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PNR > SEC Filings for PNR > Form 10-K on 25-Feb-2014All Recent SEC Filings

Show all filings for PENTAIR LTD

Form 10-K for PENTAIR LTD


25-Feb-2014

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward-looking Statements
This report contains statements that we believe to be "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact are forward-looking statements. Without limitation, any statements preceded or followed by or that include the words "targets," "plans," "believes," "expects," "intends," "will," "likely," "may," "anticipates," "estimates," "projects," "should," "would," "positioned," "strategy," "future" or words, phrases or terms of similar substance or the negative thereof, are forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties, assumptions and other factors, some of which are beyond our control, which could cause actual results to differ materially from those expressed or implied by such forward-looking statements. These factors include the ability to successfully complete the Redomicile (as defined below) and achieve the expected benefits from the Redomicile; the ability to successfully integrate Pentair, Inc. and the Flow Control (as defined below) business and achieve expected benefits from the Merger (as defined below); overall global economic and business conditions; competition and pricing pressures in the markets we serve; the strength of housing and related markets; volatility in currency exchange rates and commodity prices; inability to generate savings from excellence in operations initiatives consisting of lean enterprise, supply management and cash flow practices; increased risks associated with operating foreign businesses; the ability to deliver backlog and win future project work; failure of markets to accept new product introductions and enhancements; the impact of changes in laws and regulations, including those that limit U.S. tax benefits; the outcome of litigation and governmental proceedings; and the ability to achieve our long-term strategic operating goals. Additional information concerning these and other factors is contained in our filings with the U.S. Securities and Exchange Commission, including in Item 1A of this Annual Report on Form 10-K. All forward-looking statements speak only as of the date of this report. Pentair Ltd. assumes no obligation, and disclaims any obligation, to update the information contained in this report. Overview
Pentair Ltd. is a focused diversified industrial manufacturing company comprising four reporting segments: Valves & Controls, Process Technologies, Flow Technologies and Technical Solutions. During the fourth quarter of 2013, we reorganized our business segments to reflect a new operating structure and management of our Global Business Units, resulting in a change from three reporting segments to four. All prior period amounts related to the segment change have been retrospectively reclassified throughout this Annual Report on Form 10-K to conform to the new presentation. We now have four reporting segments: Valves & Controls, Process Technologies, Flow Technologies and Technical Solutions. We classify our operations into business segments based primarily on types of products offered and markets served. For the year ended December 31, 2013, Valves & Controls, Process Technologies, Flow Technologies and Technical Solutions accounted for 33 percent, 23 percent, 22 percent and 22 percent of total revenues, respectively.
Pentair Ltd. took its current form on September 28, 2012 as a result of a reverse acquisition (the "Merger") involving Pentair, Inc. and an indirect, wholly-owned subsidiary of Flow Control (defined below), with Pentair, Inc. surviving as an indirect, wholly-owned subsidiary of Pentair Ltd. "Flow Control" refers to Pentair Ltd. prior the Merger. Prior to the Merger, Tyco International Ltd. ("Tyco") engaged in an internal restructuring whereby it transferred to Flow Control certain assets related to the flow control business of Tyco, and Flow Control assumed from Tyco certain liabilities related to the flow control business of Tyco. On September 28, 2012 prior to the Merger, Tyco effected a spin-off of Flow Control through the pro-rata distribution of 100% of the outstanding common shares of Flow Control to Tyco's shareholders (the "Distribution"), resulting in the distribution of approximately 110.9 million of our common shares to Tyco's shareholders. The Merger was accounted for as a reverse acquisition under the purchase method of accounting with Pentair, Inc. treated as the acquirer.
In May 2011, Pentair, Inc. acquired, as part of Process Technologies, 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.
On January 30, 2014, we acquired, as part of Process Technologies, the remaining 19.9 percent ownership interest in two entities, a U.S. entity and an international entity (collectively, Pentair Residential Filtration or "PRF"), from GE Water & Process Technologies (a unit of General Electric Company) ("GE") for $134.3 million in cash. Prior to the acquisition, we held a 80.1 percent ownership equity interest in PRF, representing our and GE's respective global water softener and residential water filtration businesses.


