Franklin Electric - Q2 2015

Transcript

Operator (participant)

Good day, ladies and gentlemen, and welcome to the Franklin Electric Co., Inc. Q2 2015 earnings conference call. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. If anyone should require operator assistance, please press star then zero on your touch-tone telephone. As a reminder, today's conference call is being recorded. I would now like to turn the conference over to Jeff Frappier, Treasurer of Franklin Electric. Please go ahead, sir.

Jeff Frappier (Treasurer)

Thank you, Candice, and welcome everyone to Franklin Electric's second quarter 2015 earnings conference call. With me today are Gregg Sengstack, our CEO, Robert Stone, Senior Vice President and President of our International Water Systems unit, and John Haines, our CFO. On today's call, Gregg will review our second quarter business results, and then John will review our second quarter 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. 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. During this call, we will also discuss certain non-GAAP financial measures, which the company believes help investors understand underlying trends in the company's business more easily. A full reconciliation of non-GAAP to GAAP financial measures is included in today's earnings release, which you can find on the company's website. With that, I will now turn the call over to our CEO, Gregg Sengstack.

Gregg Sengstack (CEO)

Thank you, Jeff. Given the level of detail in our news release earlier this month and our earnings release we issued an hour ago, I'm going to focus my prepared remarks on the principal reasons behind our 13% decline in revenue and 40% decline in earnings as compared to the second quarter last year. After a weaker-than-expected April, in the middle of May, I traveled to West Texas to see firsthand the market situation. The good news was I was able to meet with a lot of contractors. The bad news was that I was able to meet with a lot of contractors. They simply could not, and with the rain, did not need to get out in the field to drill wells and install and/or work over pumps. This was before the record rains that came in June.

This was a consistent theme throughout the Great Plains and Great Lakes regions of the country. This situation has, in some locations, particularly in the central region of the country, delayed contract conversions and resulted in some market share loss, which we view as temporary. We view the loss, the share loss, as temporary due to a couple of factors. First, we already have seen that east of the Mississippi River, where we elected to reset our distribution a year ago, even with the heavy snows last winter in the Northeast and heavy rains this spring in the Ohio Valley, our overall groundwater sales are up over last year. Second, on the West Coast, where our former distributor's inventory of our products is now depleted, we are seeing an increasing number of contractors converting their business to our new distributors.

One comment to California: While the drought in California is well documented, we believe the rate of installations of new wells is actually fairly flat. There are only so many drillers and drill rigs around. What is happening is that the backlog for installations is extending out beyond a year. So while demand is high, sales are steady due to drilling capacity. So with the second wettest second quarter in recorded history in the U.S., compounded with cool temperatures, we have had the perfect storm in the U.S. pump market, frankly, which accounted for a little over half of our revenue shortfall in the quarter. The other principal volume shortfall in the U.S. was weaker than forecasted sales of Pioneer-branded mobile pumping equipment, principally used to support oil and gas exploration.

During the back half of the quarter, customers called to push out confirmed orders into the third quarter, resulting in even softer sales than expected. Turning to our international markets, after several years of double-digit sales growth in Brazil, the shrinking economy finally caught up to us, and our sales were basically flat year-over-year. While we did not own Bombas Leão, the groundwater pump company that we acquired last year, for the entire second quarter of 2014, if we had, then on a pro forma basis, our overall Brazilian business would have had another record sales quarter as demand for Bombas Leão groundwater pumps continued to grow. Even with the soft results in Brazil, our Latin American business had a strong quarter, as did our other developing regions, with the Middle East and Africa up 7% and Asia Pacific up 24% in the quarter.

The last factor that negatively impacted our forecast results was more than expected weakness in fueling system sales in China and India. After 16 consecutive quarters of year-over-year improved fueling systems earnings, the solid 8% growth of fueling system sales in the U.S., as well as growth in other regions and all product lines, was just not enough to overcome the weakness in these two important markets. In addition to the profit shortfall from lower sales. Our consolidated earnings were further depressed as we have not fully recovered the inflationary costs in markets that source product and material in U.S. dollars. We did see improving margins in those business units throughout the quarter, but we are not yet back to last year's levels.

Further, we lost absorption and production as we strive to lower inventories, even with declining sales, and are pleased that during the quarter, our cash flow from operations improved $33 million as compared to the second quarter of last year. With these results, we have taken a number of actions to adjust our cost structure to lower sales run rate, and as we announced in our release this morning, taking the softness in our Brazilian business is an opportunity to accelerate the integration of Bombas Leão. While we have no control over weather, exchange rates, or the price of oil, we continue to make good progress in those areas under our control, clearly gaining traction with our new distribution footprint in the US, expanding our global reach in developing markets, introducing new and innovative products to the markets that we serve, and prudently managing our fixed costs.

