Water was able to offset the inflation with price increases and supply management savings.

On the submersible motor front, the Faradyne joint venture has completed the field testing and approval process for four-inch submersible pump motors.

We very pleased that these motors meet or exceed our stringent designer reliability criteria.

Production in the motors begins in August, with initial deliveries to our pump business scheduled for September.

We expect a ramp-up of production and another production line will occur during the autumn.

We anticipate production along with that of other suppliers will meet demanding for submersible motors in 2007.

We're staying the course on our strategic initiatives and related investments as they are beginning to read out positively in a number of our water operations.

We're not satisfied, however with the relatively slower improvements coming from some of our operations in Water.

As a result, we made a number Management changes during the second quarter and early in the third quarter in order to realign and refocus our actions to improve performance.

In addition, we're continuing our efforts to improving manufacturing efficiencies and customer deliveries while managing cost challenges such as inflation and freight.

Where appropriate, we've implemented additional price increases to counterbalance these rising costs.

Before I turn to the Technical Products group, I would like to finish Water by highlighting some truly outstanding results contained within the overall Water group numbers.

Business with the largest overlap and thus synergy potential from the WICOR acquisition is our Pump division, the largest division in Pentair.

Despite the head winds our Pump team encountered at the outset, the team captured the supply savings from consolidated purchasing, accelerated low-cost country sourcing, moved and streamlined overlapping production, and consolidated two plants.

That work bore rich fruit this quarter.

The division posted above average growth, and their highest operating margins ever.

In fact, the pump division beat our operating margin goal of 15% for the first and I'm sure not the last time.

This demonstrating we can and will get the entire Water group to our 15% goal as our investments pay off in the second half of this year and beyond.

Our Technical Products group again set new records in the second quarter.

Total sales of $257 million reflect a 26% increase.

Excluding the impact of a Thermal Management acquisition, organic growth was approximately 37%.

Again, the effects of currency exchange were de minimus in the quarter.

Excluding that acquisition, sales in North American markets grew in the mid single digits, resulting from share gains, in targeted petrochemical food and beverage and commercial construction markets driven by new products and focused vertical marketing effort.

Sales of new products in the North American markets were strong with a number of cable management enclosures and accessories that allow faster and better organization in the data networking applications.

In addition, our global advanced telecommunication commuting architecture or ATCA sales year-to-date have tripled from the same period last year.

We've been in the forefront of this evolving standard and continue to build our leadership position in this developing area.

Our recently required thermal management businesses are performing well, with seasonally strong double-digit growth setting new records for these businesses.

In fact, McLean supported its growth by introducing a new line of air conditioners targeting outdoor applications in industrial and telecom markets.

These products fill gaps in our current offering and provide customers a more cost effective outdoor solution.

Also extend the BTU capacity of Hoffman's product offering to 20,000 from its previous maximum of 10,000 BTUs.

While European growth flowed during the second quarter due to telecom programs reaching end of life in the U.K. and Germany, the business continued to improve, driven in part by growth in test and measurements and automation and control markets.

New products such as additions to our ATCA offering, Meristar which is our new generation cabinet offering, and new back planes complemented and expanded our customer base.

Asian markets increased strongly in the quarter helped by market penetration in China, strong growth in Japan as those markets continue their recovery and OEM programs transitioning from our North American and European operations.

Technical products operating income of $40 million was a new record, exceeding the previous record set just last quarter.

Return on sales for the quarter hit 15.5%, up 70 basis points on a sequential basis.

This represents Technical Products 18th quarter of sequential margin improvement.

Both electrical and electronic margins improved, complemented by strong gains in Asia and in our new thermal management business.

Volume leverage, supply management efforts, productivity improvements and pricing were key factors in the group's performance.

Profitability improved in all three of the thermal management businesses, but particularly at McLean, where increased seasonal sales volume, together with rapid deployment of lean and supply management efforts are driving significant profit improvements.

In fact, business exceeds its sales operating income and margin targets for the first six months.

There are a few clouds on the horizon, however.

Specialty metal prices hit new highs in the second quarter.

While nickel, aluminum and zinc appears to slowly recede from the record highs in mid-May, the market moved back up to record levels by the end of the quarter.

Carbon steel prices exhibited new strength that the market didn't fully anticipate.

While steel supplies were not constrained in the first half of the year, we anticipate inflationary pressure in the second half.

