濱特爾 (PNR) 2009 Q3 法說會逐字稿

Good morning.

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

At this time, I would like to welcome everyone to the Pentair Q3 2009 earnings conference call.

All lines have been placed on mute to prevent any background noise.

After the speakers remarks, there will be a question-and-answer session.

(Operator Instructions.) Thank you.

I would now like to turn the call over to Todd Gleason, Vice President of Strategic Planning and Investor Relations.

Please go ahead, sir.

Thanks, Darla, and welcome to Pentair's third quarter earnings release conference call.

We are glad you could join us.

I am Todd Gleason, head of Investor Relations and with me today is Randy Hogan, our Chairman and Chief Executive Officer and John Stauch, our Chief Financial Officer.

On today's call, we will provide details on our third quarter results as well as update you on Pentair's outlook for 2009.

Before we begin, let me remind 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 risks outlined in Pentair's 10-K as of December 31, 2008, 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.

Today's web cast is accompanied by a presentation, which can be found in the financial information section of Pentair's Web site at www.Pentair.com.

We will reference these slides throughout our prepared remarks.

Any references to non-GAAP financials are reconciled in the appendix of the presentation.

I would also like to point out that all financial results and references to year-over-year numbers in today's call and presentation are on a continuing operations basis unless otherwise noted or highlighted.

As is our custom we will reserve time for questions and answers after our prepared remarks.

I will now hand the call over to Randy who will take you through Pentair's third quarter 2009 results; provide his perspective on the results of our businesses and the markets they serve; and provide an overview on how we are driving to deliver results in 2009.

Then John will conclude our formal comments with additional information regarding our third quarter financials and provide more detail on our outlook.

Randy?

Thanks, Todd.

And welcome everyone.

Before I begin I would like to make a few remarks.

First, thanks to the many of you that attended our Investor and Analyst Day in New York City on September 3; it was great to see so many of you in the audience and to share with you our long-term strategies.

Second, as you obviously know since you're on the call, today's conference call is starting a few hours earlier than it has been the case, historically.

We will solicit feedback on this time slot, but we do intend to permanently hold our conference call in the morning going forward.

Hope you find the earlier time convenient and helpful.

Now let's begin by reviewing our third quarter results shown on slide number two.

Sales of $663 million were down 23% and slightly below the low end of the guidance we provided in July.

We have some pluses and minuses with respect to sales, but the headline is water sales were in line with expectations, while technical product sales were lower compared to the guidance we provided in July.

Sales in our water business were down 17%.

Our largest market, North American residential, remains down year-over-year, but we continue to see modest sequential improvement.

We will discuss water in more detail in a few minutes.

Technical product sales declined 32%, about 5 points worse than expectations.

Virtually all of our major vertical markets and technical products experienced double digit declines as capital spending remains constrained.

In the quarter, we delivered reported earnings per share from continuing operations of $0.38, which includes a negative $0.04 of nonrecurring items associated with restructuring actions.

If you remove the restructuring, we delivered $0.42 of adjusted EPS, which was down 25% when compared to adjusted EPS in the third quarter of 2008.

While down year-over-year, adjusted Q3 EPS was up $0.04 sequentially when compared to Q2 2009, despite lower revenue of approximately $30 million.

The take-away is the results from our cost actions, continue to benefit us, as we progress through the year.

Total Company operating margins on an adjusted basis contracted 60 basis points.

The positive benefits from productivity and price did not offset the negative impact from the 23% sales decline.

On a sequential basis, though, margins continue to improve nicely.

Third quarter operating margins expanded 160 basis points when compared to the second quarter margins.

And when you compare Q3 margins against Q1 margins, we're up 490 basis points.

So Pentair is indeed making good margin progress.

Relative to our adjusted EPS, our third quarter effective tax rate was 32%, which is the same as the second quarter and in line with our guidance.

We continue to expect our full-year tax rate will be between 32% and 33%.

Finally, we produced $103 million of free cash flow in Q3.

Year to date, we have generated over $200 million of free cash flow, approximately $95 million more than the first three quarters of 2008.

Now let's turn to slide number three, which provides an overview of our Q3 water results.

Here are the details.

On the top of the slide, we provide our standard sales and operating income loss.

We will refer to these as we describe the performance of the water group.

Overall, water sales declined $96 million, to $462 million, or down 17% versus the third quarter last year and down 16% in local currency.

As I mentioned earlier, this was in line with the sales guidance we provided in July.

Let's review our business performance in water.

Our flow technologies business was down 14% year-over-year.

Growth in our municipal business, where we continue to have record backlog and nice order activity, did not offset continued declines in US commercial and residential markets.

However, we are maintaining our investments in global growth and new products, such as our VFD or variable frequency drive controls, to improve energy efficiency.

So we expect Q4 to start to show better year-over-year comparables.

Filtration was down 21% as we continued to see declines in commercial, residential, and industrial sales globally.

However, we are seeing stabilization in US residential filtration markets with industry shipments improving sequentially.

And with our new product launches and growing systems capabilities we are positioning our filtration business for growth in 2010.

Pool equipment was down 16% as the prolonged decline in North American residential new pool builds persists.

Pentair pool equipment sales are essentially all going to satisfy all after market replacement and upgrade demand as pool permits are down close to 80% to 90% versus three years ago.

Now let's discuss operating profits and margins for the water group.

On the top right, you can see our year-over-year operating income walk for water.

Adjusted margins were 12.1%, up 80 basis points year-over-year.

Margins came in essentially in line with our guidance as productivity actions delivered meaningful results and more than offset the impact volume declines had on margins year-over-year.

Because of continued market weakness, we instituted new restructuring actions in the quarter.

The charge associated with this action is shown on the walk as a $3 million negative impact to OP income which is how you get to our reported operating income of $53 million.

So despite the drop in sales, adjusted margins have increased year-over-year, as a result of the aggressive cost actions we've taken.

