濱特爾 (PNR) 2006 Q4 法說會逐字稿

Good morning.

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

At this time, I would like to welcome everyone to the Pentair Incorporated 2006 fourth quarter earnings conference call. [OPERATOR INSTRUCTIONS] As a reminder today, February 6, 2007, this conference is being recorded.

Thank you.

I will now turn the conference over to Mr. Randall Hogan, Chairman and CEO.

Thank you, Jody.

And good morning, or good afternoon, to everyone.

Thank you, for joining us today to discuss Pentair's results for the fourth quarter and full-year 2006, updates on recent news, and our strategy and outlook for 2007.

I'm Randy Hogan, Pentair Chairman and Chief Executive Officer.

With me today is Karen Durant, Senior Vice President of Finance and Analysis.

Before our discussion begins, I would like to remind everyone that any statements made about the company's anticipated financial results are forward-looking statements, subject to future risks and uncertainties, such as the risks outlined in Pentair's 10-K as of December 31, 2005, and Pentair's 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.

Before I get to the numbers, I would like to remind you that Pentair adopted FAS 123(R) for stock option expensing in the fourth quarter of 2005 on a modified retrospective basis.

Therefore, our fourth quarter and full-year 2006 numbers are directly comparable to our fourth quarter and full-year 2005 results.

Also, we're using some non-GAAP financial measures in our discussion and results today.

A reconciliation of these non-GAAP measures to GAAP measures has been posted on our website.

This reconciliation can be found adjacent to the conference call webcasting link on the financial information section of our website, and as included in the exhibit in the Form 8-K filed with our earnings announcement today.

Let me begin to talk about the company.

As you will recall, our fourth quarter EPS guidance was $0.30 to $0.34.

This guidance incorporated a full-year blended tax rate of between 28 and 30% and also reflected the ongoing impact of soft sales, particularly in the pool and spa markets.

Our actual fourth quarter EPS came in at $0.39.

This exceeded the high end of our guidance by $0.05.

The $0.05 upside consisted of $0.01 from operations and $0.04 tax benefits.

Our ability to use foreign tax credits in 2006 was greater than expected.

Consequently, we delivered $0.08 from taxes in the fourth quarter versus the $0.04 we contemplated in our guidance.

Fourth quarter 2006 EPS of $0.39 was up 3% from the fourth quarter of 2005.

For the full-year 2006, earnings per share finished at $1.81, slightly better than EPS from continuing operations of $1.80 from 2005.

Now let's walk down through the individual line items of our income statement.

Sales for total Pentair in the fourth quarter came in at $743 million, about 1.5% higher than fourth quarter 2005.

Growth from acquisitions and slightly favorable foreign currency translation were partially offset by low single digit organic sales declines.

This sales declines resulted from weakness in our North American markets, partially offset by our strong sales growth in our Asian and European markets.

In local currencies, Europe saw growth in the mid-single digits.

Growth in our Asian markets exceeded 30%.

For full-year 2006, our sales increased 7% from $2.9 billion in 2005 to $3.2 billion in 2006.

Foreign exchange was relatively neutral for the year and organic sales growth added about 2.5%.

Growth in North America was modestly positive.

Europe grew in the mid-single digits and Asia posted very strong sales growth in 2006.

Pentair's fourth quarter gross margins decreased year-over-year by 30 basis points.

This decrease reflects sales declines in water markets and unfavorable mix, partially offset by price and productivity in Water and strong gross margin improvements in Technical Products.

For the year, Pentair's gross margins were down 10 basis points.

You'll recall that in the third quarter we incurred about $17 million in charges to address the impact of the softer North American residential markets on our pool and spa businesses.

Approximately $9 million of these charges were taken against cost of goods sold, and without this adverse impact, our full-year gross margins would have shown a 20-basis point improvement.

As a percentage of sales, fourth quarter SG&A expense was up 60 basis points.

Higher pension and stock option expenses and spending for the development of our European IT infrastructure drove this increase in our SG&A expense.

Year-to-date, SG&A expense came in 100 basis points over the prior year, primarily as a result of our investments in growth in the aforementioned IT project.

In addition, about $8 million of the third quarter adjustments were charged to SG&A.

Approximately 25 basis points of the increase were attributable to those third quarter charges.

On a reportable business segment basis, the line item Other, which includes corporate and our captive insurance company, was about $11 million in the fourth quarter, down $8 million from the same period last year.

This decrease was the result of lower costs in our captive insurance company, lower corporate costs as a result of the actions we took in the third quarter to reduce and redeploy resources to the point of impact in our businesses, and lower expenses for M&A activity on potential acquisitions.

For the year, then, the line item Other was $54.4 million, up only 2% from 2005.

R&D costs were up 10 basis points in the quarter and 20 basis points for the year.

This increase was due to investments in new products and proportionally higher R&D spending in the thermal businesses acquired in December 2005.

Pentair's operating margin for the fourth quarter was 8.1%, down 100 basis points from the prior year.

I'll discuss margins shortly by segment.

However, I would like to note these results included the 17th consecutive quarter of year-over-year operating margin improvements for technical products.

