Franklin Electric - Q1 2014

Transcript

Operator (participant)

Good day, ladies and gentlemen. Thank you for standing by, and welcome to the Franklin Electric First Quarter 2014 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. As a reminder, this conference is being recorded. I would now like to turn the conference over to our host, Mr. Jeffery L. Taylor Treasurer. Sir, you may begin.

Jeffery Taylor (Treasurer)

Thank you, Eric, and welcome everyone to Franklin Electric's First Quarter 2014 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 first quarter business results financial results. When John is through, we will have some time for questions and answers. Before we begin, let me remind you that as we conduct this call, we will be making forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are subject to various risks and uncertainties, many of which could cause actual results to differ materially from such forward-looking statements. The discussion of these factors may be found in the company's annual report on Form 10-K and in today's earnings release.

Also, our press release and this call contain non-GAAP financial measures that include, but are not limited to, earnings after non-GAAP adjustments, fully diluted earnings per share after non-GAAP adjustments or adjusted EPS, operating income after non-GAAP adjustments, and percent operating income to net sales after non-GAAP adjustments. The company believes that these measures help investors understand underlying trends in the company's business more easily. The differences between these measures and the most comparable GAAP measures are reconciled in the tables in our earnings release. All forward-looking statements made during this call are based on information currently available, and except as required by law, the company assumes no obligation to update any forward-looking statements. With that, I will now turn the call over to our Chairman and CEO, Scott.

Scott Trumbull (Chairman and CEO)

Thank you, Jeff. During the first quarter, we again achieved record sales and earnings and increased operating income margins driven by strong water systems sales growth in developing regions and strong operating income growth in our fueling systems business. Our water systems sales in developing regions represented 33% of our consolidated sales and increased by 8% compared to the first quarter last year. This strong growth occurred despite the negative impact of declining currencies in developing regions. Our developing region water sales grew organically by 19% during the quarter after adjusting for foreign exchange, foreign exchange rates. While our fueling sales increased by about 2% during the quarter, our fueling operating income increased by 35%, driven by a combination of productivity, favorable pricing, mix, and synergies from the FLEX-ING acquisition.

These positive factors were partially offset during the quarter by lower sales and earnings for our water business, it's in the U.S. and Canada due to an unfavorable mixture. In total, our first quarter sales in the U.S. and Canada grew by about 2%. Foreign exchange rates were also a factor during the quarter, reducing our consolidated growth rate by 360 basis points. Turning to a first quarter review of our business by global market area, our water sales in the U.S. and Canada represented 38% of our consolidated sales and grew, as I mentioned earlier, by 2% during the quarter. While our sales of mobile pumping equipment sold to the pump rental channel grew, this growth was partially offset by declining sales to the groundwater and wastewater distribution channels.

Our U.S. and Canada sales in the groundwater and wastewater channels declined by about 6.5% in the quarter, driven by more significant declines during the semi-severe weather months of January and February, but were positive during the month of March as the weather moderated. During the first quarter, our second-largest corporate customer, National Pump and Compressor, was acquired by United Rentals. As you know, United is one of the largest rental companies in the world and has announced plans to use the National Pump acquisition as a platform for significant growth. We believe that over time, this has the potential to be a big positive for our Pioneer Pump product line. Our water sales in Latin America represented 13% of our consolidated sales and declined by about 2% during the quarter, but our Latin American water sales increased organically by about 9% when the currency effects are eliminated.

Most of the organic growth in Latin America occurred in Brazil, where our business was strong across virtually all regions and all product lines. In the second quarter, our new factory in Brazil is expected to open, which will give us the capacity to continue growing and enable us to streamline our operations. Our sales team in the Middle East and Africa was our star growth performer during the first quarter. This region represented 13% of our consolidated sales and grew by 25% during the quarter. Our Mideast and Africa sales grew organically by a strong 43%, excluding foreign exchange. The growth was driven by sales of groundwater pumping equipment sold under both the Impo and Franklin brand names in Turkey and North Africa. Our water sales in the Asia-Pacific region represented about 8% of our consolidated sales during the quarter and were flat compared to the prior year.

However, our Asia-Pacific sales grew organically by about 5%, excluding the impact of foreign exchange. We had strong sales of groundwater pumping equipment in Japan and Korea, which were offset by a slowdown of sales in Indonesia and Australia. Our water sales in Europe represented about 8% of our consolidated sales and grew by about 6% during the quarter. Excluding acquisitions and the impact of foreign currency translation, European sales were flat to the first quarter of 2013. We're encouraged by growing customer interest in our expanding line of all stainless steel E-Tech branded pumps produced by our Vertical acquisition in Italy. Our European sales team is having good success expanding our distribution network for these products in several large Southern European markets. Our fueling sales represented 20% of our consolidated sales and grew by about 2% during the quarter and were flat, excluding the impact of foreign exchange.

