Welcome to the Pentair Fourth Quarter 2022 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Shelly Hubbard, Vice President, Investor Relations. Please go ahead.

Thank you, Kate, and welcome to Pentair's fourth quarter 2022 earnings conference call. On the call with me are John Stauch, our President and Chief Executive Officer; and Bob Fishman, our Chief Financial Officer. On today's call, we will provide details on our fourth quarter and full year performance as outlined in this morning's press release. On the Pentair Investor Relations website, you can find our earnings release and slide deck, which is intended to supplement our prepared remarks during today's call and provide a reconciliation of differences between GAAP and non-GAAP financial measures that we will reference. The non-GAAP financial measures provided should not be considered as a substitute for or superior to the measures of financial performance prepared in accordance with GAAP. They are included as additional clarifying items to aid investors in further understanding the company's performance in addition to the impact these items and events have on the financial results. Before we begin, let me remind you that during our presentation today, we will make forward-looking statements, which are predictions, projections or other statements about future events. Listeners are cautioned that these statements are subject to certain risks and uncertainties, many of which are difficult to predict and generally beyond the control of Pentair. These risks and uncertainties can cause actual results to differ materially from our current expectations. We advise listeners to carefully review the risk factors in our most recent Form 10-Q and Form 10-K and today's release. We will also reference certain non-GAAP measures. Following our prepared remarks, we will open the call up for questions. Please limit your questions to one plus a follow-up, then re-enter the queue in order to allow everyone an opportunity to ask questions. I will now turn the call over to John.

Thank you, Shelly, and good morning, everyone. Let's begin with Slide 4, titled Executive Summary. We closed out 2022 with strong sales, segment income and adjusted EPS, which is a direct result of the hard work and dedication of our focused employees across the world. Sales increased 9% to $4.1 billion; segment income rose 12% to $768 million; ROS expanded by 40 basis points to 18.6%; and adjusted EPS increased 8% to $3.68. A few of our key wins during the year include: strategic progress on our transformation initiatives, which we expect to drive significant margin expansion over the next several years; the acquisition of Manitowoc Ice, a complementary and accretive acquisition which further enhances our commercial water solutions business; and recognition for our leadership in social responsibility and sustainability. All in, we are focused on building the Pentair in the future by investing in sustainable growth and expanding profitability through strengthening our operational and financial foundation, which we expect to create long-term value for our stakeholders. Bob will discuss our first quarter and full year 2023 guidance in more detail, but I wanted to share some [Technical Difficulty] thoughts. We are confident in our business model, diversified portfolio and our transformation initiatives, which we expect to drive long-term shareholder value and contribute significantly to 2023. As we look specifically at 2023, we are working through near-term macroeconomic-driven challenges, which we are driving -- which is driving lower-than-expected volumes in our residential businesses. However, we expect to see more normalized demand in 2024 and view 2023 as a catch-up year for excess demand that was realized in 2020 through the first half of 2022. Please turn to Slide 5, titled 5 Year Pentair Performance. Reflecting on the last five years is a focused, smart, sustainable water solutions company. We drove…

Thank you, John, and good morning, everyone. Please turn to Slide 9, labeled Q4 2022 Pentair Performance. I will also be discussing our full year performance on Slide 10. We delivered fourth quarter sales growth of 1% with core sales declining 3% as strong price contribution was not enough to offset volume decline. Consumer Solutions core sales were down 11%, as expected and previously communicated, due to residential channel inventory levels rebalancing and as a result of our lead times beginning to return to more normal levels. Industrial & Flow Technologies reported strong 11% core sales growth with strength in commercial flow and industrial solutions. For the full year, sales grew 9% with core sales up 6%. Consumer Solutions delivered 4% core sales growth, and Industrial & Flow Technologies saw core sales growth of 10%. Fourth quarter segment income increased 10%, and return on sales expanded 130 basis points year-over-year to 18.2%, driven primarily by price, significantly offsetting inflation. Productivity was negatively impacted by lower volume in the quarter. Adjusted EPS of $0.82 was down 6% versus the prior year, but exceeded our guidance for the quarter. Net interest and other expense was $28.2 million, which represented our first full quarter of new financing post the Manitowoc acquisition. And our adjusted tax rate was 12.7% during the quarter, with a share count of 165.2 million. For the full year, segment income grew 12% and return on sales expanded 40 basis points to 18.6%. Adjusted EPS increased 8% for the year to $3.68. Our tax rate ended the year at 14.5%, and our share count was 165.6 million. Please turn to Slide 11, labeled Q4 2022 Consumer Solutions Performance. In addition to the fourth quarter performance for Consumer Solutions, I will also be referencing the full year performance on Slide 12.…

We will now begin the question-and-answer session. [Operator Instructions] The first question is from Joe Giordano of Cowen. Please go ahead.