For the year, Pentair's operating margin was 9.7%, down 130 basis points from the prior year.

Investments for growth, plant consolidation, related inefficiencies, the decline in pool and spa volume, and the $17 million charge taken in the third quarter are the key contributors to the lower operating margins in the year.

Excluding the third quarter charges, the operating margin was 10.3%, down 70 basis points from 2005.

Interest expense was up $1.8 million in the fourth quarter, primarily due to higher average debt related to the December 2005 thermal acquisition and higher interest rates on our floating rate debt.

The fourth quarter effective tax rate of 18.4% was down 11.8 points year-over-year.

Fourth quarter of 2006 tax rate benefited from a significant increase in foreign tax credits as compared to the same quarter in 2005.

The full-year 2006 effective tax rate of 28.1% was down 6.6 points versus 34.7 in 2005.

The lower tax rate in 2006 was primarily the result of the one-time adjustments from the favorable resolution of prior tax years and the increased foreign tax credits in the fourth quarter.

We're continually working on tax reduction opportunities.

As indicated, we realized significant one-time benefits in 2006 related to the favorable resolution of prior tax years and we do not anticipate a -- we now anticipate a 2007 full-year blended tax rate of 35 to 36%.

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

Year-to-date free cash flow for 2006 was $181 million versus $202 million last year.

Our cash flow performance was slightly higher than our earlier projected range of $170 to $180 million and the free cash flow conversion as a percentage of net income was in line with our goal of 100%.

In 2007, we remain committed to achieving cash flow conversion of 100% of net income or more.

From a working capital perspective, day sales and accounts receivable and days and accounts payable were relatively stable year-over-year, but our days inventory on hand increased from 70 days to 76 days.

Our overall inventory levels are up due to part to the purchase of additional pump motors for competitive reasons.

Inventory reduction remain a key opportunity for Pentair in generating additional positive free cash flow in 2007.

Capital expenditures were $51 million in 2006 versus $62 million in 2005.

We're expecting 2007 capital spending of $70 to $80 million as we continue to shift production to low-cost countries and invest in growth.

Our debt to total capital ratio was 30.8% at the end of the year, down 180 basis points from the end of 2005 and down from the third quarter by 180 basis points.

We reduced our debt to total capital ratio despite funding stock buybacks of $59 million, dividend payments of $57 million, and acquisitions of $29 million, all totaling $145 million over the last 12 months.

Now I would like to provide some insights into each group, starting with water.

Fourth quarter sales in Water were $501 million, down 3% versus the $518 million for the same period in '05.

That's down approximately 4% excluding favorable foreign exchange.

These results reflect the mix of strong growth in European and Asian markets, and in the North American commercial and industrial markets.

This strength, however, was offset by a nearly 20% decline in North American pool and spa sales caused by the anticipated combined impact of slower housing and pool starts with the inventory reductions and the distribution channel.

Excluding the sales of our pool and spa businesses, water sales growth was nearly 4%.

Sales in Asia grew in excess of 30% in the fourth quarter, even excluding favorable foreign exchange.

As expected, growth is strongest in China but is complemented by continued performance improvement in Australia and by sales of our code line pressure vessels throughout the region.

As we've discussed previously, these vessels are used in desalination projects.

Globally, these projects continue to be an area of growth and positively impacted Asia's results in the last quarter.

Further, CodeLine's [inaudible] pipeline remains strong.

Build in Europe grew in the high single digits compared to the fourth quarter of 2005, excluding favorable foreign exchange.

Growth was particularly strong in the pump and filtration markets, where continued strength in commercial and fire protection markets delivered topline results.

Strong penetration into the Eastern European and Middle East markets contributed to the region's growth.

In North America, the pump markets produced mixed results in the fourth quarter, but kept an overall strong year.

Commercial pump sales hit an all-time quarterly sales record with new product introductions and new market penetration helping to deliver growth rates in the teens.

While sales in the municipal pump market were down slightly in the fourth quarter, focus on this attractive market continues to produce results as evidenced in strong orders and a record backlog at the close of 2006.

This includes our recently-announced order for water overflow pumps from the city of New Orleans through the Army Corps of Engineers.

This $20 million order for 11 pumps will be executed this year and will better prepare the city in the event of future hurricanes by adding approximately 3,850 cubic feet per second of flood discharging [asset].

As expected, sales in retail pump markets were weaker, as below-average precipitation in the Midwest and Northeast slowed demand.

In addition, sales in residential waste water markets were down due in part to strong year-over-year comparisons to post-Katrina demand in 2005 and the impact of slowing residential markets.

As discussed in our third quarter conference call, the development of our line of submersible pumps which use the FARADYNE motors produced through our joint venture with ITT Industries, continues to progress well.

The formal launch of the PENTEK XE series submersible motors occurred in the fourth quarter at the National Groundwater Association meeting and has been well received by our customers.

And we continue to expand the line with additional models that will be available later in the fourth quarter and throughout the year.

Sales in the North American filtration market were up slightly with growth in the Food Service, Industrial, and High-End Residential vertical markets masked by a slowdown in the North American, Marine, and Residential markets.