However, during the first quarter last year, our fueling systems business shipped about $4.7 million of equipment to India to fill a large tender order. This year, our full year Indian tender shipments will be about the same size as last year, but will occur later in the year. Excluding the impact of the Indian tender sales during the first quarter last year, our fueling sales grew by about 12%. Our sales of pressure pumping systems outside of India grew by 25% during the quarter as we are seeing, ongoing growing demand for the Franklin pressure pumping system increasing in virtually all developing regions of the world. We also experienced solid growth during the first quarter for our dispensing nozzles and related equipment in China.

Turning to our view of the second quarter, our short-term outlook is being influenced by a decision that we've made to restructure our groundwater distribution channel in the United States. In mid-February, we notified certain distribution outlets that after July 15th of this year, we will discontinue supplying them, and they will be replaced with other distribution outlets that we believe will represent our products more effectively. In total, the affected annual revenue of these distribution outlets represents less than 4% of our consolidated sales. We anticipate that during the transition, second quarter US groundwater sales may decline modestly due to inventory adjustments made by both our discontinued and new distributors. We are confident when this activity is complete, we will have stronger overall US distribution relationships, and our sales will benefit.

As a result, we're projecting that our second quarter 2014 global water systems sales and adjusted operating income will grow 2%-4%. We estimate that our fueling sales and adjusted operating earnings will grow in the second quarter of 2014 by 9%-11%. Finally, due to some favorable tax items in the second quarter 2013, which lowered our effective tax rate last year, we believe our effective tax rate this year in the second quarter will be about 300 basis points higher than last year. So our consolidated adjusted earnings per share growth will be in the 3%-5% range. I'll now turn the call over to John Haines, our CFO.

Jeffery Taylor (Treasurer)

Thank you, Scott. Our fully diluted earnings per share were $0.35 for the first quarter 2014 versus $0.32 for the first quarter of 2013. 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 operational performance of the company. Non-GAAP expenses for the first quarter 2014 were $200,000 and included $100,000 in restructuring costs and $100,000 in legal and advisory costs, primarily related to potential acquisitions. The first quarter 2014 non-GAAP adjustments had no EPS impact. The non-GAAP EPS adjustments in the first quarter of 2013 rounded to an EPS impact of about $0.01.

So after considering these non-GAAP adjustments, first quarter 2014 adjusted EPS was $0.35, 6% higher than the $0.33 adjusted EPS the company reported in the first quarter of 2013. Overall, the 2014 first quarter revenue, gross profit, adjusted operating income, adjusted net income, and adjusted earnings per share were records for any first quarter in the company's history. Water Systems sales were $184.6 million in the first quarter 2014, an increase of $8.2 million or about 5% versus the first quarter 2013 sales of $176.4 million. Sales from businesses acquired since the first quarter of 2013 were $0.8 million or less than 1%. Water Systems sales were reduced by $8.6 million or about 5% in the quarter due to foreign currency translation. Water Systems sales growth, excluding acquisitions and foreign currency translation, was about 9%.

Water Systems operating income after non-GAAP adjustments was $29.3 million in the first quarter 2014, flat versus the first quarter 2013. The first quarter operating income margin after non-GAAP adjustments was 15.9%, down 70 basis points from 16.6% in the first quarter of 2013. Operating income margin after non-GAAP adjustments decreased in Water Systems, primarily due to sales volume and mix in the U.S. and Canada. Fueling systems sales represented 20% of consolidated sales and were $46.8 million in the first quarter of 2014, an increase of $0.7 million or about 2% versus the first quarter 2013 sales of $46.1 million. Fueling systems sales increased by $0.6 million or about 1% in the quarter due to foreign currency translation. Fueling systems sales were flat, excluding acquisitions and foreign currency translation.

Fueling systems operating income after non-GAAP adjustments was $9.2 million in the first quarter of 2014 compared to $6.8 million after non-GAAP adjustments in the first quarter of 2013, an increase of about 35%. The first quarter operating income margin after non-GAAP adjustments was 19.7%, an increase of 490 basis points from the 14.8% of net sales in the first quarter of 2013. The increase was driven by a positive product sales mix and a combination of productivity, favorable pricing, and synergies from the FLEX-ING acquisition. The company's consolidated gross profit was $78.1 million for the first quarter of 2014, an increase of $4.2 million or about 6% from the first quarter of 2013 gross profit of $73.9 million. The gross profit as a percent of net sales was 33.8% in the first quarter, up about 60 basis points versus 33.2% in the first quarter of 2013.

