Franklin Electric - Q1 2018

Transcript

Operator (participant)

Good day, ladies and gentlemen, and welcome to the Franklin Electric report, first quarter 2018 sales and 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 be given at that time. If anyone should require operator assistance, please press star then zero on your touchtone telephone. As a reminder, this call is being recorded. I would now like to turn the conference over to John Haines, Chief Financial Officer. Sir, you may begin.

John Haines (CFO)

Thank you, Ashley, and welcome everyone to Franklin Electric's first quarter 2018 earnings conference call. With me today, I have Gregg Sengstack, our Chairman and Chief Executive Officer, and Robert Stone, the Senior Vice President and President of our International Water Systems unit. On today's call, Gregg will review our first quarter business results, and I'll review the first quarter financial results. When we're through, we'll 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. A discussion of these factors may be found in the company's annual report on Form 10-K and in today's 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'll turn the call over to our Chairman and CEO, Gregg Sengstack.

Gregg Sengstack (Chairman and CEO)

Thank you, John. 2018 started with strong organic growth in our water and fueling businesses, both domestically and internationally, driving first quarter operating income up 23% versus the first quarter of 2017. In the U.S. and Canada Water Systems business, Pioneer branded dewatering pumps continued to lead the way, more than doubling last year's revenue. Groundwater pumping systems grew double digits, and other surface pumping equipment yielded similar revenue gains. Outside the U.S., we saw strong growth in Europe, the Middle East, and Africa, which grew organically at about 7%, but this growth was not enough to offset continued weak demand in Brazil and Southeast Asia. The strong operating leverage we saw in the U.S. and Canada water business was somewhat muted by the margin compression we experienced in the international markets.

Even with these international challenges, we are pleased that our water segment operating margin improved year-over-year. In addition, you may recall that we have taken pricing actions to offset anticipated inflation. John will talk about additional pricing actions in a moment. We should see further improvement in Water Systems margins in Q2. Our Fueling Systems business delivered another record quarter. Our systems approach to the market resonates with domestic marketers, and sales in the U.S. and Canada grew by about 11%, with every major product category showing revenue growth. Internationally, we continue to grow as well, and China is the key growth engine. The country is in the early stages of a mandated multi-year upgrade to the underground piping systems in retail gas stations.

As I mentioned last quarter, we expect this upgrade to add significant revenue and income to our fueling business over the next several years. Further, some provinces are choosing to extend their upgrades beyond piping systems to pumping and leak detection systems as well. Outside of China, Fueling Systems had strong results throughout Asia and more modest growth in Europe, the Middle East, and Africa. In Latin America, we are seeing some recovery in our business as well. Turning to distribution, you may recall that last year, three significant pump suppliers elected to discontinue selling to Headwater Companies. These decisions impacted Headwater's short-term results. In the fourth quarter last year, pro forma revenue was down 11%. However, with the addition of new pump lines and a major focus on customer service, our distribution business improved sequentially.

First quarter 2018, pro forma revenue was down less than 3% compared to the first quarter of 2017 and ahead of our expectations. Headwater sells multiple pump lines from multiple manufacturers to address a range of pumping requirements. However, when Headwater replaces a former supplier's pump with a Franklin product, Headwater earns a distributor margin, and Franklin Electric earns a manufacturing margin as well. Sales of groundwater pumping equipment to Headwater in the first quarter were a key driver of growth in the Water Systems business in the U.S. and Canada. As we move into the second quarter, we expect Headwater sales will continue to strengthen. As we have noted last quarter, Headwater is a highly seasonal northern hemisphere business, which means almost the entirety of its earnings will be in the second and third quarters of each year.

Given our strong start to the year in both the water and Fueling Systems segments and our better-than-expected sequential growth in distribution, we are raising our revenue guidance for 2018. We now believe our organic revenue growth, which excludes the impact of foreign currency translation, will more likely be in the 6%-8% range. This is an increase from the 4%-5% range for water and distribution, and a 5%-7% range for fueling, provided in our previous guidance. Further, based on these higher growth assumptions and resultant earnings, we are raising our full-year 2018 estimate for earnings per share to a range of $2.27-$2.37, an increase from the $2.16-$2.28 provided in our previous guidance.

I will now turn the call over to John to discuss the numbers in more detail. John?

John Haines (CFO)

Thank you, Gregg. Our fully diluted earnings per share were $0.45 for the first quarter of 2018 versus $0.33 for the first quarter of 2017, an increase of $0.12 per share or 36% over last year. Restructuring expenses did not impact the earnings per share in the first quarter of 2018 or 2017. First quarter 2018 sales were $295.6 million, compared to 2017 first quarter sales of $220.3 million, an increase of 34%. The sales increase was from acquired distribution entities, as well as organic sales increases in both Water Systems and Fueling Systems of about 10%. Sales increased by about 4% in the quarter due to foreign currency translation.

