UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the Quarterly Period Ended June 30, 2012
OR
Commission file number 000-04689
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 þ No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§223.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ
On June 30, 2012, 99,204,048 shares of Registrant’s common stock were outstanding.
Pentair, Inc. and Subsidiaries
PART I FINANCIAL INFORMATION
PART II OTHER INFORMATION
2
ITEM 1. FINANCIAL STATEMENTS
Condensed Consolidated Statements of Income and Comprehensive Income (Loss) (Unaudited)
2012
2011
Net sales
Cost of goods sold
Gross profit
Selling, general and administrative
Research and development
Operating income
Other (income) expense:
Equity income of unconsolidated subsidiaries
Net interest expense
Income before income taxes and noncontrolling interest
Provision for income taxes
Net income before noncontrolling interest
Noncontrolling interest
Net income attributable to Pentair, Inc.
Comprehensive income (loss)
Less: Comprehensive income (loss) attributable to noncontrolling interest
Comprehensive income (loss) attributable to Pentair, Inc.
Earnings per common share attributable to Pentair, Inc.
Basic
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)
Current assets
Cash and cash equivalents
Accounts and notes receivable, net of allowances of $32,958, $39,111 and $41,120, respectively
Inventories
Deferred tax assets
Prepaid expenses and other current assets
Total current assets
Property, plant and equipment, net
Other assets
Goodwill
Intangibles, net
Other
Total other assets
Total assets
Liabilities and Shareholders’ Equity
Current liabilities
Short-term borrowings
Current maturities of long-term debt
Accounts payable
Employee compensation and benefits
Current pension and post-retirement benefits
Accrued product claims and warranties
Income taxes
Accrued rebates and sales incentives
Other current liabilities
Total current liabilities
Other liabilities
Long-term debt
Pension and other retirement compensation
Post-retirement medical and other benefits
Long-term income taxes payable
Deferred tax liabilities
Other non-current liabilities
Total liabilities
Commitments and contingencies
Shareholders’ equity
Common shares par value $0.16 2/3; 99,204,048, 98,622,564 and 98,766,335 shares issued and outstanding, respectively
Additional paid-in capital
Retained earnings
Accumulated other comprehensive income (loss)
Total shareholders’ equity
Total liabilities and shareholders’ equity
4
Condensed Consolidated Statements of Cash Flows (Unaudited)
Operating activities
Adjustments to reconcile net income to net cash provided by (used for) operating activities
Depreciation
Amortization
Deferred income taxes
Stock compensation
Excess tax benefits from stock-based compensation
Loss (gain) on sale of assets
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 (used for) operating activities
Investing activities
Capital expenditures
Proceeds from sale of property and equipment
Acquisitions, net of cash acquired
Net cash provided by (used for) investing activities
Financing activities
Net short-term borrowings
Proceeds from long-term debt
Repayment of long-term debt
Debt issuance costs
Stock issued to employees, net of shares withheld
Repurchases of common stock
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
Condensed Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)
Additional
paid-in
Accumulated
other
comprehensive
Balance - December 31, 2011
Net income
Change in cumulative translation adjustment
Changes in market value of derivative financial instruments, net of $1,436 tax
Cash dividends - $0.44 per common share
Exercise of stock options, net of 35,570 shares tendered for payment
Issuance of restricted shares, net of cancellations
Amortization of restricted shares
Shares surrendered by employees to pay taxes
Balance - June 30, 2012
capital
Retained
earnings
income (loss)
Total
Noncontrolling
interest
Balance - December 31, 2010
Changes in market value of derivative financial instruments, net of $1,249 tax
Cash dividends - $0.40 per common share
Share repurchase
Exercise of stock options, net of 3,266 shares tendered for payment
Balance - July 2, 2011
See accompanying notes to condensed consolidated financial statements
6
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 for the year ended December 31, 2011, which are included in our 2011 Annual Report on Form 10-K for the year ended December 31, 2011.
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.
In connection with preparing the unaudited condensed consolidated financial statements for the six months ended June 30, 2012, we have evaluated subsequent events for potential recognition and disclosure through the date of this filing.
In May 2011, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance to improve the consistency of fair value measurement and disclosure requirements between US Generally Accepted Accounting Principles (“GAAP”) and International Financial Reporting Standards. The provisions of this guidance change certain of the fair value principles related to the highest and best use premise, the consideration of blockage factors and other premiums and discounts, and the measurement of financial instruments held in a portfolio and instruments classified within shareholders’ equity. Further, the guidance provides additional disclosure requirements surrounding Level 3 fair value measurements, the uses of nonfinancial assets in certain circumstances, and identification of the level in the fair value hierarchy used for assets and liabilities which are not recorded at fair value, but where fair value is disclosed. This guidance is effective for fiscal years and interim periods beginning after December 15, 2011. The adoption of this guidance did not have a material impact on our financial condition or results of operations.
In June 2011, the FASB issued authoritative guidance surrounding the presentation of comprehensive income, with an objective of increasing the prominence of items reported in other comprehensive income (“OCI”). This guidance provides entities with the option to present the total of comprehensive income, the components of net income and the components of OCI in either a single continuous statement of comprehensive income or in two separate but consecutive statements. In addition, entities must present on the face of the financial statement, items reclassified from OCI to net income in the section of the financial statement where the components of net income and OCI are presented, regardless of the option selected to present comprehensive income. This guidance is effective for fiscal years and interim periods beginning after December 15, 2011. The FASB subsequently deferred the effective date of certain provisions of this standard pertaining to the reclassification of items out of accumulated other comprehensive income, pending the issuance of further guidance on that matter. We have adopted this guidance as of January 1, 2012, and have presented total comprehensive income (loss) in our Condensed Consolidated Statements of Income and Comprehensive Income (Loss).
Total stock-based compensation expense was $4.8 million for each of the three months ended June 30, 2012 and July 2, 2011, and was $10.1 million and $10.5 million for the six months ended June 30, 2012 and July 2, 2011, respectively.
During the first half of 2012, restricted shares and restricted stock units of our common stock were granted under the 2008 Omnibus Stock Incentive Plan to eligible employees with a vesting period of three to four years after issuance. Restricted share awards and restricted stock units are valued at market value on the date of grant and are typically expensed over the vesting period. Total compensation expense for restricted share awards and restricted stock units was $2.8 million and $2.5 million for the three months ended June 30, 2012 and July 2, 2011, respectively, and was $5.8 million for each of the six months ended June 30, 2012 and July 2, 2011.
During the first half of 2012, option awards were granted under the 2008 Omnibus Stock Incentive Plan with an exercise price equal to the market price of our common stock on the date of grant. Option awards are typically expensed over the vesting period. Total compensation expense for stock option awards was $2.0 million and $2.3 million for the three months ended June 30, 2012 and July 2, 2011, respectively, and $4.3 million and $4.7 million for the six months ended June 30, 2012 and July 2, 2011, respectively.
7
We estimated the fair value of each stock option award on the date of grant using a Black-Scholes option pricing model, modified for dividends and using the following assumptions:
Expected stock price volatility
Expected life
Risk-free interest rate
Dividend yield
The weighted-average fair value of options granted during the second quarter of 2012 and 2011 were $11.74 and $10.89 per share, respectively.
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 the accounting guidance, could have been affected.
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:
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
8
During 2012 and 2011, we initiated certain business restructuring initiatives aimed at reducing our fixed cost structure and realigning our business. The 2012 initiatives included the reduction in hourly and salaried headcount of approximately 140 employees, which included 85 in Water & Fluid Solutions and 55 in Technical Products. The 2011 initiatives included the reduction in hourly and salaried headcount of approximately 210 employees, which included 160 in Water & Fluid Solutions and 50 in Technical Products.