We expect to maintain this trend with respect to margins in the coming quarters.

Please turn to slide number four and let's review technical products.

Year-over-year, third quarter sales in technical products were down 32%.

As I mentioned earlier, sales declined about 5 percentage points worse than we had anticipated.

However, it is in line with most of our major end markets, which are declining at rates at or about 30%.

That said, we believe the markets have essentially bottomed out, and are relatively flat sequentially, which is demonstrated in our quarter over quarter sales volume.

Looking at the businesses within technical products, our global electrical markets declined 29%, while our global electronic sales declined 32% in local currencies.

Technical products adjusted margins were 14.4%, a decline of 180 basis points versus the Q3 2008.

Aggressive cost actions and solid execution on our restructuring efforts did not make up for the dramatic decline in sales year-over-year.

That said, margins did improve sequentially over 240 basis points, despite sales volumes decreased modestly, so we're delivering the sequential improvements we expected.

As in water, technical products took new restructuring actions in the quarter.

The $5 million charge associated with those actions is shown on the walk, and covers the cost of the additional factories that we added to the planned shutdown that we mentioned in the July call.

This helps you to reconcile to our reported operating income of $24 million.

Now, please turn to slide number five and let's review some of the key take-aways from Q3.

Starting with some of the pluses or positives we mentioned earlier, that we continue to see sequential improvements in the North American residential market.

One highlight was in August, our pool business had the first year-over-year increase in sell-through for any month in about three years.

So while sales continue to decline for residential pools in the quarter, this is an indicator that positive comparisons are in the near term horizon.

We have already discussed our Q3 margins for both water and technical products, but obviously we believe each were positives in the quarter.

In the quarter, we announced the largest contract in Pentair's history, a $65 million municipal pump order with the Army Corps of Engineers, to enhance flood controls for the City of New Orleans.

The pump station is expected to be the largest in the world, with the bulk of revenues for us being generated in 2010 and 2011.

With the focus on stimulus spending, and the need for infrastructure investments globally, we expect orders to remain strong in our municipal water business.

Another plus coming out of the third quarter was free cash flow, which as mentioned earlier was $95 million higher than our cash generation through three quarters of 2008.

The next few items are essentially neutral for Pentair.

We expected commercial and industrial markets to experience declines and certainly we saw that in the third quarter of 2009.

So basically, no blood versus our guidance.

While Asia and Middle East markets generally have slowed earlier this year, we continued to show solid growth prospects for both water and technical products in those areas.

As for the minuses, it is a volume story.

Third quarter sales missed the low end of our guidance as technical products continues to experience more dramatic sales declines than anticipated.

While we're seeing flat sequential sales performance, we expected the business of sales to improve modestly, which is yet to occur.

Overall, Q3 produced a balance of positive, neutral and negative items which is not uncommon of course, but there are more positives than negatives and we remain encouraged that the things in our control remain positive to our results.

Let's take a look at our total Company productivity.

Please turn to slide number six.

Throughout the year, we have discussed our major productivity actions.

We wanted to provide the details so you had an update on our expectations for each major action and their impact on our cost productivity.

The upper half of the slide details the $250 million of productivity we expect to generate for the full year, by component.

We are on track to deliver these savings and we've already generated about $200 million through the first three quarters.

The final component is labeled volume.

With total Company sales expected to be down about 20% for the full year, or approximately $700 million, the negative $386 million is simply the amount of nonmaterial margin drop-through that occurs if we had not taken the actions we did to adjust our cost structure.

The bottom half of the slide details the expected head count reductions by the end of the year.

Hourly head count is expected to be down 14% by the end of this year, which is in addition to the 7% reduction we had already taken in the second half of last year.

Salary head count is expected to be down 9%.

And shown in the slides, you can see we had reduced our salary work force by 5% in the second half of 2008.

It is a large drop since we started our major restructuring activities mid-last year.

In sum, there has been significant progress on our cost actions, and the way they were done lays a nice foundation going forward.

Now please turn to slide number seven.

This slide is also one of our standard update slides and it is divided into the four quadrants we talked about before, cost out, driving free cash flow, positioning for growth and our perspectives going forward.

As previously detailed we continue to execute against our cost actions.

We knew 2009 would be a very difficult year, and so far, it has been.

Only through solid execution on the cost side have we delivered on our targeted results.

We have completed most of our major facility closures.

Furthermore, our cost actions are going to yield the $250 million of productivity we just showed you.

Of that, we anticipate about $150 million to be permanent.

And we have reinforced our lean activities at each facility, all of which are focusing on their key deliverables of safety, quality, delivery, cost productivity, and cash flow.

Speaking of cash flow, moving down the left side of the slide, our ability to generate significant free cash flow remains the focus for the Company.

We still have a tremendous opportunity of working capital, and we're making progress since year to date we're already $95 million ahead of the game.

Moving to the top right of the slide, it is important to note that we remain energized about our long-term growth prospects in both water and technical products.

While sales remain in decline for 2009, we continue to introduce new products, win key orders, and position our businesses favorably for significant orders in the future.

Last quarter, we highlighted the $65 million municipal pump contract with the corps.

This quarter, we highlight the fantastic work our pool business has done to gain share through energy efficient pool pumps, and environmentally sound equipment via our Eco Select line of products.

Eco Select products now represent over 30% of our pool sales.

As I mentioned earlier, our pool equipment sell-through grew in August, the first month to demonstrate year-over-year sell-through growth in three years, which coincidentally happened on the third anniversary of the beginning of the US residential decline.

Examples such as these highlight some of the investments we continue to make in innovation, sales, and marketing that position us for growth going forward.

The final section of the chart is labeled going forward.

We will continue to execute against our cost actions, and we're implementing additional actions to increase productivity even more.

As we drive working capital actions, we're confident we will deliver strong free cash flow, which will be used for dividends and to pay down debt.

Finally, we believe that with our innovation and market investments, Pentair's positioned to take advantage of market opportunities as they emerge.