Food Service growth included two new large customers for water treatment and filtration installations in all of their new sites.

Sales and industrial markets driven by high upper teens growth rates in the newly acquired Crystal Clear business as we leveraged synergistic sales opportunities and expanded the range of existing products sold through the industrial distribution network.

After six years of double digit growth for Pentair, the pool market slowed significantly in 2006.

As we've discussed, we began to see the impact of the slowing North American residential market impact spa sales in the early part of 2006.

Then we began to see the impact on pool starts, and as a result, on our pool equipment business in the second half.

In the fourth quarter, the spa and bath business continued down over 30%, as it has been in earlier quarters of 2006.

In the pool equipment business, we saw continued sales weakness in the inventory correction by distributors that we expected.

Our pool equipment early buy programs, traditionally held in the fourth quarter to smooth out production levels, yielded substantially lower sales in the fourth quarter as compared to previous years, although early buy orders were actually better than anticipated.

These additional early buy orders are scheduled to ship in the first quarter.

We will remain cautious in our sales outlook as these early buy orders may reduce higher margin standard orders, and in addition, pool starts remain down between 15 and 20% at this time.

Thus, we're maintaining vigilance and leveraging our industry-leading sales force to gain share customer by customer.

We're exploiting the excellent market acceptance of our new IntelliFlo and IntelliPro pump line and master temp heaters.

The business will also benefit from the cost actions taken in the later half of 2006 to better position the business for the soft market conditions we face.

Finally in pool and spa, we appointed Karl Frykman Acting President of the business effective last month.

Karl is one of our highest-performing GMs, having led our backyard growth strategy and quadrupled the size of our pool tile business over the last seven years.

Operating income for the Water group totaled $36.5 million, down 34% over the same period last year.

Return on sales was 7.3%, down 340 basis points compared to the same period last year.

This decline masks the improvement we expected and we saw in Water in the quarter.

A few factors driving this 340 basis point decrease in operating margins include 160 basis point decline due to lower volume, an 80-basis point decline due to mix shift to lower-margin products -- for example, the pool finish line that's been growing nicely inside of pool -- and the strong international sales which have lower margins than our North America business.

Another 80 basis point decline was due to a $4 million excess inventory reserve recorded for pump motors that we believe we will no longer need.

This leaves only a 20-basis point decline for the net of operations, which is significantly better than the third and the second quarters.

The factors in this were in part a price increase during the quarter to offset inflationary costs and the costs associated with manufacturing inefficiencies and investments that came in lower in the fourth quarter than a year ago and lower than the run rate in the first half.

Also as expected, the North American Filtration business grew year-over-year operating income for the second quarter in a row, and operating margins expanded as well -- a trend we expect to continue.

Our highest priority in 2007 is driving continued improvements in operating margins and performance in the Water Group.

Turning our attention to Technical Products now, total sales for the fourth quarter were $242 million and for the full year we reached the $1 billion mark.

Bills for the quarter grew 13% as compared to the same period last year.

Organic growth of about 1.5%, excluding acquisitions and foreign exchange rate impact, moderated as compared to previous quarters.

This growth rate reflects sales declines in the U.S. telecom and datacom markets, which I'll discuss shortly, which masked continued strong growth in U.S. industrial and commercial markets and in non-U.S. regions.

In fact, Technical Products sales in European markets grew in the low teens at about 4%, excluding favorable foreign exchange.

You might recall the large Deutsche Telekom project which we shipped in last year's fourth quarter and first and second quarter of 2006, which has now ended.

Excluding that project, sales grew about 10% in local currency.

European markets remain relatively robust, with test and measurement and telecom markets being particularly strong and with strong results in Germany and France being partially offset by weaker performance in the U.K.

New product development contributed to the growth, including the new Veristar cabinet platform, ATCA, and a recently-developed line of outdoor cabinets.

These outdoor cabinets were designed to take advantage of our low-cost manufacturing site, which is just coming online in Poland now.

Technical Products sales in Asia increased dramatically in the quarter.

Two large OEM programs, both of which were won in the U.S. for manufacture in China, drove very strong growth while Japan continued to benefit from ATCA sales in the telecom markets as well as strong sales in the semiconductor market and a continued overall market recovery.

As I mentioned, strength across most of Technical Products was countered by softness in the U.S. telecom sales.

The wireless portion of the business, as compared to the wireline portion, was much slower than we'd anticipated, due to the delayed architecture development and implementation caused by ongoing industry consolidation.

In fact, two of our largest customers are directly impacted by the current consolidation activity in the industry.

These delays, combined with the end of life of a datacom program that we anticipated would be replaced with telecom business, has led to a mid-teens decline in U.S. electronics business sales.

We expect to see some rebound beginning in the second half of 2007, but are taking a cautious view as the industry landscape continues to shift.

Technical Products operating income for the quarter was $34.5 million, up 15% from the same period in '05.

Operating margins were 14.2% and while down sequentially as compared to the third quarter, were up 20 basis points from 2005.