Even with the current headwinds, we believe our underlying organic growth rate continues to be in the mid to high single digits. With that, I want to give you our view of the balance of the year. Looking forward, at current exchange rates, currency will remain a headwind for the balance of the year, and at current oil prices, demand for Pioneer branded dewatering pumps should be sequentially better, but will be relatively weak for the balance of the year. In the U.S., where weather conditions are slowly improving, we believe it's reasonable to assume that market demand for pumps will be no worse than the first half of the year. As I mentioned earlier, we are seeing evidence of a recovery in our market position.

Outside of the U.S., we continue to have strong organic growth in our water business, particularly in developing regions, where we get 40% of our revenue. While we are not currently expecting a recovery in our fueling systems volumes in China this year, we expect the global demand for fueling equipment to continue at 2014 levels. Given the sales forecast, which should lead to better overall margin mix, pricing actions to recover inflationary costs and fixed cost reductions, we believe that our earnings in the back half of 2015 will equal our results for the back half of 2014. I would now like to turn the call over to John Haines, our CFO.

John Haines (CFO)

Thank you, Gregg. Our fully diluted earnings per share, as reported, were $0.33 for the second quarter of 2015 versus $0.55 for the second quarter of 2014. 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. Non-GAAP expenses for the second quarter of 2015 were $1.7 million and included $0.8 million in restructuring costs, primarily for the continuing European manufacturing realignment started by the company last year, and $0.9 million of other non-GAAP expenses related to business realignment costs, primarily severance in targeted fixed cost reduction actions and retirement pension costs.

The second quarter of 2015 non-GAAP adjustments had a net EPS impact that reduced earnings by $0.02. There was a $0.05 reduction in EPS for the non-GAAP items in the second quarter of 2014, primarily retired executive pension costs. So after considering these non-GAAP items, second quarter of 2015 adjusted EPS is $0.35, which is down 42% to the $0.60 adjusted EPS the company reported in the second quarter of 2014. It is worth noting that the company estimates its 2Q 2015 adjusted earnings per share was negatively impacted by $0.05 due to the translation impacts alone of foreign exchange. As Gregg noted, we saw a significant strength in U.S. dollar versus many key currencies, which we do business in, including the euro, Brazilian real, South African rand, and Turkish lira during the quarter.

The strengthening causes the earnings of these units to be translated back to fewer U.S. dollars. Water system sales were $191.6 million in the second quarter of 2015, a decrease of $35.1 million, or about 15% versus the second quarter of 2014 sales of $226.7 million. Sales from businesses acquired since the second period of 2014 were $8.3 million, or about 4%. Water system sales were reduced by $19.5 million, or about 9% in the quarter due to foreign currency translation. Excluding acquisitions and foreign currency translation, water system sales were down about 11% compared to the second quarter of 2014.

Water system sales in the United States were down across all of our product groups and were led by a 60% decline in Pioneer-branded dewatering equipment, followed by a 24% decline in groundwater pumping equipment. As Gregg noted, the second quarter of 2015 had the second highest level of precipitation in recorded history in the United States, according to data collected by the Department of Commerce. In Texas, which is a critical groundwater market for Franklin Electric, it was the highest level of precipitation for any second quarter on record.

Water Systems operating income after non-GAAP adjustments was $25.4 million in the second quarter of 2015, down $17 million versus the second quarter of 2014. The second quarter operating income margin after non-GAAP adjustments was 13.3%, down 540 basis points from 18.7% in the second quarter of 2014. Operating income margin after non-GAAP adjustments decreased in Water Systems, primarily due to fixed cost deleveraging from lower sales and lower production rates and related burden absorption in the quarter. Fueling system sales represented 23% of the consolidated sales and were $55.8 million in the second quarter of 2015, a decrease of $2 million, or about 3% versus the second quarter of 2014 sales of $57.8 million.

Fueling system sales decreased by $3 million, or about 5% in the quarter due to foreign currency translation. Fueling system sales were up about 1%, excluding foreign currency translation and acquisitions. Fueling systems operating income after non-GAAP adjustments was $12.7 million in the second quarter of 2015, compared to $13.9 million after non-GAAP adjustments in the second quarter of 2014, a decrease of about 9%. The second quarter operating income margin after non-GAAP adjustments was 22.8%, a decrease of 120 basis points from the 24% of net sales in the second quarter of 2014. The decrease in basis points was primarily due to deleveraging fixed costs.

The company's consolidated gross profit was $80.2 million for the second quarter of 2015, a decrease of $19.2 million, or about 19% from the second quarter of 2014 gross profit of $99.4 million. The gross profit as a percent of net sales was 32.4% in the second quarter of 2015 and declined about 250 basis points versus 34.9% during the second quarter of 2014. The gross profit margin decrease was due in large part from deleveraging of fixed costs on lower sales. Selling, general and administrative expenses were $56.3 million in the second quarter of 2015, compared to $60 million in the second quarter of the prior year, a decrease of $3.7 million, or about 6%.

