UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended October 2, 2004
OR
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
Commission file number 1-11625
Pentair, Inc.
(Exact name of Registrant as specified in its charter)
Minnesota
41-0907434
5500 Wayzata Blvd, Suite 800, Golden Valley, Minnesota
55416
Registrant’s telephone number, including area code: (763) 545-1730
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
On October 29, 2004, 100,721,468 shares of the Registrant’s common stock were outstanding.
Pentair, Inc. and Subsidiaries
Part I Financial Information
Item 1.
Financial Statements
Condensed Consolidated Statements of Income for the three and nine months ended October 2, 2004 and September 27, 2003
Condensed Consolidated Balance Sheets as of October 2, 2004, December 31, 2003, and September 27, 2003
Condensed Consolidated Statements of Cash Flows for the nine months ended October 2, 2004 andSeptember 27, 2003
Notes to Condensed Consolidated Financial Statements
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
Item 4.
Controls and Procedures
Report of Independent Registered Public Accounting Firm
Part II Other Information
Legal Proceedings
Unregistered Sales of Equity Securities, Use of Proceeds and Issuer Purchases of Equity Securities
Item 6.
Exhibits
Signature
PART I FINANCIAL INFORMATION
Condensed Consolidated Statements of Income (Unaudited)
Net sales
Cost of goods sold
Gross profit
Selling, general and administrative
Research and development
Operating income
Net interest expense
Income before income taxes
Provision for income taxes
Income from continuing operations
Income from discontinued operations, net of tax
Net income
Earnings per common share
Basic
Continuing operations
Discontinued operations
Basic earnings per common share
Diluted
Weighted average common shares outstanding
Cash dividends declared per common share
See accompanying notes to condensed consolidated financial statements.
3
Condensed Consolidated Balance Sheets (Unaudited)
In thousands, except share and per-share data
Current assets
Cash and cash equivalents
Accounts and notes receivable, net
Inventories
Current assets of discontinued operations
Deferred tax assets
Prepaid expenses and other current assets
Total current assets
Property, plant and equipment, net
Other assets
Assets of discontinued operations
Goodwill
Intangibles, net
Other
Total other assets
Total assets
Current liabilities
Short-term borrowings
Current maturities of long-term debt
Accounts payable
Employee compensation and benefits
Accrued product claims and warranties
Current liabilities of discontinued operations
Income taxes
Other current liabilities
Total current liabilities
Long-term debt
Pension and other retirement compensation
Post-retirement medical and other benefits
Deferred tax liabilities
Other noncurrent liabilities
Liabilities of discontinued operations
Total liabilities
Minority interest
Commitments and contingencies
Shareholders’ equity
Common shares par value $0.16 2/3; 100,626,064, 99,005,084, and 98,775,464 shares issued and outstanding, respectively
Additional paid-in capital
Retained earnings
Unearned restricted stock compensation
Accumulated other comprehensive income (loss)
Total shareholders’ equity
Total liabilities and shareholders’ equity
4
Condensed Consolidated Statements of Cash Flows (Unaudited)
Net income from discontinued operations
Depreciation
Amortization
Deferred income taxes
Stock compensation
Accounts and notes receivable
Pension and post-retirement benefits
Other assets and liabilities
Net cash provided by continuing operations
Net cash provided by discontinued operations
Net cash provided by operating activities
Capital expenditures
Acquisitions, net of cash acquired
Payments from sale of businesses
Equity investments
Net cash used for investing activities
Net short-term borrowings (repayments)
Proceeds from long-term debt
Repayment of long-term debt
Proceeds from exercise of stock options
Dividends paid
Net cash provided by (used for) financing activities
Effect of exchange rate changes on cash and cash equivalents
Change in cash and cash equivalents
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
5
Pentair, Inc. and subsidiaries
Notes to condensed consolidated financial statements (unaudited)
We prepared the unaudited condensed consolidated financial statements following the requirements of the Securities and Exchange Commission (SEC) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by accounting principles generally accepted in the United States can be condensed or omitted.
We are responsible for the unaudited financial statements included in this document. The financial statements include all normal recurring adjustments that are considered necessary for the fair presentation of our financial position and operating results. As these are condensed financial statements, one should also read our consolidated financial statements and notes thereto which are included in our 2003 Annual Report on Form 10-K for the year ended December 31, 2003.
Revenues, expenses, cash flows, assets and liabilities can and do vary during each quarter of the year. Therefore, the results and trends in these interim financial statements may not be indicative of those for a full year.
Our fiscal year ends on December 31. We report our interim quarterly periods on a 13-week basis ending on a Saturday. As a result, the first nine months of 2004 had four additional business days when compared with the comparable 2003 period. The impact of these extra days will reverse in the fourth quarter of 2004 which will be shorter by three days than the comparable 2003 quarter.
All share and per share amounts have been restated to give retroactive effect to the June 2004 stock split (see Note 4).
On July 16, 2004, we signed a definitive agreement to sell our Tools Group to The Black and Decker Corporation (“BDK”). The Tools Group comprises the Porter-Cable, Delta, DeVilbiss Air Power, Oldham Saw, and FLEX brands, among others. Tools Group products include woodworking machinery, portable power tools, power tool accessories, metal and stoneworking tools, pneumatic tools, compressors, generators, and pressure washers. The Tools Group employed approximately 4,200 people at facilities in North America, Europe and Asia.