We have an action plan in place to mitigate the cost inflation and have identified new and significant cost reduction projects related to metal usage.

But we see this as a growing challenge.

The group's performance in the second quarter and over the last 18 quarters for that matter is a real testament to the power of services offers continued proof there are initiatives to operating excellence, international success and growth can generate concrete, sustainable results.

The way the team has applied these disciplines in the thermal management business is a model for all of Pentair.

I'll ask Dave Harrison to address the financials in his comments.

Dave?

Thank you, Randy.

As we did in the first quarter, I would like to remind you that Pentair adopted FAS 123R for stock option expensing in the fourth quarter of 2005 on a modified retrospective basis.

Therefore, our second quarter 2006 numbers are directly comparable to our second quarter 2005 results.

Our second quarter results were again solid with strong performance from technical products, enabling us to make investments in product moves, new product development and organizational changes in our water group at the same time.

We continue to see the power of diversification within Pentair.

Sales for total Pentair in the second quarter came in at $862 million, up approximately 9%, excluding the impact of the recent technical products acquisition.

We achieved sales growth of approximately 4%.

For the first half of 2006, total sales for Pentair is $1.6 billion, up 9% in total, or about 5% for an organic basis.

Second quarter EPS, from continuing operations, was $0.67, Up 12% from the $0.60 in the second quarter last year.

We realize net benefit in the second quarter of approximately $0.05 per share from one-time tax related items, partially offset by one time reorganization costs.

Year-to-date earnings per share on a continuing operations basis now stands at $1.09, up 10% from the first half 2005.

Pentair's operating margin for the second quarter was 12.5%, down 110 basis points for the prior year.

Technical products operating margin was up 250 basis points to 15.5%.

Higher margins in technical products continued to be generated from growth and cost productivity improvements.

Water group margins were down 180 basis points as a result of approximately $7 million in growth investment.

Margins were also adversely affected by plant consolidated -- plant consolidation-related inefficiencies and reorganization costs incurred to realign strategy and accelerate financial performance in Australia and Europe.

The manufacturing inefficiencies were expected and represent a substantial improvement to those experienced in the first quarter.

Pentair's second quarter gross margins increased year-over-year by 60 basis points with technical products improving by 250 basis points and water down 10 basis points, due to the continued manufacturing inefficiencies.

Both segments benefited from ongoing lean initiatives.

For the first half of 2006 Pentair's gross margins improved 40 basis points from 29.3% in 2005 to 29.7%.

As a percentage of sales, second quarter SG&A expenses were up 130 basis points, primarily reflecting the investments we made for growth and one-time reorganization costs.

Year-to-date SG&A expense came in 60 basis points over the prior year primarily as a result of our growth initiative.

From a reportable business segment basis, the line item other, which includes corporate, with $15.9 million in the second quarter, up 4.6 million from last year.

This increase was a result of investment and resources focused on growth and low-cost supply initiatives, higher pinching costs and the write-down of a tax strategy based investment.

The second quarter spin in this category was higher than the first quarter run rate, in large part due to the write-down.

R&D costs were up 40 basis points in the quarter and the first half due to increased investments in new products and proportionately higher R%D spending in the newly acquired thermal businesses where we are already seeing great results.

Interest expense was up $900,000 in the second quarter, primarily due to higher interest rates on our floating rate debt, and slightly higher debt levels.

The higher rates are attributable to eight interest rate increases from the federal reserve over the last twelve months.

Effective tax rate was down 11 percentage points in the second quarter.

The second quarter of 2005 tax rate of 39.1% included an unfavorable settlement of a routine German tax examination for prior years.

The second quarter 2006 tax rate of 28.1% included a favorable benefit from the settlement of prior year's IRS examination.

For the first half 2006, our year-to-date tax rate was 30.5% versus 37.1% in the first half of 2005.

We expect a tax rate for the remainder of 2006 to be approximately 34%, reflecting our continued efforts to reduce our effective tax rate.

Keep in mind that the tax rate in any quarter can be affected positively or negatively by adjustments that are required to be reported in the specific quarter of resolution.

Cash flow for the second quarter was $128 million. $16 million higher than last year's second quarter.

This more than offsets a seasonal outflow of cash in the first quarter, bringing the first half to $27 million, again, $16 million higher than last year.

With the current levels of receivables and inventory on the balance sheet, we believe there is ample opportunity to generate a substantial positive free cash flow in the last half of the year.