Water Systems sales were $191.8 million in the first quarter of 2018 versus the first quarter of 2017 sales of $167.6 million, an increase of 14%. Water Systems organic sales were about 11% in the quarter when you exclude the impact of foreign currency translation. Water Systems sales in the U.S. and Canada increased by 28% organically in the first quarter on broad-based improvements across each major product grouping. Pioneer branded dewatering equipment sales more than doubled in the quarter due to strengthening oil and gas end markets. Sales of groundwater pumping equipment increased by about 30%, with strength in both residential and agricultural product lines. The increase was driven by increased sales of product to the Headwater Companies, who, as we have said, have improving sequential sales performance.

Additionally, as other pump OEMs discontinue selling to Headwater, many of their products are being replaced with products from FE. Recall that in the first quarter of 2017, the Headwater Companies significantly reduced the amount of purchases from Franklin Electric in anticipation of the early second quarter acquisitions by Franklin. Finally, the product sales to Headwater from the water system segment are flowing through to the end customers and not building inventory at Headwater. The company had already announced a 3% increase in Water Systems prices in the U.S. to offset raw material inflation. Today, we will announce a second increase of 3% in the United States, effective June 1, specifically for the purpose of offsetting the Section 232 tariffs on steel and aluminum imports. We do not expect margin deterioration in 2018 due to raw material inflation or tariffs.

Water Systems sales in markets outside the U.S. and Canada increased by about 3% overall. The impact of foreign currency translation increased sales by about 5%. International water sales were led by improved sales in Europe, the Middle East, and Africa, but were offset by lower sales in Brazil and Asia when compared to the first quarter of 2017. Water Systems operating income was $25.2 million in the first quarter of 2018, up $3.8 million versus the first quarter of 2017. The increase in operating income is primarily related to higher sales. Fueling Systems sales were $59.4 million in the first quarter of 2018 versus the first quarter 2017 sales of $52.7 million, or about 13% higher.

Fueling Systems organic sales were about 9% when excluding the impact of foreign currency translation. Fueling Systems sales in the U.S. and Canada increased by about 11% compared to the first quarter of 2017. The increase was broad-based and included numerous product categories, including pumping, fuel management systems, and piping. Outside the U.S. and Canada, Fueling Systems revenues grew by about 16%, led by stronger sales in China and Europe, partially offset by lower sales in India. Fueling Systems operating income was $13.6 million in the first quarter of 2018, compared to $11 million in the first quarter of 2017. The increase in operating income is primarily related to higher sales. Distribution segment sales were $56.2 million in the first quarter of 2018.

Management estimates that the first quarter distribution sales declined by about 3% from the first quarter of 2017. The distribution segment recorded an operating loss of $0.8 million in the first quarter of 2018. The company's consolidated gross profit was $99 million for the first quarter of 2018, an increase from the first quarter of 2017 gross profit of $75.8 million. The gross profit as a percent of net sales was 33.5% in the first quarter of 2018 versus 34.4% during the first quarter of 2017. The gross profit increase was primarily due to higher sales.

The decline in gross profit margin percentage is primarily due to product and geographic sales mix shifts, as we believe that global realized price has offset material cost inflation in the quarter. Selling general and administrative expenses were $76.3 million in the first quarter of 2018, compared to $57 million in the first quarter of the prior year. The increase in SG&A expenses from acquired businesses was $17.7 million. Excluding the acquired entities, the company's SG&A expenses in the first quarter of 2018 were $58.6 million, an increase of about 3% from the first quarter of 2017. The company recognized discrete tax benefits related to certain deferred income tax positions in the first quarter of about $5 million, which lowered the first quarter effective tax rate to a 9% benefit.

This tax benefit in the first quarter was planned and included in our original earnings guidance for 2018. We also call attention to the fact that the first quarter 2017 tax rate was only 1%, again, because of discrete tax benefits realized in that quarter. Consistent with our previous guidance, the company believes the full year 2018 effective tax rate will be about 15% expense on pre-tax earnings. As we said in our earnings conference call for the fourth quarter 2017, the net impact of the new tax law in the United States on 2018 earnings per share is an improvement of about $0.08.

This estimate has not changed, and the increase in our current earnings per share guidance for 2018 we are announcing today, is entirely driven by improvements in the operating results of the company. The company ended the first quarter of 2018 with a cash balance of $67 million, which was flat to the end of 2017. Inventory levels at the end of the first quarter of 2018 were $343 million, versus year-end 2017 of $312 million. The inventory increase is primarily due to seasonal working capital needs.

