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Edited Transcript of PNR earnings conference call or presentation 23-Oct-19 1:00pm GMT

Q3 2019 Pentair PLC Earnings Call

Manchester Oct 29, 2019 (Thomson StreetEvents) -- Edited Transcript of Pentair plc earnings conference call or presentation Wednesday, October 23, 2019 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* James C. Lucas

Pentair plc - Senior VP of IR & Treasurer

* John L. Stauch

Pentair plc - President, CEO & Director

* Mark C. Borin

Pentair plc - Executive VP, CFO & Principal Accounting Officer

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Conference Call Participants

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* Brett Logan Linzey

Vertical Research Partners, LLC - VP

* Brian K. Lee

Goldman Sachs Group Inc., Research Division - VP & Senior Clean Energy Analyst

* Charles Stephen Tusa

JP Morgan Chase & Co, Research Division - MD

* Deane Michael Dray

RBC Capital Markets, LLC, Research Division - MD of Multi-Industry & Electrical Equipment

* Jeffrey David Hammond

KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst

* Joseph Craig Giordano

Cowen and Company, LLC, Research Division - MD & Senior Analyst

* Joshua Charles Pokrzywinski

Morgan Stanley, Research Division - Equity Analyst

* Julian C.H. Mitchell

Barclays Bank PLC, Research Division - Research Analyst

* Michael Patrick Halloran

Robert W. Baird & Co. Incorporated, Research Division - Associate Director of Research & Senior Research Analyst

* Nathan Hardie Jones

Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst

* Saree Emily Boroditsky

Jefferies LLC, Research Division - Equity Analyst

* Walter Scott Liptak

Seaport Global Securities LLC, Research Division - MD & Senior Industrials Analyst

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Presentation

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Operator [1]

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Ladies and gentlemen, thank you for standing by, and welcome to the Q3 2019 Pentair Earnings Conference Call. (Operator Instructions)

I would now like to hand the conference over to your speaker today, Jim Lucas. Thank you. You may begin.

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James C. Lucas, Pentair plc - Senior VP of IR & Treasurer [2]

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Thanks, Dorothy, and welcome to Pentair's third quarter 2019 earnings conference call. We're glad you could join us. I'm Jim Lucas, Senior Vice President of Investor Relations and Treasurer. And with me today is John Stauch, our President and Chief Executive Officer; and Mark Borin, our Chief Financial Officer.

On today's call, we will provide details on our third quarter 2019 performance as well as our fourth quarter and full year 2019 outlook as outlined in this morning's press release.

Before we begin, let me remind you that any statements made about the company's anticipated financial results are forward-looking statements subject to future risks and uncertainties, such as the risks outlined in Pentair's most recent Form 10-Q, Form 10-K and today's press release. Forward-looking statements included herein are made as of today and the company undertakes no obligation to update publicly such statements to reflect subsequent events or circumstances. Actual results could differ materially from anticipated results.

Today's webcast is accompanied by a presentation, which can be found in the Investor Relations section of Pentair's website. We will reference these slides throughout our prepared remarks. Any references to non-GAAP financials are reconciled in the appendix of the presentation. We will be sure to reserve time for questions and answers after our prepared remarks. (Operator Instructions)

I will now turn the call over to John.

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John L. Stauch, Pentair plc - President, CEO & Director [3]

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Thank you, Jim, and good morning, everyone. Please turn to Slide #4 titled Executive Summary. We're pleased to deliver a solid third quarter performance. In particular, a return to segment income growth and ROS expansion and building on our performance from the second quarter. We are maintaining our full year EPS guidance. We have seen price/cost stabilize, and we are encouraged to see further signs of top line stabilization in our important aquatics business.

We continue to invest in our 2 key strategic growth priorities: advancing pool growth and accelerating residential and commercial water treatment. These investments are centered around building out a consumer experience inclusive of our brand, channel, innovative products and services. We continue to believe we are well positioned to return to core sales and income growth in 2020, and I will talk a little bit more later in the call about our optimism about our long-term strategy and prospects.

I will now turn the call over to Mark to discuss our third quarter results and updated full year outlook. Mark?

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [4]

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Thank you, John. Please turn to Slide 5, labeled Q3 '19 Pentair Performance. For the third quarter, overall sales increased slightly, and we saw core sales decline 2%, segment income grow 1% and adjusted EPS increase 7%. We'll provide more color on the individual segment performance shortly.

Below the line, we saw an adjusted tax rate of 15%, net interest/other expense of $7.7 million and our average shares in the quarter were 168.6 million. The tax rate in the quarter reflects our long-term strategy spread across a lower income base in 2019, resulting in an expected full year adjusted tax rate of 17%.

Finally, free cash flow was just over $150 million and in line with normal seasonal patterns. We were pleased to see segment income grow and ROS expand despite the softer top line, and we believe this is a reflection of price/cost stabilizing following the headwinds of significant inflation we discussed in prior quarters.

Please turn to Slide 6 labeled Q3 '19 Pentair Segment Performance.

This slide lays out the third quarter performance of our 3 segments. As expected, our aquatic segment experienced a 5% core sales decline against an extremely tough comparison. Following rather abnormal weather during the first half of the year, it appeared that weather in much of the country was more normal during the quarter and the result was an improved sell-through. Aquatic saw segment income decline 9% and ROS contracted 60 basis points but still came in north of 25%. As we have repeated throughout the year, we remain focused on exiting 2019 with channel inventories more in line with historical levels.

