Franklin Electric - Q1 2013

Transcript

Operator (participant)

Good day, ladies and gentlemen, and welcome to the Franklin Electric Q1 2013 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. If anyone should require assistance during the conference, please press star, then zero on your touch-tone telephone to reach an operator. As a reminder, this conference is being recorded. I would now like to introduce your host for today's conference, Treasurer Patrick Davis. Mr. Davis, please go ahead.

Patrick Davis (Corporate Treasurer)

Thank you, Charlotte. And welcome, everybody, to Franklin Electric's Q1 2013 earnings conference call. With me today are Scott Trumbull, our Chairman and CEO; John Haines, our CFO; Robert Stone, SVP and President, International Water Systems; and Gregg Sengstack, President and COO. On today's call, Scott will review our Q1 business results, and then John will review our Q1 financial results. When John is through, we will have some time for questions and answers. Before we begin, let me remind you that any forward-looking statements contained herein, including those relating to market conditions or the company's financial results, costs, expenses, expense reductions, profit margins, inventory levels, foreign currency translation rates, liquidity expectations, business goals, and sales growth, involve risk and uncertainties.

These risks and uncertainties include, but are not limited to: general economic and currency conditions; various conditions specific to the company's business and industry; new housing starts; weather conditions; market demand; competitive factors; changes in distribution channels; supply constraints; effective price increases; raw material cost; technology factors; integration of acquisitions; litigation; government and regulatory actions; the company's accounting policies; and future trends and other risks, which are detailed in the company's SEC filings and are included in item 1A of part 1 of the company's annual report on form 10-K for the fiscal year ending December 29, 2012, exhibit 99.1 attached thereto, and in item 1A of part 2 of the company's quarterly reports on form 10-Q. These risks and uncertainties may cause actual results to differ materially from those indicated by the forward-looking statements.

All forward-looking statements made herein are based on information currently available, and except as required by law, the company assumes no obligation to update any forward-looking statements. I will now turn the call over to our Chairman and CEO. Scott?

R. Scott Trumbull (Chairman and CEO)

Thank you, Patrick. I'm pleased to report that during the Q1, our earnings per share after Non-GAAP adjustments were $0.33, an increase of 10% compared to the Q1 prior year, and a record for any Q1 in the company's histories. Our revenues increased by 10% overall compared to the Q1 prior year, and our organic sales growth, excluding both acquisitions and foreign exchange, was 6%. In addition, our gross profit and operating income margins continued to improve on a quarter-over-quarter basis, increasing by 40 basis points. While our water business achieved solid gains, our fueling business was our star performer. Fueling systems represented 21% of our consolidated sales during the Q1. Our overall fueling revenues increased by 25% compared to the Q1 prior year, while the organic sales increase was 17%.

Essentially, all of this organic sales increase occurred in developing regions, where filling station owners are continuing to convert from suction pumping systems to the Franklin pressure pumping system in order to transfer gasoline from their underground tanks to the dispensers. While about 95% of the 175,000 filling stations in the U.S. have already made this conversion, we estimate that only about 25% of the 300,000 stations in the developing world have converted. So we anticipate that our sales will continue to benefit from this conversion in the developing regions for the foreseeable future. This is particularly encouraging because when a station owner converts to our pressure pumping system, it opens the door for us to sell our pipe, containment, and leak detection products as well, because these products are specifically designed to enhance the overall performance of a pressure pumping system.

The integration of Flex-Ing Incorporated, the Texas-based producer of filling station hardware products that we purchased in the fourth quarter last year, is proceeding on schedule. We'll have all Flex-Ing manufacturing consolidated into our Madison, Wisconsin plant by the Q3 this year. All Flex-Ing sales have already been integrated. Our fueling team is also in the process of opening a new distribution center in Australia to better serve our customers there. It should be open in the Q3 this year. Our overall water systems sales increased by 7% compared to the Q1 prior year, and increased organically by 4% during the quarter. Our water systems business in the U.S. and Canada represented 38% of our consolidated sales and grew by about 12% compared to the Q1 prior year. Excluding acquisitions and foreign exchange, our organic sales in the U.S. and Canada were flat to prior year.