Effective after the close of business October 2, 2004, we completed the sale of our Tools Group to BDK for approximately $796.8 million in cash, including a $21.8 million interim net asset value increase, subject to post closing adjustments. These financial statements have been restated to reflect our Tools Group as a discontinued operation (see Note 6).
In May 2004, the Financial Accounting Standards Board (“FASB”) issued Staff Position (“FSP”) 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003, which supercedes FSP 106-1 of the same title issued in January 2004. FSP 106-2 becomes effective for the first interim or annual period beginning after June 15, 2004. FSP 106-2 provides guidance on the accounting for the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) for employers that sponsor postretirement health care plans that provide prescription drug benefits. FSP 106-2 also requires those employers to provide certain disclosures regarding the effect of the federal subsidy provided by the Act. Since our postretirement health care plan is a fully insured plan and is not eligible to receive the federal subsidy, the adoption of FSP 106-2 did not have any effect on our financial condition or results of operations.
In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on the remaining portions of EITF 03-01, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, with an effective date of June 15, 2004. EITF 03-01 provides new disclosure requirements for other-than-temporary impairments on debt and equity investments. Investors are required to disclose quantitative information about: (i) the aggregate amount of unrealized losses, and (ii) the aggregate related fair values of investments with unrealized losses, segregated into time periods during which the investment has been in an unrealized loss position of less than 12 months and greater than 12 months. In addition, investors are required to disclose the qualitative information that supports their conclusion that the impairments noted in the qualitative disclosure are not other-than temporary. In September 2004, the FASB approved FSP EITF 03-1, which defers the effective date for recognition and measurement guidance contained in EITF 03-1 until certain issues are resolved. The adoption of this EITF is not expected to have a material impact on our results of operations or financial condition.
During March 2004, the FASB issued an exposure draft of a new standard entitled Share Based Payment, which would amend Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-based Compensation, and SFAS No. 95, Statement of Cash Flows. Among other items, the new standard would require the expensing of stock options issued by the Company in the financial statements. See Note 3 for pro forma disclosures regarding the effect on income from continuing operations and earnings per share if we had applied the fair value recognition provisions of the exposure draft and SFAS No. 123. Depending on the model used to calculate stock-based compensation expense in the future, the pro forma disclosure in Note 3 may not be indicative of the stock-based compensation expense to be recognized in future financial statements. While the final statement is subject to change, it is currently anticipated it will become effective for periods beginning after June 15, 2005. We are currently in the process of evaluating this proposal.
6
Pursuant to SFAS No. 123, Accounting for Stock-Based Compensation, we apply the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, to our stock options and other stock-based compensation plans.
In accordance with APB Opinion No. 25, cost for stock-based compensation is recognized in income based on the excess, if any, of the quoted market price of the stock at the grant date of the award or other measurement date over the amount an employee must pay to acquire the stock. The exercise price for stock options granted to employees equals the fair market value of Pentair’s common stock at the date of grant, thereby resulting in no recognition of compensation expense by Pentair. Restricted stock awards are recorded as compensation cost over the requisite vesting periods based on the market value on the date of grant. Unearned compensation cost on restricted stock awards is shown as a reduction to shareholders’ equity.
The following table illustrates the effect on income from continuing operations and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation. The estimated fair value of each Pentair option is calculated using the Black-Scholes option-pricing model:
October 2
2004
September 27
2003
Income from continuing operations — as reported
Less estimated stock-based employee compensationdetermined under fair value based method, net of tax
Income from continuing operations — pro forma
Earnings per common share — continuing operations
Basic — as reported
Basic — pro forma
Diluted — as reported
Diluted — pro forma
The weighted-average fair value of options granted was $8.32 and $5.74 for the nine months ended October 2, 2004 and September 27, 2003, respectively. We estimated the fair values using the Black-Scholes option pricing model, modified for dividends, using the following assumptions:
Risk-free interest rate
Dividend yield
Expected stock price volatility
Expected lives
7
On May 17, 2004, our Board of Directors approved a 2-for-1 stock split in the form of a 100 percent stock dividend payable on June 8, 2004, to shareholders of record as of June 1, 2004. All share and per share information presented in this Form 10-Q has been retroactively restated to reflect the effect of this stock split.
Basic and diluted earnings per share from continuing operations were calculated using the following:
Weighted average common shares outstanding — basic
Dilutive impact of stock options and restricted stock
Weighted average common shares outstanding — diluted
Earnings per common share — basic
Earnings per common share — diluted
Stock options excluded from the calculation of diluted earnings per share because the effect was anti-dilutive
Effective July 31, 2004, we completed the acquisition of all of the capital stock of WICOR, Inc. (“WICOR”) from Wisconsin Energy Corporation (“WEC”) for $876.9 million in cash, including cash acquired and debt assumed of $15.5 million and $21.6 million, respectively. The acquisition was effected pursuant to a Stock Purchase Agreement, dated February 3, 2004, among the Company, WICOR and WEC. Our acquisition of WICOR, which manufactures water system, filtration and pool equipment products under the Sta-Rite, SHURflo and Hypro brands, has created a $2 billion water technology business with approximately 8,200 employees worldwide that will now be known as Pentair Water. We funded the payment of the purchase price and related fees and expenses of the WICOR acquisition with an $850 million committed line of credit (the “Bridge Facility”) and through additional borrowings available under our existing Credit Facility.
The initial allocation of purchase price for the WICOR acquisition was based on preliminary estimates and will be revised as asset valuations are finalized and further information is obtained on the fair value of liabilities.