We look forward to continuing to share that progress with you.

By taking out costs today, driving free cash flow to investment tomorrow and developing new technologies and satisfying our customers every day, we will emerge stronger for the long term.

Before I hand it over to John, I would like to review one final slide, so please turn to slide number eight.

We maintained our EPS outlook for much of the year.

But as this slide indicates, we've seen sales decline worse than we anticipated, particularly in technical products.

However, as we showed you, our execution on cost actions and our margin attainment have been very strong.

As a result, we can maintain our guidance, excluding additional restructuring.

John is going to cover our outlook in more detail, but I wanted to highlight that we continue to deliver on our commitment, and that we've generally forecasted very well in a difficult environment.

While sales have been worse than expected, especially in tech products, we expect to deliver more productivity, which will result in the anticipated margins and EPS results.

Now I will hand it over to John, who will provide additional details on our financials and also discuss our full-year 2009 outlook in more detail.

John?

Thanks, Randy.

Please turn to slide number nine.

This slide is divided into three sections.

The top section reflects the GAAP or reported earnings per share for Q3 year-to-date 2009 and our Q4 and full year outlook for EPS.

The middle section details the adjustments from GAAP to our adjusted earnings per share for those periods.

At the bottom of the slide we provide 2008 reported and adjusted EPS results for comparison purposes.

Starting with the first column labeled Q3 '09 actuals, our GAAP reported earnings per share were $0.38.

Included in this result was $0.04 of EPS for severance costs and other charges, as we took new actions in Q3 2009 to eliminate 275 positions, not included in our prior restructuring.

The majority of these actions were related to the finalization of our plant moves in our water businesses, the announced closure of an additional factory in technical products, and incremental down sizing in technical products related to Western Europe.

Removing the impact of these costs, you get to the $0.42 of adjusted earnings per share for Q3 2009.

The $0.42 is down 25% versus the $0.56 earned in the third quarter of 2008.

Please shift one column to the right, which provides similar detail regarding our year-to-date results.

Rather than walk through the numbers, I would simply point out that we now have a $0.12 delta between our reported year to date EPS of $0.88 and our adjusted EPS of $1.

We mentioned earlier that we were expecting a favorable result from a tax audit.

We still are.

But we are now expecting that benefit could be early 2010, instead of the previous expectation of Q3, or Q4, 2009.

The following two columns represent our Q4 and full-year 2009 outlook, in the same reconciliation format.

As you can see, the bulk of our restructuring charges are behind us.

While there will still be minor work left to do, the cost related to our 18 facilities, combined with our move to six global business units, is predominantly done.

We are forecasting about $0.03 of restructuring charges in Q4.

The absence of our previously expected tax benefit is shown as a TBD as the timing is still a little unpredictable.

So our adjusted Q4 EPS guidance is $0.40 to $0.44, which is basically flat to up modestly versus Q4 of last year.

For the full year, we expect adjusted EPS to be $1.40 to $1.44, which is down approximately 35% for the year.

Please turn to slide number 10.

The upper left section of the slide, outlines the major components of cash flow for the third quarter, and the year-over-year detail.

In the quarter, we generated $103 million in free cash flow.

Working capital management delivered almost $31 million of cash flow in the quarter, which was over $19 million more than working capital generated in the third quarter of 2008.

Similar to our execution around cost takeout, we are focused on free cash flow.

We continue to make nice progress, leveraging our disciplined lean efforts and feel very good about our year to date cash position of $202 million for the first three quarters of 2009.

You may have noticed a large negative Other in 2008.

I want to remind you that most of that was our litigation settlement for Verizon that occurred in Q3 of last year.

As we discussed all year, our cash usage objective has been to reduce debt.

Shown on the bottom left side, you can see we remain on target to lower our debt to around $800 million by year end.

In fact, we are currently at $815 million of debt through the third quarter.

Overall, our average interest rate is 4.3%.

Only around 10 basis points higher than Q2.

This represents a mixture of LIBOR plus 625 variable rate debt, along with fixed rate debt of approximately 5.5%.

So we remain very comfortable with our debt position, and going forward, we expect to increase our EBITDA, which will provide additional flexibility, with respect to cash usage.

Please turn to slide number 11 and let's discuss full year free cash flow and our securitization program.

Similar to other companies, Pentair has historically maintained a practice of entering into a receivables securitization program.

For Pentair, this occurred each year, in the fourth quarter.

The program was put in place to mitigate risk associated with the concentrated set of specific customer receivables.

The cost of this program has varied, but between insurance and discounting, the total cost has been around 1% to 2% of the total receivables sold, so fairly modest.

I would also mention that management is not incentivized on the securitization of receivables.

As we indicate on the lower left side of the chart, the amount of securitization has varied slightly from year to year since 2006.

Originally when we estimated our full-year free cash flow of $225 million, we forecasted approximately $50 million of securitization, similar to previous years.

However, our Q4 receivables balance and [thus] the risk, is expected to be less this year, and the overall cost of this program is higher.

Therefore, at this time, we are not expecting to securitize receivables in Q4.

Assuming we do not participate, we are maintaining our free cash flow forecast, to meet or exceed $225 million, given our year to date generation is already $202 million.

The reason for this detail is to highlight that our year-end debt position will likely be $50 million less than originally expected.

Since many rating agencies include securitizations in their outstanding debt calculation.

Additionally, we are maintaining our free cash flow forecast at $225 million, with this assumption in mind, which is why we're not raising our full-year number.

Please turn to slide number 12, and let's review our fourth quarter 2009 outlook.

This is an overview of our Q4 2009 market forecast.

About 65% of our sales are related to US markets.

As we head into Q4, our clearest information is related to sequential indicators, since we can analyze current order trends and compare them versus the last several months.

At this time, as we look at market and order trends, versus the just completed third quarter, it appears most of our major end markets are improving modestly.

The loan exception is commercial, which continues to weaken as the backlog of projects shrinks.