Our sales of groundwater and wastewater pumps in the U.S. residential market increased by 5%. Our sales to the irrigation and industrial market increased by about 12%, but these gains were partially offset by lower sales of mobile pumps used in the upstream oil and gas market. Sales of Cerus Industrial, the drive-and-control business that we acquired during the Q3 last year, increased by 13% in the key pump channel compared to their pre-acquisition sales during the Q1 prior year. We're in the process of conducting training seminars across the country for our sales force, distributors, and installing contractors on the Cerus product line. The reception has been excellent, and we anticipate continued growth as we move the Cerus product line through the Franklin Electric distribution channels.We are changing the name of Cerus Industrial to Franklin Control Systems, and we are doubling our manufacturing floor space in Hillsboro, Oregon, to create additional capacity for these products. Our Water Systems sales in Latin America represented 14% of our consolidated sales and grew by 1% compared to the Q1 last year. However, when you eliminate the impact of foreign exchange, our organic sales growth in Latin America was a healthy 9%. Franklin Motobombas, our Brazilian company, achieved organic sales growth of 26% during the quarter, buoyed by robust residential and commercial construction activity and the highly successful launch of the Franklin 4-inch Submersible Pump

We expect to take occupancy during the Q2 next year. Our strong organic sales increase in Brazil was partially offset by declining sales in Argentina, where the government has implemented import controls that are slowing but not stopping our supply to customers in that country. Our management team in Latin America is planning to open a new water systems distribution center near Bogotá, Colombia, during the Q2, which will improve our customer service and enhance our sales in this important market during the back half of this year. Our water systems sales in Europe represented 8% of our consolidated sales and grew by 6% compared to the Q1 prior year. Our organic sales growth in Europe was about 2%.

We believe our European management team is doing a good job of increasing sales and improving margins in spite of the slow economy and unusually cold and wet weather conditions during this winter and early spring. One of our growth initiatives in Europe is our election to enter the pump rental business in the United Kingdom. Our Pioneer line of mobile pumping equipment has been highly successful in the U.S. pump rental market. Late last year, we were approached by a management group with deep experience in the U.K. pump rental market seeking to partner with Franklin to introduce the Pioneer product line in the U.K., which, after the U.S., is one of the largest pump rental markets in the world. The plan they proposed included initially opening four rental depots in key markets across the U.K. After careful consideration, we've elected to proceed.

We're investing about $8 million to place Pioneer Pump rental fleets in these depots, and we believe the business will achieve break-even during the fourth quarter this year and is capable of increasing Franklin's operating income by $2-$3 million in 2014. We'll consider adding more outlets in the U.K. and expanding rental operations into other international markets as well. Our water systems sales in the Middle East and Africa represented 11% of our consolidated sales and declined by about 1% during the quarter. Again, the entire decline was attributable to foreign exchange, as our organic sales growth in the Middle East and Africa was about 6%. Our sales in the Gulf region and Turkey grew by about 10% during the quarter on strong demand for water well equipment.

IMPO, the Turkish pump and motor company that we acquired in 2011, continues to perform well and open doors of opportunity for us in the region. Our organic sales in Africa were flat during the Q1, as a modest organic growth in southern Africa was offset by a decline in several countries along the Mediterranean coast. During the Q3 this year, we'll be opening a new distribution center in Zambia to serve the growing agricultural market in that country, as well as the large mining operations in northern Zambia and the Democratic Republic of Congo. Our water sales in the Asia-Pacific region represented 8% of our consolidated sales and grew by 8% compared to the Q1 prior year. Our organic sales growth rate in Asia-Pacific was 7%.

Our sales in Southeast Asia grew by 27% compared to the Q1 prior year as we continued to benefit from the improved customer service levels brought about by our new distribution center in Singapore. Our sales in Australia grew by 20%, aided in part by the launch of our new solar-powered water well pumping system. Our sales in Taiwan declined, however, during the quarter. We believe the decline occurred due to the timing of customer inventory replenishment orders in that market. Our Asia-Pacific management team is currently working to open a new distribution center in India. The center will be located outside of Delhi and will significantly improve the availability of our products in this growing market. We anticipate opening the D.C. during the Q3 of this year.