Key Trends and Uncertainties Regarding Our Existing Business The following trends and uncertainties affected our financial performance in 2013 and 2012, and will likely impact our results in the future:
In September 2012, we completed the Merger. With an acquisition of this magnitude and complexity, there are uncertainties and risks associated with realizing the amount and timing of anticipated growth opportunities and cost and tax synergies as described in ITEM 1A - Risk Factors.

We 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 targeted 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.

End markets for new home building and new pool starts continue to show signs of rebound from their historically low levels in 2007-2011. New product introductions, expanded distribution, channel penetration and a recovering housing market resulted in volume increases for 2012 and 2013 in these end markets.

Despite the overall strength of our end-markets, we experience differing levels of volatility depending on the end-market and may continue to do so over the medium and longer term. While we believe the general trends are favorable, factors specific to each of our major end-markets may affect the capital spending plans of our customers.

Economic uncertainty in Australia has negatively impacted business results and may continue to do so for the foreseeable future.

Through 2012 and 2013, 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.

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 operating activities less capital expenditures plus proceeds from sale of property and equipment. Our free cash flow for the full year 2013 was $751.3 million, exceeding our goal of 100 percent net income conversion. We expect to generate free cash flow that equals or exceeds 105 percent of our net income in 2014. We are continuing to target reductions in working capital and particularly inventory as a percentage of sales. See the discussion of "Other financial measures" under "Liquidity and Capital Resources-Other financial measures" in this report for a reconciliation of our free cash flow.

In 2014, our operating objectives include the following:
Continued integration of Pentair, Inc. and the Flow Control business;

Increasing our presence in both fast growth and developed regions and vertical focus to grow in those markets in which we have competitive advantages;

Focusing on developing global talent in light of our increased global presence;

Optimizing our technological capabilities to increasingly generate innovative new products; and

Driving operating excellence through lean enterprise initiatives, with specific focus on sourcing and supply management, cash flow management and lean operations.

We may seek to meet our objectives of expanding our geographic reach internationally and expanding our presence in our various channels to market by acquiring technologies and products to broaden our businesses' capabilities to serve additional markets and through acquisitions. We may also consider the divestiture of discrete business units to further focus our businesses on our most attractive markets.
Proposed Redomicile
On December 10, 2013, Pentair Ltd. entered into a Merger Agreement (the "Merger Agreement") with Pentair plc, a newly-formed Irish public limited company and subsidiary of Pentair ("Pentair-Ireland"). Under the Merger Agreement, and subject to the conditions set forth in the Merger Agreement, Pentair will merge with and into Pentair-Ireland, with Pentair-Ireland being the surviving company (the "Redomicile"), thereby changing the jurisdiction of organization of the publicly-traded parent


company from Switzerland to Ireland. Pentair shareholders will receive one ordinary share of Pentair-Ireland for each common share of Pentair held immediately prior to the Redomicile.
Upon completion of the Redomicile, Pentair-Ireland intends to manage its affairs so that it is centrally managed and controlled in the United Kingdom (the "U.K.") and therefore have its tax residency in the U.K. Pentair-Ireland will continue to own and conduct the same businesses as Pentair owned and conducted prior to the Merger, except that Pentair-Ireland will replace Pentair as the publicly-traded parent company. Pentair-Ireland will remain subject to U.S. Securities and Exchange Commission ("SEC") reporting requirements and the applicable corporate governance rules of the New York Stock Exchange. The Redomicile is subject to Pentair shareholder approval of the Merger Agreement and certain other conditions. Pentair's shareholders will be asked to vote to approve the Merger Agreement at an extraordinary general meeting of shareholders, which Pentair expects to be held during the second quarter of 2014.
We anticipate that having our publicly-traded parent company incorporated in Ireland and tax resident in the U.K. will provide us the following benefits:
Incorporation of our publicly-traded parent company in Ireland would enable us to benefit by being subject to a legal and regulatory structure in a jurisdiction with a well-developed legal system and corporate law with established standards of corporate governance.

The U.K. has a developed, stable and internationally competitive tax system.

