Is Pentair a Dividend Stock to Buy?

Pentair PLC (NYSE: PNR  ) is one of the lesser known Dividend Aristocrats -- stocks that have raised their dividend for 25 consecutive years or more -- but that doesn't mean it lacks attention from certain quarters. The company specializes in water flow technology (valves, controls, and process technologies) and often gets attention from investors looking for a thematic way to play the increasing need for the management of water resources. Are these two factors -- water and a dividend -- enough to make the stock a long-term buy for income seekers?

More cyclical than you might think

The theory is as simple as it is attractive. Long-term population growth, particularly in emerging markets, will lead to a 25% increase in freshwater demand by 2030. Moreover, we live in a world where, according to the UN CEO Water Mandate, one-third of the population already lives in "water-stressed countries." Given the strains that an increasing population will put on water infrastructure, for agriculture and industry as well as human consumption, the need for investment is substantial.
So is Pentair's long-term demand assured, and should you go ahead and buy this Dividend Aristocrat?
Investing is rarely that simple, of course, and the reality is that Pentair's prospects turn out to be quite cyclical in nature. The following chart demonstrates the significant declines in its revenue and operating income in the last recession. Don't be fooled by the dramatic increases from 2012 onward; that's due to a $5 billion acquisition of the valve and flow control operations of Tyco. (More on that later.)

Source: Morningstar.

Guidance cut

Moreover, earlier this year, Pentair was forced to reduce its earnings estimates for 2014 and 2015 for a couple of cyclically related reasons. The range of its 2014 EPS guidance was reduced from $3.85-$4 to $3.65-$3.70 -- a $0.25 reduction at the midpoint. Its 2015 EPS guidance was likewise reduced from $5 to $4.50. There were two main reasons for the decline, and both are cyclically related.


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Introducing Watts Water, a Strong Commercial Construction Play for 2014

The water sector has long been favored by long-term investors who like thematic trends. The critical necessity of water in industrial and commercial applications, and the need for potable water supply for a growing global population means that the sector has strong long-term prospects. However, while the trend maybe upward, the water industry is notably exposed to demand from new housing and commercial construction project, and that hasn't been a great place to be in recent years in the West. However, with these end-markets looking set to pick up in 2014, companies like water products manufacturers Pentair $PNR and Watts Water  $WTS look  well placed.

Watts Water and Pentair look set for growth
Foolish readers know why commercial construction is a good sector to be in next year. Simply put, the commercial construction sector tends to follow the residential sector, and with the housing market in good shape going into 2014, investors in the commercial construction sector should be feeling optimistic about the coming year.

Indeed, a quick look at what analysts have penciled in for Watts and Pentair reveals a positive consensus for the next few years.

Forecast EPS Growth Rates	2013	2014	2015	2016	2012-2016 CAGR
Watts Water Technologies	4.5%	25.4%	21.0%	13.3%	15.8%
Pentair	33.8%	23.8%	22.5%	9.5%	22.1%

Source: Nasdaq.com

Pentair is attractive in its own right, but its forecast revenue mix for 2013 demonstrates that residential and commercial activity only represents 25% of its end market.

Source: Company presentations

Pentair's diversified exposure is fine if you want an industrial play, but for those investors looking specifically for a residential and commercial play then Watts Water is better placed. Pentair's diversification would normally be seen as a major plus point, but not if you want to focus on commercial construction.

Watts transforms itselfWatts stands out for its cash flow generation. For example, Watts has converted around 150% of net income into free-cash flow, or FCF, over the last three years. 

Assuming that  Watts converts 130% of net income into FCF in future, and using these rates and analysts' earnings-per-share forecasts from the table above, can give an idea of FCF per share. For the sake of simplicity, assume that EV is equivalent to current values.

Source: Nasdaq.com, author's estimates

Watts Water looks like a good value. The impressive thing about Watts is that although its trailing-12-month revenue of $1,452 million is marginally above its 2008 level of $1,432 million, the company has increased gross margins from 33.7% to 36.1% over the period.  In other words, should revenues start to increase in the future, Watts has a good opportunity to generate higher profits thanks to better margins. Moreover Watts generates 50% of its revenue from commercial operations, so it's heavily exposed to a pick up in commercial construction.

On a more negative note, Watts generated only 52% of its sales from the U.S. in 2012 with 40% coming from Europe, the Middle East and Africa, or EMEA. In fact, its guidance for 2013 assumes that EMEA will decline by 4%-5% with North American core business sales estimated to grow 3%-5%. While Europe is likely to remain soft, Watts will come up against some easier comparisons in 2014. In addition, in its latest investor presentation, management outlined that "overall market confidence appears to be improving" in EMEA, while is North American commercial market is "starting to see signs of a pick-up".  Both statements are good signs.

The bottom line
If you are looking for an overall industrial play then Pentair is worth a closer look, but for a developed market play on a resumption in residential and commercial construction spending then Watts is better placed. The company has internally transformed itself over the last few years in order to improve cash flow generation and its return on invested capital. As long as the U.S. housing market remains in recovery mode, it's a good bet that commercial construction will follow, and Watts is well placed to outperform.