The company had $119 million in borrowings on its revolving debt facilities at the end of the first quarter of 2018, and $67 million in borrowing at the end of 2017. These borrowings were primarily to fund acquisitions and working capital needs. The company purchased about 182,000 shares of its common stock for approximately $7.3 million in the open market during the first quarter of 2018. As of the end of the first quarter, the total remaining authorized shares that may be repurchased is just under 2 million. On April 23rd, the company announced a quarterly cash dividend of $0.12, an increase of about 12% from the previous quarterly dividend amount. The dividend will be payable May 17th, to shareholders of record on May 3rd.

This concludes our prepared remarks, and we would now like to turn the call over for questions.

Operator (participant)

Ladies and gentlemen, if you'd like to ask a question at this time, please press the star then the number one key on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Once you've asked your question, may I ask that you please place your line on mute to prevent any background noise? Our first question comes from Edward Marshall of Sidoti. Your line is open.

Edward Marshall (Analyst)

Good morning, guys. Good morning, gentlemen.

John Haines (CFO)

Good morning, Ed.

Operator (participant)

Hey, Ed.

Edward Marshall (Analyst)

So I just wanted to try and get a sense on what the contribution in the quarter from Valley Farms was. As I know, it was acquired during the quarter. It's all acquired revenue, the distribution, but I'm just trying to get a sense as to just that piece of it, was part of the acquired quarter.

John Haines (CFO)

Yeah, and it was not very significant. Valley Farms is a really good distributor. They have very strong performance in their branches. They're a model that has larger branches, you know, from a revenue perspective. But, you know, they're almost entirely based in Michigan and northern Indiana, and the first quarter is not a particularly strong period for them, you know, from a weather perspective. But, what we can say is, they contributed positively to operating income in the first quarter. But it was not meaningful.

Gregg Sengstack (Chairman and CEO)

And as the pro forma that we gave, where the estimated revenue being down just under 3%, included them for both the first quarter of 2017 and the first quarter of 2018, so that's an apples and apples comparison.

Edward Marshall (Analyst)

Got it. I was trying to look sequentially, but that's fine. Any additional discrete tax items in the guidance for the year?

John Haines (CFO)

There are, but nothing of any material significance, Ed, like what we saw in the $5 million or so in the first quarter. So, you know, the issue with discrete tax items are some of them you can plan, some of them you can kind of look out and see. Other ones arise throughout the year. So right now, there's no real significant discrete tax items planned for the balance of the year.

Edward Marshall (Analyst)

Got it. And then you talk about 232 pricing, and it looks like last night there were some delays to the allies on the decision on the taxes. I'm curious, how do you think that might affect your price increases as we move forward? Does it delay it, push it out to June? What, how do you think about that?

John Haines (CFO)

Well, yeah, the decision last night, as it relates to many of the European Union countries, has a far less significant impact on us. As the tariffs we're most focused on are Chinese tariffs and imports of metals and products from China. So, the 3% that we're announcing today, that will be effective June 1st, is really focused on the tariffs related to imports from China. You know, but this is a pretty fluid situation, as you know, and we're trying to stay on top of it as best we can. We certainly would not say that should something in the future, or the balance of 2018 change, that we wouldn't go back and look for additional price.

What we are trying to do is stay committed to the fact that we're not gonna let tariffs impact our margins in our Water Systems business in the United States. The month delay, Ed, is really pretty typical as it relates to price increases. You know, we try not to just spring price increases on our customers. So that's really the thinking behind the June 1st to May 1st. It's really just to allow our customers time to prepare and react to that.

Edward Marshall (Analyst)

Got it. Thanks for the comments.

Operator (participant)

Our next question comes from Matt Summerville of D.A. Davidson. Your line is open.

Matt Summerville (Analyst)

Thanks. Morning, guys.

John Haines (CFO)

Morning, Matt.

Matt Summerville (Analyst)

So with respect to your inventory sort of situation, I think, Gregg, on the last conference call, you had felt that inventories heading into 2018 were a bit on the high side. Maybe if you can kind of reconcile that comment to how you're feeling about not only your own inventories, but to John's comment, what you're seeing in distribution, just more broadly speaking on the industry. So maybe just talk about inventories a bit.

Gregg Sengstack (Chairman and CEO)

Sure, Matt. Our inventories are on the high side. Fortunately, it's a time of the year because of our being in the Northern Hemisphere, that's not a bad place to be. We would say there's the inventory in the channel is normal. And we would say that certainly in the U.S. markets, we've seen, you know, good demand and good flow through. So we expect that as the season picks up, that will help us address coming in, you know, a little bit strong in inventory. A couple other factors are that, you know, we did have a small acquisition here in the first quarter that adds to our inventory balance in the quarter.

