Franklin Electric - Q2 2023

Transcript

Operator (participant)

Hello, thank you for standing by. Welcome to the Franklin Electric Report, Q2 2023 Sales and Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. To ask a question during the session, you will need to press star one one on your telephone. You will hear an automated message advising that your hand has been raised. If you wish to lower your hand, press star one one again. Please be advised that today's conference is being recorded. It is now my pleasure to introduce Vice President of Finance and Investor Relations, Sandy Statzer.

Sandy Statzer (VP of Finance and Investor Relations)

Thank you. Thank you, Andrew, welcome everyone to Franklin Electric's Q2 2023 earnings conference call. With me today is Gregg Sengstack, our Chairperson and Chief Executive Officer, Jeff Taylor, our Vice President and Chief Financial Officer. On today's call, Gregg will review our Q2 business highlights, Jeff will provide an overview of our financial performance. We will then take questions. 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 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 will now turn the call over to Gregg Sengstack.

Gregg Sengstack (Chairperson and CEO)

Thank you, Sandy. The Franklin team delivered another strong quarter of performance, which included record sales and earnings per share results for any quarter in Franklin's history. These record top-line results were driven by our Water Systems and Distribution segments. Throughout the quarter, we saw solid demand continue across our core end markets and geographic regions, even as each business continued to face weather-related headwinds. Strong execution and disciplined expense management by our global teams enabled us to deliver solid margins in all of our businesses. This was especially notable in the Fueling Systems segment, which recorded Q2 record operating income and year-over-year operating income growth on lower year-over-year sales. The second fiscal quarter is the start of the busy season for our core Northern Hemisphere markets and when we typically build inventories to meet demand.

However, as the performance of our supply base continues to improve, during the quarter, we focused on reducing inventories to more normalized levels. This operational focus and agility allowed us to accelerate shipments and convert backlog, sequentially decreasing inventory by $26 million, reducing our backlog to $186 million. As a result, our year-to-date cash flow improved by $105 million over the prior year. We still have some work ahead of us, but we continue to make progress on our commitments to improve our cash flow generation. Turning to our segments, Water Systems delivered record sales and operating income for any quarter in its history, with revenues and operating income each increasing approximately 4%, driven by robust sales of our large dewatering pumps and year-over-year growth in other surface pump products.

Our groundwater business was solid despite being negatively impacted by weather in the U.S. and other regions in previous few years, and our intentional reduction of intersegment sales. As our lead times are improving, we are reducing transfers to our Headwater Distribution segment to rightsize their inventory of our products. We expect that other customers are rightsizing their inventories as well. We believe these weather and destocking headwinds to be transitory, and we continue to see healthy end market demand across our business. For example, in our water treatment business, our direct sales to consumers this quarter were up about 10% sequentially as we were lapping the housing market slowdown that started last summer. Overall, Water Systems reported an operating margin of 16%, flat year-over-year, as leverage from sales growth was offset by the mix impact from large dewatering pump volumes.

Fueling Systems reported a revenue decrease of 7% compared to the prior year period, while delivering strong operating margins and record Q2 operating income. Half of the sales decrease was due to us exiting our tank manufacturing business located in the United Kingdom. Fueling Systems' record Q2 operating margin of 33.2%, an increase of 290 basis points compared to the prior year period, was driven by robust demand for our higher margin, critical asset monitoring, fuel management systems, and grid solutions products. During the quarter, we experienced further supply chain improvements, though chip and certain component availability continues to be a challenge.

While we understand that major convenience store marketer customers are not reducing their planned build programs, some of the programs have slowed such that it appears that several planned 2023 new industry builds are now likely to be completed in early 2024. We expect that higher interest rates, weather, and the availability of construction labor have all had an impact on the timing of these new builds. We believe we are gaining market share in fuel management systems and continue to build momentum with convenience store marketers. Further, the well-documented stress on the electrical grid is driving investment in our Grid Solutions critical asset monitoring products. This investment appears to be accelerating. Distribution revenue increased 1% from the prior year period, despite unfavorable weather impacting the start of contractor installations. Commodity pricing continued to decline, customer inventory is trending to more normalized levels.