The increase in SG&A expenses from acquired businesses was $2 million. Excluding the acquisitions, the company's overall SG&A expenses in the second quarter of 2015 decreased by $5.7 million, or about 10% to prior year second quarter, a portion of which was related to foreign exchange. The tax rate for the second quarter of 2015 was 25%, and we believe 27% is a good estimate for the full year 2015 rate before discrete events. The company ended the second quarter of 2015 with a cash balance of $63 million, which was $3.9 million higher than at the end of 2014. The cash balance increase is attributable to cash generated from operations of about $7 million compared to the first half of the prior year, when cash used in operations was about $26 million.

The company is also announcing today a restructuring effort impacting the operations in Brazil. This effort is primarily being done to fully integrate the Bombas Leão acquisition, which was completed in June 2014, and rationalize other aspects of the existing operations in Brazil. In total, the company expects to take a pre-tax charge for business realignment costs of between $4 million and $5 million at today's exchange rates. The charges will be reflected as non-GAAP adjustments in future earnings releases and will be primarily for severance, costs to eliminate redundant commercial sales activities, asset write-offs, and fees for legal and tax services incurred specifically for the rationalization of the Brazilian legal entities. The company expects to incur these costs from the third quarter of 2015 through the end of 2018. The expected payback is less than three years.

Approximately 10% of these costs will be non-cash. The company had about $4 million of borrowing on its revolving debt facilities at the end of the second quarter 2015 versus 0 borrowings at the end of the second quarter of 2014. The company purchased about 73,000 shares of its common stock for approximately $2.5 million in the open market during the second quarter of 2015. Currently, the total remaining authorized shares that may be repurchased is about 714,000. This concludes our prepared remarks, and we would now like to turn the call over for questions.

Operator (participant)

Thank you. Ladies and gentlemen, on the phone lines, if you would like to ask a question at this time, please press star, followed by 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 Joe Radigan of KeyBanc. Your line is now open.

Joe Radigan (VP and Senior Equity Research Analyst)

Hi, good morning, guys.

John Haines (CFO)

Hey, Joe.

Joe Radigan (VP and Senior Equity Research Analyst)

First, on the Water segment, in regards to margins for, you know, for three quarters in a row now, you've been well below what you would consider structural margins in that business. So, how should we think about the back half of the year? Can, favorable mix and some of the restructuring savings, can that get you back to more of sort of that mid-teens or above structural margin range that you've talked about in the past, even with declining revenue? Or should we, you know, consider maybe second quarter margins are more appropriate for the back half of the year?

John Haines (CFO)

Joe, I think a lot of it depends on the top line, of course. You know, with the type of volume declines that we've seen in the second quarter, and that we're you know what we're currently saying right now is that, you know, if the volume declines 8%-9% that it did in the first half, in the second half, we believe that a variety of factors will get us back to even profitability. From a water margin perspective, we would expect to be back in the mid-teens. I don't know if we'll be back in that 16%-18% range, which we've provided as you know kind of the range we see the water segment operating in, but we should be back in the mid-teens or better.

The key there is to recapture some of this lost leverage on the fixed cost. Just by way of reminding, you know, or kind of restating what Gregg said, you know, we have the lost leverage is the biggest driver of this. We've dialed back production rates, which, you know, of course, mean lower absorption of and inventory levels, but lower absorption of fixed costs. We have price actions that continue to impact us more favorably sequentially as we move through the year. Part of those price actions are to offset U.S. dollar inflation in those business units that have experienced that and procure a product based in U.S. dollars. We have the fixed cost reductions.

We've made reductions in several of our business units from just a pure headcount perspective. We're closing a facility in the U.S. in Saco, Maine, which is one of our fueling facilities. We continue to get incrementally better performance out of our European unit as that restructuring effort that we announced last year continues to get a little bit better. And then the last thing, of course, is, as I just said, we're gonna kick off an effort to accelerate the integration of Bombas Leão in Brazil, and that will take some time to get done. We'll start to see benefits of that immediately.

But all of those things are net positives for the water operating income margin, but at the end of the day, it will be really what the top line does.

Joe Radigan (VP and Senior Equity Research Analyst)

Okay, that's helpful. Thanks, John. And then, I'm surprised the surface water products were down double digits in the quarter, just given the weather. I mean, I would think some of that inventory would have been worked through just, you know, with the excessive wet weather for some of that stuff. How big is that HVAC-related business? And then is that—I mean, how is the inventory overhang there? Have you pretty much worked through that, or is that gonna extend through the end of the year as well on the surface side?