Filtration Solutions reported core sales growth of 4% with solid contribution across all business lines but particularly within the smaller food and beverage business as we shipped out some of our improved backlog in both beer and sustainable gas. The integration of both Aquion and Pelican remains on track and both businesses performed in line with our expectations. Segment income grew 17% for filtration and ROS expanded 50 basis points to 16.5%.

In Flow Technologies, core sales declined 5% during the quarter. We continue to see strong headwinds in our ag business, both OEM and aftermarket. Despite the soft top line performance, segment income grew 4% and ROS expanded 170 basis points to 17.1%. As a reminder, Flow Technologies was hit hardest by tariffs and broader inflation in the second half of 2018 and the comparison in the quarter was its easiest of the year. While we continue to see mix results across the 3 segments, we are most encouraged by signs of stabilization in price/cost as well as only 1 more quarter of tough top line comparisons for aquatics.

Please turn to Slide 7 labeled Balance Sheet and Cash Flow. Our balance sheet continued to strengthen and the third quarter delivered another seasonally strong quarter of free cash flow. During the third quarter, we had one bond mature and we have one other bond maturing in the fourth quarter. As a reminder, we successfully issued a 10-year note during the second quarter. Between our healthy free cash flow and improved leverage ratios, our balance sheet remains well positioned to fund both organic and inorganic growth opportunities.

Please turn to Slide 8 labeled Q4 '19 Pentair Outlook. For the fourth quarter, we anticipate core sales to be roughly flat. We expect Aquatic Systems to be down approximately 1% to 3% as we continue to focus on making sure channel inventories return to more normalized levels by the end of the year. We expect core sales growth in both Filtration Solutions and Flow Technologies to be essentially flat. We anticipate segment income to be up approximately 6% to 8% as we expect price/cost to further stabilize and we continue to drive productivity. We expect adjusted EPS to be in a range of $0.64 to $0.66 per share.

Below the line, we expect corporate expense to be approximately $14 million to $15 million. We expect our fourth quarter adjusted tax rate to be around 17%. We expect net interest/other expense of roughly $8 million and shares to be approximately 169 million.

Please turn to Slide 9 labeled Full Year 2019 Pentair Outlook. For the full year, we expect core sales to be down roughly 1%. We expect total sales to be essentially flat with roughly 2% contribution from our 2 acquisitions, offset by 1% headwind from FX. We anticipate segment income to be down around 3%. We continue to expect our full year adjusted EPS to be approximately $2.35 per share. Other items embedded in our guidance include expected corporate expense of $60 million to $63 million, an adjusted tax rate of 17%, net interest/other expense of $35 million and an average share count for the year of roughly 170 million shares.

While there are undoubtedly many moving pieces to our 2019 path to expected flat EPS, we continue to be encouraged by signs of top line stabilization and further price/cost improvement. We are encouraged by the performance the business are delivering in light of the top line challenges faced this year.

I would now like to turn the call back to John.

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John L. Stauch, Pentair plc - President, CEO & Director [5]

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Thank you, Mark. Please turn to Slide #10 labeled Executing a Consistent Strategy. We continue to be focused on driving our long-term strategy, and we believe there's a lot of evidence that the focused investments we are making are the right investments and driving results. Most people would agree that global water quality is a challenge. While many companies are participating in offerings to solve this global issue, we have chosen to focus primarily on the residential and commercial markets.

There is little argument that consumers can benefit from taking ownership of their own water experience. They can do it to their own taste and with solutions that meet their individual needs and preferences. And Pentair has a variety of solutions to help consumers treat, move and enjoy water. In fact, Pentair is one of the few total solution providers to residential customers. Also, when we aligned on our strategy nearly 2 years ago, it started with our leading aquatics franchise. With over 5 million pools installed in the U.S. and over half of them being over a decade old, there's a large installed base to serve.

We have built a strong business focused on new product development and strong dealer loyalty. The introduction of the Variable Speed Pump nearly a decade ago created an awareness around energy savings and the result has compounded with other product categories from LED lighting to hybrid heaters. We believe that the continued adoption of automation, which is small today -- roughly 275,000 pools, versus an opportunity north of 2.5 million pools in the U.S. -- creates a new avenue of growth where we have a leading position.

Within Residential Filtration markets, the acquisitions of Aquion and Pelican earlier this year moved us from being a leading component supplier to now being a provider of systems and solutions. We have learned quite a lot in our short time owning both of these businesses, and we believe there are many paths to creating value as we help consumers solve their water challenges in their homes.

On the commercial side of the business, we have historically enjoyed a strong position in the foodservice area. Increasingly, we are focusing on total water management with customers, and we believe this presents an opportunity to better position us with many of our existing and potential customers. Within the commercial office water space, customers are increasingly looking at opportunities to decrease the use of plastic bottles. And we have a number of technologies today that can serve this space. And we believe there are opportunities to further expand in this area.

Outside of the residential and commercial verticals, we have a number of technologies we have developed around nano and ultrafiltration. As we develop new IoT products, we see even more opportunities to solve customer challenges. For instance, within the beer industry, we have approximately 150 plants globally that use our digital BMF system that enables our customers to become more sustainable, lower cost, move from static to dynamic live reporting and improve overall operating performance. We are transitioning this technology into the sustainable gas industry and we believe there are opportunities to extend this technology to other parts of our portfolio over time.