The legal requirements we will be subject to as a company incorporated in Ireland, listed on the NYSE and subject to SEC disclosure and shareholder voting requirements strike the right balance between robust external governance oversight and regulation of our executive and director pay practices and the ability of our compensation committee consisting of independent directors to determine executive compensation to provide incentives to our executive management and to offer competitive salaries and benefits.


CONSOLIDATED RESULTS OF OPERATIONS
The consolidated results of operations were as follows:

                                           Years ended December 31                 % / point change
In millions                             2013         2012        2011        2013 vs. 2012   2012 vs. 2011
Net sales                            $ 7,479.7   $ 4,416.1    $ 3,456.7           69.4  %         27.8  %
Cost of goods sold                     5,006.8     3,146.5      2,383.0           59.1  %         32.0  %
Gross profit                           2,472.9     1,269.6      1,073.7           94.8  %         18.2  %
% of net sales                            33.1 %      28.7  %      31.1 %          4.4            (2.4 )

Selling, general and administrative    1,562.1     1,158.4        694.8           34.8  %         66.7  %
% of net sales                            21.0 %      26.2  %      20.1 %         (5.2 )           6.1
Research and development                 125.8        93.6         78.2           34.4  %         19.7  %
% of net sales                             1.7 %       2.1  %       2.3 %         (0.4 )          (0.2 )

Operating income (loss)                  774.0       (43.1 )      100.2           N.M.          (143.0 )%
% of net sales                            10.3 %      (1.0 )%       2.9 %         11.3            (3.9 )

Gain on sale of businesses               (19.7 )         -            -           N.M.               -  %
Loss on early extinguishment of debt         -        75.4            -         (100.0 )%         N.M.
Net interest expense                      69.1        67.6         58.9            2.2  %         14.8  %

Net income (loss) before income
taxes and noncontrolling interest        726.4      (184.0 )       43.2           N.M.            N.M.
Provision (benefit) for income taxes     183.8       (79.4 )       46.4           N.M.            N.M.
  Effective tax rate                      25.3 %      43.1  %     107.3 %        (17.8 )         (64.2 )


N.M. Not Meaningful
Net sales
The components of the consolidated net sales change were as follows:
             2013 vs. 2012     2012 vs. 2011
Volume            7.3  %           (1.0 )%
Acquisition      62.1  %           28.3  %
Price             1.4  %            1.5  %
Currency         (1.4 )%           (1.0 )%
Total            69.4  %           27.8  %

The 69.4 percentage point increase in consolidated net sales in 2013 from 2012 was primarily the result of:
sales volume of the Flow Control businesses of $3,725.7 million in 2013, compared to $886.5 million in 2012;

organic sales growth in Process Technologies and Flow Technologies due to higher sales of certain pool products serving the North American residential housing market and increased demand for global food & beverage solutions;

growth in developed regions led by strength in the U.S. and Western Europe;

growth in emerging regions of the Middle East, Africa and Eastern Europe; and

selective increases in selling prices to mitigate inflationary cost increases.

These increases were partially offset by:
lower sales in infrastructure; and


unfavorable foreign currency effects.

The 27.8 percentage point increase in consolidated net sales in 2012 from 2011 was primarily the result of:
sales volume of the Flow Control businesses subsequent to the Merger of $886.5 million and higher sales volume related to the May 2011 acquisition of CPT;

organic sales growth in Process Technologies and Flow Technologies primarily due to higher sales of certain pump, pool and filtration products primarily serving the North American residential housing market and other global markets;

continued sales growth in fast growth regions including in Latin America and Eastern Europe; and

selective increases in selling prices to mitigate inflationary cost increases.

These increases were partially offset by:
decreases in Technical Solutions sales volume in Western Europe and in the infrastructure vertical; and

unfavorable foreign currency effects.

Gross profit
The 4.4 percentage point increase in gross profit as a percentage of sales in 2013 from 2012 was primarily the result of:
lower cost of goods sold as a result of inventory fair value step-up and customer backlog recorded as part of the Merger purchase accounting, which decreased from $179.6 million in 2012 to $86.9 million in 2013;

savings generated from our PIMS initiatives including lean and supply management practices and synergies from the combined operations subsequent to the Merger; and

selective increases in selling prices across all business segments to mitigate inflationary cost increases.