The initial purchase price for WICOR has been allocated based on management’s estimates and independent appraisals as follows:
Estimated Fair
Value
Property, plant, and equipment
Intangibles
Other noncurrent assets
Total assets acquired
Total liabilities assumed
Net assets acquired
8
The minority interest represents joint venture interests in which we are the majority shareholder and have a third party ownership interest.
A preliminary valuation of the acquired intangible assets was performed by a third party valuation specialist to assist us in determining the fair value of each identifiable intangible. Standard valuation procedures were utilized in determining the fair value of the acquired intangibles. The following table summarizes the identified intangible asset categories and their weighted average amortization period:
Period
Patented and proprietary technology
Customer relationships
Weighted average amortization period
Indefinite-life intangible assets
Trade marks and trade names
* Approximately $70.6 million of goodwill is tax deductible.
On December 31, 2003, we acquired all of the common stock of Everpure, Inc. (“Everpure”) from United States Filter Corporation, a unit of Veolia Environnement, for $217.3 million in cash, including cash acquired of $5.5 million. Everpure is a leading global provider of water filtration products and services for the commercial and consumer sectors. Everpure products include a wide array of filtration systems and cartridges for various applications. Preliminary valuations of identifiable intangible assets acquired as part of the acquisition were $91.1 million, including $49.3 million of definite-lived intangible assets with a weighted average amortization period of 16 years. Goodwill recorded as part of the initial purchase price allocation was $105.3 million, of which approximately $104.0 million is tax deductible. During the quarter ended July 3, 2004, goodwill recorded as part of the initial purchase price allocation was adjusted to $107.7 million, an increase of $2.4 million, primarily due to a final purchase price adjustment. During the quarter ended October 2, 2004, goodwill was increased approximately $19.3 million offset mainly by a decrease in amortizable intangible assets following the determination of the final allocation of goodwill and intangible assets based on a third party valuation. We continue to evaluate the purchase price allocation of Everpure and we expect to revise it as better information becomes available in the fourth quarter of 2004.
During the year ended December 31, 2003, we also completed four product line acquisitions in our Water segment for total consideration of approximately $21.4 million in cash: Hydrotemp Manufacturing Co., Inc., Letro Products, Inc. and certain assets of TwinPumps, Inc. and K&M Plastics, Inc. The allocation of the purchase price of these four product line acquisitions resulted in goodwill of $17.3 million, all of which is tax deductible. The purchase price allocations for the four product line acquisitions have been completed with no material effect on previously recorded estimates.
The following pro forma condensed consolidated financial results of operations are presented as if the acquisitions described above had been completed at the beginning of each period presented.
Pro forma net sales
Pro forma income from continuing operations
Pro forma net income
Pro forma earnings per common share - continuing operations
9
These pro forma condensed consolidated financial results have been prepared for comparative purposes only and include certain adjustments, such as increased interest expense on acquisition debt. They do not reflect the effect of synergies that would have been expected to result from the integration of these acquisitions. The pro forma information does not purport to be indicative of the results of operations that actually would have resulted had the combination occurred at the beginning of each period presented, or of future results of the consolidated entities.
On July 16, 2004, we signed a definitive agreement to sell our Tools Group to BDK. The Tools Group comprised the Porter-Cable, Delta, DeVilbiss Air Power, Oldham Saw, and FLEX brands, among others. Tools Group products include woodworking machinery, portable power tools, power tool accessories, metal and stoneworking tools, pneumatic tools, compressors, generators, and pressure washers. The Tools Group employed approximately 4,200 people at facilities in North America, Europe and Asia.
Effective after the close of business October 2, 2004, we completed the sale of our Tools Group to BDK for approximately $796.8 million in cash, including a $21.8 million interim net asset value increase, subject to post-closing adjustments.
Our financial statements have been restated to reflect the Tools Group as a discontinued operation for all periods presented. Operating results of the discontinued Tools Group are summarized below. The amounts exclude general corporate overhead previously allocated to the Tools Group. The amounts include an allocation of interest based on a ratio of the net assets of the discontinued operations to the total net assets of Pentair.
Earnings before income taxes
Income tax expense
Earnings from operations, net of income taxes
Net assets of the discontinued Tools Group consisted of the following;
December 31
Net assets
Inventories from continuing operations were comprised of:
Raw materials and supplies
Work-in-process
Finished goods
Total inventories
The net increase in inventories is primarily the result of our acquired WICOR inventories.
10
Comprehensive income and its components, net of tax, were as follows:
In thousands
Changes in cumulative foreign currency translation adjustment
Changes in market value of derivative financial instruments classified as cash flow hedges
Comprehensive income
The net foreign currency translation gain for the three months and nine months ended October 2, 2004 resulted from the strengthening of the Euro against the U.S. dollar. The net foreign currency translation loss for the three months ended September 27, 2003 resulted primarily from the weakening Euro against the U.S. dollar. The net foreign currency translation gain for the nine months ended September 27, 2003 resulted primarily from the strengthening of the Euro against the U.S. dollar.
The change in market value of derivative financial instruments for the three months and nine months ended October 2, 2004 resulted from increasing interest rates and the passage of time toward maturity of the underlying derivative instruments. The change in market value of derivative financial instruments for the three months and nine months ended September 27, 2003 resulted from changes in the value of outstanding hedging instruments, primarily related to the Euro. Fluctuations in the value of hedging instruments are offset by changes in the cash flows of the underlying exposures being hedged.