We also continue to believe there are multiple paths to drive consistent, sustainable growth, especially in our core residential and commercial businesses. Our recent acquisitions allowed us to move closer to the consumer. And while we have built a strong aquatics business, we believe that by better focusing on the consumer and not only the dealer, it will enable us to maintain an already healthy growth rate in one of our best businesses.

We believe that we have the right portfolio, the right strategy, the right culture and the right technologies to further our position as a leading water treatment company with a strong core to build from and a healthy balance sheet to support both organic and inorganic opportunities. We look forward to demonstrating our strategy to our shareholders in Q4 and in 2020 and beyond.

I would now like to turn the call over to Dorothy for Q&A. After which, I will have a few closing remarks. Dorothy, please open the line for questions. Thanks.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from the line of Steve Tusa with JPMorgan.

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Charles Stephen Tusa, JP Morgan Chase & Co, Research Division - MD [2]

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Can you just break down a little more like what's going on in the Flow business? The revenues were way off versus our model, but the profits kind of held in. And I know there's some dispersion in the margin profile of some of those businesses. So -- and that was one, I think, in the first quarter, it was tough for us to kind of figure out. What's going on in that segment? I think the other 2 are pretty straightforward. What's going on in this segment?

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John L. Stauch, Pentair plc - President, CEO & Director [3]

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Yes, Steve. Let me speak to the revenue mix, and then I'll let Mark get into the details. During the end of Q2, we saw a little false-positive on some of the ag orders. And right out of the gate in Q3, we just saw that ag did not recover at all. So we had anticipated a little more recovery sequentially in Q3 and it just flat out didn't happen. So now we've adjusted heading into Q4 and next year and the fact that we don't see ag recovering at all. And I think a lot of the global data would suggest that we probably figured it out right now. But that was a little bit of a bounce in Q3 that we had expected that didn't happen.

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Charles Stephen Tusa, JP Morgan Chase & Co, Research Division - MD [4]

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How big is ag? And isn't that relatively profitable? Shouldn't that had a -- shouldn't that have had a kind of more negative impact on the margin? Like, what am I missing on that front?

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [5]

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Steve, it's Mark. That's a great question. What we saw positive signs of here were 2 things. Really, we see price/cost getting better. As I said in my prepared comments, Flow was hit hardest by the inflation pressure. So we see price/cost turning positive in Q3 and then also productivity. We touched on that in Q2, that although we weren't -- we didn't see the productivity reading out in Q2, we saw signs that gave us a high degree of confidence that we would start to see that in Q3 and that's really what happened. So you're right that being down in ag from a mix perspective would push margins down and income down, but that was -- we were benefited by better productivity and improved price/cost. And Steve...

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Charles Stephen Tusa, JP Morgan Chase & Co, Research Division - MD [6]

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And how big is ag for you guys?

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [7]

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Ag would be somewhere in the $200 million range.

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John L. Stauch, Pentair plc - President, CEO & Director [8]

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Per year.

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Charles Stephen Tusa, JP Morgan Chase & Co, Research Division - MD [9]

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Okay. And then one last one just on aquatics. POOL made some pretty positive comments that their channel is clear. Can you kind of validate that comment or are there other considerations in thinking about next year a little bit? I would think you guys have some easy comps here coming up in the first half of '20 or is there something else that we should keep in mind when thinking about kind of the trajectory in the next year?

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John L. Stauch, Pentair plc - President, CEO & Director [10]

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Yes, Steve. So I think you're right. I mean we do track one of our largest customers' earnings calls. And we agree that inventory is definitely getting more normalized here and our goal is in between now and the end of the year to make sure that it gets into that normalized pattern. I do think though that the pricing this year is relatively more normal, which will not suggest that any in the channel would reach to do the buy aheads that we saw last year with a much more elevated pricing level.

So Mark, I don't know if you want to add any more.

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [11]

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No, I agree. I mean, as we've said, we continue to believe that by the end of the year we'll exit with normal levels, and we think of 2020 more in line with the historical normal seasonal stabilized perspective.

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Operator [12]

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Your next question comes from the line of Nathan Jones with Stifel.

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Nathan Hardie Jones, Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst [13]

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Just maybe thinking a little bit about where the return to organic growth comes from in 2020. I mean I think we've probably beaten the pool business to death and can all understand why that should return to growth.

But I mean if I'm having a look at the last couple of quarter's results, organic sales have been down with positive impacts from price. This quarter, you're down to, with 3 points to price and volume, down 5. Outside of the pool business with what I would imagine are moderating price tailwinds and some negative volume trends here, where would you expect the growth to come from in 2020 outside of pool?

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John L. Stauch, Pentair plc - President, CEO & Director [14]

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Well, I mean it's a good question, and I thank you for asking. But I mean, first of all, beyond pool, we also had some channel inventory in both filtration and flow that was built up for some of same buy ahead patterns that happened in last year's Q3 and Q4. So this year's Q3 and Q4 have those difficult comparisons. And then Q1 and Q2 of next year have much easier comparisons across both filtration, flow and aquatics.

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Nathan Hardie Jones, Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst [15]

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Okay. So some tough comp issues this year for the same reasons as pool lead to some easier ones next year. That makes sense. Can you maybe talk a little bit more about some of these -- you talked about focused investments being the right investments and driving results. Maybe talk a little bit more about where those investments are, what kind of results you're seeing them drive? And maybe specifically a little bit more about building out the channel for the commercial and residential filtration.