We are targeting cash flow of $200 million in 2006 and remain committed to our free cash flow goal of 100% conversion of net income.

Capital expenditures for the total year 2006 should be in the range of 70 to $75 million, $10 million lower than our original projection of 80 to $85 million due to continued lean efforts.

On a thirteen month moving average basis, working capital finished the quarter at 41 days, up three days from the end of 2005 and up four days from the second quarter of last year.

The second quarter we have had a continuing requirement to maintain higher levels of inventory.

To support the product moves from plant rationalizations and meet seasonal requirements of our water business.

The higher inventory levels continue to represent an opportunity remaining for cash flow that should start to read out in the second half as we get benefits from the product moves.

Our debt-to-total capital ratio was 33.1% at the end of the second quarter.

This compares to 32.6% at the end of the year and has increased slightly due to our first half free cash inflow not entirely offsetting acquisitions, dividends and stock buybacks from the first half.

Our midyear 2005 debt-to-total capital ratio was 32.7%.

We maintained our low debt to total capital ratio even after acquisitions of $160 million, dividend payments of $55 million, and stock buybacks of $43 million, all totaling $258 million.

To reiterate from the first quarter, we announced our 30th consecutive annual dividend increase.

Our total debt to total capital ratio continues to be well below our target level of 40%, giving us adequate financial resources to expand further our water and technical products businesses.

Finally, I'd like to conclude my remarks with an update on the Horizon litigation.

As you might recall, on June 29, we announced that we had received an adverse jury verdict of $193 million in this litigation.

That verdict was exclusive of prejudgment interest and attorney fees.

As stated in our initial release on this topic, we believe this verdict is not consistent with the law nor the evidence offered at the trial, and we are committed to pursuing all available means to achieve reversal of the verdict.

Based on the information available to the company at the time, at this time, no adjustment to previously established reserves was deemed necessary in the second quarter.

Pentair's EPS guidance does not reflect any potential impact of this litigation.

In the meantime, I want to assure you that we will not allow this 12-year-old issue to distract us from our -- from the execution of our current business, plans or commitments to operational excellence.

Now I would like to turn the conference back to Randy.

thanks dave. we continue to build toward the promise of higher growth and higher performance in our two attractive business segments, Water and technical products.

Based on our second quarter performance and not withstanding the mixed economic outlook, we are reiterating our previous EPS guidance of between $2.08 and $2.18 for the year, and we're initiating third quarter EPS guidance in the range between $0.46 and $0.50, an crease of 7 to 16%.

This guidance includes the cost of additional management changes we've made in the third quarter and reflects the higher inflation and freight costs we saw in the second quarter.

With the benefits of our investments beginning to read out in a number of businesses, we remain confident that our strategic initiatives should result in a bright future.

Thanks for your attention.

I now ask the operator to come on the line and provide our audience with instructions to the Q-and-A portion of this call.

Thank you. [OPERATOR INSTRUCTIONS].

Your first question comes from the line of Curt Woodworth from JP Morgan.

Randy, for the second consecutive quarter, the retail and OEM filtration products have declined, and it appears that the margins in that business are now below the pump business which has historically been your lowest margin business.

Can you comment on plans to improve both margins and growth in that part of the filtration segment.

Also comment on whether the 15% margin in pump is sustainable going forward.

Let me start with the second one.

It is a quicker answer.

I believe the pump business -- a lot of the work we've been doing in pump was to get them to a sustainable level of 15%.

Seasonality helped them in the second quarter.

Pump does have some seasonality.

And the second quarter is a strong one.

I believe the businesses cost structure and their growth potential certainly support a sustainable 15% number for pump.

In terms of pool -- in terms of filtration, it has been a continuing struggle on the retail side of filtration.

The margins have been fairly low.

We've consolidated a plant.

We've got the productivity up in that product line now, this is the Omnifilter lie.

We also have a lot of that business that's OEM.

We've lost the placement of some of those OEMs, and we have plans to offset those losses.

We expect to see some results of that in the second half.

The relationship with Brita is an exciting opportunity for us in the home filtration area, Brita being one of the leading brand names in water.

We have a couple of other programs that I think are going to replace the OEM business that we've lost there.

So it has been one of our bigger challenges in that business.

But I think that the second half will be better.

Also, on the margin side, in your prepared remarks, you commented that you feel confident the company remains on track to hit 15% margins in water by '07.