Also, during the Q1, we initiated trials with a number of additional potential customers for our new oil and gas well deliquification equipment. We currently have a backlog of 21 additional trial installations scheduled over the next five months with customers in the United States, Australia, and southern Africa. We anticipate scheduling more trials over the balance of this year. We expect to achieve 2013 sales of $2-$2.5 million while laying the groundwork for more meaningful sales of this product line in 2014 and beyond. Turning to our outlook for the Q2, we currently believe that our water sales will grow 4%-7% and that our water operating income will also increase by 4%-7%. During the H1 of last year, our sales of industrial and irrigation equipment in the U.S.

and Canada grew by 26%, aided by unusually warm and dry spring weather conditions. Even though drought conditions continue to prevail over most of the western United States, for guidance purposes, we believe it is prudent to project that sales growth in our water segment will not be as robust this year. We believe that our Q2 fueling sales will increase by 13%-16%, and fueling operating income will increase by 19%-23%, driven primarily by ongoing strength in developing regions. Overall, our Q2 consolidated sales and earnings per share are both projected to increase by 6%-10%.

We would normally expect a 6%-10% sales increase to generate an earnings per share increase in the 10%-15% range, but during the H1 of this year, we are supporting an unusually large number of business development initiatives that are currently impacting our fixed cost structure but will not generate anticipated benefits until later this year or 2014. These initiatives include the launching of our gas and oil well dewatering product line, the startup of our pump rental business in the U.K., the construction of our new plant in Brazil, the opening of new distribution centers in Colombia, Zambia, India, and Australia, the integration of Cirrus into the U.S.-Canada business unit, and the construction of our new technical center and headquarters complex in Fort Wayne.

All of these initiatives have the potential to contribute to our future success but are projected to reduce our Q2 operating income growth by $1 million-$1.5 million. I'll now turn the call over to John Haines, our CFO.

John J. Haines (CFO)

Thank you, Scott. As we had previously announced, the company executed a two-for-one stock split effective March 18, 2013. All of the information, commentary, and analysis we are providing to our shareholders in the earnings release and this conference call are using post-split share information. Our fully diluted earnings per share were $0.32 for the Q1 of 2013 versus $0.48 for the Q1 of 2012. As we note in the tables in the earnings release, the company adjusts the as-reported GAAP operating income and earnings per share for items we consider not operational in nature. We believe presenting these matters in this way gives our investors a more accurate picture of the actual operational performance of the company. In the Q1 of 2013, we made two non-GAAP adjustments that totaled about $1.1 million.

These adjustments included $700,000 of restructuring charges primarily for severance expenses as well as the Flexing integration and other miscellaneous manufacturing realignments, and $400,000 for legal fees incurred in Franklin Fueling. In total, these charges round to an EPS impact of $0.01. In the Q1 of 2012, the company made non-GAAP adjustments totaling $11.9 million, the most significant of which was a gain recognized as part of the Pioneer transaction for $12.2 million. In total, the Q1 of 2012 non-GAAP items resulted in an EPS reduction of $0.18 from the reported GAAP EPS of $0.48. So, after considering each of these non-GAAP items, Q1 2013 adjusted EPS is $0.33, which is 10% higher than the $0.30 adjusted EPS the company reported in the Q1 of 2012.

Water Systems revenues were $176.4 million in the Q1 of 2013, an increase of $11.4 million or about 7% versus the Q1 of 2012 sales of $165 million. Sales from businesses acquired since the Q1 of 2012 were $9.9 million or 6%. Water Systems sales were reduced by $4.5 million or about 3% in the quarter due to foreign currency translation. Water Systems sales growth, excluding acquisitions in foreign currency translation, was about 4%. As Scott mentioned, sales growth in groundwater pumping systems in the U.S. and Canada, along with strength in key markets in the southern hemisphere, were the principal drivers of the quarterly sales growth. Water Systems operating income after non-GAAP adjustments was $29.2 million in the Q1 of 2013, an increase of 8% versus the Q1 of 2012.