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John L. Stauch, Pentair plc - President, CEO & Director [16]

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Yes. So we have 3 specific growth priorities in both pool and residential commercial filtration. It's really about having -- I'll start with commercial first. It's about having the best commercial systems and capabilities. We're really excited about the technology that we are building to solve commercial office water opportunities. As you know, people are seeking carbonated water, and they're also seeking flavored carbonated water. So really excited about the investments we made on the technology side. And while we're more than a year away from launching any of that product, our product is a really better solution that we think that the market will benefit from. So we're excited there.

We're also, through both the acquisitions and also internally within Pentair, we're having the best residential systems. Smarter, more innovative valves technology, smarter water softener systems technology, hooking those to automation. And then having the services piece through the Pelican acquisition to complete that last mile. And we're really excited about the progress of that in-home sales capability and the build-out of what we call our mobile resource centers, which are our vans that we go out and sell with. So huge progress there.

On the pool side, we continue to see technology advancement. New technologies around filtration, new technologies around automation. So we're excited that that penetration rate will show up. And when you look at the sell-through rates of pool in both Q2 and Q3, they're back to the high single digits again. So once we get through this inventory channel issue and the pool business normalizes, I think we're very positive that we'll see that return to growth next year.

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Nathan Hardie Jones, Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst [17]

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On the commercial water filtration product, the flavored and bubbly water, have you guys done enough work to kind of talk about what you think the size of that opportunity is for you?

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John L. Stauch, Pentair plc - President, CEO & Director [18]

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I think it's really fragmented. I think the overall momentum is there. I think what we want to do is make sure that we have the systems that can give you chilled, heated, sparkling, and as you know, our Everpure filtration is a big part of that overall component. So we want to be talked about in the space, and we want to make sure we have the right systems that can solve any solution that basically a commercial customer has.

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Operator [19]

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Your next question comes from the line of Joe Giordano with Cowen.

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Joseph Craig Giordano, Cowen and Company, LLC, Research Division - MD & Senior Analyst [20]

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John, I just want to clarify something you said earlier on Steve's question regarding flow. Like, I think you mentioned that there were some [hasty] kind of exiting 2Q about ag that didn't materialize in the quarter. I was under the impression that once ag, like when we had that bad weather in the first half, that like any recovery in ag was taken out of that. So I'm just a little confused about -- can you kind of square that for me?

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John L. Stauch, Pentair plc - President, CEO & Director [21]

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Yes. There's 2 forms of ag. We have a precision ag spray business and that we did address earlier. That is a very, very high margin offering. The other part of ag is more the pivot ag spray in the irrigation side of the business. That's specifically what I was referring to.

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Joseph Craig Giordano, Cowen and Company, LLC, Research Division - MD & Senior Analyst [22]

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Okay. So this is the irrigation, not the -- okay, cool. Okay. Can you talk about maybe some of the action you're having with some -- just the internal cost initiatives? Because clearly, I mean, particularly in flow, I mean, you're seeing the margins come through on a weak growth number. So you've talked about them at a high level, maybe if there is a couple of examples you could kind of take us through as to some things that are being done differently today than maybe a year ago across the enterprise maybe.

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [23]

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Yes. Sure. One of the things we talked a lot about as we separated was optimization and really looking at where we did we have complexity and how could we get after complexity reduction. And the Flow Technologies segment was certainly one of those businesses where we saw high degree of that SKU rationalization, things that inherently drive up cost and drive down margins. And the team really got after that in -- as we exited 2017 and throughout 2018. And so we're starting to see those activities and actions pay off here in 2019.

And also, we've also talked about some of the factories where we've had some challenges. We've been investing in automation and in other technology to replace and improve some of the older equipment and machinery that's used in some of those factories. That's also starting to read out. Early stages, so there's more of that to come as we think about 2020. But we're again seeing favorable signs and encouraged by what we're seeing.

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Joseph Craig Giordano, Cowen and Company, LLC, Research Division - MD & Senior Analyst [24]

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And maybe last for me on -- if we look -- I know it's too early to talk 2020, but if we just think about a situation where there is inventories cleaned up through your partners and we can start ramping a little bit. When I think about free cash flow, nice performance here in the quarter. Is that going to be -- how much of a headwind do you see that being into '20 as things kind of ramp up and you had to start producing at a higher rate?

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [25]

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I think we still have opportunity to really focus on cash flow and would continue to view cash flow targeting at approximating adjusted net income. So we wouldn't change that point of view even though as we grow, to your point, there may be some working capital type things that we need to invest in but there are opportunities in other places that we would manage and balance out to have that long-term target still maintained.

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Operator [26]

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Your next question comes from the line of Mike Halloran with Baird.

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Michael Patrick Halloran, Robert W. Baird & Co. Incorporated, Research Division - Associate Director of Research & Senior Research Analyst [27]

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So a couple ones. First, just on capital usage here. Any thoughts to bringing back being more aggressive on the buyback side again?

And then secondarily, related to that, how does the M&A pipeline look? What's the willingness, ability to bring something in? And how are the valuations looking out there?