John Haines (CFO)

Yeah, Joe, there's a couple of factors going on. We don't disclose the individual product lines, but the HVAC business, you know, again, when it's cool, that's when you're not gonna be using those products, and it's been relatively cool in many parts of the country that would use condensate products. And you also have dewatering products, sump pumps and so on. And interesting is all the rain we got in the Midwest; it only came late in those markets in the upper Midwest, where we have some strength, and we began to see some movement of product late in the quarter, to move along there. And the other part of our, you know, surface dewatering business is Pioneer, and that obviously is way off.

Yes, I'm sure there were some incremental sales of Pioneer pumps to deal with some of the flooding. But they're, again, more principally focused for dewatering in construction, municipal bypass, oil and gas, hurricane type events, and that is yet to occur this year. So yeah, the surface business was down. Again, when you think with all the rain and everything in the central part of the United States, we would have seen a little more strength. We did late in the quarter in the upper Midwest.

Joe Radigan (VP and Senior Equity Research Analyst)

Okay. Then on the fueling side, you've got pretty tough revenue comps in the back half of the year. You know, can you, if you exclude the FX and headwind that you have, that you'll have in that business, I mean, do you expect to grow on a year-over-year basis in the back half of the year in 2015 versus last year?

John Haines (CFO)

Yeah, to your point, FX is a headwind for fueling. We do price in dollars in many markets outside the United States, but it is a drain. We're kind of saying that we look at it right now as being flattish. We don't see the catalyst of China coming back online. We have a very solid business there, and particularly with vapor recovery, and it's just been going sideways with the events in China. India is lumpy, so it's a question of when they put up new orders for bid and when that comes online. And Europe's been a little bit slow. Some of it's our tank business in Europe.

We have, we have these, a small business of underground storage tanks, and actually many of them go into the North Sea oil. And so that's been a, a negative headwind as well. It's not a highly profitable business, but it does affect the top line, but not so much the margins. So I think we've got, some headwinds there that are saying that we're looking at kind of a flattish back half to, as you pointed out, you know, fueling has been on a roll, real roll for, four years, taking a little rest of it right now.

Joe Radigan (VP and Senior Equity Research Analyst)

Okay. Thanks, Gregg. Thanks, John.

Operator (participant)

Thank you. Our next question comes from Mike Halloran of Robert Baird. Your line is now open.

Mike Halloran (Equity Research Director and Senior Analyst)

Hey, morning, guys.

John Haines (CFO)

Morning, Mike.

Mike Halloran (Equity Research Director and Senior Analyst)

Could you delineate between the smaller diameter pumps on the groundwater side and, you know, your resi-oriented stuff and how that's doing? Also, then on the larger diameter industrial kind of ag pumps, what those are looking like in the quarter, if there's any real difference in the trends there for the precipitation is impacting both pretty equally?

John Haines (CFO)

Sure, Mike. You know, the residential, which tends to be more where people live, greater populations, which are in the Northeast, east of the Mississippi. You know, the industry in the second quarter, as information we have, was down, say, low single digits. We were down more like mid- to high single digits there. So that's where we made the comment about loss of share there. You know, the large pumps is what really got hit here in the center of the country. It just, you know, they operate ag systems, and they just didn't need the water. I mean, we have more water we know what to do with, flooding, people actually dying from flooding. So it was a situation where the ag, the large diameter pumps were business was way off.

Mike Halloran (Equity Research Director and Senior Analyst)

Yeah, that makes sense, particularly given the ag landscape going into the quarter was more challenging than the resi side anyways. And then maybe some color on the rental channel in the Pioneer side. You know, obviously, the end markets there are pretty challenging. You had some, I wouldn't call it inventory build in the last year, but you certainly had some unique things going on in your portfolio with some of the customers there. So could you just talk about how the inventory is tracking with some of those rental channel partners? And when you think you can get to the point where there's kind of drop-through and pull-through from a core demand perspective.

Robert Stone (Senior VP and President of International Water Systems)

Hey, Mike, this is Robert. To say when we're gonna see a change in the pull-through demand is extremely difficult. The issue in the field is mainly that our larger customers, like United Rentals, were very heavily exposed to upstream oil and gas. And with those prices, that business basically just disappeared overnight. And so their utilization rates across their fleets, especially in this sector, are down significantly. Earlier, when Gregg was talking about sell-through on large pumps of this type, you have to keep in mind that we sort of see a slowdown when things are going down and when they're coming back up, until the utilization rates get up high enough again.

So we kind of have to ride through the downside and a little bit of the upside before we start to see more demand from rental customers. As our customers change their fleet mix and sell assets and try to refocus on other segments of the industry, that will be where we start to see some more sales pick up. And products not so oriented towards oil and gas, but rather toward municipal sewer bypass and other applications. And that's just gonna take some time.

Mike Halloran (Equity Research Director and Senior Analyst)

Great. Thanks for helping out there. And then last one for me, just to follow up on one of Joe's questions. You know, I still... I can't say I'm struggling with it, but I'm just trying to make sense of the down 8%-9% top line trends that you saw in the first half, that you're projecting the second half. I think that certainly makes sense given the end market dynamics. But getting back to flat year-over-year earnings, relative to some of the decrementals and the volume deleverage you're seeing, just seems... I guess I just need a little bit more comfort on how you get there.