The Q1 operating income margin after non-GAAP adjustments was 16.6%, an increase of 20 basis points compared to the Q1 of 2012. The margin increase was primarily the result of lower raw material and direct variable costs, partially offset by higher research and development and other new product introduction sales and marketing costs. Fueling systems sales were $46.1 million in the Q1 of 2013, an increase of $9.2 million or about 25% versus the Q1 of 2012 sales of $36.9 million. Sales from businesses acquired since the Q1 of 2012 were $2.9 million or about 8%. Fueling systems sales were reduced by $0.1 million or less than 1% in the quarter due to foreign currency translation. Fueling systems sales growth, excluding acquisitions in foreign currency translation, was about 17%.

Fueling systems sales growth was led by sales increases in developing regions compared to the prior year. Fueling systems operating income after non-GAAP adjustments was $6.8 million in the Q1 of 2013 compared to $5.6 million after non-GAAP adjustments in the Q1 of 2012, an increase of 21%. The Q1 operating income margin after non-GAAP adjustments was 14.8% and decreased by 40 basis points compared to the 15.2% of net sales in the Q1 of 2012. Operating income margin after non-GAAP adjustments declined in fueling systems primarily due to product sales mix during the quarter. The company's consolidated gross profit was $73.9 million for the Q1 of 2013, an increase of $7.6 million or about 11% from the Q1 of 2012 gross profit of $66.3 million.

The gross profit as a percent of net sales was 33.2% in the Q1 of 2013 and 32.8% for the Q1 of 2012, a 40 basis point improvement. The gross profit margin increase was primarily due to lower raw material, direct labor, and variable costs, partially offset by higher fixed costs. Selling general and administrative expenses were $50.1 million in the Q1 of 2013 compared to $45.3 million from the Q1 of the prior year, an increase of $4.8 million or about 10%. In the Q1 of 2013, increases in SG&A attributable to acquisitions were $3.2 million. Additional increases in SG&A costs during the Q1 of 2013 resulted from increased costs for marketing and selling-related expenses of $1.2 million.

These costs increased to support the integration of the Cirrus product line, including the training of the U.S.-based sales force on the Cirrus product line, the launch of the company's pump rental initiative in the U.K., the commercialization of the company's new artificial lift product offering with dedicated commercial teams that operate in the U.S., South Africa, and Australia, opening new product distribution centers, including one in Colombia and India, and other costs to integrate Flexing that were not defined as non-GAAP. As Scott indicated, these costs are necessary to advance key growth initiatives in the company and in the Q2 could reduce our consolidated operating income by $1-$1.5 million. The tax rate as a percentage of pre-tax earnings for the Q1 of 2013 was about 25%, a decrease of about 2% from the Q1 tax rate of about 27%, primarily due to R&D credits.

The effective tax rate before the impact of discrete events for the Q1 of 2013 is 28%, which we also believe is a reasonable estimate for the full-year 2013 rate. The company currently estimates that total non-GAAP adjustments to full-year earnings in 2013 will be approximately $2.5-$2.8 million, resulting primarily from restructuring activities related to the Flexing acquisition, the relocation of the company's headquarters, and other miscellaneous manufacturing realignments in North America and other international locations. The company will continue to provide quarterly reconciliations and explanations of all non-GAAP-related items. The company ended the Q1 of 2013 with a cash balance of $74.7 million, which was $28.7 million less than at the end of 2012.

The cash balance decreased primarily as a result of capital expenditures of $16.5 million, additional purchase price paid for the IMPO acquisition of $5.6 million, and normal seasonal working capital needs offset by the addition of new debt totaling $25 million related to the corporate headquarters and engineering laboratory being constructed in Fort Wayne, Indiana. The company had no outstanding balance on its revolving debt agreement at the end of the Q1 of 2013 or 2012. This concludes our prepared remarks, and we'd now like to open the call up for questions.

Operator (participant)

Certainly. Ladies and gentlemen, if you have a question at this time, please press the star and then the number one key on your touch-tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Our first question comes from the line of Matt Summerville from KeyBanc. Your line is now open, and you may proceed with your question.