Restructuring related costs included in Selling, general and administrative expenses on the Condensed Consolidated Statements of Income and Comprehensive Income (Loss) include costs for severance and other restructuring costs as follows for the six months ended June 30, 2012, and July 2, 2011, and the year ended December 31, 2011:
Severance and related costs
Asset impairment and other restructuring costs
Total restructuring costs
Restructuring accrual activity recorded in Other current liabilities and Employee compensation and benefitson the Condensed Consolidated Balance Sheets is summarized as follows for the six months ended June 30, 2012, and July 2, 2011, and the year ended December 31, 2011:
Beginning balance
Costs incurred
Cash payments and other
Ending balance
On April 4, 2012, we acquired, as part of Water & Fluid Solutions, all of the outstanding shares of capital stock of Sibrape Indústria E Comércio de Artigos Para Lazer Ltda. and its subsidiary Hidrovachek Ltda. (collectively “Sibrape”) for $19.9 million, net of cash acquired. The Sibrape results have been included in our consolidated financial statements since the date of acquisition. Sibrape offers a complete line of pool products and is a market leader in pool liner sales throughout Brazil. Goodwill recorded as part of the purchase price allocation was $8.8 million, none of which is tax deductible. Identified intangible assets acquired as part of the acquisition were $4.8 million and were comprised entirely of customer lists, which have an estimated life of 11 years. The pro forma impact of this acquisition was not deemed material.
In May 2011, we acquired, as part of Water & Fluid Solutions, the Clean Process Technologies (“CPT”) division of privately held Norit Holding B.V. for $715.3 million (€502.7 million translated at the May 12, 2011 exchange rate). CPT’s results of operations have been included in our consolidated financial statements since the date of acquisition. CPT is a global leader in membrane solutions and clean process technologies in the high growth water and beverage filtration and separation segments. CPT provides sustainable purification systems and solutions for desalination, water reuse, industrial applications and beverage segments that effectively address the increasing challenges of clean water scarcity, rising energy costs and pollution. CPT’s product offerings include innovative ultrafiltration and nanofiltration membrane technologies, aseptic valves, CO2 recovery and control systems and specialty pumping equipment. Based in the Netherlands, CPT has broad sales diversity with the majority of 2011 and 2010 revenues generated in European Union and Asia-Pacific countries.
The fair value of CPT was allocated to the assets acquired and liabilities assumed based on their estimated fair values. The excess of the fair value acquired over the identifiable assets acquired and liabilities assumed is reflected as goodwill. Goodwill recorded as part of the purchase price allocation was $451.8 million, none of which is tax deductible. Identifiable intangible assets acquired as part of the acquisition were $197.2 million, including definite-lived intangibles, such as customer relationships and proprietary technology with a weighted average amortization period of approximately 10 years.
9
The following pro forma consolidated condensed financial results of operations are presented as if the CPT acquisition described above had been completed at the beginning of the comparable period:
Pro forma net sales
Pro forma income before noncontrolling interest
Pro forma net income attributable to Pentair, Inc.
Pro forma earnings per common share
The 2011 unaudited pro forma net income was adjusted to exclude the impact of approximately $5.5 million in non-recurring items related to acquisition date fair value adjustments to inventory and customer backlog. Acquisition-related transaction costs of approximately $6.1 million and $7.8 million associated with the CPT acquisition were excluded from the pro forma net income for the three and six month periods ended July 2, 2011, respectively.
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 costs or synergies that would have been expected to result from the integration of the acquisition. 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.
In January 2011 we acquired as part of Water & Fluid Solutions all of the outstanding shares of capital stock of Hidro Filtros do Brasil (“Hidro Filtros”) for cash of $14.9 million and a note payable of $2.1 million. The Hidro Filtros results of operations have been included in our consolidated financial statements since the date of acquisition. Hidro Filtros is a leading manufacturer of water filters and filtering elements for residential and industrial applications operating in Brazil and neighboring countries. Goodwill recorded as part of the purchase price allocation was $10.1 million, none of which is tax deductible. Identified intangible assets acquired as part of the acquisition were $6.3 million including definite-lived intangibles, primarily customer relationships of $5.5 million, with an estimated life of 13 years. The pro forma impact of this acquisition was not material.
Additionally, during 2011, we completed other small acquisitions with purchase prices totaling $4.6 million, consisting of $2.9 million in cash and $1.7 million as a note payable, adding to Water & Fluid Solutions. Total goodwill recorded as part of the purchase price allocation was $4.3 million, none of which is tax deductible. The pro forma impact of these acquisitions was not material.
10
In thousands
Raw materials and supplies
Work-in-process
Finished goods
Total inventories
Property, plant and equipment
Land and land improvements
Buildings and leasehold improvements
Machinery and equipment
Construction in progress
Total property, plant and equipment
Less accumulated depreciation and amortization
The changes in the carrying amount of goodwill by segment were as follows:
Water & Fluid Solutions
Technical Products
Consolidated Total
Accumulated goodwill impairment losses were $200.5 million, $200.5 million and $0 as of June 30, 2012, December 31, 2011, and July 2, 2011, respectively.
11
The detail of acquired intangible assets consisted of the following:
Patents
Trade names
Total finite-life intangibles
Indefinite-life intangibles
Total intangibles, net
Intangible asset amortization expense was approximately $9.9 million and $10.8 million for the three months ended June 30, 2012 and July 2, 2011, respectively, and was approximately $19.7 million and $17.2 million for the six months ended June 30, 2012 and July 2, 2011, respectively.
The estimated future amortization expense for identifiable intangible assets during the remainder of 2012 and the next five years is as follows:
Estimated amortization expense
Debt and the average interest rates on debt outstanding are summarized as follows:
Commercial paper
Revolving credit facilities
Private placement - fixed rate
Private placement - floating rate
Public - fixed rate
Capital lease obligations
Less: Current maturities
12
The fair value of total debt excluding the effect of the interest rate swaps was $1,299.2 million, $1,361.0 million and $1,440.1 million as of June 30, 2012, December 31, 2011 and July 2, 2011, respectively. This fair value measurement of debt is classified as Level 2 in the valuation hierarchy as defined in Note 10, “Derivatives and Financial Instruments”.
In May 2011, we completed a public offering of $500 million aggregate principal amount of our 5.00% Senior Notes due 2021 (the “Notes”). The Notes are guaranteed by certain of our wholly-owned domestic subsidiaries that are also guarantors under our primary bank credit facility. We used the net proceeds from the offering of the Notes to finance in part the CPT acquisition.
In April 2011, we entered into a Fourth Amended and Restated Credit Agreement (the “Credit Facility”). The Credit Facility replaced our previous $800 million revolving credit facility. The Credit Facility creates an unsecured, committed credit facility of up to $700 million, with multi-currency sub facilities to support investments outside the U.S. The Credit Facility expires on April 28, 2016. Borrowings under the Credit Facility currently bear interest at the rate of London Interbank Offered Rate (“LIBOR”) plus 1.75%. Interest rates and fees on the Credit Facility will vary based on our credit ratings. We used borrowings under the Credit Facility to fund a portion of the CPT acquisition and to fund ongoing operations.
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. Our use of commercial paper as a funding vehicle depends upon the relative interest rates for our commercial paper compared to the cost of borrowing under our Credit Facility. As of June 30, 2012, we had $7.0 million of commercial paper outstanding.
In May 2012, we repaid $105 million of matured private placement debt with borrowings under the Credit Facility.
All of the commercial paper and private placement – floating rate debt 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.
Total availability under our Credit Facility was $487.4 million as of June 30, 2012, which was not limited by the leverage ratio financial covenant in the credit agreement.
Our debt agreements contain certain financial covenants, the most restrictive of which is a leverage ratio in the Credit Facility (total consolidated indebtedness, as defined, over consolidated net income before interest, taxes, depreciation, amortization and non-cash compensation expense, as defined) that may not exceed 3.5 to 1.0 as of the last date of each of our fiscal quarters. As of June 30, 2012, we were in compliance with all financial covenants in our debt agreements.