And towards that end, maybe you could just give a little more context for the changes that you've made or, or started making on the restructuring side last year, this year, that maybe hit a little bit more in the second half of the year than maybe I was thinking. Maybe a little bit more help with the mix side of things as well. I know you did a good job with Joe's question of explaining everything you've done, but just maybe help me with the timing of some of the actions you've taken, and then, specifically, where the mix is gonna swing for you.

John Haines (CFO)

Yeah, Mike, let me just add on to what I said to Joe's question. I should have said it when Joe asked it. But, you know, when we look at our back half fixed costs, now, remember when Franklin Electric talks about fixed costs, we're talking about the totality of SG&A and our manufacturing fixed cost base. So that's what we define as fixed cost. We think in the back half of 2015, that we have actions in place to lower that versus the back half of 2014, by call it 7.5%-8%.

Mike Halloran (Equity Research Director and Senior Analyst)

Got it.

John Haines (CFO)

So that's the, that's our current view. We think sequentially, from the first half to second half, Mike, first half 2015, second half 2015, it's, it's about 4%, lower. So that really is the result of, the cost actions that we have taken to date, and that, you know, if necessary, we'll, we'll continue to take. We're gonna see some benefit coming through in the back half in Europe that, you know, to get those margins kind of back to where we, had, have historically seen them, and, you know, the other things that I, I described. So that, that's the, that's the, the, the current thinking and the, and the current view.

We, we're assuming for the moment that mix will favorably impact us, that the groundwater, even though total revenue will be down, we believe that groundwater equipment will be a more favorable factor in the back half than it was in the first half.

Mike Halloran (Equity Research Director and Senior Analyst)

Yeah, no, that, that was the color I was looking for. Thanks a lot for that, John. Appreciate it, guys.

Operator (participant)

Thank you. And our next question comes from David Rose of Wedbush Securities. Your line is now open.

David Rose (Senior VP of Equity Research)

Good morning. Thank you for taking my call. Maybe just to touch a little bit more on the SG&A side. What should SG&A really look like in the back half of the year and, you know, maybe third quarter, fourth quarter progression? And then maybe you can break out a little bit more on how much of the SG&A in the quarter was for the support of the dealer reset, and how much more we should see in the back half of this year? I mean, I'm assuming that it wasn't as effective given, you know, the rains, so you're still gonna have to invest in the, in the back half. And then, and then lastly, as we, we look to next year, you know, what, what or how should we think about SG&A expansion next year?

John Haines (CFO)

Dave, I guess the way I would answer that is, you know, again, when we think about fixed costs, it's a combination of SG&A, and the fixed costs is buried in our cost of goods sold, our fixed manufacturing costs. So, we believe we've taken action to lower that versus last year's second half by 7.5%-8%, as I just stated. Now, if your question is more, you know, is that enough? We are paying attention to this very closely, of course, and we'll reset the fixed cost if we need to. We have a target, which we're not gonna share, of what we want our fixed cost run rate to be at the end of 2015.

So we enter 2016 kind of at that run rate, and we believe right now we're going to be able to make that and have taken actions to make that. If we see volume declines continuing, and we can attribute those volume declines to factors that, you know, are other than some of these macro factors, then it may be necessary to come back and look at our fixed cost base again. But right now, you know, we're trying to continue. You know, as you know about Franklin, you know, we're managing the company for the long term. We're gonna continue to do that.

These headwinds on revenue that we faced are, we think, almost entirely external macro kinds of headwinds, and we're not gonna go, you know, upset or radically disrupt the cost base of the company until we see some of these, you know, go from temporary headwinds into permanent changes in our business, which we haven't seen yet. So that is, you know, that's the balance that we're trying to maintain.

David Rose (Senior VP of Equity Research)

Hey, John, I appreciate that. I was just maybe a little bit more color in terms of, you know, expense on the dealer reset, for example. You still have to spend money in Q3, correct? Or you plan to? Or does that go away?

John Haines (CFO)

Yeah, we're not gonna cut back our support of our customers, Dave. No, absolutely.

David Rose (Senior VP of Equity Research)

And, and-

John Haines (CFO)

As we work through the-

David Rose (Senior VP of Equity Research)

... And-

John Haines (CFO)

As we work through the reset, we'll continue to, you know, contribute the resources necessary to win our new customers and gain their commitment to Franklin.

David Rose (Senior VP of Equity Research)

I think in the fourth quarter of last year, you called out roughly $5 million in expenses. That was, you know, part of a dealer reset, if I'm not mistaken. Is that similar than in the fourth quarter? I mean, that doesn't go away, is what I'm trying to get.