And also, with currency, we're also having impact on a year-over-year basis to our inventory levels as well. But, I'd say, again, generally, you know, we are moving in direction with the company, a greater focus now on inventories, just generally across the whole company, throughout, you know, this year. And we would see that, we would expect to get that, you know, our quarter-over-quarter comparisons being improving from here.

Matt Summerville (Analyst)

Got it. Then if you can, John, maybe if I missed it, I apologize. Where were you in terms of realized price, sort of round numbers year-over-year in Q1? And were you still net. I'm trying to understand if you're still net favorable on the spread between raws. Again, just getting back to the gross margin compression you saw.

John Haines (CFO)

Yeah. So, our calculation of achieved price in the quarter, Matt, is about 150 basis points. That excludes Headwater. That's really just looking at kind of Water Systems and Fueling Systems combined. That's lower than where we were in the first quarter of 2017. But we do believe that offset the raw material inflation in the quarter. Didn't offset it by a lot, but we believe that it did offset it. And that's what we're staying committed to for 2018, is to say, okay, as we see this raw material inflation coming at us, keep in front of it with price increases. So that's what we saw in the first quarter.

Matt Summerville (Analyst)

And then maybe if you can talk about a little bit more detail, what you're seeing internationally, your comps skews pretty meaningfully in Latin America for the balance of the year. I believe you're up against negative comps. They get a little bit tougher in EMEA, and they sort of bounce around a bit in Asia. But just maybe more broadly speaking, throw in a little end market color if you're able to as well, by geography. Thank you.

Gregg Sengstack (Chairman and CEO)

Sure. I'm gonna turn that question over to Robert. You know, he can talk to you about how we see the APAC region turning here in Q2, and then, you know, we're going into the winter months in Brazil. Robert, you wanna talk more about the regions around the globe in the water business?

Robert Stone (SVP and President, International Water Systems)

Sure. The situation, Matt, in Asia Pacific, we expect to start to improve really from this quarter forward. We had a very difficult comp relative to last year. That's an area also where we had some inventory in the channel. That should be turning around now. That's our expectation there. We have gotten some price. We'll probably need to get more, but not driven by tariffs, just driven by other cost increases than we will have had. Latin America, South America in particular, continues to be challenging. Market conditions are off versus prior years. Price competition is severe as everybody tries to grab as much of the smaller market as they can.

As Gregg mentioned, we're coming into the weaker part of the season for South America, and we should see that pick up here in September, October, but it's gonna take us a while to get back there. Europe and EMEA are looking strong so far this year, and we have pretty good indications that this year is going to develop nicely versus prior year. Middle East activity is picking up a bit as well, probably thanks to the oil price increases, but we're seeing some increased activity there as well. Africa, especially Southern Africa, continues to be very weak.

Economic and, again, social, political situation is not very favorable at this point in time, in spite of some perceived good news anyway with the change of leadership in South Africa and Zimbabwe. But that has to yet play out.

Matt Summerville (Analyst)

And then just maybe one final question: Just with respect to Pioneer, can you remind us, you know, where that business bottomed in revenue? I wanna say it was sub-$50 million, but maybe help me recollect that, and kind of how that bumped up in 2017, and where maybe where you expect the business to be from a revenue standpoint in 2018.

John Haines (CFO)

Yeah, Matt, so the high water mark for Pioneer, you'll recall, was 2014, where all in consolidated, it approached, a top line of $100 million. That declined very meaningfully in 2017. It was right in the $50 million-

Robert Stone (SVP and President, International Water Systems)

2015.

John Haines (CFO)

I'm sorry, 2015, it was-

Robert Stone (SVP and President, International Water Systems)

Too many fives there.

John Haines (CFO)

In 2015, it declined right into the $50 million, low $50 million mark. Kind of tread water in 2016, and then in 2017, we saw Pioneer come back some. And then this year, you know, they're having a very strong start to the year. They've got some nice channel and customer diversification going on. So, you know, we haven't put out a number specifically for Pioneer, but, you know, they're gonna be... They're gonna grow dramatically in 2018 over last year's level. I don't know that I would say they're gonna get back to that $100 million mark, but they're gonna grow very dramatically.

Matt Summerville (Analyst)

Got it. Thanks, guys.

Operator (participant)

As a reminder, ladies and gentlemen, if you have a question at this time, please press the star then the number one key on your touch-tone telephone. With no further questions in queue, I'd like to turn the call back to Gregg Sengstack for closing remarks.

Gregg Sengstack (Chairman and CEO)

Thank you, Ashley. We appreciate you joining us for this first quarter conference call. We look forward to speaking to you in July after our second quarter results are put out. Y'all have a good week.

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.