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John L. Stauch, Pentair plc - President, CEO & Director [28]

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Yes. I mean I think, clearly, we're focused on execution right now, Mike, and part of that was making sure that we're delivering on our commitments on Q2, Q3 and Q4. That's our first focus area. I think there is growing opportunities to invest in the platforms that I mentioned and we'll continue to look at those tuck-in acquisitions, as I would say, that feed more of what we've done already. But you can never time those. We have no idea where they're going. And we just want to make sure that we're protecting the balance sheet heading into next year and giving ourselves flexibility to do what we think is going to drive the most amount of value.

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Michael Patrick Halloran, Robert W. Baird & Co. Incorporated, Research Division - Associate Director of Research & Senior Research Analyst [29]

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The pipeline on that side though, John?

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John L. Stauch, Pentair plc - President, CEO & Director [30]

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Good.

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Michael Patrick Halloran, Robert W. Baird & Co. Incorporated, Research Division - Associate Director of Research & Senior Research Analyst [31]

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Okay. All right. And then just your thoughts on the price/cost side. You talked -- it seemed like you're implying that the price/cost side should be a little bit more favorable moving forward from here. Maybe talk about puts and takes on the pricing side as that kind of flattens out a little bit relative to the commodity side and how you're thinking about that moving into next year?

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [32]

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Yes. So maybe the way to think about it is, we had significant price/cost headwinds as we talked about coming out of last year and into the beginning of this year. Now what I referenced in Q3 in particular was favorability because we've got favorable price and we have inflation moderating. As you move forward, that favorable year-over-year price will start to be a little bit more in a normal -- at a more normalized level versus the unusually high price increases that we had in 2018 that spilled over into 2019. So I don't -- it's more of a stabilization story rather than a benefit. It's just mitigation of what had been a pretty significant headwind.

And on the inflation side, one thing to always kind of keep in mind is, is inflation is not just the material or commodity inflation but we certainly also have labor inflation and we don't see that going away or moderating. So that will continue to be part of how we think about what our 2020 will look like.

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Operator [33]

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Your next question comes from the line of Jeff Hammond with KeyBanc Capital Markets.

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Jeffrey David Hammond, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [34]

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Just on -- can you just talk about what is informing the lower growth rate in filtration? And then just as you look forward here and a lot about macro slowing and just where are you seeing some signs of slowing in your business outside of that ag space?

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [35]

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Sure. As I talked about in Q3, we saw pretty improved performance in the food and beverage part of the filtration business. That moderates a little bit in Q4. So that's part of the story. We do see continued stabilization and incremental improvement on the important residential and commercial side, both the systems and components businesses where our -- where those -- the investments in those acquisitions took place.

So overall, just more of a moderated view given the performance in Q3. And then would expect to kind of as we think about moving into 2020, a similar level of performance and starting to see some of the investments that John talked about reading out in improved core sales growth.

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Jeffrey David Hammond, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [36]

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Okay. And then just on pool. What are you assuming and what are customers telling you about kind of the normal early buy situation? And then just if we look into 2020, certainly, you've got some easy comps, and typically, this business grows mid- to high single digits. Should we think of 2020 as kind of an easy comp and you can get back to those levels or above?

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [37]

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So on the first question and from an early buy perspective, we're seeing kind of a consistent early buy pattern. Last year was a little bit unusual because of the blend of the impact of the price increase. But what we're seeing this year is more in line with kind of the historical trends.

In terms of next year, as we said, we're exiting Q4. You see the Q4 guide as what I would think of as back to a little bit more level of normalization, improved income performance, flattening of the top line, which had been decreasing. And as we think about 2020, we're just going to really focus on getting back to what we believe would be performance in line with our long-term objectives.

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Operator [38]

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Your next question comes from the line of Deane Dray with RBC Capital Markets.

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - MD of Multi-Industry & Electrical Equipment [39]

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How about -- can we put a little finer point on the -- working down the excess channel inventory in pool if we've been thinking it was around a $60 million excess? And just based on commentary about expected 4Q normalizing, how much should we think about that $60 million having been worked off so far?

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [40]

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Yes. So as we talked, we worked down some of that inventory in line with sort of our expectations, and we continue to see that coming down further in Q4 and exiting the year at levels that are in line with more historical seasonal patterns.

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - MD of Multi-Industry & Electrical Equipment [41]

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Okay. And then on pool, John, you talked about some of the new product development in filtration and pool and automation. Are -- just to set expectations, might you have some new automation offerings for the 2020 season?

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John L. Stauch, Pentair plc - President, CEO & Director [42]

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Yes, we do already. And I think we're learning how to sell it better. We believe everybody can benefit from that automation capability. It's a different type of sale though. And we have, we believe, the right products that can really help the user along. And we have to tweak our ability to sell technology. It's not like selling a product. It's more like selling a service or capability. And so we learned a lot this year, and I think we're encouraged by the progress we're making in Q3 and into Q4. And I think those products are going to be really accelerated as they head into next year.

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - MD of Multi-Industry & Electrical Equipment [43]

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When you say sell a service, is that something that Pentair would benefit from on a recurring basis or is that a pool dealer that would be part of their revenue stream?

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John L. Stauch, Pentair plc - President, CEO & Director [44]

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Well, clearly, the vision would be that everybody would benefit, right, and that at the end of the day, most people buy technology on more rented basis because they believe whatever they have is going to be obsoleted. We'd have to align the channel that way, Deane. But ultimately, we think that's going to be the right answer.