John Haines (CFO)

No, I think, I think some of it would go away, Dave. You know, as we're out in the marketplace, winning new customers, new distributors, you know, there's a lot of training costs, there's a lot of, like, you know, these distributors have things called open houses. They have these events where they bring contractors in. They might have a dinner, they might train. You know, they do promotional activity like that. And, you know, when you're trying to win new customers, you're gonna up the level of that, which is what we saw in large part in the back half of last year. So some of that will certainly continue, and we want it to continue. I would...

You know, without having the actual detailed number in front of me, I would say it would be at a level below last year, but that's only because we've gotten through some of the upfront, a one-time effort to win these customers.

David Rose (Senior VP of Equity Research)

Okay. That's helpful. Then, John, maybe lastly on pricing, it seems like you were a little bit disappointed on your ability to pass on price. What gives you the confidence that you can pass on price in probably what's a much more difficult environment?

Gregg Sengstack (CEO)

Dave, this is Gregg. Pricing has been something that we have historically been able to pass through. Again, as a company that supplies distribution, is generally, I would say, well-received, but it's not necessarily negatively received. When we're in a situation where there is a disruption to the marketplace, you go back in our history, back in 2006, 2007, you go back and the financial crisis in 2009, you know, that's when you get pricing aberration as the market's going through turbulence. Then the market settles back down again, and then you normally will see in our business a positive pricing environment. That's just in the United States. You get outside the United States, and again, we're able to move pricing, you know, at or above inflation.

We haven't been able to do it as quickly as we'd like, in, say, a market like Brazil, where, on imported product, we saw, you know, this dramatic increase in cost that we have to recover over a period of time. We have to be sensitive to just how fast we can move, but we typically can recover our margins, and, and, through productivity, get some expansion of margin over a period of time. Flipping back to your questions around SG&A costs, I think I heard you also talk about Europe. Again, keep in mind there that, you know, we, we had a rather big disruption in the fourth quarter last year for the size of the market, with our factory shutting down for six weeks. We've been spending, you know, a fair amount of money, importing product, and getting product over there to supply the market during the first half of the year.

That's now all kind of quieted down, and we would see the back half of the year, for example, those costs going away. Yeah, with the acquisition of Bombas Leão, I think it's been, it's been a great acquisition, a great fit. But we have duplicative costs, and, and we've been incurring those costs for a period of a year now. And we saw an opportunity with, just kind of the slowdown in, in, the—our Schneider branded products, with now we're in our new factory, in Joinville, and that's all kind of quieted down. So you take the opportunity now to accelerate taking costs out there.

These are various cost actions that we're taking around the globe, are examples of cost actions that we believe are prudent and yet are also keeping in mind an eye for the long term for the company.

David Rose (Senior VP of Equity Research)

Okay. I understand. Thank you, Gregg. I appreciate it.

Operator (participant)

Thank you. And our next question comes from Edward Marshall of Sidoti & Company. Your line is now open.

Edward Marshall (Senior Equity Research Analyst)

Good morning.

Gregg Sengstack (CEO)

Morning, Ed.

Edward Marshall (Senior Equity Research Analyst)

So on the groundwater side, I kind of wanted to talk a little bit about the timing. My sense is that there's a seasonality that hits in the first half of the year, especially around ag, as you know, we prepare for maybe a summer season. Have we missed that? I mean, now that we're sitting in the. Are we kind of in that lull where, you know, the summer's still, there's summer activity, but the predominant initial part of the growing season has already occurred, and so are we gonna wait till next year? How does that work out? Just help me out with the seasonality impact of that.

Gregg Sengstack (CEO)

Yeah, Ed, if you look at Franklin historically in more, what I would call it, more normal times, about half our revenue, half our earnings in the first half of the year, half our revenue, half our earnings in the back half of the year. You typically have a very, you know, a soft first quarter, to your point, a buildup in the second quarter. There are years where our third quarter is larger than our second quarter. So I'm talking about now over a period of years, I've been here a while. So, you know, we see that kind of moving back and forth. It was where there's been a growing season, yes, there's that season has been gone.

We have heard of, anecdotally, people are trying to plant to get a second crop in or get a crop in after the flooding has subsided. There will be a watering cycle that occurs in the third quarter. How big it is, we don't know. That's why we've kind of looked collectively at the back half of the year. But at the end of the day, people need pumps. Now, keep in mind that, you know, part of this has also been people haven't been able to get in to drill or even service pumps that are already in the field, and they're gonna need to have those pumps when they turn on. They're gonna need to replace those pumps when they don't work.

It's a little unclear to us as well as to how strong the back half will be for the growing season. But we think it's reasonable to look at it and say, you know, based on what we've seen in the first half, to estimate if we have a similar sales decline in the back half that we will have the results that we've put out there. That's how we're kind of looking at the year.