Based on my model for 3Q, it looks like margins are going to be below 13% in water.

It feels like the trajectory here is lower than you anticipated over inflation and higher freight costs.

What can you communicate to us that gives us -- would give us more confidence in that being achieved.

It has not -- it is not in water, ramping up, as quickly in the third quarter as we would like.

Investments are about where they are.

The manufacturing efficiencies look like they are going to continue.

Particularly in the spa and bath business, with very high declines in the sales rates, we're not getting the benefits that we should be getting from the plant move to Reynosa.

So we're not getting the upside on that business in particular.

And then in Europe, we had some additional inefficiencies in the second quarter.

In fact, water overall was probably about 90 basis points worse in the second quarter than we originally intended.

That's why we made some of the changes we made in leadership.

Because these are self-inflicted wounds, frankly, and we need to get them fixed.

The competitors aren't doing it to us and customers aren't do it to us.

So we got a lot more focused.

We've raised prices because inflation is higher.

So we expect -- the gap between price and inflation narrowed between the first and second quarter substantially.

And we need to get that back.

So we need to get some price increases.

And our supply management teams have been doing well but we've got to redouble our efforts there to find new ways to save money on materials.

As I talked about.

I understand why people are in a show-me mode.

I can't argue for a different position.

Third quarter margins in water should be better.

And it is within our control to fix it.

Thank you.

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

Thank you.

Hi, Randy and Dave.

Could we get more color regarding the comment of the pool business on the inventory adjustments at the distributors.

What was going on there?

What was the weather factor this quarter?

In terms of the pool business, the weather didn't help on the west coast.

The new construction on the west coast and in Florida was down in new building permits.

That said, when -- our whole pool and spa business -- the spa business isn't very big.

But the impact of a close to 20% decline in that business had on our overall sales was pretty significant.

So the whole spa and bath -- pool and spa business was only up in the single digits.

If you take out spa and bath, then it was up in the mid to a little bit higher, in our range, in our 5 to 8% range on a continuous basis.

There were a number of moves by our competitors late in the second quarter on price increases which typically pull in -- pull in sales.

Our price increase was earlier in the quarter.

So it kind of washed itself out in the quarter.

And we think that distributors did what they typically do, which is stock up on the other guy's stuff at the end of the quarter.

We track our inventories pretty close in the channel.

We use the early buy to stock people up at the beginning of the year.

As we measure our growth versus the major distributors, we think we're maintaining share.

I don't think we've gained share.

But I think we've maintained share over the course of this pool year.

And the pool year looks to be, a ten-ish kind of a number.

If you recall, we had a 20 -- well, 20% growth rate in the fourth quarter in pool equipment.

So that loaded up the channel pretty good.

That inventory adjustment at the distributors would be more of a one-quarter phenomenon?

Yes.

What we meant was, we saw inventories coming down.

We would expect them to come down, given how much they bought in the early buy.

Okay.

And then if we look back on the first quarter, two of the softer issues, areas that we expect to change, one on the filtration side.

You said the pro channel, you were adding resources there, how did that business look?

And then Municipal is expected to be up.

We didn't hear a comment on that unless I missed it.

I'm sorry, I didn't mention the word municipal, but I probably should have talked more about it.

On the pro channel, I'm very -- we're very pleased with the initiative in pro channel in filtration and in pump., for that matter.

We've invested more resources to call directly on the pro channel in filtration and it's been very, very well received.

And we think it is going to help us pull through more of the entire Pentair filtration package.

So we expect to see some -- we saw some results, positive results in the second quarter.

We expect to see more in the third and fourth quarter.

On municipal, our Fairbanks Morris businesses in pump is our largest business serving municipal.

And the growth there was very strong.

In fact, double digit growth in municipal.

So we saw that come back.

We think that rates are quite good.

When you think about municipal globally, really the code line business is going into larger municipal infrastructure plays.

And that product line for us was up strong double digit as well.

So that looked good in the quarter.

Thank you.

Your next question comes from the line of Steve Bram with TCW.

Hi, Randy.

Hi, Steve.

Actually if I could, I have three questions.

The first is, there seems to be a great deal of cyclical housing concern.

I was wondering if you could go through in your mind what the total housing exposure is for you, and how much of that is new construction versus rebuild and both in revenues and margins?

Our water business splits up between our three product lines in terms of pool, pump and filtration.

