The stock of water solutions company Pentair(NYSE: PNR) is up more than 27% over the last year, but no one should think it hasn't had a wild ride over that time. The company's sales surged during the lockdowns as its consumer solutions sales boomed, only to come down again as lockdowns eased. That turbulence manifested in Pentair's stock performance over the last few years, but there are two reasons to believe the risk is on the upside for Pentair in the next couple of years. Here's why.
Pentair is almost a Dividend King stock
After having increased its dividend for the last 48 consecutive years, Pentair will join a select club of Dividend Kings if it keeps the run going to 2026. However, that's not the only essential event scheduled for that year. Pentair is in the throes of a transformational strategy to drive significant cost improvements, productivity gains, and price improvements that will increase return on sales (another way of describing operating profit margin) from 20.8% in 2023 to 24% in 2026.
That margin increase, accompanied by annual sales growth in the mid-single-digit range, will lead to low double-digit earnings-per-share growth and a cumulative free cash flow (FCF) of $2 billion. To put that figure into context, it represents 13.6% of Pentair's current market cap of $14.66 billion, and Wall Street analysts have Pentair generating almost $900 million in FCF in 2026 when the initiative is complete.
Here are the two major catalysts that could drive Pentair's stock higher:
- The transformation initiative touched on above and how it will improve margins and productivity
- Potential cyclical upside from a lower-interest-rate environment -- most notably seen in its consumer solutions
Cyclical upside
Pentair operates out of three segments. Flow ($1.58 billion of sales in 2023) sells pump products and systems and fluid treatment solutions to a mix of residential, commercial, and industrial customers. Water solutions ($1.78 billion) are commercial and residential water treatment solutions, with about two-thirds of sales going to the commercial market and the remaining third to the residential market. Finally, Pool ($1.34 billion) sells residential and commercial pool equipment. Despite being the smallest segment in terms of revenue, its 31% segment operating margin meant it contributed 44% of overall segment profit in 2023.
Image source: Getty Images.
From this brief overview, it's easy to see how important the consumer is to Pentair, particularly consumer discretionary spending on pools and water treatment solutions.
As the results from one of its key distributors, Pool Corp, show, pool maintenance spending is relatively sold, but the discretionary element is weak in the current environment.
However, that's likely to change should interest rates come down and the housing market start to recover. This would free up pent-up discretionary spending on the home in the coming years, a potential growth kicker for Pentair's top line.
Pentair's transformational initiative
The company's margin expansion initiative is built around four pillars:
- Pricing excellence
- Sourcing excellence
- Operational excellence
- Organizational excellence
In pricing, management is moving away from broad-based increases to target price increases based on the product's value and competitive positioning.
Sourcing excellence refers to management looking at $1.6 billion of its spending and generating 10% to 12% in gross savings by consolidating suppliers, reducing complexity, and developing relationships with key suppliers. It's an ongoing process, and management already sees a 10% to 12% cost reduction in its initial wave of sourcing actions.
Operational excellence refers to implementing lean management techniques, investing in automation to improve productivity, and consolidating its manufacturing footprint. As an example of the latter, on its investor day in March, management noted that its top 15 factories (of a total of 41) are responsible for 75% of its revenue. That skew suggests Pentair has a substantive opportunity to generate productivity improvements by rationalizing plants.
Finally, at the heart of organizational excellence lies a focus on the 80/20, or the Pareto principle. In business, this is the idea that 20% of customers tend to generate 80% of revenue. By focusing on the revenue generated by those key customers, Pentair will aim to reduce its number of products and, ultimately, the number of suppliers and factories it needs to produce them.
Image source: Getty Images.
A stock to buy
If the initiatives are successful, Pentair will be a much more profitable and cash-generating company in a couple of years. Throw in the possibility of some upside to sales growth coming from a lower-interest-rate environment, and the potential for a substantial share price improvement is significant. With the results skewed on the upside, Pentair is an attractive stock.
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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