Margins were adversely affected in the quarter by increases in steel and aluminum costs, with cost increases particularly significant for stainless steel.

Despite these challenges, we drove year-over-year margin improvements through our supply savings, our strong operating productivity, and growth.

Technical Products continues to be the operations excellence pacesetter at Pentair, driving continuous improvements through the effective implementation of Pentair's Integrated Management Systems, or PIMS.

This is especially evident in the group's integration of the thermal management businesses.

This acquisition, completed in late 2005, exceeded all expectations in our first full year of ownership.

Sales growth was very strong and combined with our implementation of PIMS drove operating margins in our thermal business close to our 15% operating run rate goal for the full year.

And for the full year, Technical Products in total achieved $1 billion in sales and $149 million in operating income, yielding a 14.9% ROS.

These are results of which our team is proud and we're anxious to have them build upon.

That caps the financial and segment discussions.

I would now like to draw your attention to some of the very exciting news -- other news we've published recently.

First, I'm pleased to announce that John Stauch has been named Pentair's new Chief Financial Officer.

John comes to Pentair from Honeywell International's $11 billion Automation and Control Solutions group, where most recently he was CFO.

Prior to that, John's ten year career at Honeywell International and its predecessor Allied Signal included financial leadership roles in Investor Relations, financial planning and analysis, and division CFO positions in several global industries.

John also served as CFO at PerkinElmer Optoelectronics and began his career at General Motors.

John brings to Pentair a breadth of experience.

He's developed a strong understanding of operations in very divisional CFO roles at Honeywell and exhibits successful leadership in complex global business environments.

He has a strong background in Investor Relations, having served in that capacity for Honeywell International's predecessor, Allied Signals.

I'm confident in his abilities with then they'll serve Pentair well.

I look forward to introducing John to our investment community soon.

John will transition to his new role in February.

As most of you know, he succeeds Dave Harrison, who last year announced his intent to retire.

Dave has served as Pentair's CFO for eight years and I'm fortunate to have Dave's finance partnerships through one of the most productive periods in Pentair's history.

Second, I'm excited that Dr. Philip Rolchigo has joined Pentair as Vice President of Water Technology, responsible for all product and technology development globally.

In particular, he will lead our technology strategy in flow and filtration and is already making valuable contributions to our global growth initiatives in RO, Industrial, and Food Service markets.

Bill joins Pentair from General Electric, where he led global separation technologies in the Water and Processed Technologies unit.

His leadership will help us extend our technology competencies and keep ahead of the trends in our Water markets.

Third, I would like to review the good news we recently received on the Horizon litigation.

As we announced January 17th, the judge hearing our post-trial motions in this case ruled favorably and dismissed the largest portion of the claim against Pentair as a matter of law.

The ruling overturns the earlier jury verdict of $135 million on the claim of lost enterprise value.

On the claim of lost profits, the judge also overturned the earlier jury verdict for $47.6 million, finding it manifestly erroneous and ordered a new trial on that portion of the claim.

These rulings are consistent with our assessments of the merits of the case and we made no adjustment to the accrual for this matter, other than to accrue for another quarter's worth of interest.

As you may recall, this case stems from an outbreak of Legionnaire's disease on the Celebrity Horizon cruise ship in 1994, five years before we purchased Essef Corporation.

We're obviously pleased with the most recent update on the matter and remain committed to putting this matter to rest for good.

Finally, I'm pleased to report we have recently closed on previously-announced transactions that demonstrate our global growth strategy.

Last week, we completed our purchase of Jung Pump.

This company presents some great cross-selling opportunities in Western Europe and brings a very strong market position in Germany and excellent positioning in Eastern Europe.

And it also beefs up our 50-cycle pump offering.

Last quarter we completed the Beijing Jieming transaction, which expands our local market knowledge and distribution network throughout China.

Now I would like to turn your attention to our outlook for 2007.

As I've highlighted through my comments today, we remain committed to Pentair's corporate financial objectives -- sales growth organically of 5 to 8% per year, segment and operating margins of 15%, return on invested capital of 20%, and 100% cash flow conversion and net income.

Obviously we didn't hit a lot of those in 2006.

While we're keeping those goals in our sights, in 2007 we're dedicated to managing through the residential downturn and making big improvements in our Water Group's operating performance.

This year, we expect productivity initiatives and cost reductions coupled with growth in the commercial, municipal and international markets to generate at least $35 million in operating profit improvements.

We expect margin improvements to begin in the first quarter.

Mike Schrock, now COO of all Pentair operations, is focused on driving PIMS more effectively throughout our water operations and is devoting particular attention to improvements in our pool and spa businesses, as well as our water operations in Europe where we expect to get the majority of that $35 million improvement.

Further, we anticipate that with low-single digit sales growth, we'll be able to reestablish double digit earnings growth in 2007 as a result of the cost actions we've taken in combination with the margin expansion initiatives already underway.

We are reiterating our full-year 2007 EPS guidance from continuing operations of between $2 and $2.15.

In addition, we're initiating EPS guidance for the first quarter of 2007 in a range between $0.37 and $0.41.