In addition to the Credit Facility, we have various other credit facilities with an aggregate availability of $73.1 million, of which $7.6 million was outstanding at June 30, 2012. Borrowings under these credit facilities bear interest at variable rates.
Debt outstanding at June 30, 2012 matures on a calendar year basis as follows:
Contractual debt obligation maturities
Total maturities
As part of the CPT acquisition, we assumed two capital lease obligations related to land and buildings. As of June 30, 2012, December 31, 2011 and July 2, 2011, we recorded cost of $22.0 million, $22.7 million and $25.6 million and accumulated amortization of $5.2 million, $5.1 million and $5.3 million, respectively, all of which are included in Property, plant and equipment on the Condensed Consolidated Balance Sheets.
Capital lease obligations consist of total future minimum lease payments of $17.4 million less the imputed interest of $2.7 million as of June 30, 2012.
13
Fair value measurements
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Assets and liabilities measured at fair value are classified using the following hierarchy, which is based upon the transparency of inputs to the valuation as of the measurement date:
In making fair value measurements, observable market data must be used when available. When inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement.
Cash-flow Hedges
In August 2007, we entered into a $105 million interest rate swap agreement with a major financial institution to exchange variable rate interest payment obligations for a fixed rate obligation without the exchange of the underlying principal amounts in order to manage interest rate exposures. The effective date of the swap was August 30, 2007. The swap agreement had a fixed interest rate of 4.89% and expired in May 2012. The fixed interest rate of 4.89% plus the .50% interest rate spread over LIBOR resulted in an effective fixed interest rate of 5.39%. The fair value of the swap was a liability of $1.7 million and $4.2 million at December 31, 2011 and July 2, 2011, respectively, and was recorded in Accumulated other comprehensive income (loss) (“AOCI”) on the Condensed Consolidated Balance Sheets.
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 principal amounts in order to manage interest rate exposures. The effective date of the fixed rate swap was April 25, 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 an effective fixed interest rate of 5.28%. The fair value of the swap was a liability of $4.5 million, $6.3 million and $8.3 million at June 30, 2012, December 31, 2011 and July 2, 2011, respectively, and was recorded in AOCI on the Condensed Consolidated Balance Sheets.
The variable to fixed interest rate swaps are designated as and are effective as cash-flow hedges. The fair values of these swaps are recorded as assets or liabilities on the Condensed Consolidated Balance Sheets, with changes in their fair value included in AOCI. Derivative gains and losses included in AOCI are reclassified into earnings at the time the related interest expense is recognized or the settlement of the related commitment occurs. Realized income/expense and amounts to/from swap counterparties are recorded in Net interest expense in our Condensed Consolidated Statements of Income and Comprehensive Income (Loss). We realized incremental expense resulting from the swaps of $1.7 million and $2.3 million for the three months ended and $3.9 million and $4.7 million for the six months ended June 30, 2012 and July 2, 2011, respectively.
Failure of one or more of our swap counterparties would result in the loss of any benefit to us of the swap agreement. In this case, we would continue to be obligated to pay the variable interest payments per the underlying debt agreements which are at a variable interest rate of 3 month LIBOR plus 0.60% for $100 million of debt. Additionally, failure of one or all of our swap counterparties would not eliminate our obligation to continue to make payments under our existing swap agreements if we continue to be in a net pay position.
Our interest rate swaps are carried at fair value measured on a recurring basis. Fair values are determined through the use of models that consider various assumptions, including time value, yield curves, as well as other relevant economic measures, which are inputs that are classified as Level 2 in the valuation hierarchy defined by the accounting guidance.
14
In April 2011, as part of our planned debt issuance to fund the CPT acquisition, we entered into interest rate swap contracts to hedge movement in interest rates through the expected date of closing for a portion of the expected fixed rate debt offering. The swaps had a notional amount of $400 million with an average interest rate of 3.65%. In May 2011, upon the sale of the Notes, the swaps were terminated at a cost of $11.0 million. Because we used the contracts to hedge future interest payments, the short term and long term portions are recorded in Prepaid expenses and other current assets and Other, respectively, within the Condensed Consolidated Balance Sheets and will be amortized as interest exposure over the 10 year life of the Notes.
Foreign currency contract
We manage our economic and transaction exposure to certain market-based risks through the use of foreign currency derivative instruments. Our objective in holding derivatives is to reduce the volatility of net earnings and cash flows associated with changes in foreign currency exchange rates.
In March 2011, we entered into a foreign currency option contract to reduce our exposure to fluctuations in the euro related to our €503 million acquisition of CPT. The contract had a notional amount of €286.0 million, a strike price of 1.4375 and matured May 13, 2011. The fair value of the contract was an asset of $2.8 million at April 2, 2011, and was recorded in Prepaid expenses and other current assets on the Condensed Consolidated Balance Sheets. In May 2011, we sold the foreign currency option contract for $1.0 million. The net cost of $2.1 million was recorded in Selling, general and administrative on the Condensed Consolidated Statements of Income and Comprehensive Income (Loss).
Fair value of financial information
Financial assets and liabilities measured at fair value on a recurring basis were as follows:
Fair value
(Level 1)
(Level 2)
(Level 3)
Cash-flow hedges
Deferred compensation plan (1)
Total recurring fair value measurements
Nonrecurring fair value measurements
Goodwill (2)
Total nonrecurring fair value measurement
15
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 six months ended June 30, 2012 was 21.9% compared to 30.4% for the six months ended July 2, 2011. Our effective tax rate was lower due to the resolution of U.S. federal and state tax audits, the mix of global earnings and favorable benefits related to the May 2011 acquisition of CPT.
We continue to actively pursue initiatives to reduce our effective tax rate. The tax rate in any quarter can be affected positively or negatively by adjustments that are required to be reported in the specific quarter of resolution.
The total gross liability for uncertain tax positions was $13.3 million, $26.5 million and $24.8 million at June 30, 2012, December 31, 2011 and July 2, 2011, respectively. We record penalties and interest related to unrecognized tax benefits in Provision for income taxes and Net interest expense, respectively, on the Condensed Consolidated Statements of Income and Comprehensive Income (Loss), which is consistent with our past practices.
16
Components of net periodic benefit cost were as follows:
June 30,
July 2,
Service cost
Interest cost
Expected return on plan assets
Amortization of prior year service cost (benefit)
Recognized net actuarial loss (gains)
Net periodic benefit cost (income)
Financial information by reportable segment is shown below:
Net sales to external customers
Consolidated
Intersegment sales
Operating income (loss)
17
The changes in the carrying amount of service and product warranties for the six months ended June 30, 2012, and July 2, 2011, and the year ended December 31, 2011, were as follows:
December 31,
Balance at beginning of the year
Service and product warranty provision
Payments
Acquired
Translation
Balance at end of the period
There have been no further material developments from the disclosures contained in our 2011 Annual Report on Form 10-K.
18
Certain of the domestic subsidiaries (the “Guarantor Subsidiaries”) of Pentair, Inc. (the “Parent Company”), each of which is directly or indirectly wholly-owned by the Parent Company, jointly and severally, and fully and unconditionally, guarantee the Parent Company’s indebtedness under the Notes and the Credit Facility. The following supplemental financial information sets forth the Condensed Consolidated Statements of Income and Comprehensive Income (Loss), the Condensed Consolidated Balance Sheets, and the Condensed Consolidated Statements of Cash Flows for the Parent Company, the Guarantor Subsidiaries, the Non-Guarantor Subsidiaries, and total consolidated Pentair and subsidiaries.
Condensed Consolidated Statements of Income and Comprehensive Income (Loss)
For the three months ended June 30, 2012
Earnings from investment in subsidiaries
Net interest (income) expense
Less: Comprehensive income attributable to noncontrolling interest
19
For the six months ended June 30, 2012
20
Condensed Consolidated Balance Sheets
June 30, 2012
Parent
company
Guarantor
subsidiaries
Non-guarantor
Accounts and notes receivable, net
Investments in/advances to subsidiaries
Due to (from) affiliates
Shareholders’ equity attributable to Pentair, Inc.