As a reminder, for Pentair, North American commercial water revenue is around $150 million annually, and commercial revenue and technical products related to building, is approximately $50 million annually.

In all other North American markets, things are stabilizing, and improving very modestly, with six-week order trends improving in all market segments, including the normal impact of seasonality, which means they are actually improving more than the sequential benefit we are actually seeing.

For Western Europe, markets appear to parallel US markets, as we are seeing similar trends.

We anticipate orders in sales in December will once again moderate for the holidays.

In our faster growth markets like China, we have seen a sharp recovery when compared to the initial decrease caused by the global recession.

And our low penetration and new product launches in the Middle East and India continue to give us confidence we will grow in those markets even as things remain unpredictable.

Please turn to slide number 13 and let's look at our Q4 forecast.

For Q4, we expect revenue to be between $655 million and $670 million, down about 14% year-over-year, and approximately flat with Q3 of 2009.

We expect water revenue to be around 10% to 12% down year-over-year, but a sequential improvement from the 17% decline in Q3.

We expect technical products to be down around 18% to 20% year-over-year.

You may remember that Q4 2008 was the first quarter that turned negative in technical products, so definitely some easier comparisons year-over-year in Q4.

Additionally, we expect technical products revenue to increase versus Q3, which will be the first sequential upturn in revenue since mid 2008.

So once again, we believe that the technical products markets have bottomed.

Adjusting operating income is expected to be between $72 million and $77 million, which will produce overall Pentair operating margins of around 11%, up around 170 basis points year-over-year.

We expect water margins to remain around 12%, up about 180 basis points year-over-year, and technical products margins to be about 15%, up 170 to 190 basis points year-over-year.

All evidence of our cost out actions, and provides additional optimism that when the top line begins to grow that we will see the conversion we have positioned the Company to achieve.

Adjusted EPS as previously mentioned is expected to be between $0.40 to $0.44 per share, essentially flat to up modestly year-over-year.

We expect our tax rate to be around 32% to 33%, our Q4 interest expense to be around $9 million, and expect our share count to creep up to about 98.9 million shares outstanding.

And finally we expect cash flow to be approximately $25 million for Q4, without any securitization.

Please turn to slide number 14.

Here is our expectation for the full year.

Our total Company, full-year sales outlook, remains $2.7 billion, or down about 20%.

Our operating income will be around $255 million, and our operating margins around 9.6%.

We have proven through three quarters that our cost actions will yield significant 2009 and 2010 savings.

Currently, we are forecasting $250 million in productivity savings in 2009, and we are seeing the benefit from material that we expected.

We are maintaining our adjusted EPS guidance of $1.40 plus and with just one more quarter to go, we have introduced a high end of $1.44.

We continue to see signs of stabilization, and even some pockets of improvement, but it is too early to determine meaningful trends for 2010.

And we will provide you with a 2010 outlook on the fourth quarter earnings call.

In summary, we executed against our major actions very well again in the third quarter.

But markets remain challenging.

We took additional actions, which were necessary to provide support to our full year outlook and improve our ROIC going forward.

We also feel good about our cash generation; and our ability to expand EBITDA next year will give us the flexibility in our balance sheet we used to enjoy and that we want to have at our disposal for 2010 and beyond.

We'd now like to answer any questions you might have.

Operator, please open the line for questions.

Thank you.

(Operator Instructions.) Your first question comes from the line of Hamzah Mazari.

Thank you.

You could give us some color on what you are seeing with inventory in your distribution channel?

On the filtration product side, you commented on some destocking and some market softness there, as well as on the technical products side, on the electrical side, could you give us a sense of where we are in the de-stocking process?

What you're seeing in the channel?

I think consistent with what you're hearing from other companies out there, inventories are low.

As a general rule of thumb, where we have been able to see our sell-through, where we have very clear visibility between our customers and the end markets, our sell-through is generally mirroring or is a little greater than what our sell to the distributors has been.

So I think that would confirm what you're hearing from everybody else, that distributor levels are low.

And the nature of the orders still reflect that, too.

A non-stocking order usually is smaller, with more SKU's on it and more urgent and we are still seeing a lot, a higher portion of those kind of orders.

So I don't think that the restocking, to whatever extent it will happen, has yet really begun in earnest.

And just to follow up, on the technical product side, you talked about sales coming in worse than expected.

Is it fair to say that you saw end markets within technical products get worse during the quarter, but now we're running sequentially flat?

And then is that fair, one?

And then could you give some more detail on end markets within technical products?

For example, last quarter, you said datacom was down 50%.

Has that gotten worse?

And could you give us some detail on what the industrial side is running, and the electrical side as well?

I will take the first part and I will hand over to Randy for the color on the vertical marks.

Really, what we saw in technical products for Q2 to Q3 was a modest decrease, $207 million down to $202 million.

What caused the disappointment was we had assumed that sequentially Q2 was the bottom, and that we would see a pickup heading into Q3.

That, in fact, did not happen.

The year-over-year growth rates for Q2 and Q3 in technical products were generally the same, down 32 and down 32.

And so I think it was more hope that we would see recovery quicker than we have.

And I think when we look at the way we're exiting September, and heading into early October, we feel comfortable, we will see sequential growth from Q3 to Q4.

In terms of what we're seeing in the vertical market, addressing specifically datacom.

Datacom, we had another rough quarter in sales; it was down another -- year-over-year about 48%.

Part of that is timing, one order that -- one of our larger orders that just basically got pushed out.

It is not a loss of a job.

Just the volume has declined and we expect that volume will be better in the fourth quarter on that particular job.

In terms of when we look across all the markets, they all look down.

And that part reinforces the destocking, right?

Because they're not all down.

But the ones that look best right now, are not surprising ones that are serving the public sector.

Institutions, water, actually is one of the brighter spots for, on the electrical side.

And then on the electronics side, security, military, medical are the best.

Still down, for us year-over-year, but down modestly.