This guidance is based on the following expectations: a $0.02 to $0.03 loss from Jung Pump in the quarter due to only having two months of operations and having the full effect of the inventory fair value markup in the quarter.

For the year, though, you can expect Jung Pump to have a neutral impact on earnings, flat to slightly increased sales for Water and a year-over-year improvement in operating margins for Water of 0 to 50 basis points, flat sales for Technical Product, as we continue to evaluate the impact of telecom in the United States, and a sequential decline of 50 to 100 basis points in margins due to that telecom softness and material inflation that will not be offset by recently implemented price increases until after the first quarter.

Corporate and other costs for 2007 of $13 to $14 million per quarter, and as discussed earlier, a tax rate of 35 to 36%. 2006 was a challenging year for Pentair.

However, with a strengthened and streamlined leadership team in place, a clear road map for margin improvement in Water, a cautious outlook on sales volume, and progress on our growth investments globally, we believe Pentair is better-positioned to drive higher performance in 2007 and beyond.

Thanks for your attention.

I'd now ask the operator, Jody, to come online and provide our audience with instructions for the Q&A portion of the call.

[OPERATOR INSTRUCTIONS] Your first question comes from Curt Woodworth with JPMorgan.

Yes, hi.

Hi, Curt.

Randy, on the $35 million of productivity improvement you're targeting for 2007, how much of that is based on pure cost saves that you see within the business versus leverage you expect to get from the commercial and industrial portion of your businesses?

Well, most of the $35 million is cost.

I'm expecting some $15 million of that in the pool and spa business, $10 million in Europe, and $10 million of other productivity from the rest of Water.

So I expect -- and then volume would be on top of there.

Okay.

In terms of looking at the margins this quarter, you outlined the volume impact of 160 basis points -- is it fair to say that that was entirely attributed to the pool and spa business?

And also, can you give us a sense for what portion of total sales this quarter were in pool and spa, so we can do the math on that?

Well, we don't split out the sales beneath the segments, as you recall.

But basically, the business was down almost 20% of what our pool and spa business was.

As we said, we expected early buy to be down $30 to $60 million in the quarter in sales.

We were in that range in sales.

Orders was actually a little better.

Orders were not down as much as $30 million because we set the business -- basically, we set the business production rates to hit that lower level.

We maintained our discipline and we just basically scheduled those early buy orders into the first quarter.

There was some -- as I mentioned in the call, some of the volume decline was in our waste water business, which is a profitable business for us in pump.

But the majority of the sales decline was in spa and pool in the fourth quarter.

And if you think about it, we had 4% volume decline, but we had price in the fourth quarter.

So in essence, our unit volume decline in the quarter was over 5%.

That's what yields 160 basis point decline.

Okay, and just one final question if I may.

Can you give us an update on FARADYNE?

Is it safe to say that you're sourcing most of the motors for your four and six inch submersible pumps from that venture given you essentially wrote off --

I'd rather not go into the specifics on the reserve.

We took a reserve against those motors are still perfectly fine.

Okay.

And there's a range of them.

The FARADYNE joint venture is only four inch motors.

Oh, four inch, okay.

So we have a strategy that includes both making and buying from FARADYNE and sourcing from other, and also using our own inventory that we've built up over the year.

I expect -- we've said this before.

I think that battle is going to be kind of ugly, and we're prepared for it to be ugly.

But we like our hand right now.

Okay, great.

Thanks.

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

Thanks.

Good afternoon, Randy.

Hey, Jim.

First question.

On the Filtration side, can you give us a little bit of color on what specifically is driving the turnaround there, and specifically, are there lessons learned that can be applied to the pool business, or are they really separate issues altogether?

I think there's always lessons to learn from the turnaround that we're seeing in Filtration.

I think a big piece of that is since Jack Dempsey went in there and triaged priorities and doubled down, if you will, on the PIMS implementation, the better focus on priorities, the focus on the prochannel, and some of these nonresidential markets together with PIMS is really what's driving the improvement in Filtration.

I think in the case of Pool and Spa, they've had a much bigger challenge because of the -- number one, the volume decline in Spa, and then the volatility around the orders.

And I think what we have now is we have, I think Carl and his team have strong discipline in terms of establishing how we're going to run the factories and then having a better dialogue between sales and operations so that we can, one, meet customer demands, which are our first priority, and two, get some productivity while we're doing it.

Okay.

So one of the things that Filtration did, and actually our Pump business has done now, is they spent time with our Hoffman business, which is our high-performing business on lean, and gone to school a little bit on it.

Okay, that's helpful.

And with regards to the mix issue in the quarter, can you bring us up to date -- I know you can't give us specifics, but just frame a reference of what the margin difference in the geographies within Water -- Europe, Asia, North America, just kind of what the scale is there?

Well, Asia is single digits.

Right now Europe is single digits because of the productivity challenges and the investments, but typically it's been 15% before and we expect it can get back there.

And North America should run higher than that.

We think ultimately all of the businesses can get to the 15%, but right now, Asia is low because we've made these investments and I think we've got an infrastructure in place that can support a lot higher sales.