21
Condensed Consolidated Statements of Cash Flows
Net change in advances to subsidiaries
22
For the three months ended July 2, 2011
Operating (loss) income
23
For the six months ended July 2, 2011
24
July 2, 2011
Non-
guarantorsubsidiaries
25
26
December 31, 2011
27
On March 27, 2012, we entered into a definitive agreement to merge with the flow control business of Tyco International Ltd. (“Tyco”) in a tax-free, all-stock merger (the “Merger”). We expect the Merger will bring together complementary leaders in water and fluid solutions, valves and controls, and equipment protection products to create a premier industrial growth company. The Tyco flow control business had net revenue and operating income for its fiscal year ended September 30, 2011 of $3.6 billion and $296 million, respectively. The transaction values the Tyco flow control business at approximately $4.4 billion based on the June 13, 2012, Pentair stock price, including assumed net debt of $275 million and noncontrolling interest. If the Merger is not completed, depending on the reasons for the termination of the merger agreement, Pentair would be required to pay Tyco a termination fee of $145 million.
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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. All statements, other than statements of historical fact are forward-looking statements. 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 similar words or the negative thereof or variations thereon. 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 are subject to risks, uncertainties and assumptions that could cause actual results to differ materially from those expressed or implied by such forward-looking statements. Consequently, we cannot guarantee any forward-looking statements. Investors are cautioned not to place undue reliance on any forward-looking statements. The risks and uncertainties that may impact achievement of forward-looking statements include, but are not limited to:
general economic and political conditions, such as political instability, credit market uncertainty, the rate of economic growth or decline in our principal geographic or product markets or fluctuations in exchange rates;
changes in general economic and industry conditions in markets in which we participate, such as:
magnitude, timing and scope of the global economic recovery or any potential future downturn;
stabilization or strength of the North American and Western European housing markets;
the strength of product demand and the markets we serve;
the intensity of competition, including that from foreign competitors;
pricing pressures;
the financial condition of our customers;
market acceptance of our new product introductions and enhancements;
the introduction of new products and enhancements by competitors;
our ability to maintain and expand relationships with large customers;
our ability to source raw material commodities from our suppliers without interruption and at reasonable prices; and
our ability to source components from third parties, in particular from foreign manufacturers, without interruption and at reasonable prices;
increased risks associated with operating foreign businesses;
risks associated with our level of indebtedness and leverage and the potential need for additional financing in the future;
our ability to access capital markets and obtain anticipated financing under favorable terms;
changes in our business strategies, including acquisition and divestiture activities;
our ability to identify, complete and integrate acquisitions successfully and to realize expected synergies on our anticipated timetable;
any impairment of goodwill and indefinite-lived intangible assets as a result of deterioration in our markets;
domestic and foreign governmental and regulatory policies;
changes in operating factors, such as continued improvement in manufacturing activities and the achievement of related efficiencies, cost reductions and inventory risks due to shifts in market demand and costs associated with moving production to lower-cost locations and faster growth;
our ability to generate savings from our excellence in operations initiatives consisting of lean enterprise, supply management and cash flow practices;
unanticipated developments that could occur with respect to contingencies such as litigation, intellectual property matters, product liability exposures and environmental matters;
our ability to accurately evaluate the effects of contingent liabilities such as tax, product liability, environmental and other claims; and
those we identify under “Risk Factors” in Item 1A of this report and in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2011.
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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 & Fluid Solutions and Technical Products. Water & Fluid Solutions is a global leader in providing innovative products and systems used worldwide in the movement, storage, treatment and enjoyment of water. Technical Products is a leader in the global enclosures and thermal management markets, designing and manufacturing standard, modified and custom enclosures that house and protect sensitive electronics and electrical components and protect the people that use them. In 2011, Water & Fluid Solutions and Technical Products accounted for approximately 2/3 and 1/3 of total revenues, respectively.
Water & Fluid Solutions has progressively become a more important part of our business portfolio with sales increasing from approximately $125 million in 1995 to approximately $2.4 billion in 2011. We believe the water industry is structurally attractive as a result of a growing demand for clean water and the large global market size. Our vision is to be a leading global provider of innovative products and systems used in the movement, storage, treatment and enjoyment of water.
Technical Products operates in a large global market with significant potential for growth in industry segments such as industrial, energy, infrastructure and communications. We believe we have the largest industrial and commercial distribution network in North America for enclosures and the highest brand recognition in the industry in North America.
On March 27, 2012, we entered into a definitive agreement to merge with the flow control business of Tyco International Ltd. (“Tyco”) in a tax-free, all-stock merger (the “Merger”). We expect the Merger will bring together complementary leaders in water and fluid solutions, valves and controls, and equipment protection products to create a premier industrial growth company. The Tyco flow control business had net revenue and operating income for its fiscal year ended September 30, 2011 of $3.6 billion and $296 million, respectively. The transaction values the Tyco flow control business at approximately $4.4 billion based on the June 13, 2012 Pentair stock price, including assumed net debt of $275 million and noncontrolling interest.
The Merger is expected to occur immediately after Tyco distributes all of the shares of Tyco Flow Control International Ltd. (“Tyco Flow Control”), the entity that will hold the Tyco flow control business prior to the distribution, to its shareholders in a tax-free pro rata dividend (the “Distribution”). In connection with the Merger, Tyco Flow Control will be renamed Pentair Ltd. (“New Pentair”). In the Merger, a wholly-owned subsidiary of New Pentair will merge with and into us, with our company surviving as a wholly-owned subsidiary of New Pentair. At the effective time of the Merger, each of our outstanding common shares will be converted into the right to receive one New Pentair common share. Upon completion of the Distribution and the Merger, New Pentair common shares will be listed on the New York Stock Exchange with our shareholders owning approximately 47.5% of New Pentair and Tyco shareholders owning approximately 52.5% of New Pentair. Completion of the Distribution and the Merger is expected to occur at the end of September 2012, subject to the approval of the Distribution by Tyco shareholders, the approval of the Merger by our shareholders, regulatory approvals and customary closing conditions. Our executive officers will become the executive officers of New Pentair and our board of directors, together with up to two new directors selected by Tyco and reasonably acceptable to us, will be the board of directors of New Pentair. We will be treated as the accounting acquirer under generally accepted accounting principles in the United States. See ITEM 1A – Risk Factors of this Quarterly Report on Form 10-Q regarding risks posed to our shareholders as a result of the proposed Distribution and Merger.
On April 4, 2012, we acquired, as part of Water & Fluid Solutions, all of the outstanding shares of capital stock of Sibrape Indústria E Comércio de Artigos Para Lazer Ltda. and its subsidiary Hidrovachek Ltda. (collectively “Sibrape”) for $19.9 million, net of cash acquired. The Sibrape results have been included in our consolidated financial statements since the date of acquisition. Sibrape offers a complete line of pool products and is a market leader in pool liner sales throughout Brazil. Goodwill recorded as part of the purchase price allocation was $8.8 million, none of which is tax deductible. Identified intangible assets acquired as part of the acquisition were $4.8 million and were comprised entirely of customer lists, which have an estimated life of 11 years.
In May 2011, we acquired as part of Water & Fluid Solutions, the Clean Process Technologies (“CPT”) division of privately held Norit Holding B.V. for $715.3 million (€502.7 million translated at the May 12, 2011 exchange rate). CPT’s results of operations have been included in our consolidated financial statements since the date of acquisition. CPT is a global leader in membrane solutions and clean process technologies in the high growth water and beverage filtration and separation segments. CPT provides sustainable purification systems and solutions for desalination, water reuse, industrial applications and beverage segments that effectively address the increasing challenges of clean water scarcity, rising energy costs and pollution. CPT’s product offerings include innovative ultrafiltration and nanofiltration membrane technologies, aseptic valves, CO2 recovery and control systems and specialty pumping equipment. Based in the Netherlands, CPT has broad sales diversity with the majority of 2011 and 2010 revenues generated in European Union and Asia-Pacific countries.