Changes in the carrying amount of goodwill for the nine months ended October 2, 2004 by segment were as follows:
Balance December 31, 2003
Acquired
Purchase accounting adjustments
Foreign currency translation
Balance October 2, 2004
The purchase accounting adjustment in the Water segment was primarily related to a $19.3 million increase to goodwill offset mainly by a decrease in amortizable intangible assets related to the acquisition of Everpure. The adjustment was driven by the determination of the final allocation of goodwill and intangible assets based on a third party valuation.
Intangible assets, other than goodwill, are comprised of:
Finite-life intangible assets
Patents
Non-compete agreements
Proprietary technology
Total finite-life intangible assets
Trademarks
Total intangibles, net
11
Amortization expense for the nine months ended October 2, 2004 was approximately $4.4 million. On a calendar year basis, the estimated future amortization expense for identifiable intangible assets during the next five years is as follows:
Estimated amortization expense
Debt and the average interest rate on debt outstanding is summarized as follows:
Commercial paper, maturing within 41 days
Revolving credit facilities
Private placement - fixed rate
Private placement - floating rate
Senior notes
Total contractual debt obligations
Interest rate swap monetization deferred income
Fair value adjustment of hedged debt
Total long-term debt, including current portion per balance sheet
Less current maturities
Total debt
We currently have a $500 million multi-currency revolving credit facility (the “Credit Facility”) with various banks that expires on July 25, 2006. Interest rates and fees on the Credit Facility vary based on our credit ratings.
We are authorized to sell short-term commercial paper notes to the extent availability exists under the Credit Facility. We use the Credit Facility as back-up liquidity to support 100% of commercial paper outstanding. As of October 2, 2004, we had $169.6 million of commercial paper outstanding that matured within 41 days. All of the commercial paper was classified as long-term as we have the intent and the ability to refinance such obligations on a long-term basis under the Credit Facility. Availability under our Credit Facility at October 2, 2004, including outstanding commercial paper, was approximately $258 million.
Effective following the close of business on July 31, 2004, we completed the acquisition of WICOR. We funded the payment of the purchase price and related fees and expenses of the WICOR acquisition with the $850 million Bridge Facility and through additional borrowings available under our existing Credit Facility. The interest rate and facility fee on the Bridge Facility varies based on our credit rating. Based on our existing credit rating, the interest rate on the Bridge Facility and loans under the Credit Facility during the period of the Bridge Facility is LIBOR plus 1.375%. Upon the settlement of the Bridge Facility, the interest rate on loans under the Credit Facility is LIBOR plus 1.125%.
On October 4, 2004, we received approximately $796.8 million of proceeds from the sale of our Tools Group to BDK. As required under the terms of the Bridge Facility, we used the proceeds from the Tools Group sale to pay down the Bridge Facility. We repaid the remainder of the Bridge Facility with availability under the Credit Facility.
We were in compliance with all debt covenants as of October 2, 2004.
In addition to the Credit Facility, we have $40 million of uncommitted credit facilities, under which we had no borrowings as of October 2, 2004.
12
Long-term debt outstanding at October 2, 2004, matures on a calendar year basis by contractual debt maturity as follows (excluding effects of the Bridge Facility):
Contractual long-term debt obligation maturities
Other maturities
Total maturities
Components of net periodic benefit cost for the three months and nine months ended October 2, 2004 and September 27, 2003 are as follows:
Service cost
Interest cost
Expected return on plan assets
Amortization of transition obligation
Amortization of prior year service cost (benefit)
Recognized net actuarial loss
Net periodic benefit cost
Employer Contributions
We previously disclosed in our financial statements for the year ended December 31, 2003, that we expected to make contributions in the range of $10 million to $15 million to our pension plans in 2004 and we believe the expected contribution range continues to be appropriate.
13
Financial information by reportable segment for the three months and nine months ended October 2, 2004 and September 27, 2003 are shown below:
Net sales to external customers
Water
Enclosures
Consolidated
Intersegment sales
Operating income (loss)
Capital Expenditures
Other operating loss is primarily composed of unallocated corporate expenses, our captive insurance subsidiary, intermediate finance companies, divested operations, and intercompany eliminations.
Identifiable assets by reportable segment are shown below:
14
The following table presents certain net sales geographic information:
North America
Europe
Asia and Other
Net sales are based on the location in which the sale originated. No foreign country’s net sales to unaffiliated customers were material.
Operating lease commitments
Net rental expense under operating leases for the nine months ended October 2, 2004 and September 27, 2003 is as follows:
Gross rental expense
Sublease rental expense
Net rental expense
Future minimum lease commitments under non-cancelable operating leases, principally related to facilities, vehicles, and machinery and equipment, is as follows:
Minimum sublease rentals
Net future minimum lease
commitments
Environmental
We have been named as defendants, targets, or potentially responsible parties (PRPs) in a small number of environmental cleanups, in which our current or former business units have generally been given de minimis status. To date, none of these claims have resulted in cleanup costs, fines, penalties, or damages in an amount material to our financial position or results of operations. We have disposed of a number of businesses over the past 10 years and in certain cases, such as the disposition of the Cross Pointe Paper Corporation uncoated paper business in 1995, the Federal Cartridge Company ammunition business in 1997, and Lincoln Industrial in 2001, we have retained responsibility and potential liability for certain environmental obligations. We have received claims for indemnification from purchasers both of the paper business and the ammunition business and have established what we believe to be adequate accruals for potential liabilities arising out of retained responsibilities. We have recently settled one such claim in 2003 and our recorded accrual was adequate.