Hey guys, good morning.

Good morning.

Hi, Joe.

Maybe, I'm going to start [not] (ph) on Pool. Can you talk about the residential portfolio that you have within the old Consumer Solutions group? You made a couple of acquisitions over the years, Pelican, Aquion and Rocean, and small deals, but now we're talking about some exits that you're making. So, maybe just give us an update on where that portfolio is? Where is it maybe versus what you thought it might look like when you started making those deals? And kind of like an update on the strategy going forward from there?

Yes. I mean, first of all, I think about it as roughly still 40% of the overall Water Solutions segment. And think of all the core that we were focused on for the last five to ten years, which is really about the trade and the professional channel, all being a big part of our strategy and still performing. What we did exit was our attempts at the direct-to-consumer side of the business, which we felt were not going to gain the traction that we originally hoped they would, but also they were confusing the trade channel as far as our partnership to support them. And so, now we're focused on being back to where we were, which is pulling demand through our professional trade channel and ensuring that we're winning with the best products and solutions, Joe.

That makes sense. And then just a follow-up on the 2025 margin target. Can you maybe walk us through the relative contributions from the three segments? Like, I guess, Pool doesn't have as much upside given how strong it's been, but if you could kind of help us frame that up?

Yes. Joe, we were pleased to be able to increase the ROS expansion due to the -- what we're seeing in the transformation initiatives. We still have work to do to break it out by segment, but overall, we would expect each of the segments to be contributors to that ROS expansion.

And so, when you think of the increase in the target, as Bob mentioned, 100 basis points of that comes from candidly the fact that we're mixing up with the Manitowoc acquisition. And then we felt like stepping up the expectations on the transformation was helpful for two reasons. One is, we believe that we're making progress with the actual work we're doing. But the second one is we have inefficiencies that we uncovered over the last couple of years of being challenged by the supply chain, which we want to make sure are included in the transformation journey that we're on.

And just to bridge the gap, when we had our Investor Day, we talked about going from 18% to 21% in 2025. We then acquired Manitowoc. So that gave us another approximately 100 basis points to bring us to 22%, and then we found another 100 basis points in the transformation initiatives to get us to the 23%.

The next question is from Bryan Blair of Oppenheimer. Please go ahead.

Thank you. Good morning, guys.

Good morning.

Just to confirm, your 2023 guidance implies mid-single digit core growth in commercial water solutions. Is that correct?

Yes. Yes, it does.

Okay. And having owned Manitowoc Ice bit longer, any update you can offer on the commercial synergies that you've seen to date or what's expected between Everpure, Manitowoc and KBI?

Yes, we're really pleased with the start. I think these all come together nicely and I think we continue to see significant opportunities for our customers to benefit from the end-to-end solutions that we now provide in commercial water solutions.

And just to provide a little more detail, the Water Solutions does have commercial [up] (ph) approximately 40%, residential down approximately 10%.

Right. He was asking for core though, and I was giving the core of mid-single digits.

Got it.

The next question is from Mike Halloran of Baird. Please go ahead.

Hey, good morning, everyone. First, a follow-up to Joe's second question. Just what kind of volume assumptions are embedded in those margin targets, if any? Or are those exclusive volume expectations over the next few years? In other words, is there a level of revenue or volumes you need to get to be able to achieve these targets?

Well, I mean, we're making significant impact in 2023 even with the down volume. So, I think the jumpstart in 2023 reflects the aggressive efforts to get the labor in line with the volume and also to recover those inefficiencies. As we go forward, we'd be looking at the normalized growth rates of each of the segments being included in our efforts to get to the ROS targets that we implied.

Okay. That makes sense. And then, just from a guidance perspective, could you help with the cadencing a little bit through the year. When you think about normal seasonality and there's a lot of moving pieces particularly in Pools, some of the destocking, how are you guys thinking about what the normal seasonal cadence looks like by segment within the guidance?

We are starting to move back to a more typical seasonality where Q2 is typically our largest quarter followed by Q3. I would say that we expect to see slightly less than 50% of our EPS in the first half, primarily because interest expense is a little bit higher in the first half and transformation initiatives play out a little bit more strongly in the back half. But we are returning to more traditional seasonality than what we saw during the COVID years.