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The fair value of CPT was allocated to the assets acquired and liabilities assumed based on their estimated fair values. The excess of the fair value acquired over the identifiable assets acquired and liabilities assumed is reflected as goodwill. Goodwill recorded as part of the purchase price allocation was $451.8 million, none of which is tax deductible. Identifiable intangible assets acquired as part of the acquisition were $197.2 million, including definite-lived intangibles, such as customer relationships, proprietary technology and trade names with a weighted average amortization period of approximately 10 years.
In January 2011 we acquired as part of Water & Fluid Solutions, all of the outstanding shares of capital stock of Hidro Filtros do Brasil (“Hidro Filtros”) for cash of $14.9 million and a note payable of $2.1 million. The Hidro Filtros results of operations have been included in our consolidated financial statements since the date of acquisition. Hidro Filtros is a leading manufacturer of water filters and filtering elements for residential and industrial applications operating in Brazil and neighboring countries. Goodwill recorded as part of the purchase price allocation was $10.1 million, none of which is tax deductible. Identified intangible assets acquired as part of the acquisition were $6.3 million including definite-lived intangibles, primarily customer relationships, of $5.5 million with an estimated life of 13 years.
Additionally, during 2011, we completed other small acquisitions with purchase prices totaling $4.6 million, consisting of $2.9 million in cash and $1.7 million as a note payable, adding to Water & Fluid Solutions. Total goodwill recorded as part of the purchase price allocation was $4.3 million, none of which is tax deductible.
In the fourth quarter of 2011, we completed our annual goodwill impairment review. As a result, we recorded a pre-tax non-cash impairment charge of $200.5 million in the fourth quarter of 2011. This represents impairment of goodwill in our Residential Filtration reporting unit, part of Water & Fluid Solutions. The impairment charge resulted from changes in our forecasts in light of economic conditions prevailing in these markets and due to continued softness in the end-markets served by residential water treatment components.
Key Trends and Uncertainties Regarding Our Existing Business
The following trends and uncertainties affected our financial performance in 2011 and the first six months of 2012 and will likely impact our results in the future:
Since 2010, most markets we serve have shown signs of improvement since the global recession in 2008 and 2009. Because our businesses are significantly affected by general economic trends, a lack of continued improvement in our most important markets addressed below would likely have an adverse impact on our results of operations for 2012 and beyond.
We have also identified specific market opportunities that we continue to pursue that we find attractive, both within and outside the United States. We are reinforcing our businesses to more effectively address these opportunities through research and development and additional sales and marketing resources. Unless we successfully penetrate these product and geographic markets, our organic growth would likely be limited.
After four years of new home building and new pool start contraction in the United States, these end markets stabilized in 2010. Although stabilized, these end markets have not shown significant signs of improvement and continue at historically low levels. In the fourth quarter of 2011, as a result of these current economic conditions and end market softness, we recorded a goodwill impairment charge of $200.5 million. While new product introductions, expanded distribution and channel penetration have resulted in volume increases for the first half of 2012, continued stagnation in new housing construction and new pool starts could negatively impact our ability to grow sales in the future and could have a material adverse effect on our results of operations. Overall, we believe approximately 35% of Pentair sales are used in global residential applications for replacement, refurbishment, remodeling, repair and new construction.
Order rates and sales improved in our industrial business in 2010 and 2011 after slowing significantly in 2009. During the first half of 2012, order rates have remained stable while sales have declined. We believe that the outlook for industrial markets in the second half of 2012 is mixed. Any significant reduction in global capital spending could adversely impact our results in the future.
Through 2011 and the first six months of 2012, we experienced material and other cost inflation. We strive for productivity improvements, and we implement increases in selling prices to help mitigate this inflation. We expect the current economic environment will result in continuing price volatility for many of our raw materials. Commodity prices have begun to moderate, but we are uncertain as to the timing and impact of these market changes.
Primarily due to lower discount rates, our unfunded pension liabilities increased by $41 million to approximately $242 million as of the end of 2011. In 2012, our pension expense continues to increase over 2011 levels.
We have a long-term goal to consistently generate free cash flow that equals or exceeds 100 percent of our net income. We define free cash flow as cash flow from continuing operating activities less capital expenditures plus proceeds from sale of property and
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equipment. Free cash flow for the full year 2011 was approximately $248 million, exceeding our goal of 100% net income conversion. We continue to expect to generate free cash flow in excess of net income before noncontrolling interest in 2012. We are continuing to target reductions in working capital and particularly inventory, as a percentage of sales. See our discussion of Other financial measures under the caption “Liquidity and Capital Resources” in this report for a reconciliation of our free cash flow.
In 2012, our operating objectives include the following:
Increasing our presence in fast growth regions and vertical market focus to grow in those markets in which we have competitive advantages;
Optimizing our technological capabilities to increasingly generate innovative new products;
Driving operating excellence through lean enterprise initiatives, with specific focus on sourcing and supply management, cash flow management and lean operations; and
Focusing on developing global talent in light of our increased global presence (39% of our 2011 net sales were generated outside the United States).
We may seek to meet our objectives of expanding our geographic reach internationally, expanding our presence in our various channels to market and acquiring technologies and products to broaden our businesses’ capabilities to serve additional markets through acquisitions. We may also consider the divestiture of discrete business units to further focus our businesses on their most attractive markets.
RESULTS OF OPERATIONS
Net Sales
Consolidated net sales and the change from the prior year period were as follows:
The components of the change in net sales from the prior year period were as follows:
Volume
Acquisition
Price
Currency
Consolidated net sales
The 3.4 and 5.8 percentage point increases in consolidated net sales in the second quarter and first half, respectively, of 2012 from 2011 were primarily driven by:
higher sales volume related to the May 2011 acquisition of CPT;
organic Water & Fluid Solutions sales growth related to higher sales of certain pool products primarily serving the North American residential housing market and filtration products in other global markets; and
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selective increases in selling prices to mitigate inflationary cost increases.
These increases were partially offset by:
unfavorable foreign currency effects; and
decreases in Technical Products sales volume in Western Europe and in the communications vertical market.
Net sales by segment and the change from prior year period were as follows:
The 6.9 and 10.0 percentage point increases in Water & Fluid Solutions net sales in the second quarter and first half, respectively, of 2012 from 2011 were primarily driven by:
organic sales growth related to higher sales of certain pool products primarily serving the North American residential housing market and filtration products in other global markets;
continued sales growth in fast growth regions led by strength in Latin America; and
unfavorable foreign currency effects.
The 4.4 and 2.9 percentage point decreases in Technical Products net sales in the second quarter and first half, respectively, of 2012 from 2011 were primarily driven by:
decreases in sales volume in Western Europe and in the communications vertical market; and
unfavorable foreign currency effects
These decreases were partially offset by:
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Gross Profit
%of
sales
Percentage point change
The 1.6 and 1.3 percentage point increases in gross profit as a percentage of sales in the second quarter and first half, respectively, of 2012 from 2011 were primarily the result of:
cost savings generated from our Pentair Integrated Management System (“PIMS”) initiatives including lean and supply management practices;
selective increases in selling prices in Water & Fluid Solutions and Technical Products to mitigate inflationary cost increases; and
higher cost of goods sold in 2011 as a result of the inventory fair market value step-up and customer backlog recorded as part of the CPT purchase accounting.
inflationary increases related to raw materials and labor costs.