The gross profit margin increase was due to lower fixed costs, leverage on fixed costs from higher sales, productivity improvements with lower direct labor and variable costs, partially offset by higher raw material costs. Selling general and administrative expenses were $52 million in the first quarter of 2014 compared to $50.1 million in the first quarter last year, an increase of $1.9 million or about 4%. SG&A expenses as a percent of sales were 22.5% in the first quarter of 2014, which was flat to the first quarter last year. The tax rate for Q1 2014 was about 25%, flat to the 2013 first quarter rate. The rate before discrete events was about 28%. Discrete adjustments during the first quarter were primarily for foreign tax rate changes and their impact on deferred tax liabilities.

As Scott mentioned, our guidance for the second quarter 2014 EPS growth is being impacted by a nearly 300 basis points increase in our tax rate compared to the second quarter of 2013. The tax rate as a percentage of pre-tax earnings for the second quarter of 2013 was about 25%, primarily due to the completion of income tax audit and the favorable resolution of matters that were previously under review. We estimate an average effective tax rate after discrete events for the back half of 2014 to be about 25%, an improvement of over 150 basis points from the back half of 2013. The company ended the first quarter of 2014 with a cash balance of $102.1 million, which was $32.5 million lower than 2013.

Cash balance decrease is primarily attributable to the seasonality of the business, including lower sales in the first quarter and the annual incentive compensation payment. The cash balance at the end of the first quarter of 2014 increased by 37% versus the $74.7 million balance at the end of the first quarter of 2013. The company had $15 million of outstanding balance on its revolving debt agreement at the end of the first quarter of 2014. The company had no outstanding balance on its revolving debt agreement at the end of the first quarter of 2013. During the first quarter, the company purchased about 25,000 shares of its own stock for approximately $1 million in the open market. This concludes our prepared remarks, and we would now like to turn the call over for questions.

Operator (participant)

Ladies and gentlemen, if you have any questions at this time, please press the star, then the one key on your touch-tone telephone. You may remove yourself from the queue at any time by pressing the pound key. Again, to ask a question at this time, please press star, then one on your touch-tone telephone. And our first question comes from Matt Somerville of KeyBanc. Please go ahead.

Speaker 8

Hey, good afternoon, guys. This is Joe. I'm from Matt. First, a couple questions on the distribution channel realignment. Do you expect to see a decline in sales following that July 15th deadline, or do you already have other distribution outlets lined up that you think is gonna fill that, that void completely?

Gregg Sengstack (Executive Chairperson)

Joe, this is Gregg Sengstack. We are discontinuing supply to about 30 outlets. We're adding about 50 to 60 outlets. So it's just gonna be a question of timing of liquidation of inventories and adding of inventories, making room for Franklin products. So that's what's gonna be going on during the next several months.

Speaker 8

Okay. And then, Gregg, will you incur any costs associated with setting up those new outlets? You know, any sort of either incentives, or are you helping them get set up in any way?

Gregg Sengstack (Executive Chairperson)

Of course, when you're bringing on new outlets, you're gonna have some, additional upfront costs, travel costs, incentive costs. I'm not sure how meaningful they're gonna be to our overall results, but we'll have some costs.

Speaker 8

Okay. Would you expect to see any sort of prebuy in the second quarter from the outlets that you're discontinuing, shipping product to, ahead of that July deadline, or no?

Gregg Sengstack (Executive Chairperson)

I just don't have a lot of clarity around that. I think that there'll be. It just depends on the market, I think. And again, you know, weather's been a big factor for us starting the year. I'm not gonna have a lot of clarity about whether it'll be a lot of buy-up or buy-down. That's why we wanted to give you guys a little heads up on that.

Speaker 8

Okay. But there's nothing in your agreements that says that, you know, that they can't buy ahead. That I guess the last time there was sort of a, you know, a different scenario. But then, you know, with the change in strategy, you had an inventory overhang as, you know, there was just some inventory, like, safety stock bought. You don't expect something significant like that. I don't imagine.

Gregg Sengstack (Executive Chairperson)

Yeah. If you're going back in history, of course, that was a very different situation. This is obviously a much smaller overall revenue number. And what we're gonna say is that people can buy the ordinary course. It's all.

Speaker 8

Okay.

Gregg Sengstack (Executive Chairperson)

Will not be a situation like you saw in the past.

