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 1, 2005
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 ¨
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
On November 8, 2005, 101,182,879 shares of the Registrant’s common stock were outstanding.
Pentair, Inc. and Subsidiaries
Part I Financial Information
Part II Other Information
Signature
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PART I FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Condensed Consolidated Statements of Income (Unaudited)
Net sales
Cost of goods sold
Gross profit
Selling, general and administrative
Research and development
Operating income
Gain on sale of investment
Net interest expense
Income from continuing operations 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
Diluted earnings per common share
Weighted average common shares outstanding
Cash dividends declared per common share
See accompanying notes to condensed consolidated financial statements.
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Condensed Consolidated Balance Sheets (Unaudited)
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
Non-current 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
Accrued rebates and sales incentives
Other current liabilities
Total current liabilities
Long-term debt
Pension and other retirement compensation
Post-retirement medical and other benefits
Deferred tax liabilities
Other non-current liabilities
Non-current liabilities of discontinued operations
Total liabilities
Commitments and contingencies
Shareholders’ equity
Common shares par value $0.16 2/3; 101,884,698, 100,967,385, and 100,159,018 shares issued and outstanding, respectively
Additional paid-in capital
Retained earnings
Unearned restricted stock compensation
Accumulated other comprehensive income
Total shareholders’ equity
Total liabilities and shareholders’ equity
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Condensed Consolidated Statements of Cash Flows (Unaudited)
Operating activities
Adjustments to reconcile net income to net cash provided by operating activities
Net income from discontinued operations
Depreciation
Amortization
Deferred income taxes
Stock compensation
Changes in assets and liabilities, net of effects of business acquisitions and dispositions
Accounts and notes receivable
Pension and post-retirement benefits
Other assets and liabilities
Net cash provided by continuing operations
Net cash (used for) provided by operating activities of discontinued operations
Net cash provided by operating activities
Investing activities
Capital expenditures
Proceeds from sale of property and equipment
Acquisitions, net of cash acquired
Divestitures
Proceeds from sale of investment
Net cash used for investing activities
Financing activities
Net short-term borrowings
Proceeds from long-term debt
Repayment of long-term debt
Proceeds from exercise of stock options
Dividends paid
Net cash (used for) provided by 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
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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 2004 Annual Report on Form 10-K for the year ended December 31, 2004.
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.
Certain reclassifications have been made to prior years’ consolidated financial statements to conform to the current year’s presentation.
In December 2004, the FASB issued Statement of Financial Accounting Standard (SFAS) No. 123R (revised 2004), Share-Based Payment, which replaces SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. On April 14, 2005, the SEC announced a deferral of the effective date of SFAS No. 123R for calendar year companies until the beginning of 2006. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. The pro forma disclosures permitted under SFAS No. 123 no longer will be an alternative to financial statement recognition. Under SFAS No. 123R, we must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. SFAS No. 123R permits a prospective or two retrospective versions of application, under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods by the original SFAS No. 123 either as of the beginning of the year of adoption or for all periods presented. We are required to adopt SFAS No. 123R no later than the first quarter of fiscal 2006, and continue to evaluate early adoption in the fourth quarter of 2005. Upon adoption, we will begin recognizing an expense for unvested share-based compensation that has been issued or will be issued after the adoption date. We have not yet determined the transition option we will utilize to adopt SFAS No. 123R. The adoption of SFAS No. 123R will have an impact on our consolidated results of operations and earnings per share. The exact impact of SFAS No. 123R cannot be quantified at this time because it will depend on the level of share-based payments granted in the future and the method used to value such awards, estimated compensation expense for prior periods can be found below in “Stock-based Compensation”.
In November 2004, the FASB issued SFAS No. 151, Inventory Costs—An Amendment of ARB No. 43, Chapter 4. SFAS No. 151 amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Among other provisions, SFAS No. 151 requires that items such as idle facility expense, excessive spoilage, double freight, and rehandling costs be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal” as stated in ARB No. 43. Additionally, SFAS No. 151 requires that the allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No 151 is effective for fiscal years beginning after June 15, 2005 and is required to be adopted by us on January 1, 2006. We are currently evaluating the impact the adoption of SFAS No. 151 will have on our consolidated results of operations and financial condition, but do not expect SFAS No. 151 to have a material impact.