Operating income decreased about 24%, primarily driven by lower commodity prices. The segment delivered an operating margin of 9.2%, a historically strong margin of 300 basis points below last year's record operating margin, which was aided by last year's strong inflationary environment. More importantly, the operating margin increased sequentially by 590 basis points, reflecting a normal seasonal pickup in the Q2. The team remains focused on executing our strategy to grow and leverage the foundation we built in the Distribution business over the last several years. Our balanced capital allocation strategy remains unchanged. We evaluate each opportunity on its economic and strategic merits, and continue to return capital to shareholders through dividends and share repurchases, invest in our business and explore M&A opportunities.

We are mindful of the macroeconomic pressures that continue to persist and the transitory issues of weather and the impact of channel inventory rightsizing across all three of our reporting segments, we're optimistic about the underlying demand in our core markets. Our Q2 results keeps us on track with the full year 2023 guidance, which was raised last quarter. We are reaffirming our 2023 full-year sales and EPS guidance range of $2.15 billion-$2.25 billion in revenue and $4.25 to $4.45 percent in earnings per share, respectively. Before turning the call over to Jeff, I'd like to mention our 2023 sustainability report, which was just published in June and is expanded from previous years.

This year's sustainability report provides an update on the progress we have made on several ESG initiatives, as well as areas of focus for the next few years. I'm proud of the progress we have made in our ESG performance, as reflected in this year's sustainability report, but as I said earlier, we have more work to do. With that, I will now turn the call over to Jeff for the financial highlights.

Jeff Taylor (VP and CFO)

Thanks, Gregg. Good morning, everyone. Overall, it was a record Q2 for Franklin Electric. We established new quarterly records for consolidated sales and earnings per share. Q2 2023 consolidated sales were a record $569.1 million, a year-over-year increase of 3%, despite a 2% headwind due to foreign currency translation. Our fully diluted earnings per share were $1.27 for the Q2 of 2023, versus $1.26 for the Q2 of 2022. Water Systems sales in the US and Canada were up 4% compared to the Q2 of 2022 due to price and volume. Foreign currency translation decreased Canadian sales by 1%. The sales growth in the US and Canada was led by sales of large dewatering equipment, which increased approximately 100%.

Wet weather across most of the U.S. in the first half of the year and some destocking in the U.S. Pro channel led to lower sales of groundwater pumping equipment. Water Systems sales in markets outside the U.S. and Canada were up 3%. Foreign currency translation decreased sales outside the U.S. and Canada by 10%. Sales increases in EMEA and Latin America more than offset slightly lower sales in the Asia Pacific markets. Water Systems operating income was $50.8 million in the Q2 of 2023, up $1.8 million or 4% versus the Q2 of 2022. Operating income margin was 15.8%, flat compared to last year. The increase in operating income was primarily due to higher sales.

Distribution Q2 sales were a record $193.1 million, versus Q2 2022 sales of $191.1 million, a 1% increase. The Distribution segment's operating income was $17.8 million for the Q2, a year-over-year decrease of $5.5 million. Operating income margin was 9.2% of sales in the Q2 of 2023, versus 12.2% in the prior year. The Distribution segment was negatively impacted by wetter weather, consistent with our prior comments relating to Water Systems. Income was also negatively impacted by margin compression from lower pricing on commodity-based products sold through the business. Fueling Systems sales were $80.4 million in 2023 versus Q2 2022, sales of $86.0 million, a 7% decrease.

Fueling Systems sales in the U.S. and Canada decreased 6% compared to the Q2 of 2022 due to lower demand from destocking and channel inventory as supply availability and lead times improved. We experienced growth in our fuel management systems and pumping systems, as well as our grid solutions business. Outside the U.S. and Canada, Fueling Systems revenues decreased 8%, primarily due to the divestiture of the tank business in 2022 and lower sales in the Asia Pacific region. Fueling Systems operating income was $26.7 million, a Q2 record, compared to $26.1 million in the Q2 of 2022. The Q2 of 2023, operating income margin was 33.2%, compared to 30.3% of net sales in the prior years.