We're launching in this quarter the new Pentair Home app, which basically is a broad umbrella that takes all of the suite of products that Pentair offers and allows it to be connected into that home app. And we're hopeful that as the consumer sees more and more things that are available to either connecting with Alexa or Google Home or Apple or whatever your device is that you start to see the benefits of someone monitoring your water quality and then starting to buy some of the products and services that would attach to that.

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Deane Michael Dray, RBC Capital Markets, LLC, Research Division - MD of Multi-Industry & Electrical Equipment [45]

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That's good to hear. And just last one for me. When you talk about the commercial office water opportunity, are you thinking -- and still, we agree that it's still very fragmented. Are you thinking of a rental opportunity or would this be equipment sales or both?

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John L. Stauch, Pentair plc - President, CEO & Director [46]

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Today, it's about having the right systems and likely us selling them. Deane, as you know, the market does rent them. The end solution providers do rent units. Don't know yet if that's the space that we want to be in. But we were -- we introduced carbonated water some 8 to 10 years ago. We were probably early in the market. We have all the technology and we deliver that for foodservice. And so how do we bring that into a commercial office environment in a productive way? If that's what people want.

As you guys know, there's a lot of fickle drinkers. The first one is get tea and coffee. Most all tea and coffee needs to be filtered, so you don't scale to units or cause damage to those units and our filtration plays a big part in that. And if we expand that filtration into other forms of water, we think there's a huge opportunity for Pentair. Look, this is forward thinking. We believe we have the technology where it's probably not a '20 launch. It's probably somewhere in 2021.

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Operator [47]

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Your next question comes from the line of Josh Pokrzywinski from Morgan Stanley.

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Joshua Charles Pokrzywinski, Morgan Stanley, Research Division - Equity Analyst [48]

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Quick question on price/cost. I guess with working down channel inventory and kind of generalized market weakness, some of that related to weather earlier in the year, I would imagine it's harder to get price certainly, probably more room for incentives than to try to raise prices in the channel. Is that something we should expect to start expanding more rapidly from this point now that we've kind of cleared the season, cleared the channel overhang from an inventory perspective?

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [49]

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I think the best way to think about it is, as I said before, is just more of a normalized level of price. As you know, a big chunk of the price that we see overall comes from the pool business. They had unusually high price last year in response to inflation. This year, they had a price increase that would've gone into effect in September, which is the normal time frame that those price increases go into place. And I'd call that more in a -- more normal historical level. And something similar in the other businesses.

So we're not seeing -- we didn't see any unusual reaction to price this year as a result of channel inventories. But we do see just going to a more normalized level given that last year's higher price was really driven by that incremental inflation.

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Joshua Charles Pokrzywinski, Morgan Stanley, Research Division - Equity Analyst [50]

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Got it. And then, I guess, as it pertains to the aquatic season just as we kind of wound it down there in the third quarter. Obviously, you had a slow start with weather, particularly in some of the warmer regions that would've been bigger contributors in the first quarter. Did any of that get made up later in the year just with the season maybe stretching out longer, not even weather related but just thinking of folks are always going to be busy kind of May through August but maybe they do an extra job in September. Is that something that you guys notice and maybe sets up a comp we should think about in -- at least in sell-through next year?

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John L. Stauch, Pentair plc - President, CEO & Director [51]

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Yes. I think some of it will -- I don't think, first of all, the comp is meaningful enough. But yes, those pool builders will continue to work as long as they can in those areas and they'll fill in jobs in the slower season that they would have otherwise not done. But they will also probably likely celebrate the holidays that exist in Q4. So you're not going to see that same level of build that you tend to see in the more summer seasons.

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Operator [52]

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Your next question comes from the line of Saree Boroditsky with Jefferies.

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Saree Emily Boroditsky, Jefferies LLC, Research Division - Equity Analyst [53]

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Could you provide some color on what you saw geographically? I believe last quarter, you talked about Europe and China being positive. Did that continue? And any expectations as we look forward towards the end of the year?

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [54]

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Sure. That -- it did continue. So we had commented earlier in the year that we saw some weakness in Europe, particularly on the filtration side as we move through the year in Q2 and then again in Q3 and we really see through the balance of the year. We saw improvement there. So Europe now is back to moderating growth and China as well is returned to a reasonably good growth level.

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Saree Emily Boroditsky, Jefferies LLC, Research Division - Equity Analyst [55]

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Okay. And then just a more longer-term question on aquatics. How should we think about the impact from the Variable Speed Pump legislation that goes into effect in 2021?

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John L. Stauch, Pentair plc - President, CEO & Director [56]

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We believe in 2021, it should help our overall sales. Variable Speed Pumps for us today are probably just over half of our total pumps sold. They do sell at a higher sell-through value. So we do believe as the transition happens, those of us who've been through these transitions before always have to question when are those dates going to really happen and will there be slippage and also how does the inventory work its way through. And so we're not putting anything into 2020, obviously, and we'll see if there's a relative bump in 2021. But overall, it should be positive to our business.

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Operator [57]

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Your next question comes from the line of Julian Mitchell with Barclays.

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Julian C.H. Mitchell, Barclays Bank PLC, Research Division - Research Analyst [58]

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Maybe just following up on that geographic point. You've emphasized some of the weakness in ag, and we've talked a lot already about residential trends in the U.S. in the past few months. Just wondered if you could give any detail around what you're seeing in some of the more commercial or industrial markets in the U.S., if there's been any particular shift in demand from month-to-month since July?