Okay.

Thank you very much.

Appreciate it.

You're welcome.

Your next question comes from the line of Mike Schneider.

Good morning, guys.

Good morning, Mike.

Just thinking of a technical product for a minute, so the pushout of the major project, you said from Q3 out, is that why you have confidence now in making the call that indeed volumes will be $10 million better in Q4?

Well, it is really -- we were -- when we looked at second going into third, the business felt good.

And as we look at third going into fourth, the data looks better.

That's why we feel better.

Okay.

And is the project pushout, the large food and beverage order that you spoke of earlier this summer?

No it was the datacom actually in Asia.

Okay.

And then just switching to water.

So filtration is really the only business that seems to have sequentially deteriorated, can you just drill down into that, either by market or by brand, and just give us some insight as to still what is getting worse within there.

Is it all Everpure or is there more going on?

Well, you know, if you take a look at the net filtration businesses, it is a modest decrease.

The point I made in my comments, Mike, is historically Q2 is our best quarter, and we see a seasonal downturn in Q3 and Q4.

The fact that we're actually staying fairly steady, tells you the markets are improving, but the normal seasonality is working against it.

And then the other insight there would be Europe.

Europe, for filtration, was weaker.

And part of that is the natural summer months we experience.

And we have seen some recovery here in September and October.

Yes, filtration is our most global business in water.

And to John's point, Europe, I think we're continuing to see destocking in the third quarter and the distribution channel.

To your point about Everpure, actually Everpure has a lot of momentum going for it.

I think we're actually going to be seeing growth from them.

It may be share, but we've had a number of good wins.

And what is interesting is if you just take -- it is a global business, but if you just take a look at its largest market, which is the US, the food service industry, as far back as we can see, 17 years, at least, this is the first time that there has been a decline in the number of restaurants in America in the last 17 years.

There has been that draw-back.

And we think that is over.

We think if a restaurant has gotten this far, it is probably going to make it through.

And so we're beginning to see an increase in activity.

So I think it is interesting, because you think about our water business, and it is only about 13% of our sales are commercial, and it is really split between new construction, which is the flow side, and then Everpure, the food service side, and we think actually in that part of commercial, we are probably bottomed out.

And we are beyond the bottom.

So I feel pretty good about Everpure.

And Mike, just to follow up, the combined filtration business is [down] $3 million from Q2 to Q3 and if you take out the benefit of the acquisition last year, they were down 9 sequentially from Q2 to Q3.

Just not sure if you had that information, I just wanted to make sure you had it.

Could you give us an update just on the joint venture now with the GE residential products?

Where are you in the combination of the businesses?

What has gone better than expected in the first few quarters?

What is not up to your expectations?

We just haven't heard much about it.

Well, volume has been the biggest disappointment, right?

The fact that the residential market fell even further.

Just to back up, when we put these businesses together, it was to get in a position to win even bigger, when the residential market recovers.

This additional step-down has complicated things, so we really would like some more volume in there.

I think that the radical combination and the shutdown of the factories has gone about according to oil.

We're done with the major shutdowns.

We're now improving our delivery, improving our touch with customers so that we can grow going forward.

The thing that has gone better, frankly, is the innovation.

I'm really excited about a number of the things we're doing, both in terms of what we're doing with the channels, as well as -- and the distribution, but also in terms of the new products we have coming in point of use, and even on the point of entry, so that's how I'd assess it right now.

Okay.

And then John, just specific on corporate expense, or unallocated expense, if you pick apart this segment, guidance for Q4, then the annual, it looks like you're anticipating that corporate expense line to go from what was it, about a $10, $11 million run rate, possibly as high as $15 million in Q4, and I realize that's the plug, and there may be some cushion built in there, but is there anything unusual coming in Q4, in that line item, to explain the jump?

The only incremental unusual, as we go from Q3, Q4, is we tend to adjust our year-to-date insurance rates.

We have some incremental stock option expense based upon wherever the stock is trading at and then there is some hope on some potential business that we've accrued for in that corporate line.

Okay.

And final question, just slide six, where you go through total Company productivity, John, you laid out that volume is a $386 million decrement, in this stair step on a $700 million decline.

Can you just give us the -- the implications of that 55% decremental impact of volume?

Is that what you model now on the way up?

Is that the type of incremental margins we should be expecting at least early in the recovery before you start adding head count and fixed overhead?

I like that.

It works easier, as you know, on the way down than it does on the way up.

The way we're modeling it there, as you see in the impact of sales minus materials and material for us, call it roughly 40% of sales, and then what we've been able to do on the way down, is take variable labor out at a rate slightly higher than what the volume decline has been.

We feel very confident we won't have to add the labor in at the same rate of the growth.

So there should be some incremental --

Some will come back.

Some will come back, obviously.

And Mike, this is Todd.

I remind you too, we talked in fair detail about this last quarter, that Q2 versus Q1 sequentially showed growth, and that sequential conversion was around 45%, which is -- we said at the time a decent indicator of -- because we think sequentials is important as year-over-year in this environment, is as least a decent indicator of probably a really strong drop-through.

And the difference is basically material, plus sales commissions, plus variable labor is how you get [to it].

Mike, just to follow up, think 35% to 40% is a reasonable expectation of the growth and the reason I would hedge a little bit on what we lost on the way down is the question of where the mix will be.

So not all our revenue is as profitable as other components and I feel good about 35% to 40%, as we look forward in 2010, and then as our investments kick in, it probably begins to compress to more of a 30% conversion going forward.

Got it.

Thanks again.

Thank you.

Your next question comes from the line of Christopher Glynn.

Thanks, good morning.

Good morning.

Just reconciling some of the directional pieces in the water margin, Randy, you had a broader comment that maintained the trend of improvement in coming quarters, and I'm initially taking that as a sequential comment.

Yes.

But you have some incremental restructuring here in the second half.

Maybe raws deflation has a little further to go.