In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets—An Amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions. SFAS No. 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, Accounting for Nonmonetary Transactions, and replaces it with an exception for exchanges that do not have commercial substance. SFAS No. 153 specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153 is effective for the fiscal periods beginning after June 15, 2005 and was required to be adopted by us in the third quarter of fiscal 2005. The adoption of SFAS No. 153 did not have a material impact on our consolidated financial position, results of operations or cash flow.
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Pursuant to SFAS No. 123, Accounting for Stock-Based Compensation, we apply the recognition and measurement principles of 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 our common stock at the date of grant, thereby resulting in no recognition of compensation expense by us. However, from time to time, we have elected to modify the terms of the original grant. Those modified grants have been accounted for as a new award and are measured using the intrinsic value method under APB Opinion No. 25, resulting in the inclusion of compensation expense in our consolidated statement of income. 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 net income 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 option to purchase our common stock is calculated using the Black-Scholes option-pricing model:
Plus stock-based employee compensation included in net income, net of tax
Less estimated stock-based employee compensation determined under fair value based method, net of tax
Net income — pro forma
Basic — as reported
Basic — pro forma
Diluted — as reported
Diluted — pro forma
The pro forma amounts shown above are not indicative of the pro forma effect in future years since the estimated fair value of options is amortized to expense over the vesting period, and the number of options granted varies from year to year.
The weighted-average fair value of options granted was $11.45 and $8.32 for the nine months ended October 1, 2005 and October 2, 2004, respectively. We estimated the fair values using the Black-Scholes option pricing model, modified for dividends, using the following assumptions:
Expected stock price volatility
Expected life
Risk-free interest rate
Dividend yield
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These estimates require us to make assumptions based on historical results, observance of trends in our stock price, changes in option exercise behavior, future expectations, and other relevant factors. If other assumptions had been used, stock-based compensation expense, as calculated and recorded under SFAS No. 123, could have been impacted.
Beginning in the first quarter of 2005, we refined our estimates of the expected option life and expected stock price volatility following the increase in our stock price and increase in exercise activity in the first half of 2005. As a result of our analysis, we decreased our estimate of the expected life of new options granted to employees from approximately 5.0 years to 3.6 years. We based the expected life assumption on historical experience as well as the terms and vesting periods of the options granted. For purposes of determining expected volatility, we considered a rolling-average of historical volatility measured over a period approximately equal to the expected option term.
The risk-free rate for periods that coincide with the expected life of the options is based on the U.S. Treasury Department yield curve in effect at the time of grant.
Basic and diluted earnings per share were calculated using the following:
Earnings per common share — basic
Earnings per common share — diluted
Weighted average common shares outstanding — basic
Dilutive impact of stock options and restricted stock
Weighted average common shares outstanding — diluted
Stock options excluded from the calculation of diluted earnings per share because the exercise price was greater than the average market price of the common shares
On February 23, 2005, we acquired certain assets of Delta Environmental Products, Inc. and affiliates (collectively, “DEP”), a privately-held company, for $10.2 million, including a cash payment of $10.0 million, transaction costs of $0.1 million, and debt assumed of $0.1 million. The DEP product line addresses the water and wastewater markets and is part of our Water Group. Goodwill recorded as part of the initial purchase price allocation was $9.3 million, all of which is tax deductible. During the second and third quarter of 2005, we recorded additional transaction costs of $0.2 million. We continue to evaluate the purchase price allocation for the DEP acquisition.
Effective July 31, 2004, we completed the acquisition of all of the capital stock of WICOR, Inc. (“WICOR”) from Wisconsin Energy Corporation for $889.6 million, including a third quarter 2004 cash payment of $871.1 million, cash acquired of $15.5 million, transaction costs of $5.8 million, and debt assumed of $21.6 million. In the fourth quarter of 2004, we received a $14.0 million final purchase price adjustment, a $0.3 million decrease in cash acquired, and recorded an additional $5.1 million in transaction costs. In the first three quarters of 2005, we recorded an additional $0.4 million in transaction costs.
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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 from continuing operations
Pro forma net income from continuing operations
Pro forma earnings per common share—continuing operations
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.
Inventories were comprised of:
Raw materials and supplies
Work-in-process
Finished goods
Total inventories
The net increase in inventories from the third quarter of 2004 was primarily the result of increased sourcing out of Asia, plant rationalization activities, and higher value of inventories due to rising raw material input costs.