In addition, there are pending environmental issues concerning a limited number of sites, including one site acquired in the acquisition of Essef Corporation in 1999 that relates to operations no longer carried out at that site. We have established what we believe to be adequate accruals for remediation costs at this and other sites. We do not believe that projected response costs will result in a material liability.
We may be named as a PRP at other sites in the future, for both divested and acquired businesses. When it has been possible to provide reasonable estimates of our liability with respect to environmental sites, provisions have been made in accordance with accounting principles generally accepted in the United States of America. As of October 2, 2004, our reserve for such environmental liabilities was approximately $9.5 million, measured on an undiscounted basis. We cannot ensure that environmental requirements will not change or become more stringent over time or that our eventual environmental cleanup costs and liabilities will not exceed the amount of our current reserves.
15
Litigation
We are occasionally a party to litigation arising in the normal course of business. We regularly analyze current information and, as necessary, provide accruals for probable liabilities based on the expected eventual disposition of these matters. We believe the effect on our consolidated results of operations and financial position, if any, for the disposition of all currently pending matters will not be material.
Warranties and guarantees
From time to time in connection with the disposition of businesses or product lines, Pentair may agree to indemnify purchasers for various potential liabilities relating to the sold business, such as pre-closing tax, product liability, warranty, environmental, or other obligations. The subject matter, amounts, and duration of any such indemnification obligations vary for each type of liability indemnified and may vary widely from transaction to transaction.
We accrue for costs associated with guarantees when it is probable that a liability has been incurred and the amount can be reasonably estimated. The most likely cost to be incurred is accrued based on an evaluation of currently available facts, and where no amount within a range of estimates is more likely, the minimum is accrued.
We have guaranteed the indebtedness of a customer, whose outstanding debt at October 2, 2004 and December 31, 2003 was $1.7 million and $2.0 million, respectively. The debt amount is a declining balance and scheduled to be paid in full by June 2007. The liability relating to the guarantee is not material.
We provide service and warranty policies on our products. Liability under service and warranty policies is based upon a review of historical warranty and service claim experience. Adjustments are made to accruals as claim data and historical experience warrant. In addition, we incur discretionary costs to service our products in connection with product performance issues.
The changes in the carrying amount of service and product warranties from continuing operations for the nine months ended October 2, 2004 and September 27, 2003 are as follows:
Balance at beginning of the period
Service and product warranty provision
Payments
Warranty liabilities acquired
Translation
Balance at end of the period
The $250 million Senior Notes due 2009 are jointly and severally guaranteed by domestic subsidiaries (the “Guarantor Subsidiaries”), each of which is directly or indirectly wholly-owned by Pentair (the “Parent Company”). The following supplemental financial information sets forth the condensed consolidated balance sheets as of October 4, 2004 and December 31, 2003, the related condensed consolidated statements of income for the three-month and nine-month periods ended October 2, 2004 and September 27, 2003, and statements of cash flows for the nine-month periods ended October 2, 2004 and September 27, 2003, for the Parent Company, the Guarantor Subsidiaries, the non-guarantor subsidiaries and total consolidated Pentair and subsidiaries.
16
Unaudited Condensed Consolidated Statements of Income
For the three months ended October 2, 2004
Operating (loss) income
Net interest (income) expense
For the nine months ended October 2, 2004
17
Unaudited Condensed Consolidated Balance Sheets
October 2, 2004
Investments in subsidiaries
Liabilities and Shareholders’ Equity
Due to / (from) affiliates
18
Unaudited Condensed Consolidated Statements of Cash Flows
Operating activities
Adjustments to reconcile net income to net cash provided by operating activities:
Other amortization
Changes in assets and liabilities, net of effects of business acquisitions and dispositions
Investing activities
Investment in subsidiaries
Financing activities
Effect of exchange rate changes on cash
19
For the three months ended September 27, 2003
For the nine months ended September 27, 2003
20
December 31, 2003
21
22
Effective after the close of business October 2, 2004, we completed the sale of our Tools Group to BDK for approximately $796.8 million in cash, including a $21.8 million interim net asset value increase, subject to post-closing adjustments. The disposition was effected pursuant to a Purchase Agreement between BDK and Pentair dated July 16, 2004. We used the proceeds from the Tools Group sale to repay the $850 million Bridge Facility used to acquire WICOR. We repaid the remainder of the Bridge Facility through borrowings under our Credit Facility on October 4, 2004. We retained certain insurance liabilities, employee compensation and benefit liabilities, environmental liabilities, long-term debt, pension obligations and post-retirement obligations of the Tools Group.
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This report contains statements that we believe to be “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements give our current expectations or forecasts of future events. Forward-looking statements generally can be identified by the use of forward-looking terminology such as “may,” “will,” “expected,” “intend,” “estimate,” “anticipate,” “believe,” “project,” or “continue,” or the negative thereof or similar words. From time to time, we also may provide oral or written forward-looking statements in other materials we release to the public. Any or all of our forward-looking statements in this report and in any public statements we make could be materially different from actual results. They can be affected by assumptions we might make or by known or unknown risks or uncertainties. Consequently, we cannot guarantee any forward-looking statements. Investors are cautioned not to place undue reliance on any forward-looking statements. Investors should also understand that it is not possible to predict or identify all such factors and should not consider the following list to be a complete statement of all potential risks and uncertainties.
The following factors may impact the achievement of forward-looking statements:
The foregoing factors are not exhaustive, and new factors may emerge or changes to the foregoing factors may occur that would impact our business. We assume no obligation, and disclaim any duty, to update the forward-looking statements in this report.