And I would just add that you should assume that most of the residential channel challenges will come through Q1, Q2 and Q3, and we have easier comparisons in the back half of the year as we look at what those year-over-year impacts would be.

The next question is from Julian Mitchell of Barclays. Please go ahead.

Thanks. Good morning. I just wanted to understand your sort of conviction level around the price tailwinds. You had 5 points of price dialed in for this year after sort of low teens ending last year. So, maybe sort of give some more color on the price confidence and how you see the sort of needed inventory liquidation in a lot of pool products perhaps weighing on that?

Yes. So, I'll start and then Bob can bring some more in. I think first of all, the price that we're anticipating is actions that have already been taken. And we feel good about the decisions we've made and we feel like we have, as we said, stickiness in the channel. I do think it's fair to assume that as we get through the year, we have to anticipate that there might be ideas from the channel to participate in rebates or discounts. We've assumed a little of that in our guide. But we're hopeful that our balanced view of the revenue projections that we have don't encourage us to think that we need to do significant discounting to achieve our expectations.

And you're seeing sort of competitors acting in a disciplined fashion to -- for the time being?

I don't know about that. I mean, we don't have any information to the contrary.

The next question is from Nathan Jones with Stifel. Please go ahead.

Good morning, everyone.

Good morning.

Appreciate all the detail in the presentation this morning. I'm going to ask about Pool. You talked about in the prepared comments Bob, 2019 through 2023 double-digit growth in Pool, [indiscernible] what's in the guidance for '23. I think historically that had been more like 7% or 8%. Can you talk about what was price versus volume in that? How much higher was price than you would normally have? I'm just trying to get an idea in a sense of, are we kind of back to a normalized volume growth? If you take that period from '19 to '23 where we pulled forward demand early, we're giving some [backing] (ph) and now are we kind of back to that normal trend line?

We think if you looked at it, Nathan, on a sell-through basis, we'll be normalized from a volume from a sell-through basis. Obviously, we got a little disconnected on the sell-in versus the sell-out. But overall, we believe we're tracking to historical volume levels with where we end up. So, you should assume that we've had a significant price benefit over the last four years that we've realized.

Okay. That makes sense. So, on a volume level, we're back to normalized. That's good to know. With the change in the reporting structure, is there a change in the way you're managing any of those businesses? And if so, how do you think that benefits the customer experience of buying to Pentair? Just any color you can give us on the change in reporting strategy if there's a change in the actual business management structure?

Yes. We've committed a lot of effort and resources to run at what we call the category level, which is the products that go to the market and serve the customer streams. So that's our focus. And the new segment line-up allows us to be aligned. Pool for pool, and then, we've been able to split the Water Solutions businesses to the residential and commercial where we have the varying go-to-market channels, and IFT remain the same. So, we feel really good about our customer-centric efforts both on sales, marketing and NPI. And we're very encouraged on how the new segments will help enable the focus on the growth journeys of these three different areas.

The next question is from Brian Lee of Goldman Sachs. Please go ahead.

Hey, guys. Good morning. Thanks for taking the questions.

Hi, Brian.

Maybe just shifting -- hey, back to the margin outlook here. I appreciate the update of you through '25. I guess just sort of drilling into '23 a bit here, you mentioned the 100 basis points from the Manitowoc. When I look at just Slide 19, can you kind of give us a sense of if that's your sort of entire transformation contribution in '23? Or maybe just walk us through some of the pieces, including how much of that 100 basis points from Manitowoc is embedded in the '23?

Yes, let me do that. I would say roughly 50 basis points to 60 basis points comes from Manitowoc of that 160 basis point increase. So, the way that you should think about Manitowoc is we had roughly $150 million of revenue in our P&L in 2022; $60 million in Q3, $90 million in Q4. And as we mentioned before, we drive about 30% of Ross on that Manitowoc business. We'll increase to about $370 million of revenue in 2023. So, think of revenue going up about $220 million in Manitowoc at that 30% income level. We also get by exiting the residential businesses, we'll lose about $25 million of revenue in 2023, but we'll gain about $10 million of income, those were loss making businesses in 2022. So, when I talked about acquisitions and divestitures benefiting about 5% top-line and roughly 35% from a ROS perspective, that was the breakout.