Comprehensive income and its components, net of tax, were as follows:
Changes in cumulative foreign currency translation adjustment
Changes in market value of derivative financial instruments classified as cash flow hedges
Comprehensive income
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Changes in the carrying amount of goodwill for the nine months ended October 1, 2005 by segment were as follows:
Balance at December 31, 2004
Acquired
Purchase accounting adjustments
Foreign currency translation
Balance at October 1, 2005
The acquired goodwill in the Water segment is related to our acquisition of DEP during the first quarter of 2005.
Purchase accounting adjustments recorded during 2005 relate to the WICOR and DEP acquisitions. During the third quarter of 2005, we finalized our evaluation of the purchase price allocation for the WICOR acquisition. The final third quarter adjustments included contingent liabilities, reserves for plant rationalizations, and deferred income taxes.
Intangible assets, other than goodwill, are comprised of:
Finite-life intangibles
Patents
Non-compete agreements
Proprietary technology
Customer relationships
Total finite-life intangibles
Indefinite-life intangibles
Brand names
Total intangibles, net
Intangible asset amortization expense for the nine months ended October 1, 2005 and October 2, 2004 was approximately $8.6 million and $4.4 million, respectively. 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
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Debt and the average interest rate on debt outstanding is summarized as follows:
Commercial paper, maturing within 56 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
As of October 1, 2005, we had a multi-currency revolving Credit Facility (the “Credit Facility”) of $800 million expiring on March 4, 2010. The interest rate on the loans under the $800 million Credit Facility is LIBOR plus 0.625%. Interest rates and fees on the Credit Facility vary based on our credit ratings.
In July 2005, we amended our floating rate private placement note purchase agreement, decreasing the interest rate on the notes by .550% to LIBOR plus .600%. Additionally, the amendment extended the prepayment provisions of the note purchase agreement permitting prepayment on or after July 25, 2006.
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 1, 2005, we had $152.2 million of commercial paper outstanding that matured within 56 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.
We were in compliance with all debt covenants as of October 1, 2005.
In addition to the Credit Facility, we have $25 million of uncommitted credit facilities, under which we had no borrowings as of October 1, 2005.
Long-term debt outstanding at October 1, 2005, matures on a calendar year basis by contractual debt maturity as follows:
Contractual long-term debt obligation maturities
Other maturities
Total maturities
In September, 2005, we entered into a $100 million interest rate swap agreement with several major financial institutions to exchange variable rate interest payment obligations for fixed rate obligations without the exchange of the underlying principle amounts in order to manage interest rate exposures. The effective date of the fixed rate swap is April 2006. The swap agreement has a fixed interest rate of 4.68% and expires in July 2013. The fixed interest rate of 4.68% plus the .60% interest rate spread over LIBOR, results in a total fixed interest rate of 5.28%. The fair value of the swap at October 1, 2005 was $0.
The variable to fixed interest rate swap is designated as and is effective as a cash-flow hedge. The fair value of the swap will be recorded on the balance sheet, with changes in fair values included in Other Comprehensive Income (“OCI”). Derivative gains and losses included in OCI are reclassified into earnings at the time the related interest rate expense is recognized or the settlement of the related commitment occurs.
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As part of our sale of Lincoln Industrial Corporation in 2001, we received 37,500 shares of 5% Series C Junior Convertible Redeemable Preferred Stock convertible into a 15 percent equity interest in the new organization – LN Holdings Corporation. During the second quarter of 2005, we sold our interest in the stock of LN Holdings Corporation for cash consideration of $23.6 million, resulting in a pre-tax gain of $5.2 million. The terms of the sale agreement establish two escrow accounts totaling $14 million to be used for payment of any potential adjustments to the purchase price, transaction expenses, and indemnification for certain losses such as environmental claims. After any such payments are made from the escrow accounts, any remaining escrow balances are to be distributed by April 2008 to the former shareholders in accordance with their ownership percentages. Any funds received from settlement of escrows in future periods will be accounted for as additional gain on the sale of this interest.
The provision for income taxes consists of provisions for federal, state and foreign income taxes. We operate in an international environment with operations in various locations outside the U.S. Accordingly, the consolidated income tax rate is a composite rate reflecting the earnings in the various locations and the applicable rates.