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [59]

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Nothing significant from a month-to-month perspective. 80% of our business overall is driven by the residential and commercial end markets. And as we move through the balance of the year, we've talked about sort of the inventory impact. But beyond that, the underlying demand has remained positive and we continue to see that kind of reading out through the balance of the year.

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Julian C.H. Mitchell, Barclays Bank PLC, Research Division - Research Analyst [60]

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And then on your sort of segment income bridge, I guess, on Slide 5. When we're thinking about the productivity portion of that in aggregate, it looks like it's probably, I don't know, maybe a $20 million tailwind or something for the year as a whole. If you could just sort of clarify if that sounds about right.

And then when thinking about next year, do we think about some of those measures that you've accelerated around productivity pushing that number up? Or is that a pretty good run rate for the current demand environment?

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [61]

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Yes. I think what you're seeing in Q3 is more in line with the level that we would anticipate it in. And I think to remember kind of what makes that up, there's multiple elements. So there's material productivity, which is where we're working on trying to mitigate some of the inflation headwinds. There's operating cost productivity. They would think about that as looking at opportunities to reduce G&A costs. And then there's factory productivity.

But then what offsets that is also the investments we're making in the growth areas around R&D and selling, marketing, investments in technology and things like that. So as we think about this year and into next year, we'll continue to look for increasing levels of productivity but utilizing some of that to continue to invest in the areas where we see the biggest growth opportunities.

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Julian C.H. Mitchell, Barclays Bank PLC, Research Division - Research Analyst [62]

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And one last quick one for me. Looking at the filtration operating performance, you had pretty healthy sales growth there in Q3. The incremental margin was around 20% or so. Is that a reasonable sort of placeholder for that business with its current mix? Or did you see anything sort of onetime within that figure?

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John L. Stauch, Pentair plc - President, CEO & Director [63]

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I wouldn't call it onetime. But this is where we do have the residential systems and also the consumer services, and we are significantly investing in those businesses, right? So we're very encouraged by the top line growth we have. And we continue to add back both digital marketing, advertising, branding and R&D spend to really accelerate the long-term growth there. So I think this is a more normalized pattern as we head into 2020 as benefiting from the growth and then reinvesting a portion of that income back in to fuel more growth.

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Operator [64]

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Your next question comes from the line of Walter Liptak with Seaport Global.

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Walter Scott Liptak, Seaport Global Securities LLC, Research Division - MD & Senior Industrials Analyst [65]

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I wanted to ask a geographic question in the sense of the comments about the EU filtration kind of moving up to moderating growth and China doing okay now. I wonder if you could just give a little bit more detail about why? Because when we look at macro numbers, Europe continues to get worse. China, the GDP numbers continue to weaken. What's going on with your sectors, with your market share that's helping those regions?

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John L. Stauch, Pentair plc - President, CEO & Director [66]

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Yes. So let me talk about China first. Our China business, we said before in China and Southeast Asia overall is residential filtration primarily and think about that being just north of $100-and-some million on an annual basis. So the growth rates we're talking about are really about us starting from a relatively low base in a very enormous market in which we have a dedicated China team and we have a dedicated factory, dedicated R&D lab. And we really invest a lot in new product growth and marketing. So we're winning in a space that may or may not overall be growing but we have a lot of runway left in that area.

In Europe, Mark gave the overall numbers and that is appropriate. Within those overall numbers, there's things that are doing well in Europe and there's things that aren't doing so well in Europe. So as we look at some of the global industrial product lines, we definitely saw slowdowns. And when you take a look at some of the more installed base residential and commercial aftermarket businesses, they're doing okay. In no way would we call it a robust market environment.

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Walter Scott Liptak, Seaport Global Securities LLC, Research Division - MD & Senior Industrials Analyst [67]

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Okay. Can you help us with the size of the EU industrial business?

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [68]

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Yes. It's roughly $100 million.

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John L. Stauch, Pentair plc - President, CEO & Director [69]

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Yes, $100 million total for year?

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [70]

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For the year, right, not in the quarter.

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Walter Scott Liptak, Seaport Global Securities LLC, Research Division - MD & Senior Industrials Analyst [71]

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Okay, great. And then just switch gears over to the R&D. Hearing about the investments. In 2020, is it similar levels of R&D but more focused around some of these growth opportunities? Or should we expect some kind of a step-up in R&D spend?

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John L. Stauch, Pentair plc - President, CEO & Director [72]

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Yes. I think you're going to expect a step up. I've said many times that we have the ability to invest a lot more in R&D. And we'll feel better about that investment when we feel marketing has done the work to produce the road map of where our R&D will be best utilized. We're really excited about our automation platforms, and we have a global innovation center around automation, a one Pentair solution that will work across the enterprise, really excited about that road map.

And then around our treatment, water treatment innovation center. Really excited about the nano and ultrafiltration technologies out of the CPT acquisition, our X-Flow business, and expanding those into both residential and commercial. Very excited. And then as I mentioned earlier, building systems capability that takes that technology and gives the overall solution. Those are the double downs for me and the team and I'm going to accelerate that investment in 2020 and probably '21, and we're encouraged and excited by the products at the other end of that investment.

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Operator [73]

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Your next question comes from the line of Brian Lee with Goldman Sachs.