And the other piece I mentioned was that the pool -- Pool would have shown a bigger decline in sales, except for we have some of these pass-through products, like pool finishes, which have pass-through margins on it.

So those are the two biggest impacts, I think, on the margin.

Because 80 basis points is pretty big, that's $4 million in the quarter on mix.

Okay.

But that's how I calculate it.

Final question.

You alluded to a management change on the Pool side, you look at the turnaround that took place in Filtration, instilling new leadership there.

Dave's retiring, new CFO coming in.

With the management team you have in place, do you feel you have the right team in place today?

And can you maybe speak a little bit about building the bench as well?

Sure, I'd be glad to.

One thing -- I'm delighted to have Karl as Acting President of Pool and Spa.

Actually, Scott Levin, the prior President, left to take a CEO job a lot closer to his home in -- private equity CEO job.

So wasn't quite the same cause, although certainly pool has had its challenges.

But we have -- we've been building the team, some of which you've seen on the outside, some of which you can't see, but in particular, I'm pleased with the general management cadre we've built over the last couple years.

These are the future Presidents of our division and they're people from high-quality companies as well as people we've developed and moved from Hoffman, for instance.

I feel pretty good about that bench.

We have about 24 P&Ls underneath our eight divisions and I feel good about the team we have at that level.

What we want to do is we want to have consistent leadership around PIMS and around lean from all of those general managers and all our Presidents and I think that's a prospect that Mike and I both feel is going to yield results over the next year or two.

Anytime you go through a transition of a job as important as the CFO, it can lead to some uncertainty.

I'm really pleased to have John on board, have Mike in position as COO, and we can lock and load around what we need to do.

Which is, number one, Water margins, and number two, reestablish the organic growth at the 5 to 8% range.

Okay.

Thank you very much.

Okay.

Your next question comes from Robert McCarthy with Bank of America.

Good morning.

Hey, Rob.

Question just on your guides for the first quarter.

You are running up against relatively easy compare, particularly in the Pool and Spa side, I think you posted about 2% organic growth last year, and you are anniversarying a very tough comp and obviously this most recent quarter with 4Q '05.

I guess my question is, is there some conservatism baked into that number, because it looks like it's a relatively low bar for the first quarter on the border side?

Rob, I guess I would say, number one, I would not hold our predictive capability up as a paragon.

Understood.

Number two, we still see volume.

When we look at the pool market -- it's interesting, because if you look at housing -- we're comparing pool market permits.

One of the things we've done, I think we have a really good view now of pool starts and we're using that as a guide.

It's a fairly sober guide because pool permits just measures the number of pool starts and we know there's been a mix shift to higher end pools which has higher content for us, but without going through all that, we think the whole year pool market was down in '05 to '06 almost a little less than 15%.

But in the second half, it was down some 18% or so in the third quarter and down a little bit more than that, 20% in the fourth quarter.

Right.

So right now --

And that's market, that's not you, because you had a step down.

That's market.

And we've had these inventory correction, so we're a little bit higher than that --

Right.

-- in the quarter.

As we look at the first quarter right now, the channel sitting there with early buy and they're going to get more early buy.

We won't really know how the year breaks, but we do expect a note of caution in the part of them putting more inventory in the first quarter.

So we're trying to be sober about the volume expectations.

What about the pricing expectations, though?

Because you would expect pricing to certainly help the compares just given the fact that they didn't participate in the early buy program?

Well, we are going to ship -- actually for us, we didn't ship many early buy quarters in the first quarter last year, they were all standard orders and this is probably a good 5 point margin difference between the two.

Okay.

So in other words --

So we're shipping early buy, which does not replace standard buy.

So we're actually be under a little margin pressure there.

You will be under a little margin pressure there?

That's what we expect.

Unless the standard orders come through at the same rate as they did last year.

But as I said, we really won't know until March how the year is going to break.

Right.

And then really where you'll see it is 2Q, particularly.

Right, we'll see the orders in the second quarter.

Some will ship in March.

But right now we don't -- right now, we just think it's -- given what we're seeing in terms of pool starts --

Right.

-- we think we shall be cautious about the volume expectation.

Understood.

Now I guess the biggest volatility in your guidance driving you to the low end or the high end would be obviously what we just discussed there and then obviously the uncertainty around the North American telecom market, right?

Right, right.

And in that area, we were disappointed it was deeper than we thought.

We talked before about telecoms, some weakness.

But being down in the teens in the fourth quarter was something that we didn't anticipate.

And while we're hearing from our customers it's going to get better and some other reports that say it's going to get better, as we look at the first quarter, we don't see it getting better in the first quarter, which is why we set that guidance.

And the other thing is stainless steel.

Stainless steel has been a great growth product, we love it.

It's going into petrochemical and hostile environments, but stainless steel -- nickel got as high as $18 recently.

Now we've raised prices, but they've got to roll through before we can cover that.

Let's talk about the cost, the $35 million, I think, you alluded to that you effectively anniversaried; is that right?

Well, no, there's the $17 million charge, that's not in the $35 million.

Right.

That's not in the $35 million.

[inaudible] the operating improvement.