The effective income tax rate for the nine months ended October 1, 2005 was 35.4% compared to 35.0% for the nine months ended October 2, 2004. The year-to-date 2005 tax rate includes a $1 million third quarter favorable accrual adjustment related to the filing of the 2004 Federal tax return, and a first quarter favorable settlement of an IRS examination for the periods 1998-2001 resulting in a release of tax contingency reserves in the amount of $1.3 million. This is offset by a second quarter adjustment for an anticipated unfavorable settlement of $3.2 million related to a routine German tax examination for prior years. We estimate our effective income tax rate for the remainder of this year will be 35.0%, resulting in a 2005 full year effective annual rate of 35.0%. This estimate includes our initial analysis of the anticipated impact of the American Jobs Creation Act. This impact may be adjusted as we refine our calculations and as additional guidance is received from the U.S. Treasury Department or Congress.
Components of net periodic benefit cost for the three and nine months ended October 1, 2005 and October 2, 2004 were 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
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Employer Contributions
We previously disclosed in our financial statements for the year ended December 31, 2004 that we expected to make contributions in the range of $5 million to $10 million to our pension plans in 2005. We believe the expected contribution range continues to be appropriate.
Financial information by reportable segment of continuing operations for the three and nine months ended October 1, 2005 and October 2, 2004 is shown below:
Net sales to external customers
Water
Enclosures
Consolidated
Intersegment sales
Operating income (loss)
Other operating loss is primarily composed of unallocated corporate expenses, our captive insurance subsidiary, intermediate finance companies, divested operations, and intercompany eliminations.
The changes in the carrying amount of service and product warranties for the nine months ended October 1, 2005 and October 2, 2004 were as follows:
Balance at beginning of the year
Service and product warranty provision
Payments
Translation
Balance at end of the period
Environmental and Product Liability Claims
There have been no further material developments regarding the above from that contained in our 2004 Annual Report on Form 10-K, other than those matters identified below.
Horizon litigation
Twenty-eight separate lawsuits involving 29 primary plaintiffs, a class action, and claims for indemnity by Celebrity Cruise Lines, Inc. (Celebrity) were brought in the U. S. District Court for the Southern District of New York against Essef Corporation (Essef) and certain of its subsidiaries prior to our acquisition of Essef in August 1999.
The claims against Essef and its involved subsidiaries were based upon the allegation that Essef designed, manufactured, and marketed two sand swimming pool filters that were installed as a part of the spa system on the Horizon, and allegations that the spa and filters contained Legionnaire’s disease bacteria that infected certain passengers on a cruise in July 1994.
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The individual and class claims by passengers were tried and resulted in an adverse jury verdict finding liability on the part of the Essef defendants (70%) and Celebrity and its sister company, Fantasia (together 30%).
After expiration of post-trial appeals, we paid all outstanding punitive damage awards of $7.0 million in the Horizon cases, plus interest of approximately $1.6 million in January 2004. We had reserved for the amount of punitive damages awarded at the time of the Essef acquisition. A reserve for the $1.6 million interest cost was recorded in 2003. All of the personal injury cases have now been resolved through either settlement or trial.
The only remaining unresolved claims in this case are those brought by Celebrity for damages resulting from the outbreak. Celebrity filed an amended complaint seeking attorney fees and costs for prior litigation as well as out-of-pocket losses, lost profits, and loss of business enterprise value. Discovery commenced late in 2004, and was completed in August 2005. Celebrity’s claims for damages exceed $185 million. Assuming matters of causation, standing, indemnity and proof are decided against Essef, our experts believe that damages should amount to no more than approximately $16 to $25 million. Dispositive motions in this matter were filed in August 2005, which we believe will be decided in the fourth quarter. Trial will be scheduled after resolution of these motions. We believe our reserves for liability, plus remaining insurance limits, should be adequate to cover any potential liability to Celebrity. We are vigorously defending against these claims.
We are occasionally a party to other 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.
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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 1, 2005 and December 31, 2004, the related condensed consolidated statements of income for the three-months and nine-months ended October 1, 2005 and October 2, 2004, and statements of cash flows for the nine-months ended October 1, 2005 and October 2, 2004, for the Parent Company, the Guarantor Subsidiaries, the non-guarantor subsidiaries and total consolidated Pentair and subsidiaries.