Joe O’Dea (Equity Research Analyst)

Thanks. Good evening, guys. This is Joe on for Matt. Just on your commentary about the moderating growth forecast for ag in the U.S. and Canada, is that you being conservative based on the comp issue, or are you hearing or seeing indications from the distributor base that would justify some cause for concern or caution there?

Gregg Sengstack (President and COO)

Our distributor and contractor customers' commentary is positive for the Q2. If you look at the drought maps, you'll see that drought conditions continue to prevail across most of the western part of the United States and, in fact, are, compared to the same period prior year, somewhat more severe. So they're anticipating strong sales. However, I believe we're going into the quarter with a little higher inventories in the trade this year than we went into the quarter last year. If you recall last year, as an anecdotal case in point, on the first day of spring in Indiana last year, it was 80 degrees Fahrenheit. This year, it was 19 degrees Fahrenheit. It's been wetter and colder, and contractors have not been able to get into the fields for installations as early this year as they did last year.

So I think the season has shifted out a little bit. Last year, our distributor shelves were depleted pretty heavily, and I think this year they're filled to normal levels. As a result, we just have higher inventories in the trade than we did at this time last year, and that's a factor in our thinking as well.

Joe O’Dea (Equity Research Analyst)

Okay. Can you comment on the pricing environment? Have you announced a list price increase to the channel this year? Kind of as a follow-up to that, how would you characterize the promotional activity that you typically see around towards the ends of the quarters?

Gregg Sengstack (President and COO)

Okay. We did have a price increase early in the Q1 in our water business in the U.S., and it followed.

John J. Haines (CFO)

Yeah. Generally, Joe, this is John Haines. We have 2%-3% price increases. It depends on the product and the market that we're in, but generally in our water systems businesses, globally, we would say 2%-3%. Timing goes from kind of January 1st through April 1st or thereabouts.

Gregg Sengstack (President and COO)

Okay. At the end of the Q1, in the U.S. and Canada and again, the U.S. and Canada represents about 38% of our total sales, so we're only speaking of that particular market. But in the U.S. and Canada, it is customary in the industry. Every year, there are promotions just at the end of the Q1 because all of the suppliers want to have their products on the shelves when the season starts, usually in mid to late April. And so it's customary that there is a promotion. I would say that the promotional activity this year was modestly more heavy at the end of the Q1 than the promotional activity was last year.

Joe O’Dea (Equity Research Analyst)

Okay. And then on the fueling side, you talked about the growth there coming from developing regions. I'm assuming a lot of that's from the conversion that you've talked about in the past in India. What's the average cost for a station owner to convert to a pressure system? And then what's the attach rate that you typically see for your adjacent products, the piping, the leak detection, etc.?

Gregg Sengstack (President and COO)

Joe, this is Gregg Sengstack. Conversion cost is a little difficult to come up with for a complete fueling station because there are other costs that are outside of our products. So the conversion cost can range from $50-$100,000 or more. But when you're getting into specifically our pump products, you're looking at a conversion cost of, say, $2-$5,000 in the pump product line. We can then have anywhere from $20-$50,000 of additional products going into the station related to piping, containment, and monitoring systems, and so on. But it depends on the country, on the major oil, or the independent marketers doing the upgrade. But that could have that kind of range of revenue that would follow on at a later date.

Joe, I do want to make the point that while India has been a really good market for these products, our growth story as far as this conversion is concerned is much broader than India. I mean, we're achieving very solid sales gains in the Middle East, in Latin America, and across the whole Asia-Pacific region as well with that product line. So it's materially broader than India. The second thing is that we call it a conversion. And of course, your mental image of a conversion is somebody takes out an old system and puts in a new system. In fact, a big part of it is all of the new infrastructure that's going in to support new filling stations, and just a higher percentage of it is now pressure than suction.