Selling, general and administrative (SG&A)
SG&A
The 1.0 and 1.6 percentage point increases in SG&A expense as a percentage of sales in the second quarter and first half, respectively, of 2012 from 2011 were primarily due to:
costs associated with the proposed transaction with Tyco Flow Control;
higher costs associated with the integration and intangible amortization related to the May 2011 acquisition of CPT;
restructuring actions taken in 2012; and
certain increases in labor and related costs.
Research and development (R&D)
R&D
R&D expense as a percentage of sales increased 0.1 percentage points and decreased 0.1 percentage points in the second quarter and first half, respectively, of 2012 from 2011.
Increases were primarily due to:
higher costs associated with the May 2011 acquisition of CPT; and
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continued investments in the development of new products to generate growth.
Decreases were primarily due to:
higher sales volume in Water & Fluid Solutions, which resulted in increased leverage on the fixed operating expenses.
Operating Income
Operating income in the Water & Fluid Solutions as a percentage of net sales in the first half of 2012 was unchanged from 2011. The 0.2 percentage point increase in Water & Fluid Solutions segment operating income as a percentage of net sales in the second quarter of 2012 from 2011 was primarily the result of:
savings generated from our PIMS initiatives including lean and supply management practices; and
restructuring actions taken in 2012.
The 1.7 and 1.4 percentage point increases in Technical Products operating income as a percentage of sales in the second quarter and first half, respectively, of 2012 from 2011 were primarily the result of:
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The 10.0 and 28.9 percentage point increases in interest expense in the second quarter and first half, respectively, of 2012 from 2011 were primarily the result of:
higher debt levels in the second quarter of 2012 following the May 2011 acquisition of CPT.
interest benefits related to tax adjustments in 2012.
Effective tax rate
The 0.4 and 8.5 percentage point decreases in the effective tax rate in the second quarter and first half, respectively, of 2012 from 2011 were primarily the result of:
the resolution of U.S. federal and state tax audits in the first half of 2012 that did not occur in 2011; and
the mix of global earnings, including the impact of the CPT acquisition.
LIQUIDITY AND CAPITAL RESOURCES
We generally fund cash requirements for working capital, capital expenditures, equity investments, acquisitions, debt repayments, dividend payments and share repurchases from cash generated from operations, availability under existing committed revolving credit facilities and in certain instances, public and private debt and equity offerings. We have grown our businesses in significant part in the past through acquisitions financed by credit provided under our revolving credit facilities and from time to time, by private or public debt issuance. Our primary revolving credit facilities have generally been adequate for these purposes, although we have negotiated additional credit facilities as needed to allow us to complete acquisitions.
We are focusing on increasing our cash flow and repaying existing debt, while continuing to fund our research and development, marketing and capital investment initiatives. Our intent is to maintain investment grade ratings and a solid liquidity position.
We experience seasonal cash flows primarily due to seasonal demand in a number of markets within Water & Fluid Solutions. We generally borrow in the first quarter of our fiscal year for operational purposes, which usage reverses in the second quarter as the seasonality of our businesses peaks. End-user demand for pool and certain pumping equipment follows warm weather trends and is at seasonal highs from April to August. The magnitude of the sales spike is partially mitigated by employing some advance sale “early buy” programs (generally including extended payment terms and/or additional discounts). Demand for residential and agricultural water systems is also impacted by weather patterns, particularly by heavy flooding and droughts.
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Cash provided by operating activities was $166.8 million in the first six months of 2012 compared with $152.6 million in the prior year period. The increase in cash provided from operating activities was due primarily to an increase in net income before noncontrolling interest, partially offset by an increase in working capital and other long-term assets and a decrease in long-term liabilities.
Cash used for investing activities was $49.4 million for the first six months of 2012 compared to $768.1 million in the prior year period. The current period activity relates mainly to cash used in acquisitions and capital expenditures. The decrease from the comparable prior year period was primarily due to a decrease in cash used in acquisitions.
Cash used in acquisitions, net of cash acquired, for the first six months of 2012 was $19.9 million compared with $733.1 million in the prior year period. In April 2012, we acquired, as part of Water & Fluid Solutions, all of the outstanding shares of capital stock of Sibrape for $19.9 million, net of cash acquired. In May 2011, we acquired as part of Water & Fluid Solutions, the CPT division of privately held Norit Holdings B.V. for $715.3 million. In January 2011, we acquired as part of Water & Fluid Solutions, all of the outstanding shares of capital stock of Hidro Filtros for cash of $14.9 million and a note payable of $2.1 million.
Capital expenditures in the first six months of 2012 were $31.3 million compared with $35.2 million in the prior year period. We currently anticipate capital expenditures for fiscal 2012 will be approximately $75 million to $85 million, primarily for capacity expansions in our key growth markets, new product development, and replacement equipment.
Net cash used for financing activities was $98.1 million in the first six months of 2012 compared with cash provided by financing activities of $638.3 million in the prior year period. The decrease primarily relates to borrowing utilized to fund the CPT acquisition in May 2011. Additionally, financing activities included draw downs and repayments on our revolving credit facilities to fund our operations in the normal course of business, payments of dividends, cash received/used for stock issued to employees and tax benefits related to stock-based compensation.
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In addition to the Credit Facility, we have various other credit facilities with an aggregate availability of $73.1 million, of which $7.6 million was outstanding at June 30, 2012. Borrowings under these credit facilities bear interest at variable rates. Additionally, as part of the CPT acquisition we assumed certain capital leases with an outstanding balance of $14.7 million at June 30, 2012.
Our cost of and ability to obtain debt financing may be impacted by our credit ratings. Our long-term debt is rated at BBB- by Standard & Poor’s (“S&P”) with stable outlook and Baa3 by Moody’s with stable outlook.
We issue short-term commercial paper notes that are currently not rated by S&P or Moody’s. Even though our short-term commercial paper is unrated, we believe a downgrade in our credit rating could have a negative impact on our ability to continue to issue unrated commercial paper.
We do not expect that a one rating downgrade of our credit rating by either S&P or Moody’s would substantially affect our ability to access the long-term debt capital markets. However, depending upon market conditions, the amount, timing and pricing of new borrowings and interest rates under our Credit Facility could be adversely affected. If both of our credit ratings were downgraded to below BBB-/Baa3, our flexibility to access the term debt capital markets would be reduced.
A credit rating is a current opinion of the creditworthiness of an obligor with respect to a specific financial obligation, a specific class of financial obligations or a specific financial program. The credit rating takes into consideration the creditworthiness of guarantors, insurers or other forms of credit enhancement on the obligation and takes into account the currency in which the obligation is denominated. The ratings outlook also highlights the potential direction of a short or long-term rating. It focuses on identifiable events and short-term trends that cause ratings to be placed under observation by the respective rating agencies. A change in rating outlook does not mean a rating change is inevitable.
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 annually. We believe we have the ability and sufficient capacity to meet these cash requirements by using available cash and internally generated funds and to borrow under our committed and uncommitted credit facilities.
Dividends paid in the first six months of 2012 were $44.1 million, or $0.44 per common share, compared with $39.7 million, or $0.40 per common share, in the prior year period. We have increased dividends every year for the last 36 years and expect to continue paying dividends on a quarterly basis.
The total gross liability for uncertain tax positions was $13.3 million, $26.5 million and $24.8 million at June 30, 2012, December 31, 2011 and, July 2, 2011, respectively. We are not able to reasonably estimate the amount by which the estimate will increase or decrease over time; however, at this time, we do not expect a significant payment related to these obligations within the next twelve months.
Impact of Tyco Flow Control merger
In connection with the consummation of the Merger, we may refinance some or all of the indebtedness described above, subject to the terms of the merger agreement, which provides that we may not repay, incur or refinance any indebtedness to the extent such action would cause us not to be rated investment grade by any rating agency.