Edward Marshall (Senior Equity Research Analyst)

When I think about your business, I mean, predominantly aftermarket to new builds. I mean, what's the ratio there or the percentage of the two different businesses, the aftermarket?

Gregg Sengstack (CEO)

That's a question we often get asked, and it kind of depends. All right, so let's take the U.S. residential market. Let's talk, there's maybe 15 million wells in the United States, as an estimate, and there are about a-- so that means about 15% of the households have wells, approximately. Maybe it's 12. And so then you look at new housing starts, and people focus on new housing starts. So if you say 12% of new houses have wells, and so it's, what, 80,000 new houses? And so you'd say that, you know, if you're selling approximately 750,000 or 1 million pumps into the United States in a year, it's a very large replacement business, with relatively marginal new installs.

Now you're going to say, "Okay, now I have an, I have an ag pump." Okay, now, if the water table has dropped, as we're talking about in California, and you're drilling a new well, is that a replacement or is that a new install? And it's kind of difficult to parse that data. But you'd say that, you know, the large portion of even of those installations are replacements. So we have a very large kind of replacement base. We've kind of said around 80%, we think, is a replacement market on average. But there's really... It is very difficult to kind of parse the data.

Edward Marshall (Senior Equity Research Analyst)

Gotcha. Where are we in the shift of distributors? I know you had some comments there, but I think as we talked over the last couple of quarters, we've expected some restocking potentially to occur. My sense is that did not occur. What would you say? I mean, did you see any kind of restocking on the distributor level? I understand there's some inventories there, but maybe you can help me out with just your understanding of where the market is today.

Gregg Sengstack (CEO)

Sure. You need to take that in kind of two bites. So we made a decision to reset our distribution effective the first of July of last year, east of the Mississippi, and let's, I'll call it kind of west of the Rockies. And there, you know, for example, east of the Mississippi, even with the weather situation, we're seeing sales up over year-over-year, and so we're seeing the throughput. And west of the Rockies, as I mentioned in my prepared comments, we're seeing where our inventory is no longer available now with our prior distributors, that is now available, people are converting over to our new or renewed relationships with other distributors.

Now, the center of the country, the distributor that we were working with that kind of elected to leave us, we saw, you know, a degradation in the sales patterns to them in the back half of last year. So we made a decision in the center of the country to change our distribution, effective basically the first of April. And in that case, you know, we're doing that right in the middle of these, you know, record, well, record rainfall in Texas, near record rainfall everywhere in the center of the country and the upper Midwest. And so there, you know, we're just seeing there's just not been a lot of demand, and so there's been not a lot of throughput.

We do have information that, and again, if you go back to those areas of the country where we had reset last year, that actual throughput from distribution is higher than some of what they're buying from us because everyone's trying to manage, or not everyone, but several are trying to manage their inventory levels down. So that's why it's a little bit cloudy to give you again, greater detail than what I just said.

Edward Marshall (Senior Equity Research Analyst)

Okay. Everything in perspective, I understand that you chose not to give the general guidance that you provide on a quarterly basis, and I understand it must be difficult right now from your seat to kind of predict. I'm wondering what the month of July has done thus far. I know it's less than 30 days of business. Have you seen any improvements in either the dewatering or the groundwater as it's related to, you know, the U.S. business that gives you some confidence as you move into the second half of the year?

Gregg Sengstack (CEO)

Yes. We've seen that in a dewatering space where we have some backlog that sequentially, and that's why in my prepared comments, I made that comment, that sequentially we should see some improvement. But keep in mind, in the back half of last year, we had really big sales of dewatering equipment. And we are seeing some decent order rates here, good order rates in July in our groundwater space. But, you know, we're just a few weeks into the period, and so that's why we looked at this and said, "Let's look at the back half." And collectively, as we looked at the back half, we thought what was a reasonable approach to give you guys some feedback and some guidance.

Edward Marshall (Senior Equity Research Analyst)

Great. I appreciate it. Thanks, guys.

Operator (participant)

Thank you. And our next question comes from Kevin Bennett of Sterne Agee. Your line is now open.

Kevin Bennett (Equity Analyst)

Thanks. Good morning, guys.

Gregg Sengstack (CEO)

Hey, Kevin.

John Haines (CFO)

Good morning, Kevin.

Gregg Sengstack (CEO)

Morning.

Kevin Bennett (Equity Analyst)

Gregg, first, back to the fueling segment for a second. I'm wondering if you can potentially help quantify the declines in India and China?

John Haines (CFO)

We don't get into individual countries, but it's been, you know, $2 million of business in China. Of course, in India, you know, we had some great wins last year with the fuel pumping side, and so those have not been replaced this year. We just haven't seen the tender activity we saw last year, and it's in that order of magnitude. Yeah. So, you know, Kevin, the other thing on that is that we, you know, to Gregg's point, these Indian sales, you know, are lumpy. We had a pretty significant second quarter last year in India.