It splits up about 40, 30, 30. 40% pump.

And 30% filtration.

And 30% pool.

The pool business,the whole spa business, which is maybe 15% of that is an OEM business, where we're selling pumps and controls and fittings to the people that make jetted tubs.

And make the backyard spas.

We believe that that's -- that there's a replacement component to that.

But certainly a lot of the jetted tubs in particular would go into new homes.

So we expect to see -- and we believe there is some caution out there right now in that spa and bath business on affecting housing.

On the pool equipment side, which is the traditional pool -- and we're very strong in the below ground.

That's a 50 to 60% replacement versus new business.

By most people's calculations.

And our business skews towards the sun belt.

So that's why I made the comment about us believing that that business would be somewhat shielded by that replacement business.

In the filtration business, most of it is -- most of it, our most profitable business is commercial.

And a little bit of industrial.

The residential business is mostly replacement business today.

Most of it is cartridges going into replacement.

And even in the water treatment and water softening world, what happens in the industry, the pro channel in particular has more resources to put in place to go after replacements when the housing goes down.

And we've seen that now through three cycles.

So we're pretty confident that that works that way.

And then in pump, about 75% of our pump business now is residential and commercial.

And it is probably about 50/50.

Right now what we're seeing is very strong commercial.

We also saw very strong residential.

And most of the residential business is replacement in the pump business, because it's such a huge install base.

The pump content on new homes isn't that high.

So we believe even though residential is a large segment of what we do, we don't believe housing -- I can't give you an exact number.

I would be winging it.

We don't think that housing is going to have a huge --

Looking at those percentages, would you think that non-replacement housing was more than 10% of the segment's revenues?

I can't say without sitting down and giving you a number.

I can't disagree with it, but I can't validate it either.

Okay.

My second question was, both on this call and on other calls there's been a lift -- can you hear me?

Yes.

We're here.

There's been a lifting of various discretionary investments impacting results.

I believe the number was $7 million for this quarter.

Right.

Which is some number -- about $0.04 a share for this quarter.

Could you sort of sum up what these investments are year-to-date, what they will look like for the full year, and how much of those investments are growth investments?

It is fairly decent chunk of change.

If is a chunk of change.

And we're watching it closely.

The buckets -- we spent about 7 to 8 in the first quarter as well.

So we're $14 million year-to-date.

That number will be a little bit lower in the third quarter and lower again in the fourth quarter, as some of the project nature of it declines.

The split is, we have -- the first split I would put into low-cost sourcing.

We have China sourcing activity, plus several China and Poland start-up costs in our factories.

Those are basically under absorption in the new factories that we built.

We have growth, which includes some Asia talent investments in terms of general management in country and also sales and marketing leadership, and in terms of engineering as I mentioned in India, in our design center.

It also includes some investments in Europe, particularly, they don't focus on eastern Europe and the Middle East.

And I guess I would put in that category -- well, in addition, there is R & D investments in North America, particularly working on OEM business like I mentioned in terms of Brita and Ecolab.

And I guess the last category I would mention is the pump motor JV is the other piece.

So the pump motor JV, as it ramps up in production, it will become less of an investment and more of a business operation where we will be making some money.

Oh, and thanks.

The last and one big piece, which is project, which is an SAP implementation we have in Europe.

Which is peaking this quarter, third quarter and fourth quarter are the biggest investments on that SAP implementation in Europe.

And lastly, Randy, before I let you go back to others, given that you had 90 basis points of, to use your words, self-inflicted margin in water this quarter.

We have, I don't know, $0.10 to $0.12 at least of earnings from these investments that come back into '07.

That EBITDA is 1.6 times all in, your businesses are trading in the mid 7s today.

I was wondering if there is any price at which your think your stock is a good investment or the Board and have these discussions been entered into, which seems to me with transitory issues and one half times debt to EBITDA and free cash flow equal to net income a fairly large share repurchase would be in order.

The subject is a subject we talk about with the Board on a regular basis and will continue to do so.

Obviously we're disappointed that people aren't pricing our potential.

They are pricing to near-term glitches.

And certainly the market has a right to do that.

We do have strong cash flow, you're right.

We believe it is an investable business.

Is it your recommendation to the Board that a share buyback should be underway?

I wouldn't make a comment about that.

Steve, we can comment on the fact in the second quarter we did buy back a small amount, 559,000 shares for $18.3 million.