Overview
We are a focused diversified industrial manufacturer operating in two segments: Water and Enclosures. Our Water segment manufactures and markets essential products and systems used in the movement, treatment, storage and enjoyment of water and generated 67 percent of total revenues in the first nine months of 2004. Our Enclosures segment designs, manufactures and markets standard, modified and custom enclosures that protect sensitive controls and components for markets that include industrial machinery, data communications, networking, telecommunications, test and measurement, automotive, medical, security, defense, and general electronics. Our Enclosures segment accounted for 33 percent of total revenues in the first nine months of 2004.
Our Water segment has progressively become a more important part of our business portfolio with sales increasing from $100 million in 1995 to approximately $1.1 billion in 2003. We have identified a target market totaling $50 billion, representing a portion of the $350 billion global water market. We continue to capitalize on growth opportunities in the water industry as evidenced by four product line acquisitions in our Water segment in 2003 as well as the acquisition of Everpure on December 31, 2003 and year-over-year sales growth, exclusive of acquisitions and favorable currency translation, in the first nine months of 2004. Effective July 31, 2004, we completed the acquisition of all of the shares of capital stock of WICOR, Inc. (“WICOR”) from Wisconsin Energy Corporation (“WEC”), for $876.9 million in cash, including cash acquired and debt assumed of $15.5 million and $21.6 million, respectively. Our acquisition of WICOR, which manufactures water system, filtration and pool equipment products under the Sta-Rite, SHURflo and Hypro brands, has helped create a $2 billion water technology business with approximately 8,200 employees worldwide that will now be known as Pentair Water.
Our Enclosures segment operates in a large global market with significant room for growth in industry niches such as defense, security, medical, and networking. We believe we have the largest industrial and commercial distribution network in North America and highest brand recognition in the industry. During 2001 and 2002, the Enclosures segment experienced significantly lower sales volumes as a result of severely reduced capital spending in the industrial market and over-capacity and weak demand in the datacom and telecom markets.
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However, this segment experienced growth in 2003 and the first nine months of 2004 across the electrical and electronic markets and we believe it is well positioned to continue to improve performance. In addition, through the success of our Pentair Integrated Management System (PIMS) and supply management initiatives, we have increased Enclosures segment sequential margins for eleven consecutive quarters.
Effective after the close of business October 2, 2004, we completed the sale of our Tools Group to The Black & Decker Corporation (“BDK”) for approximately $796.8 million in cash, including a $21.8 million interim net asset value increase, subject to post-closing adjustments. The disposition was effected pursuant to a Purchase Agreement between BDK and Pentair dated July 16, 2004. We used the proceeds from the Tools Group sale to repay the $850 million committed line of credit (the “Bridge Facility”) used to acquire WICOR. We repaid the remainder of the Bridge Facility through borrowings under our Credit Facility on October 4, 2004. We retained certain insurance liabilities, employee compensation and benefit liabilities, environmental liabilities, long-term debt, pension obligations and post-retirement obligations of the Tools Group.
Key Trends and Uncertainties
The following trends and uncertainties affected our financial performance in the first nine months of 2004:
Outlook
In the fourth quarter of 2004 and beyond, our operating objectives include the following:
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RESULTS OF OPERATIONS
Consolidated net sales and the change from the prior year period were as follows:
Net sales as reported
The components of the net sales change in 2004 from 2003 were as follows
Volume
Price
Currency
Total
Consolidated net sales
The 45.8 percent and 31.4 percent increases in consolidated net sales in the third quarter and first nine months of 2004 from 2003 were primarily driven by:
Sales by segment and the change from the prior year period were as follows:
The 57.5 percent and 35.4 percent increases in Water segment net sales in the third quarter and first nine months of 2004 from 2003 were primarily driven by:
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The 24.0 percent and 23.8 percent increases in Enclosures segment net sales in the third quarter and first nine months of 2004 from 2003 were primarily driven by:
Percentage point change
The 1.4 percentage point and 2.1 percentage point increases in gross profit as a percent of sales in the third quarter and first nine months of 2004 from 2003 were primarily the result of:
These increases were partially offset by:
Selling, general and administrative (SG&A)
SG&A
The 1.6 percentage point and 1.1 percentage point increases in SG&A expense as a percent of sales in the third quarter and first nine months of 2004 from 2003 were primarily due to:
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Research and development (R&D)
R&D
The unchanged R&D expense as a percent of sales in the third quarter and first nine months of 2004 from 2003 was primarily due to:
The 2.3 percentage point and 0.3 percentage point decreases in Water segment operating income as a percent of sales in the third quarter and first nine months of 2004 from 2003 were primarily the result of:
These decreases were partially offset by:
The 3.5 percentage point and 3.8 percentage point increases in Enclosures segment operating income as a percent of sales in the third quarter and first nine months of 2004 from 2003 were primarily the result of:
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The 102.0 percent and 41.7 percent increases in interest expense in the third quarter and first nine months of 2004 from 2003 were primarily the result of:
Provision for income taxes from continuing operations
Effective tax rate
The 5.5 percent and 3.3 percent increases in the tax rate in the third quarter and first nine months of 2004 from 2003 were primarily the result of:
We expect our full year effective tax rate in 2004 to be 35 percent and we expect a 100 basis point increase in our effective tax rate in 2005 to 36 percent. We will continue to pursue tax rate reduction opportunities.
LIQUIDITY AND CAPITAL RESOURCES
Cash requirements for working capital, capital expenditures, equity investments, acquisitions, debt repayments, and dividend payments are generally funded from cash generated from operations, availability under existing committed revolving credit facilities, and in certain instances, public and private debt and equity offerings.
