Published by Bob Ciura on November 14th, 2017
The Dividend Aristocrats prove that when it comes to investing, boring isn’t always a bad thing.
The Dividend Aristocrats are a group of 51 companies in the S&P 500 Index, with 25+ consecutive years of dividend increases.
We review all 51 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 41 years in a row.
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.
For now, Pentair operates two segments:
- Water (58% of revenue)
- Electrical (42% of revenue)
But this stands to change, as Pentair is about to split into two publicly-traded companies. The Water business will generate annual revenue of approximately $2.8 billion.
Source: Pentair Separation Presentation, page 8
This business will manufacture products that improve the quality and availability of water, and for food and beverage processing.
The Electrical business will operate under the name nVent Electric, and will generate annual revenue of approximately $2.1 billion. This segment will focus on building protection and industrial efficiency.
Source: Pentair Separation Presentation, page 10
The strategic rationale for the split is that management believes each company will be able to operate better independently. Each company will have a simplified corporate structure, and greater flexibility.
Pentair believes each company will pursue growth more effectively, and as a result, hold a higher combined valuation than the current company. The split is expected to be completed by the second quarter of 2018.
The growth prospects for Pentair are strong. Both of its core businesses, water and electrical, are in growing industries.
2016 was a good year for the company. Sales increased 6%, to $4.9 billion. Operating profit increased 11%. Adjusted earnings-per-share increased 7.8%, due to sales growth, cost cuts, and lower interest expense.
The company has gotten off to an even better start to 2017.
Over the first three quarters of 2017, Pentair’s earnings-per-share increased 21%. Water segment revenue increased 2.8% over the first nine months, while electrical revenue declined by 0.5% in that time.
The third quarter was particularly strong. Adjusted earnings-per-share increased 22%.
Source: Q3 Earnings Presentation, page 6
The company expects adjusted earnings-per-share growth of 16% in 2017, to be driven by sales growth, cost cuts, and lower interest expense.
Acquisitions are a major growth catalyst for Pentair.
In 2015, Pentair acquired Erico Global for $1.8 billion. The deal broadened Pentair’s product and geographic diversification.
Erico is a global manufacturer of engineered electrical and fastening products, for electrical, mechanical and civil applications.
Pentair also divested its Valves & Controls business in a $3.1 billion sale, the proceeds of which were used to pay down debt, which will help lower the company’s interest costs.
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.
Source: Electrical Products Group Presentation, page 13
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.
Valuation & Expected Returns
Pentair has a price-to-earnings ratio of 30.5, which makes the stock appear to be significantly overvalued. Over the past 10 years, the stock has held an average price-to-earnings ratio of 17.8.
However, Pentair’s reported earnings include a number of non-recurring items that negatively impacted GAAP results. Adjusting for this makes the stock seem much cheaper.
Using 2017 adjusted earnings-per-share guidance of $3.53, Pentair has a price-to-earnings ratio of 19.3.
Source: Value Line
Pentair does not seem to be overvalued, but it is not undervalued either. As a result, the stock seems to be fairly valued, given its growth prospects.
As a result, investors cannot rely on the price-to-earnings ratio expanding much beyond the current level of 19.3. That said, Pentair can still generate positive returns.
Going forward, shareholder returns will be driven by earnings growth and dividends. A potential breakdown of future returns is as follows:
- 2%-4% organic revenue growth
- 1% revenue growth from acquisitions
- 1% margin expansion
- 2% dividend yield
Based on this forecast, total returns would reach 6%-8% per year. This is a satisfactory return, even without the benefit of an expanding price-to-earnings ratio.
Pentair has a strong business model, and competitive advantages. These qualities have fueled its steady dividend growth over the past four decades.
Pentair stock is not a screaming bargain based on valuation, but it can still generate positive returns going forward. And, it is likely to increase its dividend each year.