More than that has traded today.

Thank you.

Your next question comes from the line of Jeff Germanotta with William Blair and company.

Go ahead.

Jeff must not be there.

Go on to the next.

Next question has been withdrawn.

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

Thanks, good afternoon.

Randy, I want to go back to one of your comments in the prepared remarks when you were discussing the margin issues in water.

You highlighted new products that came out that carry lower margins in the initial introduction which kind of runs counter to what you see with most new product offerings.

I was hoping you might be able to offer some color there.

Those products are in the pool business and they've been very successful.

Right now, the initial margins were planned to be low because we're sourcing a lot of it as opposed to making a lot of it.

We're going to insource it into our China factories.

That was always part of the plan.

We actually sold a lot more of those products than we intended to, and we saw a negative mix shift in our pool business as a result.

It was in the controls and chlorinator part of it.

So those margin issues only apply to what is going on in the pool right now.

That does.

To those specific comments.

Talking about with Asia is growing a lot.

And the margins there are low.

Versus the margins in North America and Europe.

Okay.

They shift in terms of that as well.

With regards to some of the reorg issues, some of the management changes you alluded to, as well earlier in the call, could you talk a little bit -- I guess go a little bit into more detail on Europe in terms of the opportunities that you're seeing there.

I mean clearly stepping up the investments, both eastern Europe and the Middle East.

The opportunities there.

But just as western Europe as well.

We see a lot of opportunities there, and management got ahead of itself and tried to do too much at once.

And overinvested.

And not on the list of things we were tracking.

But in terms of the sum of the sales and marketing and operations.

Margins declined as a result.

We've made some changes to get clearer focus on productivity in the plant and customer service and priority ordering the investment so that we get the margins back as quickly as we can.

Okay.

Finally, in terms of the SAP, where are you in terms of the transition there?

Are you on plan?

Any update you can give there.

We're on plan.

We're going to start cutting over businesses in the fourth quarter.

And we're going to do them location by location in a measured way.

It is not going to be a big bang.

Okay.

And finally, technical products, if you could expand a little bit on what you're seeing on the European telecom side.

They had -- actually -- That's why I commented about the end of -- we knew these programs were going to end.

And there were some large programs, projects for some of the end customer telecom companies.

And the projects came end of life.

And we didn't bid, in one case we didn't win the follow-up in the other case.

So we had planned and expected those to decline and hurt the second quarter.

They won't hurt as we begin lapping those things in the third and fourth quarter.

And we actually think that the European market and tech products is looking a lot brighter than it has.

I expect higher growth in the second half in European tech products in the second quarter.

Closer to what we saw in the first quarter.

And in terms of the margin gap of Europe versus North America, do you continue to see that shrink?

And how sustainable is that?

Even with much growth, we did make nice step up in margins in Europe.

In fact, if you take a look at all tech products Every single piece of it, Asia actually achieved double digit margins.

Which is first time ever.

That's outstanding.

Europe took a nice step up.

And of course North America was already doing very, very well.

So really, all businesses continue to make progress on margins.

Okay.

Thank you.

Your next question comes from the line of Michael Schneider with Robert W. Baird and company.

Hey, Mike.

First maybe you could just go back to the restructuring and the investment expenses, Randy.

I'm looking, $14 million year-to-date.

You mentioned they would be lower in 3Q, lower in 4Q.

Is the budget for this group of expenses something around $18 to $20 million?

Is that the number we should be thinking about for the year?

A little higher than that.

A little higher.

Higher than 20.

Okay.

And then one of the callers mentioned, that's an add back in 2007.

Maybe you could address that.

Is it indeed that these expenses fall away in 2007 such that you don't --

I would say it is half and half.

Half are investments that are sustained.

For instance the talent investments we've made in Asia and the Middle East and eastern Europe.

We have not yet concluded we're going to reduce our investments in R & D because we continue to want to invest in higher levels of growth.

So I would call it a half and half kind of a thing.

Okay.

And then looking at the guidance for the fourth quarter, if I run the numbers to the midpoint of say $2.13 a share, it looks like water margins have to have a pretty substantial ramp in the fourth quarter.

Right.

You've already mentioned this.

Some of these investments fade.

But what else changes?

Because if you recall, the fourth quarter of last year, you had a huge quarter with 11% organic growth and decent margins of 11%.