In 2000, in Latin America and in China and India, those three areas combined, the total new passenger vehicle sales were 3 million units. Last year, they were over 15 million units in those same regions. That's annual new passenger vehicles. As you know, the growth of new passenger vehicles is exploding in developing regions, and that's driving a big increase in the demand for fueling infrastructure. And it's working out that as that new investment's coming in, a higher and higher percentage of it is going into these pressure pumping systems.

Joe O’Dea (Equity Research Analyst)

Great. Thanks very much, guys.

Operator (participant)

Thank you. Our next question comes from the line of Mike Halloran from Robert W. Baird. Your line is now open, and you may proceed with your question.

Michael Halloran (Equity Research Analyst)

Afternoon, everyone.

Gregg Sengstack (President and COO)

Good afternoon, Mike.

Michael Halloran (Equity Research Analyst)

On the wastewater pump demand in North America, could you talk about how that's tracked and specifically how inventory levels have, if those have worked off at all through the quarter? Then with some of the flooding activity that's happened lately, how you expect that to impact demand as we work through the quarter here?

Gregg Sengstack (President and COO)

Yeah. Wastewater shipments overall in the first two months of the year were more abundant and started picking up in the second part of March. I'll say at this point, we're having trouble keeping up with demand. Inventories have been essentially depleted on our wastewater pump product line, and that has been growing nicely. Now, wastewater tends to be a little less profitable for us than our ag line, and so we're very happy about the wastewater growth, but we're keeping an eye on that ag shipment number as well.

Michael Halloran (Equity Research Analyst)

Then on the dewatering side, some of the tougher trends that you guys saw with that product in the Q1, certainly not unanticipated. Have you guys seen any signs that the end market demand on that side with some of the oil and gas and other applications are picking up? If not, kind of when you talk to your customer base, did they have any sense for when that environment might start tracking a little bit better?

Gregg Sengstack (President and COO)

Yeah. Last year, we acquired Pioneer at the end of the Q1, and their sales were quite strong in the Q1 and strong in the Q2, and then in the back half of last year, just fell off rather sharply. And we're seeing almost the exact opposite pattern forming with Pioneer this year. Now, essentially, all of our other product lines, we put them in inventory, and they sell from inventory, so we have no backlog. But Pioneer is a totally different kind of business. They're assembling these high-ticket mobile pumping systems, and they work completely from a backlog. So we have pretty good visibility on their sales trend because we can watch their backlog grow. And we're anticipating very nice sales increases in our Pioneer product line in the back half of this year. So I think the Q1 was down.

The Q2 will continue to be down, but a little bit. The Q1 was our sales were actually up at Pioneer, but only because we didn't acquire Pioneer till the end of the Q1. If on a pro forma basis, they would have been down, they'll be down a little in the Q2, and then we're going to see a very strong back half.

Michael Halloran (Equity Research Analyst)

Makes sense. Then on the cost pressures that you lined out on the Q2, essentially incremental margins driven by the growth initiatives that you guys are putting into place, is this a case where those costs will linger for a while until the growth initiatives come in to offset, or are some of that $1 million-$1.5 million more one-time in nature, and those will dissipate as you work through the year? Any way you could kind of.

Gregg Sengstack (President and COO)

Some of them are one-time, and others will stay but won't be relevant because we'll have the contribution from the sales to offset them. So right now, these new distribution centers are just costing us money. In the back half of this year, they'll start providing incremental sales. And the same is true, we believe, with our UK rental initiative. And we think really as we go into 2014, the oil and gas initiative will start paying for itself. We will complete the construction of our new headquarters facility here in the Q2 of this year, or it may go over a little bit into the Q3, but not much. So that will be largely behind us. And the new Brazil plant will be up and operating in the Q2 next year.

Some of them will extend into 2014 and just be costs that will eventually go away, and others will start having the revenue to offset the expenses that will probably continue to incur to support the business.

Michael Halloran (Equity Research Analyst)

Makes sense. I appreciate the time.

Operator (participant)

Thank you. That's all the time we have for questions. I would like to turn the call back to CEO Scott Trumbull for closing remarks.

R. Scott Trumbull (Chairman and CEO)

We thank you for your interest in Franklin Electric and look forward to speaking with you at the end of the next quarter.

Operator (participant)

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.