Unaudited Condensed Consolidated Statements of Income
For the three months ended October 1, 2005
Operating (loss) income
Net interest (income) expense
Income before income taxes
For the nine months ended October 1, 2005
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Unaudited Condensed Consolidated Balance Sheets
October 1, 2005
Investments in subsidiaries
Due to / (from) affiliates
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Unaudited Condensed Consolidated Statements of Cash Flows
Adjustments to reconcile net income to net cash provided by operating activities:
Net cash used for operating activities of discontinued operations
Investment in subsidiaries
Net cash (used for) provided by investing activities
Net cash used for financing activities
Effect of exchange rate changes on cash
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For the three months ended October 2, 2004
For the nine months ended October 2, 2004
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December 31, 2004
Shareholders' equity
Total liabilities and shareholders' equity
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Net cash provided by operating activities of discontinued operations
Net cash provided by financing activities
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On October 17, 2005, we entered into a definitive agreement to acquire certain assets of APW, Ltd., including the McLean Thermal Management, Aspen Motion Technologies and Electronic Solutions businesses for approximately $137.5 million, excluding transaction costs and subject to a post-closing net asset value adjustment. After taking into account the net present value of anticipated tax benefits, we expect the net purchase price to be approximately $120.0 million. These businesses provide thermal management solutions and integration services to the telecommunications, data communications, medical and security markets. We expect to close the transaction, which is subject to regulatory approval and other customary closing conditions, in the fourth quarter of 2005.
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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,” “expect,” “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 manufacturing company comprised of two operating segments: Water and Enclosures. Our Water Group is a global leader in providing innovative products and systems used worldwide in the movement, treatment, storage and enjoyment of water. Our Enclosures Group is a leader in the global enclosures market, designing and manufacturing standard, modified and custom enclosures that protect sensitive electronics and electrical components. For fiscal year 2005, our Water Group and Enclosures Group are forecasted to generate approximately 73 percent and 27 percent of total revenues, respectively.
Our Water Group has progressively become a more significant part of our business portfolio with sales increasing from $100 million in 1995 to approximately $1.6 billion in 2004, or approximately $2.0 billion on a pro forma basis (as if our Water Group acquisitions had been completed at the beginning of 2004). The water industry is structurally attractive as a result of a growing demand for clean water and its large global market, of which we have identified a target industry segment totaling $50 billion. Our vision is to become a leading global provider of innovative products and systems used in the movement, treatment, storage and enjoyment of water.
We have achieved $26 million in synergies, net of integration costs, in the first nine months of 2005 with respect to the acquisition of the former WICOR, Inc. (“WICOR”) businesses via key initiatives including PIMS, material cost savings and administrative cost savings, and expect to achieve $37 million for calendar year 2005. We also expect to achieve significant working capital reductions, net fixed asset reductions, and revenue synergies from cross-selling opportunities during the first two years of ownership as a result of the acquisition. Integration of the former WICOR businesses proceeded as expected during the first nine months of 2005 with 16 facilities closed or consolidated to date.
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Our Enclosures Group operates in a large global market with significant potential for growth in industry segments 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. From mid 2001 through mid 2003, the Enclosures Group experienced significantly lower sales volumes as a result of severely reduced capital spending in the industrial and commercial markets and over-capacity and weak demand in the datacom and telecom markets. In 2004 and the first nine months of 2005, sales volumes increased due to the addition of new distributors, new products, and higher sales in all targeted markets. In addition, through the success of our PIMS and supply management initiatives, we have increased Enclosures segment margins for fifteen consecutive quarters.