How far out do you think we are from getting to the point where sequentially it's just more strictly the volume levers that we think about?

We're going to probably have our highest margin quarter in what tends to be one of our weakest water quarters.

So I think that is where we feel confident that when you get to Q2, which is our best quarter, we're going to see the benefit of this cost reduction, in a significantly larger way.

That would be my general --

I agree.

The second quarter is always the peak.

This is the margin, being as good in the fourth quarter, as it is going to be, is the anomaly, and I think we will see water at its wholesome best in the second quarter.

Okay.

And John, your comments about seeing the operating margin being the highest in one of your traditional weakest quarters, did that refer to -- were you referring to the quarter you just reported?

Q4.

Q4 is traditionally for water.

Seasonally fourth quarter is generally a lower one, and season -- and quarter two and three are higher.

Just seasonality, that's all we're referring to.

And then just wondering if you know anything about the stimulus opportunity that you didn't know a month or two ago?

You know, it is really the same thing.

The activity is picking up in terms of discussions; we still were a couple million dollars that we've won.

Obviously, we want to win a lot more than that, and we didn't think a lot was going to be let this year.

But we expect a lot more will be let next year and hopefully in the first quarter.

And I know you have had some tangible comments on the water side, but thought that tech products could play there, too.

Anything more tangible?

Yes, the thing is, and that's one of the big focuses for our Hoffman line of products and that distribution.

We -- enclosures are ubiquitous.

They're used everywhere.

If there is a capital dollar spent, there is an enclosure sold.

So the business is all over making sure the distributors are using the same data as we're using on the water side in terms of chasing down the opportunities that are there.

And you know, I saw last week, one of our panel builders who is actually biggest business is in water and they're actually seeing growth right now.

And they're 100% Hoffman.

So that's what I meant when I said technical products is going after stimulus as well.

Thanks for the help.

Thank you.

The next question comes from the line of Michael Cox.

Good morning.

And congratulations on the quarter, guys.

Good morning.

Thanks.

My first question is on the SG&A in the quarter did increase sequentially despite the drop in sales sequentially and I understand part of that is probably from the restructuring, but I was wondering if you could provide a little more color on that sequential change.

On the reported side, you are seeing the restructuring in there.

If you take a look at SG&A, on an adjusted basis, it was up about $2 million to $3 million, and the delta would be primarily some bad debt expense that we accrued, and we have a pretty standard policy on bad debt, and when customers go past 180 days, past due, we accrue and that's what are you going to see as the delta.

That's helpful.

And then on the gross margin side, it is the first time we've seen above 30% for a year now and I would be curious as to whether these structural changes have been made that allow you to maintain that even in perhaps a seasonally slower quarter here over the next couple of quarters.

The biggest drop in that is finally seeing the material improvement.

And you know, when you take a look at Q3, we're a couple hundred basis points better than we were in materials, as a percentage of sales, a year ago.

And that is the help.

We have seen it.

But because of the way we throw it into standards and release it out of standards, it was about six months in arrears.

And we're starting to see the benefit of the materials start to flow through.

So yes, we would expect to sustain it into Q4.

My last question is in terms of your sales projections for the fourth quarter, and as you're looking at early in 2010, what have you imbedded for Forex, perhaps a benefit relative to last year?

It is interesting, as you pointed out foreign exchange is actually positive in Q4 for the first time for the year.

So for us if you look at Q3 year-over-year versus Q4 year-over-year, that is about a 3% benefit sequentially.

Okay.

Great.

Thank you very much.

Thank you.

Your next question comes from the line of Shannon O'Callaghan.

Good morning, guys.

Hey, Shannon.

Just on the tech products margins longer term here, you guys have slowed this slide back at your Investor Day with the errors of tech products and the future looked like 13% to 17%, but it looks like you are all going to be at 15% in a horrible market in 4Q.

Was that range intended that way?

Or do you see potential upside of that based on what you've seen happen here this year?

Yes, I am actually -- I'm very pleased with their margins; I'm disappointed that the sales went down as much.

It is a business that is pretty attractive, even at the bottom of the cycle, which is where we think we are today.

Q4 by the way is 15%.

For the full year, 13%, which is actually the goal we set for the business at the beginning.

So that's -- that's consistent with where we thought they would be.

The 15% in the fourth quarter, we thought they would be close to that, on higher sales.

So the fact that they're there on a little bit lower sales is better.

I would tell you that at the peak in this business, I wouldn't say that the margin needs to be higher.

What I want this business to do is grow more aggressively globally.

And I would like to invest and continue to invest in that business to do it.

I think our global opportunities in this business are enormous.

Absolutely enormous.

So, if you think about 13% being the bottom, and you know, 20%-ish, plus, the top, pretty nice business, particularly if we can globalize.

Okay.

And then how do you feel about where you've set the cost structure here in terms of if things come back quicker than you think?

Where is that threshold where you do have to bring a significant amount of costs back, do you think?

What kind of sales growth would you need to see before you need to bring some cost back into the system?

I will take the first half.

And then I will have Randy conclude.

I think clearly, we have capacity in all of our factories.

If you look at our shifts and if you look at the way we took out labor, we have very little temporary labor, which we tend to have to handle the seasonal upticks, so our capacity in our factories is pretty set for a sizable upturn here.

Where we would be challenged, like other companies would be challenged, is in our material supply.

And we're doing everything we can in the areas that we think we're going to grow to make sure that our suppliers are prepared and ready and that we have insight into our channels and into our customers' customers to make sure that we've got demand if it ticks up quickly back to our supply base.

Yes, I think -- I'm not concerned about factories.

In terms of -- we have a couple of flexes, first of all, we're not -- we virtually have nobody on overtime.

And if we have overtime, we have temporaries and of course we can add shifts.

So inside our factories, I think we've got a pretty good idea of what we will do.

So the challenge, the real key is to make sure our suppliers are ready to go, too.

So there is a lot of discussion and activity around that.