The following table presents selected working capital measurements calculated from our monthly operating results based on a 13-month moving average and indicates our emphasis on working capital management:
Days of sales in accounts receivable
Days inventory on hand
Days in accounts payable
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Cash provided by operating activities was $197.7 million in the first nine months of 2004, or $19.4 million higher compared with the same period in 2003. The increase was primarily attributable to an increase in net income. Working capital productivity improved, even with a 13 percent increase in organic sales growth and higher initial levels of working capital within WICOR. In the future, we expect WICOR to increase our working capital ratios until our post-acquisition integration activities are farther along and our PIMS initiatives are established.
Capital expenditures in the first nine months of 2004 were $28.6 million compared with $29.7 million in the prior year period. We anticipate capital expenditures for fiscal 2004 to be approximately $40 to $45 million, primarily for new product development, selective increases in equipment capacity and general maintenance capital.
Effective July 31, 2004, we completed the acquisition of all of the shares of capital stock of WICOR from WEC, for $876.9 million in cash, including cash acquired and debt assumed of $15.5 million and $21.6 million, respectively.
On April 5, 2004, we acquired all of the remaining stock of the Tools Group’s Asian joint venture for $21.8 million in cash, $6.4 million of which is to be paid 15 days following the sale of the Tools Group, plus contingent payments based on future sales and return on sales. The level of return on sales targets achieved in the second quarter required a payment of $0.9 million, which has been recorded as an increase to goodwill. The acquisition included cash acquired of $6.2 million and debt assumed of $9.0 million. The investment in the Tools Group’s Asian joint venture business is currently recorded as part of discontinued operations.
In the second quarter of 2004, we paid $3.9 million in purchase price adjustments related to the December 31, 2003 acquisition of Everpure. The adjustment primarily related to the final determination of closing date net assets.
In the first quarter of 2004, we paid $2.3 million for acquisition fees primarily related to the December 31, 2003 acquisition of Everpure.
During the first nine months of 2003, we completed four product line acquisitions for total consideration of approximately $21.4 million in cash including transaction costs.
In the first quarter of 2003, we received $1.9 million in purchase price adjustments related to our fourth quarter 2002 acquisition of Plymouth Products. The adjustment primarily related to final determination of closing date net assets.
In January 2003, we paid $2.4 million for a final adjustment to the selling price related to the disposition of Lincoln Industrial. This had no effect on earnings in 2003 as the amount was offset by previously established reserves.
Net cash provided by financing activities was $738.4 million in the first nine months of 2004 compared with net cash used by financing activities of $102.5 million in the first nine months of 2003. Financing activities included the utilization of the $850 million committed line of credit (the “Bridge Facility”) to fund the WICOR acquisition, draw downs and repayments on our revolving credit facilities to fund our operations in the normal course of business, dividends paid and cash received from stock option exercises.
Effective following the close of business on July 31, 2004, we completed the acquisition of WICOR. We funded the payment of the purchase price and related fees and expenses of the WICOR acquisition with the Bridge Facility and through additional borrowings available under our existing Credit Facility. The interest rate on the Bridge Facility and loans under the Credit Facility during the period of the Bridge Facility was LIBOR plus 1.375%.
On October 4, 2004, we received approximately $796.8 million of proceeds from the sale of our Tools Group to BDK. As required under the terms of the Bridge Facility, we used the proceeds from the Tools Group sale to pay down the Bridge Facility. We repaid the remainder of the Bridge Facility with availability under the Credit Facility. Upon the pay off of the Bridge Facility and based on our existing credit rating, the interest rate on loans under the Credit Facility is LIBOR plus 1.125%.
As a result of our announcement of an agreement to acquire WICOR in February 2004, Moody’s Investor Services confirmed the long-term rating for our Credit Facilities of Baa3 and changed our outlook to negative from stable. At the same time, Standard and Poor’s Rating Services placed our BBB corporate credit and other ratings on CreditWatch with negative implications. Following the completion of the
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sale of our Tools Group to BDK, Standard and Poor’s Rating Services affirmed our BBB corporate credit and other ratings, removed the CreditWatch and changed our outlook to negative. The change in rating outlook to negative from stable was a reflection of Standard and Poor’s concern over integration risks associated with the acquisition of WICOR and an acquisitive growth strategy.
Also in February 2004, Moody’s Investor Services placed the Baa3 senior unsecured rating on our $250 million notes and the Baa3 rating on our senior notes under our $225 million shelf registration under review for possible downgrade, due to structural subordination thereof. Existing lenders under our Credit Facility and private placement notes benefit from guarantees from our domestic subsidiaries, while the $250 million senior note holders historically did not benefit from such guarantees. In connection with the closing of the WICOR acquisition, our domestic subsidiaries executed a similar guarantee for the benefit of the $250 million senior note holders to avoid the downgrade due to the structural subordination.
As of October 2, 2004, our capital structure consisted of $1,597.6 million in total indebtedness and $1,390.0 million in shareholders’ equity. The ratio of debt-to-total capital at October 2, 2004 was 53.5 percent, compared with 39.0 percent at December 31, 2003 and 35.6 percent at September 27, 2003. Our targeted debt-to-total capital ratio is approximately 40 percent. As of October 2, 2004, we exceeded this targeted ratio due to the timing difference between the acquisition of WICOR and our disposition of the Tools Group. On October 4, 2004, we received approximately $796.8 million of proceeds from the sale of our Tools Group to BDK. As required under the terms of the Bridge Facility, we used the proceeds from the Tools Group sale to pay down the $850 million Bridge Facility. We repaid the remainder of the Bridge Facility with availability under the Credit Facility. Adjusting for the $796.8 million of proceeds received from the October 4, 2004 sale of our Tools Group, our pro forma debt-to-capital ratio would be approximately 37.0 percent, below our targeted debt-to-capital ratio of 40.0 percent.