Speaker 9

Okay. That's helpful. And then, Middle East and Africa, I mean, that's been a region that's been growing nicely for several quarters now. But, you know, 43% organic growth, that's significantly better than any growth rate we've seen here recently. What can you give a little more color on what drove that in the quarter and maybe somehow sustainable? I maybe not 43%, but an elevated growth rate is there?

Gregg Sengstack (Executive Chairperson)

We had a very good quarter, partly due to timing. We won some tenders in North Africa, which you cannot predict year-over-year. But we've just steadily increased our penetration in this area, and a lot of nice things came together. As you said, going forward, we would not expect that kind of growth year-over-year, quarter-over-quarter.

Speaker 8

Okay. And then, maybe lastly, on the fueling side, the India tender shipments that are planned for later in the year, will it all fall in a single quarter similar to the first quarter of 2013, or is it gonna be more spread out over the course of the year? And then is it correct to assume that that'll have a similar dilutive impact on margins that tender business as it did in 2013?

Gregg Sengstack (Executive Chairperson)

We're gonna see that business that we currently have in-house go out through second and third quarters, maybe, going into the fourth quarter a little bit. There may be some additional business coming, but it's not clear at this point. It would have a dilutive impact on margins. On the flip side, as we've commented, we've you know fully in brought the FLEX-ING acquisition in, and so we're getting some benefit there.

Speaker 8

Okay. And then actually, maybe if I could just sneak one more in. You guys commented on URI acquiring National Pump. I mean, obviously, they publicly have talked about increasing their fleet size pretty meaningfully over the next few years. Based on your conversations, when, you know, could you expect to see a benefit there? This business had some pretty impressive growth rates in the back half of the year. So, I mean, is there do you think you can continue to grow off of that base given, you know, URI's comments or just maybe some color around how that's gonna benefit you?

Gregg Sengstack (Executive Chairperson)

Yeah. Robert will address that. He's the executive closest to that transaction.

Robert Stone (SVP and President, International Water Systems)

Joe, we would expect the impact of the URI business to materialize in the back half of this year and the first part of next year. We have significant orders with NPC, the company that URI acquired. And those shipments will be primarily going out second and third quarter. And then, I would say that the URI business with its additional branches would start to show up in the back half of this year, first part of next year.

Speaker 8

Okay. Perfect. Thanks very much, guys. I appreciate all the help.

Operator (participant)

Our next question comes from Mike Halloran of Robert W. Baird. Please go ahead.

Mike Halloran (Senior Research Analyst)

Afternoon, everyone. First, could you talk about what you're seeing on the ag side of the portfolio and what sort of trends you're expecting for the second quarter and, I guess, for the rest of the year?

Gregg Sengstack (Executive Chairperson)

Yeah. Mike, again, we're not, you know, we're in a much larger replacement business than, say, what you might be seeing from the people like Valmont and others at Lindsay who are selling equipment. And so we have a larger P&A component, is replacement aspect of it. We have been impacted. It's been a slow start to the year because of weather, and it just depends on weather patterns whether we're gonna see this acceleration earlier or later in the second quarter in North America. Europe, we haven't seen quite the severity of rain that we saw last year, and southern hemisphere is, you know, is doing just fine.

Mike Halloran (Senior Research Analyst)

And when you look at the core North America trends, if you could somehow just normalize for weather and then normalize for this channel shift that's gonna happen here, how would you characterize the underlying fundamentals, both in the wastewater side as well as the groundwater side? And just give a thought process on what that core underlying demand trend looks like.

Gregg Sengstack (Executive Chairperson)

You know, our, our business, maybe a little pun intended, flows like water. I mean, it's, it's a pretty steady business. The underlying trends, you know, are, are pretty steady. Again, large replacement is a big part of that. We did have a, you know, a very wet last year. We do not believe there's an appreciable amount of inventory in the channel above or below normals. So I think that, you know, Scott's pointed out that a couple 300 basis points of impact, due to the severity of weather, so we would think that should be coming out over time. We're expecting this second quarter may be a little bit bumpy on the, on the purchases, but that should, you know, come out over time and that the business will continue to grow at, you know, at modest, single-digit rates.

Mike Halloran (Senior Research Analyst)

It doesn't sound like if you normalize for everything, then on the ag side, you're seeing that big of a change. On the residential and some of the larger diameter stuff, you're seeing much change here. It sounds, if you adjust for everything, pretty stable underlying environment from your perspective, or am I putting words in your mouth?

Gregg Sengstack (Executive Chairperson)

No, I'd say at this point, that's, that's the best view we've got.

Mike Halloran (Senior Research Analyst)

All right. Appreciate the time.