Okay. That's great. Appreciate that color. And then, just a quick question on the Pool side. I don't know if you quantified this, but you're talking about the channel inventory sort of coming down maybe normalizing in the 2Q-3Q timeframe. Can you quantify sort of where you see inventory levels sort of weeks and then -- or I guess months and where you would need to get to sort of get a normalized level?

Yes, I'm looking at it slightly different than that. I think we've shared with you that we think we're down about 20% each on new pool builds and also the aftermarket remodeled side. So, think of that as each of those two 20% is down 20%. And then, we group the aftermarket and the inventory piece, and we assume that what we're going to see is lower pull-through from the sell-through and demand, because as Bob mentioned, we think some of the aftermarket demand was serviced earlier. And because of that, we feel like we got to balance the shipments into the channel and the industry to serve that lower demand. And most of that we think happens over Q1, Q2 and Q3.

The next question is from Steve Tusa of J.P. Morgan. Please go ahead.

Hi, guys. Good morning.

Hey, Steve.

Hi, Steve.

Just the inflation number, I'm not sure if you said that so far, what's the actual number? I mean, you could kind of eyeball the chart there, but just curious what the actual inflation headwind is for '23?

It'd be about 4.5% is how we view it at this point.

Okay. So, on absolute basis, what does that kind of convert to?

Well, if you think about prices being about 5%, so call that, $200 million benefit, I think about inflation at 4.5% is being around $180 million.

Okay. So, moderately positive. When you think about the pricing in the other businesses, anything going on there? Any kind of surcharges? Or anything moving around in the non, I guess, the more industrial businesses?

No, real surcharges, Steve. We're back to more normalized price actions and having to go out and compete competitively from a standpoint of making sure that quoting those jobs by anticipating the impact of inflation, and then winning [the future] (ph) sourcing inflation as we satisfy the industrial projects.

The next question is from Andy Kaplowitz of Citigroup. Please go ahead.

Hey, good morning, guys.

Good morning.

Hi, Andy.

So, supply chain inflation, obviously, looked better in Consumer Solutions in Q4, but I think you mentioned productivity was negative because of a decline in revenue. I know you said you expect inefficiencies to lessen as you go into '23. So, just sort of what that happened in Q4 was just lower revenue, and do you still see that sort of $50 million of incremental improvement for manufacturing inefficiency getting better in '23 versus '22?

We do. Go ahead, Bob.

Absolutely. So, the significantly lower volume in Q4, while we put actions in place, that's what primarily drove the negative productivity. As we look at 2023, those inefficiencies whether it was air freighting, spot buys, whether it was supply chain challenges, those will reduce significantly and, obviously, help our productivity. Those will be one area. Then, just the actions we took in Q4 around adjusting for the lower volume will benefit us. And then, in addition to that, the transformation initiatives that are starting to benefit us in 2023.

Very helpful. And then, Bob, maybe the conviction level to get back to free cash flow conversion of 100%? And if you do get there, obviously, you've got some leverage here, but we've seen more recent announcements of a little bit of consolidation in, call it, the water equipment space. So, where does Pentair go from here on the M&A front?

Yes, I'll definitely take the first one. We have high confidence in our free cash flow. We will benefit from working capital coming down in 2023, primarily inventories. We've established targets and are starting to chart progress. So, I'm confident around the inventory space. We'll also see benefits versus 2022 in terms of accruals and cash being paid out. So, overall, there's three or four different areas that give us confidence in the free cash flow. Historically, we do drive a 100% of net income. And when we've had a challenging year, we turn around the next year and get back to our typical path. So, high confidence there.

Yes. And as far as the M&A, I mean, short term, we're going to service the debt just because of the high interest rates. We love our strategy. We believe the move and proven enjoy gives us a lot of flexibility to add to our existing portfolio. But we're going to be smart. I mean, call me old fashioned, but I think ROIC matters in the long run. It used to be how we measured performance. I still think it matters and I think we have to be disciplined with your capital. And we need to make sure if we put that capital work that we can make these acquisitions deliver to the expectations.

The next question is from Deane Dray of RBC Capital Markets. Please go ahead.

Thank you. Good morning, everyone, and welcome to Shelly.

Thank you.

We also, John, agree, ROIC matters.

Thank you.

Hey. And on Manitowoc, just can we circle back on this? One of the obvious upsides was the whole cross-sell opportunity, making sure every one of those ice machines has a Pentair filter. Just can you share with us on the take rate there? Any initiatives that you have to make sure that that process happens smoothly?