Key Trends and Uncertainties
The following trends and uncertainties affected our financial performance in the first nine months of 2005 and will likely impact our results in the future:
Outlook
In 2005 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:
The components of the net sales change in 2005 from 2004 were as follows:
Volume
Price
Currency
Total
Consolidated net sales
The 17.9 percent and the 36.1 percent increase in consolidated net sales in the third quarter and the first nine months, respectively, of 2005 from 2004 was primarily driven by:
Net sales by segment and the change from the prior year period were as follows:
The 20.9 percent and the 47.5 percent increase in Water segment net sales in the third quarter and first nine months, respectively, of 2005 from 2004 was primarily driven by:
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These increases were partially offset by:
The 10.6 percent and 12.8 percent increase in Enclosures segment net sales in the third quarter and the first nine months, respectively, of 2005 from 2004 was primarily driven by:
Percentage point change
The 0.1 percentage point increase in gross profit as a percent of sales in the third quarter of 2005 from 2004 was primarily the result of:
The 0.1 percentage point decrease in gross profit as a percent of sales in the first nine months of 2005 from 2004 was primarily the result of:
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Selling, general and administrative (SG&A)
SG&A
The 0.7 and 1.0 percentage point decrease in SG&A expense as a percent of sales in the third quarter and the first nine months, respectively, of 2005 from 2004 was primarily due to:
These decreases were partially offset by:
Research and development (R&D)
R&D
The 0.2 percentage point increase in R&D expense as a percent of sales in the third quarter and the first nine months of 2005 from 2004 was primarily due to:
The 0.6 percentage point increase in Water segment operating income as a percent of sales in the third quarter of 2005 from 2004 was primarily the result of:
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The 0.1 percentage point decrease in Water segment operating income as a percent of sales in the first nine months of 2005 was primarily the result of:
The 1.4 and 1.6 percentage point increase in Enclosures segment operating income as a percent of sales in the third quarter and the first nine months, respectively, of 2005 from 2004 was primarily the result of:
The gain on sale of investment of $5.2 million for the nine month period ended October 2, 2005 represents the gain from the sale of our interest in the stock of LN Holdings Corporation.
The 3.8 percentage point decrease in interest expense from continuing operations in the third quarter of 2005 from 2004 was primarily the result of:
The 28.2 percentage point increase in interest expense from continuing operations in the first nine months of 2005 from 2004 was primarily the result of:
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Provision for income taxes from continuing operations
Effective tax rate
The 5.2 percentage point decrease in the tax rate in the third quarter of 2005 from 2004 was primarily the result of:
The 0.4 percent increase in the tax rate in the first nine months of 2005 from 2004 was primarily the result of:
We estimate our effective income tax rate for the fourth quarter of this year will be 35.0% resulting in a full year effective annual rate of 35.0%. This estimate includes our initial analysis of the anticipated impact of the U.S. American Jobs Creation Act. This impact may be adjusted as we refine our calculations and as additional guidance is received from the Treasury Department.
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.
We experience seasonal cash flows primarily due to seasonal demand in a number of markets within our Water segment. End-user demand for pool/spa equipment follows warm weather trends and is at seasonal highs from March to July. We mitigate the magnitude of the sales spike somewhat through effective use of the distribution channel by employing some advance sales programs (generally including, but not limited to, extended payment terms). Demand for residential water systems is also affected by weather patterns particularly related to droughts and heavy flooding.
The following table presents selected working capital measurements calculated from our monthly operating results based on a 13-month moving average:
Days of sales in accounts receivable
Days inventory on hand
Days in accounts payable
Cash provided by operating activities was $134.3 million in the first nine months of 2005 compared with cash provided by operating activities of $197.7 million in the prior year period. The decrease in cash provided by operating activities is due to working capital increases related to the rationalization of Water segment operations, various customer rebates and lower accruals for employee bonus plans. The increased days of sales in accounts receivable as of October 1, 2005 compared to December 31, 2004 was driven by sales occurring
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late in the third quarter of 2005. The increased days inventory on hand as of October 1, 2005 compared to December 31, 2004 was driven by the increased inventory levels attributable to increased sourcing out of Asia, higher value of inventories due to rising raw material input costs, and inventory redundancies associated with the ramp-up of new facilities and the wind-down of old facilities. The working capital ratios as of October 1, 2005 versus December 31, 2004 have increased, primarily for the same reasons. In the future, we expect our working capital ratios to improve as we are able to capitalize on the anticipated success of our post-acquisition integration activities and PIMS initiatives.
Capital expenditures in the first nine months of 2005 were $50.6 million compared with $28.6 million in the prior year period. We currently anticipate capital expenditures for fiscal 2005 will be approximately $65 to $70 million, primarily for integration of the former WICOR businesses into existing or new facilities, selective increases in equipment capacity, new product development, and general maintenance capital.
Cash proceeds from the sale of property and equipment of $11.5 million in the first nine months of 2005 were primarily related to the sale of two California facilities.
On February 23, 2005, we acquired the assets of DEP, a privately held company, for $10.2 million, including a cash payment of $10.0 million, transaction costs of $0.1 million, plus debt assumed of $0.1 million. The DEP product line addresses the water and wastewater markets and is part of our Water Group.