These increases were partially offset by:
inflationary increases related to raw materials and labor costs.

The 2.4 percentage point decrease in gross profit as a percentage of sales in 2012 from 2011 was primarily the result of:
higher cost of goods sold of $179.6 million in 2012 as a result of inventory fair value step-up and customer backlog recorded as part of the Merger purchase accounting; and

inflationary increases related to raw materials and labor costs.

These decreases were partially offset by:
cost savings generated from our PIMS initiatives including lean and supply management practices;

selective increases in selling prices in Process Technologies, Flow Technologies, and Technical Solutions to mitigate inflationary cost increases; and

higher cost of goods sold in 2011 as a result of the inventory fair value step-up and customer backlog recorded as part of the CPT purchase accounting.

Selling, general and administrative ("SG&A") The 5.2 percentage point decrease in SG&A expense as a percentage of sales in 2013 from 2012 was primarily the result of:
"mark-to-market" actuarial gains related to pension and other post-retirement benefit plans of $63.2 million in 2013, compared to "mark-to-market" actuarial losses of $146.2 million in 2012;

costs associated with the Merger in 2012 that did not reoccur in 2013, including $23.2 million in transaction advisory fees, $21.8 million of change of control costs and $34.1 million of other transaction costs;

trade name impairment charge of $11.0 million for 2013, compared to $60.7 million in 2012;

sales volume of the Flow Control businesses subsequent to the Merger, which resulted in increased leverage on our fixed operating expenses; and


savings generated from back-office consolidation, reduction in personnel and other lean initiatives.

These decreases were partially offset by:
restructuring costs of $113.5 million in 2013, compared to $66.9 million in 2012;

certain increases for labor and related costs; and

intangible asset amortization associated with the Merger.

The 6.1 percentage point increase in SG&A expense as a percentage of sales in 2012 from 2011 was primarily the result of:
"mark-to-market" actuarial losses related to pension and other post-retirement benefit plans of $146.2 million in 2012, an increase of $80.0 million from 2011;

costs associated with the Merger, including $23.2 million in transaction advisory fees, $21.8 million of change of control costs and $34.1 million of other transaction costs;

restructuring costs of $66.9 million in 2012, compared to $13.0 million in 2011;

trade name impairment charge of $60.7 million;

intangible asset amortization related to the Merger and to the May 2011 acquisition of CPT; and

continued investments in future growth with emphasis on international markets, including personnel and business infrastructure investments.

These increases were partially offset by:
a nonrecurring goodwill impairment charge in 2011 of $200.5 million in Process Technologies; and

sales volume of the Flow Control businesses subsequent to the Merger, which resulted in increased leverage on our fixed operating expenses.

Research and development ("R&D")
The 0.4 percentage point decrease in R&D expense as a percentage of sales in 2013 from 2012 was primarily the result of:
lower R&D expenditures in 2013 versus 2012 as compared to sales volume from the Flow Control businesses.

This decrease was partially offset by:
continued investments in the development of innovative new products for future growth.

The 0.2 percentage point decrease in R&D expense as a percentage of sales in 2012 from 2011 was primarily the result of:
sales volume of the Flow Control businesses subsequent to the Merger, which resulted in increased leverage on the R&D spending; and

higher sales volumes in Process Technologies which resulted in increased leverage on the R&D spending.

These decreases were partially offset by:
continued investments in the development of new products to generate growth.

Net interest expense
The 2.2 percentage point increase in net interest expense in 2013 from 2012 was primarily the result of:
the impact of higher debt levels following the Merger; and

additional interest expense of $2.1 million in the second quarter of 2013 for the working capital and net indebtedness adjustment related to the Merger.

These increases were partially offset by:
reduced overall interest rates in effect on our outstanding debt; and


the impact of higher cash balances following the Merger.

The 14.8 percentage point increase in net interest expense in 2012 from 2011 was primarily the result of:
the impact of higher debt levels following the Merger.

This increase was partially offset by:
reduced overall interest rates in effect on our outstanding debt.