Yes. Deane, first of all, I still think we think across all the synergies we said that we're going to experience those. And we do believe, as we said, there's certainly account management and making sure that we can service the key accounts across all three platforms, KBI being one of those platforms as well on the service side. We do believe that every ice machine should have a filter and we would hope that it's our filter since we think we are the best filtration company. But that has been [independent] (ph) choice, of course, made by the distributor and the end market. And I think we can help them be aware of why our filters do better and we do believe that take rate is going to be serviced over time.

Got it. And then, for Bob, the idea here is you've got this whole working capital normalization happening. Wouldn't it be fair to expect that cash conversion would be well above 100% at some point in '23, just given the kind of cash conversion that you'd expect from working capital alone?

We've looked at the free cash flow and certainly don't want to get ahead of ourselves. One of the pacing items is the transformation piece. So, we expect to spend less on transformation and restructuring in 2023 than we did in '22, but we still have to invest to drive the benefit. So, those will be good payback items that we spend the money on, but that is one of the items that contains the free cash flow slightly. The only other thing I want to mention on your first question relating to scorekeeping for Manitowoc is that as we drive synergies, it's all within commercial water solutions, but some of the benefits goes to commercial filtration as they sell filters, some of it goes to our Ken's Beverage as they drive more services relating to the ice machine. So, all of the synergies are not necessarily captured in just Manitowoc Ice.

The next question is from Jeff Hammond of KeyBanc Capital Markets. Please go ahead.

Hey, good morning, guys.

Hey, Jeff.

Good morning.

Just on -- just back on Pool and the destocking, I'm just wondering, one, kind of how you think of inventories on your balance sheet versus those at the distributor channel? And then, just if any early buy kind of played in any part and kind of the pacing of destocking?

To the second one, and really when we think of inventories, you have -- a reminder that some of our inventories are across the entire portfolio. Our project businesses, our electronics, the tougher to get componentry is where a lot of our inventory resides, Jeff. It's not like we're sitting on finished goods inventory ready to go out. So, it's not that simple.

Okay. Just on res pool, I think you put -- around Pool, you've got 28% margins in '22. How should we think about decrementals as you go through this transition and kind of where you think those margins bottom out?

We expect to drive margin improvement in 2023, Jeff. I mean, as a reminder, our volume in Pool was down roughly 30% in Q4. And that's one of the reasons we didn't get to get that leverage up. And as we take a look at 2023 when we get the costs in line and balance out against these new production levels, we do believe we're going to drive margin improvement in Pool in 2023.

The next question is from Scott Graham of Loop Capital Markets. Please go ahead.

Hey, good morning, and welcome, Shelley. So, just to couple of questions, one on the Pool, one on the commercial water treatment. I know you said for commercial water to expect sort of a mid-single digit growth this year, I'm curious does that include Manitowoc Ice on sort of pro forma...

I -- no. And I'm sorry that we weren't clear. I thought the question was what was core growth of commercial water solutions, and I said mid-single digits. Inclusive, of the acquisitions, it's much higher than that, which is on the chart as mid-teens.

Right. No, that I certainly understand.

They all included.

Yes, that I certainly understand. What would you think that the growth would be in Manitowoc Ice in pro forma?

Mid singles.

Okay. Thank you. The other question is around Pool. So, there's a pretty big change in your assumption. I think you were looking at, thinking, last quarter that aftermarket would be about flat, and now you're kind of looping that together with the continued destock. And I'm just curious because there are more pools in the grounds, so I would have almost thought that naturally that aftermarket might have even been up this year. So, is that essentially saying that the destock is kind of more than 100% of the decline? Or am I thinking about that right?

Yes. I think it's really the result of the significant growth in '20 and '21 and first half of '22 that the industry saw. And if you think about a more normalized growth, it would suggest that key items like heaters and lighting were probably pulled into those earlier years. And that is probably challenging the aftermarket assumptions. Now all of that's great, because we're adding to content in existing pools and there will be some replacement of those products down the road. So, I think long-term trajectories are fine. We just think that some of the demand was pulled into the earlier years.

This concludes our question-and-answer session. I would like to turn the conference back over to John Stauch, President and Chief Executive Officer, for closing remarks.

Thank you, and thank you for joining us today. We're excited about the future Pentair and focused on creating a better world for people on the planet through smart sustainable water solutions. Our focus on driving superior shareholder value is fueled by our mission to help the world sustainably move, improve and enjoy water, life's most essential resource. Kate, you may conclude the call.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.