The operating improvement.

Is some of that just anniversarying some of the investment of FARADYNE, or is FARADYNE a separate issue?

Well, part of that -- FARADYNE -- we don't expect FARADYNE to be in a profit position for the first half anyway.

For the first half anyway.

And that's a piece of it.

Right.

It's the productivity in Europe, it's the productivity in the pool business.

I mentioned earlier, we expect to see a big step up in the pool and spa business despite the flat volume because we've been working on getting productivity and we're beginning to see that.

We're working on the spa turnaround.

We lost a fairly substantial amount of money in that business.

Just getting it to break even is going to have a nice impact for us year-over-year, and we're not going to see -- we're expecting, for instance in Spa, we're expecting eventually to flatten out on sales and we'll be able to -- we won't be chasing ourselves in terms of production.

Finally, on the employment of the new CFO, what day does he start and what is his initial mandate from your end -- what is his initial marching orders, and what do you expect in the near to immediate term from him in terms of just looking at the organization and coming back with you with a plan?

He's starting next week, I'm very pleased he could start that quickly.

The first thing he needs to do is get up to speed on our businesses.

The two areas that I was looking for in our next CFO is someone who could take our Investor Relations to the next level, number one.

And number two, take our operating finance partnership to the next level.

So it's really around focusing on -- not the controller side, not the treasury side, but on the operating finance side.

Understood.

Thank you for your time.

Your next question comes from Deane Dray with Goldman Sachs.

Thank you.

Randy, could you give us an update on the Spa business, last update you said it was at a fix or sell mode.

Where does that stand today?

Well, the business, we saw another -- not sequentially, but year-over-year, a 30% decline in volume in the fourth quarter, so we're not in a position to make money yet.

The plan has been set and is being executed in terms of SKU reduction and in terms of productivity in both Mexico and in China.

We're expecting to see that build over the next couple of quarters.

It won't be until midyear that we make any decision beyond that.

Right now, we're focused on getting that margin turnaround we expect that the volume declines will slow.

So that's what we're expecting in the first half.

Is part of the fix to address the inventory issue in Mexico?

Yes, we need to get some orders to ship that stuff.

The inventories are too high, definitely.

Okay.

Speaking of inventories, can you give a little more clarity on this inventory reserve that you've taken this quarter.

Was this related specifically to FARADYNE?

Let me leave it at -- I don't want to go into the specifics.

As we built a strategy to replace, to find new sources to replace the Franklin motors, we built a strategy that was both make and buy.

And then we have a range of products and we built inventories and what we found is we took stock and we looked at how well we were doing with FARADYNE and decided we didn't need all the -- we likely wouldn't use all of the motors that we had in inventory within our one-year period.

And we reserve in excess of one-year when we have it.

That's our accounting policy.

It's inventory we already had on hand and it's multiple sources.

So it's not obsolete inventory, just --

No, no.

Not obsolete.

It's excess, these are motors that are perfectly salable and perfectly usable.

If you will, we had plans and we had contingency plans.

Right now, it looks like we won't need all our contingency plans.

Got it.

And then related to that pump win in New Orleans.

Yes.

$22 million of revenue, 11 pumps -- walk us through the bidding process.

Was it an auction?

And how might the margins compare to the pump overall margins?

Well, let me start with the margins.

And we didn't -- I'd say four or five years ago, the municipal business was not a focus for us to grow because the margins were sub 10% and we weren't sure if we could get them higher.

The folks in our Fairbanks Morse business have done a great job of improving productivity and flow and we're in that business now where we're actually above 10%.

These products will yield good margins because we're going to get really good operating leverage as they ship in the second and third quarter.

It was a bid business -- there aren't that many people that can do that -- and speed was a factor as well.

Is there a design change from the previous motors -- pumps that you had in place there?

There's always some.

I can't get into to the -- I can't answer what's technically different.

They're similar, but they're updated.

I think the motor source may have changed, but don't hold me to that.

Okay.

Just a couple other housekeeping.

CapEx looked like it came in light for '06 by about $9 million.

Was there a project that was delayed?

Has that been pushed into '07?

Our Poland plant and tech products, I think some of that will happen more in this year.

That's one reason why we're saying 70 to 80, but it wasn't pushed.

Right now they're underrunning their capital plan.

And last question.

It sounds from your guidance that the Technical Products will indeed, all good things have to come to an end, their streak of consecutive quarters of margin improvement.

At what point do you feel that goes into effect?

And is there any ramification?

And you had said before that you thought that margins would just be flattish.

Now you're actually guiding down, is that true?

Correct.

We are guiding down.

The two things, as we look at the first quarter, as I said, we saw telecom business being down in the teens in North America and in the fourth quarter, we're seeing the same thing in the first quarter and we need to get that to ground -- that's something we're working on to make sure that we understand it and that we're taking the appropriate actions based on that.

That's one thing we're working on.

The second is stainless steel and the cost of stainless steel is breathtaking right now.

While we have the ability to recover price, we don't get it right away.

We're committed to get that business back to 15%.

We didn't get it there to fall away from that, even though it will be below that and falling away from that in the first quarter.