Gain on sale of businesses, net
During 2013, we sold businesses that were part of Technical Solutions and Flow Technologies for a cash purchase price of $30.1 million and $13.4 million, respectively, net of transaction costs, resulting in a net gain of $16.8 million and $2.9 million, respectively.
Loss on early extinguishment of debt
In October 2012, we redeemed the remaining outstanding aggregate principal of our 5.65% fixed rate senior notes due 2013-2017 totaling $400 million and our 1.05% floating rate senior notes due 2013 totaling $100 million (the "Fixed/Floating Rate Notes"). The redemptions included make-whole premiums of $65.8 million. Concurrent with the redemption of the Fixed/Floating Rate Notes, we terminated a related interest rate swap that was designated as a cash flow hedge, which resulted in the reclassification of $3.4 million of previously unrecognized variable to fixed swap losses from Accumulated Other Comprehensive Income (Loss) ("AOCI") to earnings in October 2012. All costs associated with the redemption were recorded as a Loss on the early extinguishment of debt including $0.6 million of unamortized deferred financing costs.
In December 2012, Pentair Finance S.A. ("PFSA"), completed an exchange offer pursuant to which it exchanged $373 million in aggregate principal amount of 5.00% Senior Notes due 2021 of Pentair, Inc. a wholly-owned, indirect subsidiary of the Company for a like amount of new 5.00% Senior Notes due 2021 of PFSA, plus $5.6 million in transaction-related costs which were recorded as a Loss on the early extinguishment of debt.
Provision (benefit) for income taxes
The 17.8% percentage point decrease in the effective tax rate in 2013 from 2012 was primarily due to:
the mix of global earnings, including the impact of the Merger; and

the decrease in non-deductible transaction costs during 2013 compared to 2012.

The decreases were partially offset by:
the favorable tax impact related to the 2012 exchange offer that did not occur in 2013; and

the favorable resolution of U.S. federal and state tax audits in 2012 that did not occur in 2013.

The 64.2 percentage point decrease in the effective tax rate in 2012 from 2011 was primarily due to:
the unfavorable tax impact of the $200.5 million goodwill impairment charge in 2011;

the favorable resolution of U.S. federal and state tax audits in 2012 that did not occur in 2011;

the mix of global earnings, including the impact of the Merger and the CPT acquisition; and

the favorable tax impact related to the 2012 exchange offer.

These decreases were partially offset by:
nonrecurring impacts of the Merger, including non-deductible transaction costs and loss of domestic manufacturing deduction tax benefits.


SEGMENT RESULTS OF OPERATIONS
This summary that follows provides a discussion of the results of operations of
each of our four reportable operating segments (Valves & Controls, Process
Technologies, Flow Technologies and Technical Solutions). Each of these segments
is comprised of various product offerings that serve multiple end markets.
Valves & Controls
The Valves & Controls segment designs, manufactures, markets and services
valves, fittings, automation and controls and actuators for the energy and
industrial verticals.
The net sales and operating income (loss) for Valves & Controls were as follows:
                            Years ended December 31               % / point change
In millions                  2013         2012     2011    2013 vs. 2012   2012 vs. 2011
Net sales               $    2,469.2   $ 548.6    $  -           350.1 %        - %
Operating income (loss)        161.4     (76.8 )     -           310.2 %        - %
% of net sales                   6.5 %   (14.0 )%    - %          20.5          -

Net sales
The components of the change in Valves & Controls net sales were as follows:
2013 vs. 2012

Volume            20.7  %
Acquisition      331.3  %
Price              1.7  %
Currency          (3.6 )%
Total            350.1  %

The 350.1 percentage point increase in Valves & Controls net sales in 2013 from 2012 was primarily the result of:
a full year of sales volume in 2013, compared to one quarter in 2012; and

continued sales growth in the Middle East and the oil & gas industry.

The Valves & Controls net sales in 2012 were the result of:
sales volume of the Flow Control businesses subsequent to the Merger of $548.6 million. Valves & Controls was a new reporting segment, effective with the Merger and as a result, 2012 net sales represents the segment's sales for the fourth quarter of 2012.

Operating income (loss)
The 20.5 percentage point increase in operating income for Valves & Controls as a percentage of net sales in 2013 from 2012 was primarily the result of: . . .

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