All right.

And then just last one is talking about the EBITDA increasing and getting the debt levels down, what is the -- what is the future thought, you know, when you get to some target level?

What is that level?

What do you start doing with your cash at that point?

What does the M&A world look like and what are you thinking?

Well, it will be to fund growth.

I'm particularly pleased that we've maintained our dividend increases through this period.

And we're paying down debt.

And we want to fund growth, too.

And that growth could be M&A or it could be organic in terms of putting capital to work and new product innovation, or to help us globalize, so in terms of M&A, it is beginning to pick up a little bit, nothing happening yet, but on the water side, people still think things are worth more than we might think they are.

And on the tech product side, we haven't seen anything of real interest [in a bit].

So when do you hit that point?

Can we think of M&A as sort of off the table for you guys for now and when does that change or --

No I think we're -- I wouldn't say it is off.

Right now, we're still focused on a couple of things.

One is to help us globalize.

So we're looking at that, in terms of -- and in terms of expansion and capability.

And that's true in both businesses.

Now in the case of tech products, we tend to do organically; we just built a new factory that we started this year, in India, and we have expanded the factory in China for them.

And I still see some possibilities for water in Asia.

So for us, it would be bolt-ons and geography and technology.

And you know, if we can't do that, we will maybe trim back some stock again.

That's the way we look at it is what we can we do on the organic side, what can we do on the acquisition side and what do we do with extra cash that is left.

Okay.

Thanks guys.

We will be in a good position to deal with it next year so that will be a nice position to be in.

Sounds good.

Thanks, guys.

Thank you.

Your next question comes from the line of Jeff Hammond.

Hi, good morning, guys.

Good morning.

Just want to understand a little bit better the moving pieces within water because you're taking down your second half res by about $15 million, and yet you're speaking about continuing to see signs of improving North America residential.

So can you just tell me what the offsets are and maybe give me a little bit better color on what you're exactly seeing in the North America res water that makes you feel better.

One is we are in the residential business in Europe and we are in the residential business in Asia and both softened from what we thought they would be.

So the comment about North America is not inconsistent with the data.

Because the additional softening wasn't North America so much.

It was Europe being lower than we thought it would be.

And actually, as I mentioned, Asia slowed down for us.

Now, we see it coming back.

But it was slower than we would have liked so those are the keys there.

And we look at the US, and we think the US residential will continue to modestly improve.

And where are you exactly seeing improvements?

Actually in your shipments or in order rates, or is there --

In order rates, here is --

Order rates and sell through at distribution.

And here is where we're challenged.

If you take a look at last year, and you can go back and historically take a look at this, and last year had a little tech products correction, but we're generally, we're down $100 million from Q3 to Q4, and in total Pentair revenue, and the majority of that is the seasonality of our pool business, and the residential businesses, which don't have a strong winter here in North America, or in those areas that experience winter.

And what we're seeing this year is actually increased from Q3 to Q4 in the residential businesses, and that's where I was mentioning that the seasonality year-over-year is being offset by the sequential uptick in those order rates and those sales.

Okay.

That's helpful.

And then can you just -- I know you're not prepared to give any color really on 2010 guidance but can you give us a sense of based on all of the restructuring actions you've taken, what you think your incremental cost savings are in 2010, and then as you look at this $100 million of cost savings, it is temporary, based on the trajectory of your business, how much do you think of that comes back?

Well, we said that we were going after and felt that we were going to get $300 million in the aggregate, between 2009 and 2010, and all of our analysis confirms that.

So $250 million realized this year.

And $50 million carry-over next year.

And there is some head winds.

Things like merit increases.

And some of the short term things we did.

And I would say offsetting that is a little bit better feeling of material right now.

So I still feel comfortable with everything we shared earlier.

$300 million in total.

Which is $250 million this year and an incremental $50 million next year.

And any temporary costs come back, you make up with productivity?

I think we make up in incremental material.

Okay.

And just clarification on tech products, I think you mentioned in an earlier question there was maybe a project that got -- it got deferred or pushed.

Is there a way to quantify that?

Is that really just going from Q3 to Q4?

And in the next year or two.

I don't know the specific numbers.

It was a hole in the third quarter.

Basically it was just -- it is a large project that the customer in Asia pushed it out.

But is it more that some of that comes back in the fourth quarter that gives you confidence; you go from the low $200 million to $210 million?

Yes, we think their receipts, our sales to them will be higher in the fourth quarter.

But underlying order activity, September and October is a little bit better to support it as well?

Yes.

Okay, thanks.

Your next question comes from the line of Brian Drab.

Good morning.

I have just a couple quick questions at this point.

Hi, Brian.

Hi.

First of all, on the pool market, can you give us a little more color there, and some of the key indicators you're looking at, permits, and how you think the 2010 season is going to shape up?

Well, we haven't really focused on the 2010 season right now, but it can't be worse, it has got to be better, and when you basically have no new pools being built.

Well, early by the signs.

The best thing, right now, is we -- if you go several years back, there were supplier pull-aheads and you saw people doing things to shape demand.

Most of that, because of credit, and distributor needs, have shaken out of the system.

So what we're seeing is generally a normal season now and a sell-through consistent with where our orders and sales are.

So I think we feel like there is not extra stock in the channel and as we head into next year, pool permits from this point are as Randy said in his notes, 80% to 90% down versus where they were at peak.

So pretty strong after-market demand and new housing builds will drive a little bit better pool permit sales so net-net right now, if we had to make a call, I think pool feels like it could be slightly off next year, but that could change.

Okay.

Great.

And just one other question, on the technical products side, just really strong margin performance, given sales were down over 30%.

Can you give us any more resolution in terms of margins between the electrical and electronics business and the trends you're seeing?

Is one sub- segment trending better than the other?

We've always sort of said the electrical and electronics are a tale of two cities.

Electrical is highly, highly profitable.

Electronics is thinner margins.