What gives you the confidence that you're going to see the ramp I suppose in volume and margins in the face of such a tough comparison?

The biggest change is the manufacturing inefficiencies and the productivity from the investments we made really kick in.

The biggest swing is in productivity and a return to better price over inflation.

I mentioned that we saw a real narrowing of the gap of price over inflation the second quarter versus the first quarter.

We've raised some prices here in the third quarter and we expect fuller benefits.

And then a slightly lower investment level as I mentioned earlier in the longer term investments.

And on the volume side, Dave, could you give us some color as to what you're assuming against that 11% comparison in the fourth quarter?

As we said in the beginning of the year, we basically have talked about mid-single digit type of growth.

Through the first half of the year, we have been very pleased we've been able to get that overall.

And we're starting to see the water businesses step up a little bit from where they started out in the first quarter.

But, again, mid-single digit type of growth.

Okay.

And then just geographically, you called out that Asia is up 30%.

Do you happen to have what organic growth was, say in North America and Europe?

Organic growth was up low single digits in Europe.

And then it would have been in the 5 to 8% range in North America.

Final question just on this price mix issue, Randy, where do you believe the organic growth of 4% this quarter, how much was price?

Price actually declined.

I think we said in the first quarter that price overall was in the two to three range.

In between there.

It was actually less than 2%.

Not that close to 2%.

We saw a decline in price.

A lot of that was in tech products.

It wasn't all in water.

But we did see a decline on the realized price year over year, which is why needed the price bump again, because inflation didn't go up.

And so we've done that.

Mike on your point, too, I would like to point out again, that it is disappointing to us we're not seeing a stronger readout in filtration and pool in Europe.

In the margin and improvements we've invested in the third quarter.

You are seeing it -- you can't see it yet.

But we can see it in the pump business, which was pointed out earlier.

Pump used to be our lowest profitability business.

It is not anymore.

We know these investments work.

We know we can improve the margins.

And while we're disappointed that we haven't gotten -- haven't seen the results yet in the other businesses, we're confident we're going to see it.

Along those lines of the pump margins, are the costs of Faradyne being booked against the pump business?

Or is that 15% margin exclusive of the Faradyne cost.

Actually they are incorporated.

You can put it down there and they still would have beaten 15%, I think.

They would have.

Okay.

Thank you very much.

Your next question comes from the line of John Quealy with Canaccord Adams.

Good afternoon.

Two questions.

First on new products, Randy if you could sum up for us both technical products and water roughly what the percentage is of new products in those sales and what you expect that to go to in the next year.

John, I didn't run the specific numbers.

In tech products, as I mentioned, the ATCA, which is a new packaging standard, those sales tripled in electronics.

That's increasing pretty substantially.

And I just can't give you a number or percentage.

I would have to go back up and add them all together.

Sort of a sanity check, is it sort of in the 10 to 15% range?

I think that is reasonable.

We expect that to grow.

We would like that to grow.

Sales haven't yet.

Things like the Brita program, these are really new products.

And following up on the Brita opportunity, can you give us an order of magnitude of how much whether in volume or contract price that contract could have resulted in?

Also other types of bids or opportunities you have to jump back in that OEM residential market?

We have an agreement not to say the numbers.

But it is significant enough for us to mention it.

We've been working for some time on OEM businesses where we could be a partner with someone with a strong brand.

And we're very delighted that that has led to the results we've had with Brita.

We also, on the number -- part of our strategy is to go after some of the lost retail business that used to be what I would call high-end branded with our mid-tier brand, Omnifilter.

And we believe we're going to have success with that.

In other words we're bypassing some of the OEMs where they decided they didn't want to buy from us anymore.

And my last question, on technical products, Argent eclipsing 15%, seems to contradict I think what you said last quarter when we may see margins coming in in that particular business line.

Is that mostly due to thermal?

And what do you think peak margins could be in that area?

Obviously we've got some commodity head winds here.

Our goal for both water and tech products is to beat 15% on a sustained basis.

That remains the goal for the business.

In the second quarter, the thermal business is seasonal, with a lot of air conditioners sold in the second quarter as people -- as install baseplates and people add thermal management to keep their electronics cool.

And it did really, really well.

And so in strong double digit growth across the board in those conditions.

We're not counting on that continuing.

We're counting on the single digit kind of organic growth across the board in technical products.

And we do think we'll hit some inflation.

So I would say we expect to hang around 15.