We expect to continue to have cash requirements to support working capital needs and capital expenditures, to pay interest and service debt and to pay dividends to shareholders. In order to meet these cash requirements, we intend to use available cash and internally generated funds and to borrow under our committed and uncommitted credit facilities.
Dividends paid in the first nine months of 2004 were $32.0 million or $0.320 per common share compared with $30.1 million or $0.305 per common share in the prior year period. We anticipate the continuation of the practice of paying dividends on a quarterly basis.
The following summarizes our significant contractual obligations that impact our liquidity:
Long-term debt obligations
Capital lease obligations
Operating lease obligations, net of sublease rentals
Purchase obligations
Other long-term liabilities
Total contractual cash obligations, net
A purchase obligation is defined as an agreement to purchase goods or services that is enforceable and legally binding on us that specifies all significant terms. The purchase obligation amounts do not represent our total anticipated future purchases, but represent those purchases for which we are contractually obligated. As of October 2, 2004, we did not have any purchase obligations requiring cash outflows of $1 million or greater per year.
Pension
Other financial measures
In addition to measuring our cash flow generation or usage based upon operating, investing, and financing classifications included in the consolidated statements of cash flows, we also measure our free cash flow. Free cash flow is a non-GAAP financial measure that we use to assess our cash flow performance and have a long-term goal to consistently generate free cash flow that equals or exceeds 100 percent conversion of net income. We believe free cash flow is an important measure of operating performance because it provides us and our investors a measurement of cash generated from operations that is available to pay dividends and repay debt. In addition, free cash flow is
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used as one criterion to measure and pay compensation-based incentives. The following table is a reconciliation of free cash flow with cash flows from continuing and discontinued operating activities:
Cash flow provided by operating activities
Capital expenditures continuing operations
Capital expenditures discontinued operations
Free Cash Flow
We expect 2004 free cash flow to be approximately $200 million.
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NEW ACCOUNTING STANDARDS
See Note 2 (New Accounting Standards) of ITEM 1.
CRITICAL ACCOUNTING POLICIES
In our Annual Report on Form 10-K for the year ended December 31, 2003, we identified the critical accounting policies which affect our more significant estimates and assumptions used in preparing our consolidated financial statements. We have not changed these policies from those previously disclosed in our annual report.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest rate risk
Effective following the close of business on July 31, 2004, we completed the acquisition of WICOR. We funded the payment of the purchase price and related fees and expenses of the WICOR acquisition with the Bridge Facility and through additional borrowings available under our existing Credit Facility. The interest rate on the Bridge Facility and loans under the Credit Facility during the period of the Bridge Facility, was LIBOR plus 1.375%.
On October 4, 2004, we received approximately $796.8 million of proceeds from the sale of our Tools Group to BDK. As required under the terms of the Bridge Facility, we used the proceeds from the Tools Group sale to pay down the Bridge Facility. We repaid the remainder of the Bridge Facility with availability under the Credit Facility. Upon the settlement of the Bridge Facility and based on our existing credit rating, the interest rate on loans under the Credit Facility is LIBOR plus 1.125%.
There have been no other material changes in our market risk during the quarter ended October 2, 2004. For additional information, refer to Item 7A of our 2003 Annual Report on Form 10-K.
ITEM 4. CONTROLS AND PROCEDURES
We maintain a system of disclosure controls and procedures designed to provide reasonable assurance as to the reliability of our published financial statements and other disclosures included in this report. Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the quarter ended October 2, 2004 pursuant to Rule 13a-15(b) of the Securities Exchange Act of 1934. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the quarter ended October 2, 2004 in timely alerting them to material information relating to Pentair, Inc. (including its consolidated subsidiaries) required to be included in reports we file with the Securities and Exchange Commission.
There was no change in our internal control over financial reporting that occurred during the quarter ended October 2, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders of Pentair, Inc.
We have reviewed the accompanying condensed consolidated balance sheets of Pentair, Inc. and Subsidiaries (the “Company”) as of October 2, 2004 and September 27, 2003, the related condensed consolidated statements of income for the three-month and nine-month periods ended October 2, 2004 and September 27, 2003, and cash flows for the nine-month periods ended October 2, 2004 and September 27, 2003. These interim financial statements are the responsibility of the Company’s management.
We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should be made to such condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.
We have previously audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of the Company as of December 31, 2003, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for the year then ended (not presented herein); and in our report dated March 4, 2004, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2003 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
DELOITTE & TOUCHE LLP
Minneapolis, Minnesota
November 11, 2004
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PART II OTHER INFORMATION
ITEM 1. Legal Proceedings
Environmental and Product Liability Claims
There have been no further material developments regarding the above from that contained in our 2003 Annual Report on Form 10-K.
ITEM 2. Unregistered Sales of Equity Securities, Use of Proceeds and Issuer Purchases of Equity Securities
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on November 11, 2004.
PENTAIR, INC.
Registrant
By
/s/ David D. Harrison
David D. Harrison
Executive Vice President and Chief Financial Officer
(Chief Accounting Officer)
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