We think we're gonna have more sales in the back half in India, so it really comes back to how they time their tenders, how they place orders, award, and then place orders under those tenders. So there's nothing relative to India that we're concerned about. Fundamentally, we view it more as just the timing of how they're buying.

Kevin Bennett (Equity Analyst)

Got it. That makes sense, John. And then, you know, sticking, I guess, with China for a second, you know, we all see the headlines and, you know, the stock market crashes every day and auto sales are down. Are you guys worried, I guess, that there's something structurally wrong with China? Or do you think that, you know, I guess, the reduction in state-owned oil company procurements is kind of more of a temporary issue?

Gregg Sengstack (CEO)

Well, I'm sure there are many more people that have a deeper understanding of China than I on that subject. I would say this, and we have a relatively small water business in China, so we have seen the impact of the construction market on our water business in China, and it certainly has not been encouraging. With respect to fueling, I think, you know, the slowdown in China is real. We're seeing it also in our artificial lift. We don't talk a lot about artificial lift right now because the price of gas is so low.

But just the, we're continuing to put in, you know, some wells in China, but it seems to be that the Chinese, you know, are shifting back to, or comfortable with using more diesel fuel, as opposed to, natural gas, which, diesel's gonna be, higher pollutant than natural gas. And they've made that apparent decision, or at least it seems that the market's behaving that way. So, it looks like, you know, the Chinese, from the standpoint of where we're focused, which is in vapor recovery, improvement of the infrastructure in China, the foot's off the gas pedal. We would expect that to change over time, but, we don't have as much visibility into China as I think some of your other people you cover.

Kevin Bennett (Equity Analyst)

Gotcha. Sure, that makes sense. And then two more for me. First, Gregg, you know, given all the headwinds that we've talked about, is there anything in the near future to really drive some top-line growth, whether it's a new product or, you know, potential M&A? Are you guys not really focused on that right now, or something we're not thinking about?

Gregg Sengstack (CEO)

Well, you know, first off, new products, we have a very, what we believe is a very robust pipeline of new products. We measure them every quarter. We're looking at our new products relative to our forecast. It's been something that the company has been focused on and deliberately increasing our R&D investment over the last many years. We're introducing new drive products, new connected products, new integrated system products, like our Inline 400, new high efficiency products, like our permanent magnet rewindable products. And so we're continuing to introduce new products, and that is generally systematically helping our top line and part of our organic growth story, which we see, you know, to be in the mid- to high-single digits in a normal environment.

With respect to M&A, you know, as we have talked about M&A over the years at Franklin, you know, we have bought about a couple companies a year, but a lot of that relates to the timing of the sellers, because these are family businesses, and in one case, we talked to a family for nine years before we acquired the company. In other cases, we talked to people for nine months. And so, it's a little hard to gauge when acquisitions come into place. Last year, we did three deals. A couple of them were small, and we continue to look for opportunity, but timing is a little bit outside our control. We can be there.

We continue the dialogues, and when people are ready to make a decision, we like to be believe that we're a good acquirer. But beyond that, I wouldn't want to get into any details about particular transactions.

John Haines (CFO)

But Kevin, just to be clear, nothing in the current environment is making us think about acquisitions strategically different right now. We're, you know, for the right transactions, Gregg is absolutely right. The timing of these things is difficult to predict, but we're an acquirer for the right transactions, and we will remain that. And that view of the world hasn't changed in light of these quarterly results or kind of what we see happening in 2015.

Kevin Bennett (Equity Analyst)

Got it. That's helpful, John. And then last question for me. You know, given what's happened with your stock price, I'm wondering if you guys are thinking about the buyback any differently than you have before or, you know, planning on leaning more heavily on that, given where the stock is?

John Haines (CFO)

You know, Kevin, as we've talked in the past and we've said publicly, you know, our first priority for free cash flow is accretive acquisitions. We're in a CapEx environment now that has certainly settled down to below our D&A levels from the last few years, where we had major projects going on. So we won't need as much money for CapEx. We think $35 million or less this year. So as we generate cash in our company, then we should have more opportunity for share repurchases, and that's something that, you know, is one of the tools in the toolkit, if you will. So as I said, we have about 714,000 shares remaining on our current authorization.

And, as we've also discussed in the past, you know, we have a view of what we think a forward multiple for this company should be. And, when the market price is below that, then we will act accordingly from a repurchase perspective. So that thinking is not really any different than, you know, we've had for some time now, and the market opportunity may be greater now.

Kevin Bennett (Equity Analyst)

Perfect. Thanks, John.

Operator (participant)

Thank you. And I'm showing no further questions at this time. I'd like to turn the conference back over to Mr. Gregg Sengstack for any closing remarks.

Gregg Sengstack (CEO)

Well, again, thank you for joining us on this conference call, and look forward to speaking to you after our quarter three results. 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. Have a great day, everyone.