Prior to the Distribution, New Pentair will incur indebtedness in an amount not to exceed $500 million upon terms negotiated by us. A portion of the proceeds of the indebtedness will be transferred to Tyco. After accounting for the transfer of proceeds to Tyco, the payment of transaction expenses and transfer of excess cash to Tyco, New Pentair will have an additional net indebtedness upon consummation of the Distribution and the Merger of $275 million.
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Other financial measures
In addition to measuring our cash flow generation or usage based upon operating, investing and financing classifications included in the Condensed Consolidated Statements of Cash Flows, we also measure our free cash flow. We have a long-term goal to consistently generate free cash flow that equals or exceeds 100% conversion of net income before noncontrolling interest. Free cash flow is a non-Generally Accepted Accounting Principles financial measure that we use to assess our cash flow performance. 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, make acquisitions, repay debt and repurchase shares. In addition, free cash flow is used as a criterion to measure and pay compensation-based incentives. Our measure of free cash flow may not be comparable to similarly titled measures reported by other companies. The following table is a reconciliation of free cash flow:
Free cash flow
NEW ACCOUNTING STANDARDS
See Note 2 (New Accounting Standards) of ITEM 1.
CRITICAL ACCOUNTING POLICIES
In our 2011 Annual Report on Form 10-K, 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 June 30, 2012. For additional information, refer to Item 7A of our 2011 Annual Report on Form 10-K.
Evaluation of Disclosure 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 June 30, 2012 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 June 30, 2012 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.
Changes in Internal Controls
There was no change in our internal control over financial reporting that occurred during the quarter ended June 30, 2012 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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ITEM 1. Legal Proceedings
There have been no material changes from the risk factors previously disclosed in ITEM 1A. of our 2011 Annual Report on Form 10-K, except for the addition of the risk factors set forth below.
On March 27, 2012, Pentair, Inc. (“Pentair”) entered into a definitive agreement to merge with the flow control business (the “Tyco Flow Control Business”) of Tyco International Ltd. (“Tyco”) in a tax-free, all-stock merger (the “Merger”). The Merger is expected to occur immediately after Tyco distributes all of the shares of Tyco Flow Control International Ltd. (“Tyco Flow Control”), the entity that will hold the Tyco Flow Control Business prior to the distribution, to its shareholders in a tax-free pro rata dividend (the “Distribution,”) as part of a series of transactions necessary to consummate the separation of Tyco Flow Control from Tyco (the “Spin-off” and together with the Merger, the “Transactions”). In connection with the Merger, Tyco Flow Control will be renamed Pentair Ltd. (“New Pentair”) and a wholly-owned subsidiary of New Pentair will merge with and into Pentair, with Pentair surviving as a wholly-owned subsidiary of New Pentair. Upon completion of the Spin-off and the Merger, Pentair shareholders will own approximately 47.5% of New Pentair and Tyco shareholders will own approximately 52.5% of New Pentair. Completion of the Spin-off and the Merger is subject to the approval of the Distribution by Tyco shareholders, the approval of the Merger by Pentair shareholders, regulatory approvals and customary closing conditions. The following risk factors relate to risks posed to Pentair shareholders from the proposed Transactions. Additional risks exist that are related to the ownership of the combined flow control and Pentair businesses following the Transactions. These risks are detailed in the documents filed by Pentair, Tyco and Tyco Flow Control with the Securities and Exchange Commission related to the Transactions.
The calculation of the consideration payable pursuant to the Merger will not be adjusted based on the performance of Pentair or the Tyco Flow Control Business. Accordingly, the relative market value of the New Pentair common shares that Pentair shareholders receive in the Merger may not reflect the performance of Pentair and the Tyco Flow Control Business.
In the Merger, holders of Pentair common shares will receive one common share of New Pentair for every Pentair common share they hold at the time of the Merger with the result that former Pentair shareholders will own approximately 47.5% of New Pentair common shares and Tyco shareholders will own approximately 52.5% of New Pentair common shares, on a fully-diluted basis after giving effect to the Merger. Tyco shareholders who receive New Pentair common shares in the Distribution will not receive any new shares in the Merger and will continue to hold their existing shares of Tyco and New Pentair. The one-to-one exchange ratio and overall allocation of New Pentair common shares will not be adjusted for changes in the economic performance of the Tyco Flow Control Business and Pentair or the market price of Pentair common shares. If the economic performance of the Tyco Flow Control Business relative to Pentair declines (or the economic performance of Pentair relative to the Tyco Flow Control Business improves) prior to completion of the Merger, Pentair shareholders will not receive any additional compensation or adjustment to account for the effective diminishment in the value of their New Pentair common shares received in the Merger.
New Pentair may not realize the anticipated growth opportunities and cost synergies from the Merger.
The success of the Transactions will depend, in part, on the ability of New Pentair to realize the anticipated growth opportunities and cost synergies as a result of the Merger. New Pentair’s success in realizing these growth opportunities and cost synergies, and the timing of this realization, depends on the successful integration of Pentair and the Tyco Flow Control Business. Even if New Pentair is able to integrate Pentair and the Tyco Flow Control Business successfully, this integration may not result in the realization of the full benefits of the growth opportunities and cost synergies that Pentair and New Pentair currently expect from this integration or that these benefits will be achieved within the anticipated time frame or at all. For example, New Pentair may not be able to eliminate duplicative costs. Moreover, New Pentair may incur substantial expenses in connection with the integration of Pentair and the Tyco Flow Control Business. While it is anticipated that certain expenses will be incurred, such expenses are difficult to estimate accurately, and may exceed current estimates. Accordingly, the benefits from the Merger may be offset by costs incurred or delays in integrating the businesses.
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The integration of Pentair and the Tyco Flow Control Business following the Merger may present significant challenges.
There is a significant degree of difficulty and management distraction inherent in the process of establishing New Pentair as an independent public company and integrating Pentair and the Tyco Flow Control Business. These difficulties include:
the challenge of establishing New Pentair as a separately traded independent public company while integrating Pentair and the Tyco Flow Control Business and carrying on the ongoing operations of each entity;
the necessity of coordinating geographically separate organizations;
the challenge of integrating the business cultures of Pentair and the Tyco Flow Control Business, which may prove to be incompatible;
the challenge and cost of integrating the information technology systems of Pentair and the Tyco Flow Control Business; and
the potential difficulty in retaining key officers and personnel of Pentair and the Tyco Flow Control Business.
The process of integrating operations could cause an interruption of, or loss of momentum in, the activities of Pentair and the Tyco Flow Control Business. Members of New Pentair senior management may be required to devote considerable amounts of time to this integration process, which will decrease the time they will have to manage the combined company, service existing customers, attract new customers and develop new products or strategies. If senior management is not able to effectively manage the integration process, or if any significant business activities are interrupted as a result of the integration process, Pentair and the Tyco Flow Control Business could suffer. There can be no assurance that New Pentair will successfully or cost-effectively integrate Pentair and the Tyco Flow Control Business. The failure to do so could have a material adverse effect on New Pentair’s business, financial condition and results of operations.
There is currently no public market for New Pentair common shares and New Pentair cannot be certain that an active trading market will develop or be sustained after the Spin-off and the Merger, and following the Spin-off and the Merger New Pentair’s share price may fluctuate significantly.
Although Pentair’s common shares trade on the New York Stock Exchange (the “NYSE”), there is currently no public market for New Pentair common shares. New Pentair intends to list its common shares on the NYSE under the symbol “PNR,” which is currently the trading symbol for Pentair. It is anticipated that on or shortly before the record date for the Distribution, trading of the New Pentair common shares will begin on a “when-issued” basis and such trading will continue up to and including the distribution date. However, there can be no assurance that an active trading market for New Pentair common shares will develop as a result of the Spin-off and the Merger or be sustained in the future. The lack of an active market may make it more difficult for New Pentair shareholders to sell their common shares and could lead to the price of New Pentair common shares being depressed or more volatile.