In the third quarter 2005, we paid $10.4 million in purchase price adjustments related to the October 2004 sale of our former Tools Group to The Black & Decker Corporation. The adjustments related to posting closing adjustments per the purchase agreement.
In July 2004, we acquired all of the shares of capital stock of WICOR from Wisconsin Energy Corporation, for $876.9 million in cash. We also had various purchase price adjustments relating to the acquisition of Everpure and the acquisition of the remaining stock of Pentair’s former Tools Group’s Asian joint venture.
In April 2005, we sold our interest in the stock of LN Holdings Corporation for cash consideration of $23.6 million, resulting in a pre-tax gain of $5.2 million and an after tax gain of $3.3 million.
Net cash used by financing activities was $77.6 million in the first nine months of 2005 compared with $738.4 million provided by financing activities in the prior year period. Financing activities included draw downs and repayments on our revolving credit facilities to fund our operations in the normal course of business and payments of dividends, reduced by cash received from stock option exercises. 2004 financing activities included the utilization of the $850 million committed line of credit to fund the WICOR acquisition.
In March 2005, we amended and restated our multi-currency revolving Credit Facility (the “Credit Facility”), increasing the size of the facility from $500 million to $800 million with a term of five years. The interest rate on the loans under the $800 million Credit Facility is LIBOR plus 0.625%. Interest rates and fees on the Credit Facility vary based on our credit ratings.
Our current credit ratings are as follows:
Standard & Poor’s
Moody’s
As of October 1, 2005, our capital structure consisted of $689.4 million in total indebtedness and $1,545.5 million in shareholders’ equity. The ratio of debt-to-total capital at October 1, 2005 was 30.8 percent, compared with 33.7 percent at December 31, 2004 and 53.5 percent at October 2, 2004. Our targeted debt-to-total capital ratio is approximately 40 percent. We will exceed this target ratio from time to time as needed for operational purposes and/or acquisitions.
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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 2005 were $39.9 million, or $0.390 per common share, compared with $32.0 million, or $0.32 per common share, in the prior year period. We anticipate the continuation of the practice of paying dividends on a quarterly basis.
There have been no material changes with respect to the contractual obligations or off-balance sheet arrangements described in our Annual Report on Form 10-K for the year ended December 31, 2004, other than the aforementioned increase in the size of our Credit Facility from $500 million to $800 million with a term of five years.
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 and our conversion of net income. Free cash flow and conversion of net income are non-GAAP financial measures 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 and conversion of net income are important measures 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 and conversion of net income are used as a criterion to measure and pay incentives. Our measure of free cash flow and conversion of net income may not be comparable to similarly titled measures reported by other companies. The following table is a reconciliation of free cash flow and a calculation of the conversion of net income with cash flows from continuing and discontinued operating activities:
Cash flow provided by operating activities
Free cash flow
Conversion of net income
In 2005, we are targeting free cash flow in a range of $170 to $190 million. Our working capital in 2005 is expected to be higher than previously anticipated as a result of increases in safety stocks of certain materials, such as resins and motors, and higher inventories of products sourced out of China.
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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, 2004, 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.
There have been no material changes in our market risk during the quarter ended October 1, 2005, except for the item noted below. For additional information, refer to Item 7A of our 2004 Annual Report on Form 10-K.
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 1, 2005 pursuant to Rule 13a-15(b) of the Securities Exchange Act of 1934 (the “Exchange Act”). Based upon their 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 1, 2005 to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized, and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms, and to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosures.
There was no change in our internal control over financial reporting that occurred during the quarter ended October 1, 2005 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 1, 2005 and October 2, 2004, the related condensed consolidated statements of income for the three and nine month periods ended October 1, 2005 and October 2, 2004, and cash flows for the nine-month periods ended October 1, 2005 and October 2, 2004. 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, 2004, 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 10, 2005, 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, 2004 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 4, 2005
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PART II OTHER INFORMATION
July 3 – July 30, 2005
July 31 – August 27, 2005
August 28 – October 1, 2005
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ITEM 6. Exhibits
(a) Exhibits
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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 9, 2005.
PENTAIR, INC.
Registrant
David D. Harrison
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Exhibit Index to Form 10-Q for the Period Ended October 1, 2005
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