Pentair PLC: Relatively Overpriced (NYSE:PNR)

It’s been about two years since I suggested that I’d buy Pentair PLC (NYSE:PNR) if the relative merits of the stock were superior to Treasuries. The problem for me was that the stock was inferior to the Treasury, so I eschewed the shares. After dropping about 26% over the next five months, the stock spiked higher in price and has now returned about 72% relative to the 29% return for the S&P 500 over the same time period. I thought it’d be worthwhile to have another look at this so-called “dividend aristocrat” and so I’m taking another look. I’m going to review the latest financial data, and once again compare this stock to the risk-free alternatives available to investors right now.

My writing is, and will forever be, “a bit extra” to borrow a likely now outdated phrase from the young. Given that all of the bad jokes and proper spelling can be a bit much for some people to take, I offer up a thesis statement at the beginning of each of my articles, so you have the opportunity to get in, get some exposure to my perspective, and get out again before things get too woozy. You’re welcome. I’m of the view that Pentair is fine enough, though it’s not “blowing the doors off.” My problem here is the same as it was previously, though it’s even more stretched now. I can’t understand why someone would take on the added risk of owning a stock relative to a Treasury Note while being compensated less. The share price would need to fall massively to convince me to buy, when Treasuries are offering much more predictable, safer returns in my view. Thus ends my thesis statement. If you read on from here, that’s on you.

Financial Snapshot

After a relatively troubled 2022, the financial fortunes of the company have turned around reasonably well in my view. This is largely the result of a drop in cost of sales to a more reasonable level of about $2.6 billion for the year. I’d also say that growth over the past year has been sclerotic, with revenue and net income down by 1.1% and up by 1.9% respectively. That written, the capital structure is much improved, with debt down a whopping 16.4% compared to the same period a year ago. Given the above, I’d be happy to buy the stock if the valuation is reasonable, and if the dividend is sustainable.

Dividend Sustainability

I’ll admit it. I actually like accrual accounting. There. Judge all you want. The problem is that accrual is less useful a tool in my view when judging the sustainability of a dividend. In that circumstance, I turn my attention to cash flows. In particular, I want to compare the current and likely future sources of cash to the schedule of contractual obligations that a firm has, as well as the investments that must be made in the business. The larger the gap between the level of cash and the various obligations, the happier I am.

As of the most recent filing, the company has about $170 million cash on the balance sheet. Additionally, over the past three years, they’ve earned about $530 million in cash from operations, net of the impacts of acquisitions and divestitures, and spent an average of about $159 million on the business. So, I’m assuming that the company has the capacity to generate a net positive $374 million in cash annually.

In terms of contractual obligations, the company will spend about $363 million this year, and an additional $2.25 billion afterward. I’m sorry to report that I don’t have any more clarity on the timing here. So, this year’s obligations are approximately equal to the delta between CFO and CFI.

Given the above, I’m not overly sanguine about the firm growing dividends without taking on more debt. They may borrow in order to raise the dividend, but this simply adds risk to the capital structure, which defeats the purpose in my view. Given the above, the firm needs to be trading at a deep discount before I get excited about buying.

The Stock v The Treasury Note

I think it reasonable to assume that Pentair will continue to grow its dividend. That’s not the issue for me. My issue, as I often repeat, is the idea that everything in the domain of investing is relative, and that investors should always seek the highest risk adjusted return available to them. To that end, I want to answer the question “by what amount will Pentair need to grow its dividend to match the cash flows earned on the 10-Year Treasury Note over the next decade?”

In addition, given the risk involved, I want to earn more cash from this stock than from the Treasury. I want to work out what price an investor would need to pay in order to earn a sufficient risk premium over the Treasury rate. Different investors will have different hurdles to overcome, but I would need to earn an additional 40% more cash from the stock before I get excited about buying.

To the first question about matching the Treasury note, the dividend needs to grow at a CAGR of 29.37% over the next decade to match the cash flows received by investors in the 10-Year Treasury Note. Even the most ardent bull in this stock would have to admit that that rate of growth is highly unlikely. I’m willing to assert that at this point, the investor in the Treasury Note will receive more cash over the next decade than will the investor in this “dividend aristocrat.”

In terms of the second question, If I want an additional 40% cash from the stock over the next decade to compensate for the risks of owning a security over a Treasury. The Treasury Note investors will receive $3,775 over the next decade for every $8,427 they invest. Note, I’m using $8,427 because the Pentair share price is currently $84.27. Using the arithmetic skills not so lovingly beaten into me by the good sisters at Holy Spirit School many, many decades ago, that works out to a requirement to receive $5,285 in dividend income. If we assume that the dividend grows over the next decade at the same rate it’s grown over the past five years (CAGR 4.8%), that lines up with a current 5% dividend yield. In order to get a 5% yield out of this stock at the moment, the price would need to drop to a price of ~$18.40 per share, or about 78% below the current market price.

Given that I’m a relativist (where investing is concerned, anyway), I think it makes more sense to buy the 10-Year Treasury Note than to buy this stock. This view is based on the idea that the investor in the risk free instrument ends up receiving significantly more cash as the investor in the riskier stock. That makes no sense to me, because it makes no sense to take on extra risk (of stock ownership) and receive no extra reward for your trouble. Additionally, for those who fret that there’s no upside in Treasury Notes at the moment, I would counter that rates will likely come down over the next decade, and such a move will create a decent capital gain in Treasury Notes.

Of course this view will change if the stock drops massively in price. I’d be very happy to buy at a price under $20 per share, but at the moment, I see no reason to get excited.

Finally, just like everyone’s hurdle rate is different, so too is their tax situation. Some people have these investments inside sheltered accounts, and some people don’t. Some are in relatively “extreme” tax brackets, and some are not. Given that, I think it worthwhile to acknowledge the difference in how dividends are treated relative to Treasuries (for American investors, anyway), but I don’t think it’s helpful to offer up broad strokes of comments on this score other than a recommendation to talk to a tax expert when doing your own due diligence.

A Note of Caution

Just because my math lines up nicely, the market can obviously remain irrational for a great many years. I’m not interested in finding the investment that’s going to go up the fastest. I’m interested in measuring the relative risks and merits of different instruments and acting accordingly. I applied the same logic two years ago, and, although I was glad to avoid the 26% drop in price after my article was published, the market took these shares for a ride higher about half a year after I reviewed the stock. I would say that much of this ride has been based on very little substance, but that doesn’t make the relative trade any more comfortable in the moment. I think the stock price can continue to go higher from here, and an investor who, like me, decides to eschew these shares would be wise to remember that.

Because I’m the sort to absolutely beat a proverbial horse, or any other ungulate in order to drive home my point, allow me to demonstrate what I’m saying graphically. The graph below is the yield on the 10-Year Treasury Note over the past five years. The arrow that I’ve so deftly drawn for your enjoyment and edification points out the state of the world when I last suggested that Treasuries were better investments than this stock. Since then, the yield on the 10-Year Note has risen about 50%, to the point where we’re in a world where you can now receive 4.435% on lower risk Treasuries.

So, the yield on the 10-Year has grown fairly massively over the past two years, while the stock has risen higher. There’s no reason to assume that this condition can’t persist for another few years. The shares may continue to rise. In my view, when the share price does inevitably unwind it will be quite ugly, and I’d rather avoid that pain, which is why I’m avoiding the shares.