Pentair, Tyco and New Pentair cannot predict the prices at which New Pentair common shares may trade after the Spin-off and the Merger. The market price of New Pentair common shares may fluctuate widely, depending on many factors, some of which may be beyond New Pentair’s control, including:
New Pentair’s business profile and market capitalization may not fit the investment objectives of some Pentair and Tyco shareholders and, as a result, these shareholders may sell New Pentair’s shares after the Transactions are completed;
actual or anticipated fluctuations in the operating results of New Pentair due to factors related to New Pentair’s business;
success or failure of New Pentair’s combined business strategy;
New Pentair’s quarterly or annual earnings, or those of other companies in New Pentair’s industry;
New Pentair’s ability to obtain third-party financing as needed;
announcements by New Pentair or New Pentair’s competitors of significant acquisitions or dispositions;
changes in accounting standards, policies, guidance, interpretations or principles;
the failure of securities analysts to cover New Pentair’s common shares after the Transactions are completed;
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changes in earnings estimates by securities analysts or New Pentair’s ability to meet those estimates;
the operating and stock price performance of other comparable companies;
investor perception of New Pentair;
natural or other environmental disasters that investors believe may affect New Pentair;
overall market fluctuations;
results from any material litigation, including asbestos claims, government investigations or environmental liabilities;
changes in laws and regulations affecting New Pentair’s business; and
general economic conditions and other external factors.
Stock markets in general have experienced volatility that has often been unrelated to the operating performance of a particular company. These broad market fluctuations could adversely affect the trading price of New Pentair common shares. Until an orderly market develops, the trading prices for New Pentair common shares may fluctuate significantly. New Pentair common shares will be freely transferable, except for those shares received or held by affiliates of New Pentair as the term “affiliates” is defined under the Securities Act of 1933.
Substantial sales of New Pentair common shares may occur in connection with the Spin-off and the Merger, which could cause New Pentair stock price to decline.
The New Pentair common shares that Tyco distributes to its shareholders in the Distribution and that are issued to Pentair shareholders in the Merger generally may be sold immediately in the public market. Although Pentair and Tyco have no actual knowledge of any plan or intention on the part of any significant shareholder to sell New Pentair common shares following the Spin-off and the Merger, it is likely that some Tyco shareholders and some Pentair shareholders, including some large shareholders, will sell New Pentair common shares received in the Distribution and the Merger, respectively, for various reasons such as if New Pentair’s business profile or market capitalization as a combined company following the Transactions does not fit their investment objectives. In particular, Tyco is a member of the S&P 500 Index, while New Pentair may not be in the future. Accordingly, certain Tyco and Pentair shareholders may elect or be required to sell New Pentair shares following the Spin-off and the Merger due to investment guidelines or other reasons. The sales of significant amounts of New Pentair common shares or the perception in the market that this will occur may result in the lowering of the market price of New Pentair common shares.
Regulatory agencies may delay or impose conditions on approval of the Spin-off and the Merger, which may diminish the anticipated benefits of the Transactions.
Completion of the Spin-off and the Merger is conditioned upon the receipt of required government consents and approvals, including required approvals from foreign regulatory agencies. While Pentair and Tyco intend to pursue vigorously all required governmental approvals and do not know of any reason why they would not be able to obtain the necessary approvals in a timely manner, the requirement to receive these approvals before the Spin-off and the Merger could delay the completion of the Distribution and the Merger, possibly for a significant period of time after Tyco shareholders have approved the Distribution and after Pentair shareholders have approved the Merger. In addition, these governmental agencies may attempt to condition their approval of the Merger on the imposition of conditions that could have a material adverse effect on New Pentair’s operating results or the value of New Pentair common shares after the Spin-off and Merger are completed. Any delay in the completion of the Spin-off and the Merger could diminish anticipated benefits of the Transactions or result in additional transaction costs, loss of revenue or other effects associated with uncertainty about the Transactions. Any uncertainty over the ability of Tyco and Pentair to complete the Spin-off and the Merger could make it more difficult for Tyco and Pentair to retain key employees or to pursue business strategies. In addition, until the Distribution and the Merger are completed, the attention of Pentair and Tyco management may be diverted from ongoing business concerns and regular business responsibilities to the extent management is focused on matters relating to the Transactions, such as obtaining regulatory approvals.
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The pendency of the Merger could potentially adversely affect the business and operations of Pentair and the Tyco Flow Control Business.
In connection with the pending Merger, some customers of each of Pentair and the Tyco Flow Control Business may delay or defer decisions or may end their relationships with Pentair and the Tyco Flow Control Business, which could negatively affect the revenues, earnings and cash flows of Pentair and the Tyco Flow Control Business, regardless of whether the Merger is completed. Similarly, it is possible that current and prospective employees of Pentair and the Tyco Flow Control Business could experience uncertainty about their future roles with the combined company following the Merger, which could materially adversely affect the ability of each of Pentair and the Tyco Flow Control Business to attract and retain key personnel during the pendency of the Merger.
Failure to complete the Merger could adversely impact the market price of Pentair as well as Pentair’s business and operating results.
If the Merger is not completed for any reason, the price of Pentair common shares may decline to the extent that the market price of Pentair common shares reflects positive market assumptions that the Distribution and the Merger will be completed and the related benefits will be realized. Pentair may also be subject to additional risks if the Merger is not completed, including:
depending on the reasons for termination of the Merger Agreement, the requirement that Pentair pay Tyco a termination fee of $145 million;
substantial costs related to the Merger, such as legal, accounting, filing, financial advisory and financial printing fees, must be paid regardless of whether the Merger is completed; and
potential disruption to Pentair’s business and distraction of its workforce and management team.
As a result of the Transactions, current Pentair shareholder’s ownership interest in Pentair will be diluted from 100% of Pentair to less than a majority of New Pentair.
Pentair shareholders immediately prior to the Merger will, in the aggregate, own a significantly smaller percentage of New Pentair after the Merger’s completion. Following completion of the Merger, Pentair shareholders immediately prior to the Merger collectively will own approximately 47.5% of New Pentair on a fully-diluted basis. Consequently, Pentair shareholders immediately after the Merger, collectively, will be able to exercise less influence over the management and policies of New Pentair than they could exercise over the management and policies of Pentair immediately prior to the Merger. The directors of Pentair prior to the Merger will comprise ten of the up to twelve members of the board of directors of New Pentair following the Merger.
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The following table provides information with respect to purchases we made of our common stock during the second quarter of 2012:
April 1 — April 28, 2012
April 29 — May 26, 2012
May 27 — June 30, 2012
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In June 2011, the Financial Accounting Standards Board issued guidance on the presentation of comprehensive income in financial statements. Entities are required to present total comprehensive income either in a single, continuous statement of comprehensive income or in two separate, but consecutive, statements. We adopted this standard as of January 1, 2012, and will present net income and other comprehensive income in two separate statements in our annual financial statements. The table below reflects the retrospective application of this guidance for each of the three years ended December 31st. The retrospective application did not have a material impact on our financial condition or results of operations.
Pentair, Inc and Subsidiaries
Consolidated Statements of Comprehensive Income (Loss)
Other comprehensive income (loss), net of tax
Cumulative translation adjustment
Change in market value of derivative financial instruments, net of taxes of $2,884, $229 and ($2,323), respectively
Adjustment in retirement liability, net of taxes of ($26,650), ($8,159) and $164, respectively
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The following will be added to the Condensed Consolidated Statements of Comprehensive Income (Loss) included in the Financial Statements of Subsidiary Guarantors Note to our annual financial statements:
Year Ended
(in thousands)
December 31, 2010
December 31, 2009
Less: Comprehensive loss attributable to noncontrolling interest
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ITEM 6. Exhibits
(a) Exhibits
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SIGNATURES
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 July 24, 2012.
/s/ John L. Stauch
/s/ Mark C. Borin
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Exhibit Index to Form 10-Q for the Period Ended June 30, 2012
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