They both benefited though, both margins improved because the big lift in the third quarter was material.

We finally were getting materials readout that we have been waiting -- we knew was coming and arrived fully in the third quarter.

So they both benefited from the material, the material productivity.

We're clearly talking about steel when you're talking about material primarily?

Primarily, yes.

They also did a great job of reacting to the demand early and taking out the variable portions of the manufacturing side.

Yes.

Okay.

Great.

That's all I've got.

Thanks.

Thank you.

Darla, this is Todd.

Just noting that we're getting close to the end of our hour.

If there is anyone left in the queue we certainly want to get to them, if not, we will wrap up.

Yes, you do have a question from the line of Scott Graham.

Okay, Scott?

Hey, good morning.

Hey, Scott.

Good morning.

If we could put aside the $30 million, $40 million, $50 million worth of raw materials benefits that's part of your overall $300-plus million plan, and just sort of focus on spot rates of materials right now, John, you indicated that you were actually more optimistic about the ability to capture some raw materials benefits next year.

Could you tell us why that would be with raw materials sequentially rising now, is that a manufacturing, engineering thing or why --?

Candidly, it is because we measure it like any Company would measure, both the gross pipeline going in and results coming out and what Randy and I and our Chief Operating Officer, Mike Schrock have heard for some time is that the gross material inputs going in are better and, quite frankly, we're now finally seeing it.

When we look at material percentage of sales and the improvement we're seeing in that line, that's all in; that's price, that's mix, and that's the commodity savings.

And that's what we really care about is what's the benefit to Pentair, and we're capturing it.

That's why we feel more confident.

So you feel a big part this is you're using less.

It is more that the promises of where the savings are coming from are finding their way into the P&L.

Essentially we're FIFO.

We've seen it on the books; we just -- it hasn't gotten [to] the P&L.

It was in inventory, the better costs and even if costs go up, we will still have a better cost in inventory for a while.

Plus depending on whether we go, how long out we go, on materials or not, we can lock in.

And right now, I think we're in pretty good shape.

Okay.

So on the materials for the third quarter, the gross margin rose.

Was that solely from materials or was there some other restructuring involved there, net of the volume decline?

Could you maybe give us a couple of buckets on that?

Sure, the material, as I mentioned earlier, was roughly 200 basis points plus of improvement.

And the gross margin has actually improved 150.

Now I caution you that labor was a sizable benefit as well.

And the thing that gets squeezed is the fixed costs, as the revenue comes down.

So that's the component.

Really, productive job on reducing labor rates, which came down almost 100 basis points, and as a percentage of sales, and material, better than 200 basis points, and the other offset would be the squeeze on the fixed manufacturing costs.

Okay.

So because of the way you're handling materials, internally, not to say that the 200 basis points is a sustainable number, but even though materials prices across the board are sequentially higher, you can still derive a benefit from materials nevertheless.

Yes.

Okay.

Good.

For a time.

Sure.

And we will know when that time ends.

We will be able to talk about it.

So it is not like you need to go out and announce a price increase in weak conditions to offset?

No.

Okay.

Very good.

The next question was really just about the municipal business, and obviously, I know you guys have high hopes for this business, and just wondering, how you guys are marketing the New Orleans win to municipalities, in the States and even internationally, and what kind of traction are you seeing on that?

It is a high visibility job.

And certainly our sales force is talking to it, about it wherever they can.

And we're not doing any kind of advertising with it, or -- it is a highly technical sale.

And it is about specifications.

So you want to make sure that the engineering firms, the CH2M Hills and the Black and Beaches, and the CDM's and all are aware of it, and Mitsubishi and Dolsan and make sure that the high fluxes, the folks in Asia know about it.

So that is primarily what we're doing.

Our main focus on that job is execution right now.

And we're off to a good start.

It is a lot going on.

There are no shipments but there is a lot of engineering going on.

There is a lot of testing.

That's all I had.

Thanks.

Thank you.

Anybody else in the queue?

Yes, we have a question from John Quealy.

Okay.

John?

Good morning, thanks.

This is Chip Moore for John.

Just wondering if you could give us a little more color on free cash flow moving forward?

You made reference to having some more to do on working capital.

If you could quantify how much more you think you can get there, and then on cap ex, how we should be thinking about that, if you expect that to hold steady, at current levels?

Thanks.

Yes, I will answer cap ex first, we have been pretty active moving factories, and any time you move a factory, there is a higher level of capital expenditures than you would like, especially with moving it to places like China where you're not really allowed to import the equipment but you generally have to buy new.

And I think -- so we think on that cap ex let's say stays flat from Q3 levels to Q4.

On the working capital side, we've done a good job taking out working capital, as the revenues come down and what we have really benefited for in the drop in revenue that has been the working capital benefit.

I think we can do better around our improvement in the processes, again primarily around the fact that the plant moves are behind us and now we don't need the type of safety stock and double counting of inventory that our plants like to have to protect themselves against customers.

So I've seen an opportunity to inventory.

We have instituted a series of payment term increases and payables that we are starting to see the benefit of and I expect more of that in Q4.

And as we get more global, we are seeing some leakage in our receivable days so we're looking for the inventory in payables to offset the globalization of our receivable base.

That's where I see the opportunities.

Great, thanks.

Thank you.

Okay.

Darla.

Do we have anyone else in the queue?

There is no one else in queue.

You may proceed with closing remarks.

Thank you.

Thank you all for listening.

We will be around for further questions if there are any.

And please, this is the end of the call, could give directions on the recording?

Certainly.

Thank you for participating in today's Pentair Q3 2009 earnings conference call.

This call will be available for replay beginning at 12 pm Eastern Time today, through 11:59 pm Eastern Time, on Friday, November 20, 2009.

The conference I.D.

number for the replay is 33 55 50 56.

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number for the replay is 33 55 50 56.

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

Once again, 1-800-642-1687 or 1-706-645-9291.

This concludes today's conference call.

You may now disconnect.