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Brian K. Lee, Goldman Sachs Group Inc., Research Division - VP & Senior Clean Energy Analyst [74]

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Maybe just first one on price. Going back to that topic to clarify a bit. I know 2019 was a bit abnormal with the 3 points here, and I know it's early for 2020. But do you think it's reasonable to assume we just settle back to somewhere around 1 point in price for next year like we've seen in past years? Or was the pricing this year late enough in the year where there's still some spillover into the early part of next year?

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [75]

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Yes. I think about it as slightly higher than that, 1% that we've seen prior to 2018, for the few years prior to that, it had been right around 1%. But that was -- I call that like historically low. So something in the 2% range is probably a little bit more in line with what would be historically normal.

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John L. Stauch, Pentair plc - President, CEO & Director [76]

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With a round-up range on that, 50 basis points, okay? I mean I think it's too early to say. The businesses that went out in September, as Mark said, I mean we were out in that range, as Mark said, and we saw all those pricing stick and we're generally well received by the overall customers. And those are more normal, and then we'll see how the others do.

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Brian K. Lee, Goldman Sachs Group Inc., Research Division - VP & Senior Clean Energy Analyst [77]

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Okay. Great. That's helpful. And then just a second question going back to flow for a second. I know you kind of walked back the core growth outlook for that segment through the year and you sort of did the opposite last year and walking it up through the year. So how derisked is the view here for 4Q just given how lumpy it's been all year? And then as you think about 2020, is this a segment you'd expect to grow year-on-year along with the overall business?

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John L. Stauch, Pentair plc - President, CEO & Director [78]

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I can't call it derisked. I can just tell you that it represents the last multiple quarters' trends. It doesn't produce any incremental upside sequentially through things growing off of how they did the previous quarter, and then there is some year-over-year benefit as you look at Q1 and Q2 in this business next year. And then we'll see how confident we are when we come up with a guide of being able to drive organic growth in Q3 and Q4 of next year.

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Operator [79]

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Your next question comes from the line of Brett Linzey with Vertical Research Partners.

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Brett Logan Linzey, Vertical Research Partners, LLC - VP [80]

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Just wanted to come back to aquatics. You talked about some of the technology and growth priorities you have there in pool. As we think about those incremental costs and price moderating but also some relief on ROS and other spending, what's the right incremental margin range we should be thinking about next year as you maybe see a more normal top line?

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John L. Stauch, Pentair plc - President, CEO & Director [81]

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This business has a fairly sizable drop-through because it's sales minus material and a really efficient manufacturing process. So good drop-throughs. I'm not going to give you an answer because this is a huge value contributor to Pentair and I want to invest in this. And I think we have some really exciting technology in the pipeline here as well, and we'd like to put some investment back in the sales channel, primarily around the aftermarket side. I think we do a really nice job with our dealer channel covering both new pools and remodeled pools.

I think our opportunity is in being further down the aftermarket cycle with the services channel and making sure we're the company of choice for consumers in that services play. And then also making sure that we go back to our roots. And I still say we are the technology leader but we used to be significantly more advanced than we are today and we believe we have those technologies in the pipeline and need to drive them through a new product development phase. And that would be the investment thesis for 2020 as well.

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Brett Logan Linzey, Vertical Research Partners, LLC - VP [82]

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Okay, great. And then shifting to restructuring. You took, I think, $6 million this quarter, $7 million last quarter. Are you budgeting more spending in Q4?

And then just thinking about the payback. Did most of that get realized in the quarter or do you see some of that rolling over into 2020 from a savings standpoint?

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [83]

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We -- so we don't include in our guidance an expectation around restructuring, but I would anticipate there would be some incremental restructuring again in Q4. And the investments and restructuring that we've made in this year really wouldn't see those necessarily reading out now but those would be part of how we think about 2020.

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John L. Stauch, Pentair plc - President, CEO & Director [84]

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As Mark mentioned, we're attacking some of the factories and some of the efforts within the factories. Those tend to have a little bit longer payoff than just structural changes to the business. So they're the right investments. We do have a larger footprint than we need and it isn't always geographically perfect. So we've addressed some of that especially in the flow side, as Mark mentioned. And while we're seeing the margin improvement, I think there's still an opportunity for more margin improvement down the road.

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Brett Logan Linzey, Vertical Research Partners, LLC - VP [85]

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Okay. And geographically, where were those costs focused? Restructuring?

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John L. Stauch, Pentair plc - President, CEO & Director [86]

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A little bit everywhere.

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Mark C. Borin, Pentair plc - Executive VP, CFO & Principal Accounting Officer [87]

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Yes.

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Operator [88]

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And there are no further questions at this time. I will turn the call back over to our speakers for closing remarks.

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John L. Stauch, Pentair plc - President, CEO & Director [89]

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Thank you for joining us today. We're encouraged by our third quarter performance, and we continue to see further signs of stabilization in our core business. We saw further productivity improvement in the quarter, and we continue to build on our strong culture. We have been investing and we'll continue to invest in our key growth strategies as well as digital enterprise capabilities to better serve our customers. We have a strong capital structure, solid free cash flow, and we will continue to invest in our strategy to be the leading residential and commercial water treatment company. Thank you for your continued interest. Dorothy, you can conclude the call.

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Operator [90]

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Thank you, ladies and gentlemen. That does conclude today's conference call. We thank you for your participation and ask that you please disconnect your lines.