Great.

Just lastly.

I'm sure Dave Harrison is listening.

I just want to say many thanks for all his help and best wishes.

Great, thanks.

I'm sure he is.

[OPERATOR INSTRUCTIONS]

Okay.

Your next question comes from Dan Whang with Lehman Brothers.

Yes.

Good afternoon, Randy.

Hey, Dan.

First question was, could you go into a little bit more detail on the rate of investment spend during the quarter?

I think that's been running around $7 or $6 million in the first three.

The -- you're talking about in Water?

Yes, I think it's been --

Right.

We had a number of investments including the motor JV and the SG&A in Europe and the SG&A in Asia and the China -- we talked about Poland.

We were running about $7 to $8 million, that dropped off to about $3 million as expected in the fourth quarter.

The fourth quarter is about $3 million?

Yes, it was $3 million incremental.

So it's falling off like we expected it to.

With the biggest portion of that being the continued IT project in Europe.

Okay.

Just looking into '07, I think previously you thought that maybe that versus the overall spend investment spend in '06 that it might be maybe half of that amount in '07.

Is that still stand, and what's -- what are the remaining areas that the investment would be focused on, and what's still left to do?

The way we're looking at it, we think productivity will more than offset those things.

We're looking at first quarter -- we're looking at every quarter being up in margins and Water with it being 0 to 50 basis points up in the first quarter and second quarter anyway -- well, first quarter.

And every quarter thereafter we expect margins certainly in the second half to be a lot stronger.

Obviously that's a ramp, but it's a ramp that we're intending to drive.

The only real incremental is the continued in the first half, in particular the IT project in Europe.

But we expect to be able to cover that with the productivity we're going to see in Europe.

Okay.

In terms of the prebuy that you had talked about where you will ship some of that in the first quarter -- could you talk about how much in dollar amounts are we talking about that you talked about?

We said -- we expected to be down $30 and as much as $60 million in the quarter in early buy sales.

We were down above $30 million in sales.

The orders were maybe $10 to $15 million better than that.

But once we set the rate, we weren't going to jerk around operations and the early buy orders are shippable either the fourth quarter or the first quarter.

So we booked those into the first quarter.

So it's a meaningful number that we took through backlog into this quarter.

They're shipping now.

And as I said, they are -- there are truckload shipments and larger orders and they get probably about 5% lower margins than regular standard orders.

Okay.

I think you had talked about pricing contributing in the quarter.

Looking out into '07, you see resin prices, maybe that's being pulled back with oil prices coming down, but you talked about stainless steel still being strong, how should we think about pricing contribution to the top line?

Yes.

Water's done a pretty good job on price versus inflation in the second half.

I'll talk about each segment separately.

And in the quarter, in fact, in fourth quarter, price over inflation was positive.

We think going forward, with the pricing disciplines in water despite the softness, we've still taken some price increases and I'm expecting that price over inflation will remain positive.

Tech Products, on the other hand, in the fourth quarter was negative.

Price was lower than inflation and that's what we're seeing into the first quarter, that I was referencing earlier.

Right.

I'll ask Karen -- what was price for the company?

Overall, right around 3%.

3%.

Okay.

And in '07, that rate probably remained at those levels, or --?

Yes, I think so.

I think in general we try to take price increases to offset inflation, and then we have productivity in our factories too -- that helps -- but in general we've had about 3% price increases on average.

Okay.

Finally, in terms of your expected plan for free cash in '07, it seems like you are continuing to target the 100% conversion from net income.

You've done some buyback and some acquisitions, but any thoughts on that going into '07?

Well, we still have -- we used the $100 million authorization, we used $59 million, so we still have about $40 million of that left to do.

So we continue to look at acquisitions.

In particular, we're interested in water reuse and filtration and global are sort of the three key areas we're focused on.

And also any product line extensions that have attractive margin opportunities and fit our core businesses.

Okay.

We have time for one -- I'm sorry.

Thank you.

We have time for one more question.

We're all afternoon for others.

Your last question, sir, comes from John Quealy of Canaccord Adams.

Hi.

This is actually Mark Siegel for John.

Just in terms of how we look at the North American market, Filtration was a low single digit grower, Pump was essentially flat and obviously Pool and Spa was down noticeably.

Just going forward, are those fair assumptions in the coming quarter, or how should we look at that?

I don't think pool is going to be down as dramatically as it was in the fourth quarter.

Beyond that, I'd agree with what you said.

Pump flattish and Filtration low single digits.

Okay, great.

Thanks.

That's it for me.

Okay.

Thank you all very much.

Jody, if you could come on and give replay instructions, I'd appreciate it.

Yes, sir.

Thank you for participating in today's Pentair Incorporated 2006 fourth quarter earnings conference call.

This call will be available for replay beginning at 3:00 P.M.

Eastern Standard Time today through the 11:59 p.m.

Eastern Standard Time on Thursday February 8, 2007.

The conference ID number for the replay is 5545391.

Again, the conference ID number for the replay is 5545391.

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

Thank you.

You may now disconnect.

Thank you very much.