But I'm not sure we're counting on 15 the rest of the year.

Thank you.

We have time for one more question.

Thank you, sir.

Your final question comes from the line of Debra Coy with the Stanford Group.

Thanks, Randy.

Hi, Debra.

Hi, guys.

Just to try to add up the outlook as we've talked around all the pieces.

Particularly looking at water, it does appear that, as Dave said earlier, we've kind of picked up the pace to the lower single digits across all of the segments, excluding the spa business.

And it still sounds like we're going to have to get back to the mid-single digits over the next couple of quarters to make the -- to make the full-year expectations and then going into '07.

Where are you seeing the continued pick-up likely to come from on the top line assuming you can get some of the margin back?

The second part of my question, can you give a little bit more color on the self-inflicted wounds, as you say?

Was that mostly in Europe?

Was that partly in the U.S.?

What do you expect your new management changes to really do differently than they've done so far?

In terms of the growth, commercial markets remain very strong.

Municipal is strong.

Pump in general has a lot of momentum on growth and their backlog looks good.

We think filtration actually increases from the growth rate in the second quarter here as we -- as our new programs kick in sales and the OEM losses we had are behind us.

And what do you think it was?

You said industrial and muni were up in filtration and commercial and residential were weaker.

You didn't say kind of where the growth rate came in for filtration.

Low single digits.

Okay.

Right.

And we expect that to be able to find the mid-single digits.

We do have the momentum on the programs.

We're going to get these OEM losses behind us.

We also made some changes in filtration, in terms of the restructuring of management.

Including in North America?

In North America.

So, I think we have a priority ordered set of things to get done there.

In terms of the self-inflicted wounds, I would characterize the manufacturing inefficiencies we've been talking about for about three quarters now as part of that.

But also we need to be more proactive as we see inflation coming at us at and more proactive on the price and productivity programs to offset it.

I would throw freight in there as well.

I think we need to do a much better job managing our freight.

Part of our freight is expense.

Part of our freight is what I would call inefficiencies that we hadn't yet captured in terms of moving product between plants and moving products from our low-cost sources to our end market.

So that's what I mean.

These things are things that we should have done better the first time out.

But there are also things that are still within our control to fix.

Do you think that you're gaining some share back?

Because it certainly had seemed like during all of this integration process that some share had been lost in product lines across -- in filtration.

Do you think you're getting it back?

I think pump I feel good about our share and our growth.

I think in filtration, we haven't yet begun to gain share from our pro channel focus.

But we've stopped the loss of share there, I believe.

And then in food service, I would say we've held our own all along.

It was really in the retail where we lost some of that business.

Where we haven't yet regained share.

But with programs like our Omnifilter programs and our branded program, I think we got more momentum there as well.

Plus Asia is going to continue to grow.

We believe Europe was more of a pause in terms of growth rates on the filtration side on the second quarter.

We expect to see better growth rates in filtration Europe in the second half.

So it sounds like, as Steve mentioned earlier, that so much of the concern has been the exposure to the residential housing market.

And we certainly have seen that in the spa business.

You don't really see looking across your business lines that there is another bump in the road related to the housing market slowdown.

We remain as cautious as anybody.

We've had the water business in this form now for about two years with WICOR.

But six years beyond.

We did go through one downturn.

But housing held up.

And our sales held up through that.

I can't really empirically say that housing downturn will have no impact.

But the things we're doing to mitigate any impact are focused on other vertical markets, commercial.

We're looking at other segments and filtration beyond residential.

Like commercial.

Beyond commercial into some industrial niche applications where we can complement some of the bigger dogs in that arena.

We've had some success in that.

Most of our growth initiatives are aimed at not residential, which will help us if any downturn happens.

And of course, any downturn in North America would only have an echo impact in Asia and Europe, which is where we're counting on more growth.

All right.

Thank you.

That's helpful.

Okay.

Thank you very much.

Operator, if you could come on and give directions for the call-in number?

Thank you for participating in today's Pentair, Incorporated second quarter conference call.

This call will be available for replay beginning at 3:00 p.m. eastern standard time today through 11:00 eastern time on Saturday, July 29, 2006.

The conference I.D. number for the replay is 3613261.

Again, the conference I.D. number for the replay is 3613261.

The number to dial for the replay is 1-800-642-1687, or 706-645-9291.

Thank you.

This concludes' today's conference call.

You may now disconnect.