Updated on February 15th, 2019 by Josh Arnold
The Dividend Aristocrats prove that when it comes to investing, boring isn’t always a bad thing.
The Dividend Aristocrats are a group of 57 companies in the S&P 500 Index that have at least 25 consecutive years of dividend increases.
We review all 57 Dividend Aristocrats each year. The next stock in the series is industrial manufacturer Pentair plc (PNR).
Pentair does not have an exciting business model. It most likely will not be featured as the next hot growth stock any time soon.
Instead, it is a slow-and-steady dividend stock that has created substantial shareholder wealth over the past several decades. Pentair has increased its dividend for a very impressive 42 years in a row. The company’s dividend is also very safe, which is a topic we explore in the following video:
This article will discuss Pentair’s business model, and why it might be the most under-the-radar Dividend Aristocrat.
Pentair is based in the U.K., but has large operations across Europe and in the U.S., among other international regions.
The company was formed in 1966. In 1968, Pentair acquired Peavey Paper Mills, which gave it a top position in paper products. Paper fueled the company’s growth over the next decade, until management decided to diversify into other product categories.
Pentair’s first investment outside of paper products was the acquisition of Porter-Cable, a manufacturer of portable electronic power tools. In the decades since, Pentair has continued to diversify its product line with bolt-on acquisitions.
The company recently spun off its Technical Solutions business and now operates as a pure-play water solutions company.
Source: Investor Presentation
Pentair now operates in three reporting segments:
- Aquatic Systems (37% of revenue)
- Filtration Systems (35% of revenue)
- Flow Technologies (28% of revenue)
The pure-play water company now generates just over $3 billion in revenue, and focuses on improving the availability and quality of water. The spin-off was competed in the second quarter of 2018 and the new business is now called nVent Electric, trading under the ticker NVT.
Pentair reported fourth quarter and full-year earnings in late January (1/29/19), and the results were strong once again. Core sales were up 6% on a consolidated basis as the company’s Aquatic Systems segment posted a 13% gain. Filtration Solutions was flat and Flow Technologies added 4% to help drive the top line higher.
Pentair continues to see very strong organic growth on a consolidated basis as Aquatic Systems performs very well and offsets relative weakness elsewhere.
Segment income was up 5% on a consolidated basis as the company’s return on sales rose 40 bps year-over-year to 18.1%. Aquatic Systems, unsurprisingly, led the way with a 10% gain in segment income. Filtration Systems saw a 7% segment income boost despite flat revenue as its margins improved markedly during the quarter.
The same was not true, however, for Flow Technologies, as its segment income declined 7% despite the 4% boost to the top line.
In total, earnings-per-share came in at $0.60 on an adjusted basis, good for a 21% increase over the comparable period in 2017. For the full year, earnings-per-share was $2.35, a gain of 21% over 2017.
Source: Earnings Presentation
The company also generated $410 million in free cash flow in 2018, which it used to buy back $500 million of shares and return a further ~$125 million in dividends.
Pentair’s outlook for 2019 bodes well for the company as it expects adjusted earnings-per-share of $2.55 at the midpoint of its guidance, representing ~9% growth. This will be driven primarily by higher revenue, which will be the result of a small organic revenue gain and a sizable increase from acquisitions in the Filtration Solutions business.
Overall, growth prospects for Pentair remain strong. Indeed, all of its core segments are slated to grow in fiscal 2019, albeit at different rates.
Pentair has already announced two sizable acquisitions this year. In early January, it announced it was buying Aquion for $160 million in cash. Aquion offers a line of water treatment products for the residential and commercial water treatment industry.
Pentair also acquired Pelican Water Systems for $120 million in cash. Pelican Water Systems provides whole home residential water treatment systems. We expect Pentair will continue its long history of seeking to acquire growth, and it is certainly off to a good start in 2019.
Competitive Advantages & Recession Performance
One of the competitive factors that has fueled Pentair’s impressive growth, is its lean cost structure. This is no accident; Pentair has employed a strategy called Pentair Integrated Management System, or PIMS, which has enabled its high profit margins.
PIMS enables leaner manufacturing processes and drives efficiency throughout the company’s supply chain and distribution. Even though the effort is years old at this point, it continues to permeate the company’s strategy today. The impact is a culture and mindset with a relentless focus on cutting costs from its model.
The PIMS is an organization-wide system. It effects talent management by providing employees with the proper incentives and providing all employees with individual responsibility down to the operator level.
Within the PIMS system, the ‘Lean Enterprise’ system helps to increase profit margins. It drives margin expansion by increasing productivity at manufacturing sites, and helps identify acquisition targets with the highest cost savings opportunities.
Its competitive advantages and high margins allowed the company to remain profitable during the Great Recession of during 2007-2009:
- 2007 earnings-per-share of $2.08
- 2008 earnings-per-share of $2.20 (5.8% increase)
- 2009 earnings-per-share of $1.47 (33% decline)
- 2010 earnings-per-share of $2.00 (36% increase)
As a global industrial manufacturer, Pentair is not immune from recessions. However, it quickly bounced back. Pentair’s earnings-per-share reached a new high in 2011. Given that Pentair is now a pure-play water treatment company, we expect the next recession will have a milder impact on the company’s earnings.
Pentair is now focused on services that can be considered needs and not wants, so we believe the company’s recession resistance has improved in recent years.
Valuation & Expected Returns
Pentair has a price-to-earnings ratio of 16.4 after the company’s fourth-quarter earnings report. This is a fairly low valuation for the stock, given its historical averages. In the past 10 years, Pentair stock traded for an average price-to-earnings ratio of 18.2.
Based upon the company’s historical price-to-earnings ratios as well as its projected growth, we’ve assessed fair value at 18 times earnings. That makes the stock somewhat undervalued today despite the strong performance of 2018 and the company’s bright outlook.
Given this, we see the stock as somewhat undervalued, and that will help drive total returns looking forward. In total, we see annual returns of 11% to 12% accruing to shareholders of Pentair, consisting of the 1.8% dividend yield, 6.5% earnings-per-share growth, as well as a ~3% tailwind from a higher valuation.
An expected return above 11% is a very satisfactory rate of return. That is good enough for us to rate the shares a buy given the reasonable valuation, very strong history of dividend increases, and robust growth outlook.
Pentair has a strong business model, and competitive advantages. This is particularly true in the company’s new, pure-play water model. These qualities have fueled its steady dividend growth over the past four decades and we don’t see any reason to believe that won’t continue for many years to come.
While Pentair isn’t considered tremendously cheap today, it is very reasonably priced, has a decent dividend yield, and it has a promising future outlook. The company should be able to continue increasing its dividend each year. We rates share of Pentair a buy after the strong fourth-quarter report and 2019 outlook.