Operator (participant)

Our next question comes from David Rose of Wedbush Securities. Please go ahead.

David Rose (SVP)

Good afternoon, gentlemen. Couple follow-up questions. I mean, starting in the Middle East, just so we don't have to call this out next year, what was the size of the tender for the Middle East so we look at Q1 comp next year, roughly?

Robert Stone (SVP and President, International Water Systems)

Roughly, $2 million.

David Rose (SVP)

I'm sorry. Can you repeat that?

Robert Stone (SVP and President, International Water Systems)

$2 million.

David Rose (SVP)

Okay. On the working capital side, what drove the significant increase in working capital above and beyond sales?

John Haines (CFO)

David, this is John Haines. We typically see a seasonal increase in what they are in inventory as our northern hemisphere businesses prepare for their, you know, their high season in the second quarter. Our inventory increased in a variety of different places around the globe. We have new distribution centers that drove some of that. We also have some new products that are driving some of that. So a lot of that is in preparation of availability for the second quarter season in the northern hemisphere markets. Receivables are basically growing, you know, with sales. So there was really nothing unique when we look at that.

You know, one of the things we look at is on a year-over-year basis, inventory AR left payables as a % of sales is kind of a key measure that we pay attention to. Year-over-year, at the end of the first quarter, that was pretty flat.

David Rose (SVP)

Yeah. I was just looking at, you know, our inventory was up 50% year-over-year. So, I just wasn't sure if there was anything unusual.

John Haines (CFO)

Yeah. Inventory plus AR less payables is about 30% of sales at the end of the first quarter of this year, and it was about 28% at the end of the first quarter last year. So, anything unusual, I would say no.

David Rose (SVP)

Okay. Can you comment on the, it looks like you had an acquisition in the quarter, small. Can you talk about that?

John Haines (CFO)

Yeah. We've made a small investment in business. We do that from time to time as we think that it makes sense for the company. And given the size, it's about as much detail as we're gonna give at this point.

David Rose (SVP)

Did it contribute anything to revenues in the quarter?

John Haines (CFO)

Yeah. So, Mike. I think he's talking about the acquisition in the U.K. We did that last year. That was last year.

David Rose (SVP)

No, it was this first quarter, this year, this year.

John Haines (CFO)

We made a minority investment in a business.

Gregg Sengstack (Executive Chairperson)

Yeah. Or, where are you seeing that, David, in the K?

David Rose (SVP)

I'm looking at your, your Q, well, not your Q, but your income statement. You've gotten, you know, expenditures for acquisitions.

John Haines (CFO)

Oh, I'm sorry. I'm sorry. Yeah. To Gregg's point, in the first quarter, we made a minority investment in a water pumping company. We, from time to time, will make minority investments in companies around the world that we think can offer a strategic platform for us that we can grow off of. Sometimes, though, it's not in our best interest to disclose more about that because it clearly offers an insight into our strategic intent. And given the materiality of this one, what you see on the cash flow there, what you'll read in the Q will be about all we'll say on that.

David Rose (SVP)

Okay. Can you add whether it was U.S. or international?

John Haines (CFO)

It was in North America.

David Rose (SVP)

Okay. All right. Well, that's helpful. And then lastly, in terms of what you're doing with the channel, the restructuring the groundwater distribution channel, how did you assess the new distributors? Can you walk us through the process of, you know, how someone made the cut and what you were looking at?

John Haines (CFO)

Well, if you go back in history, we have followed a policy or a practice, I guess, of selective distribution and working with regional distributors. And we elected that we wanted to get back to that. We had our distributors getting more national in nature, and we wanted to get back more to the regional distributors. We know them very well. We've known them over the years. And so we elected to refocus our efforts with these regional distributors.

David Rose (SVP)

Okay. Thank you.

Operator (participant)

There are no further questions. I'd like to turn it back to Scott Trumbull for final remarks.

Scott Trumbull (Chairman and CEO)

As has previously been announced on Friday of this week, I'll be stepping down as CEO of Franklin and turning the reins over to Gregg Sengstack. When I came to Franklin as CEO 11 years ago, I was convinced it was a company with great growth potential. Since then, Franklin people worldwide have provided our shareholders with a 14% compound annual rate of return. As I leave, I continue to believe that Franklin has great growth potential. Gregg has played a key role in all of our successes, and I'm turning the company and its shareholders over to very capable hands. I will be eternally grateful to our board and shareholders for giving me the opportunity to lead this great company. Thank you.

Operator (participant)

Well, ladies and gentlemen, this does conclude today's conference. Thank you for your attendance. You may now disconnect. Everyone, have a great day.