Operating income and margin increased primarily due to price realization, favorable product and geographic sales mix shift, and disciplined expense management. Franklin Electric's consolidated gross profit was $188.5 million for the Q2 of 2023, down slightly from last year's Q2 gross profit of $189.3 million. The gross profit as a percentage of net sales was 33.1% in the Q2 of 2023, versus 34.3% in the prior year. Gross profit margin was negatively impacted by weather and margin compression from unfavorable pricing of commodity-based products sold through the business. Selling, general, and administrative, or SG&A expense was $107.4 million in the Q2 of 2023, compared to $108.3 million in the Q2 of 2022.

The decrease in SG&A expense was largely due to disciplined expense management, including lower spending in marketing and advertising in the quarter. SG&A cost as a percent of net sales decreased to 18.9% in the Q2 of 2023, from 19.7% in the Q2 of 2022. Consolidated operating income was $84.9 million in the Q2 of 2023, down $0.1 million, or less than 1% from $81.0 million in the Q2 of 2022, despite an unfavorable foreign exchange translational headwind of approximately $1 million. Q2 2023 operating income margin was 14.2% versus 14.7% of net sales in the Q2 of 2022. The decrease in operating income and operating margin was primarily due to the decrease in operating income from the Distribution segment.

Interest expense was higher due to higher interest rates. Foreign exchange losses were higher, primarily due to the stronger US dollar and our operations outside the U.S., particularly in Turkey and Argentina. The effective tax rate was 19% for the quarter, compared to 22% in the prior year quarter. We generated approximately $43 million of operating cash flow in the first half of 2023, compared to using or negative $62 million in operating cash flow in the first half 2022, an improvement of $105 million. In 2021 and 2022, we invested in higher levels of working capital to support our growth. In 2023, we expect working capital to continue to return to more normal levels, leading to improved cash flows.

The company purchased approximately 9,000 shares of common stock in the open market for about $0.9 million during the Q2 of 2023. At the end of the Q2 2023, the remaining share authorization is approximately 1.1 million shares. Yesterday, the company announced a quarterly cash dividend of $0.225 that will be paid August 17th to shareholders of record as of August 3rd. This concludes our prepared remarks. We'll now turn the call back over to Andrew for questions.

Operator (participant)

Thank you. As a reminder, if you have a question at this time, please press star 1 1 on your telephone. If your question has been answered or you wish to remove yourself from the queue, please press star 1 1 again. One moment, please, for our first question. Our first question comes from the line of Matt Summerville with D.A. Davidson.

Matt Summerville (MD and Senior Research Analyst)

Thanks. A couple of questions. Can you maybe just put a finer point on what you saw from a destocking standpoint, when in the quarter it started, if you're still seeing a lingering impact into the Q3, and maybe is there a way to quantify how much of an impact it had on Q2? Maybe just start there, and then I have a follow-up.

Gregg Sengstack (Chairperson and CEO)

Yeah, Matt, this is Gregg, and I'm sure Jeff will have a follow-on to this. You know, it's a little tough for us to parse it out because of the, you know, look, we had a couple of years of really dry weather. You know, we've seen the housing slow down from last summer. You know, sales in the, in the quarter in groundwater, we probably have the most visibility in the United States. You can see that, you know, the Headwater sales are out the door, are up 1%. In actual units are up a little bit more than that because the value of the commodity piece was lower, you know, in dollars per, you know, commodity that we sold, like pipe or wire.

That's, that's our, you know, kind of best indicator is that the that business was actually up out the door. Yet, you know, we reduced our transfers by about $10 million into the business, intentionally reduced their inventory. You know, that's a, that's a bogey. Let's say that that's, you know, 40% of kind of our sales from that channel. You can maybe extrapolate from that. It's. It was, you know, kind of throughout the quarter. I really maybe couldn't put a finer point. Jeff may have a better, a different point of view, a better point of view.

Jeff Taylor (VP and CFO)

No, I don't have a hard number on that to quantify the amount of destocking. As Gregg said, it's really hard to kinda separate how much was weather-related versus how much was destocking. What I can tell you is that, you know, we are seeing supply chain improve. Our delivery times to our customers have improved in the Q2. Our delivery times from our suppliers improved in the quarter. We think that, you know, others are seeing that as well, which is allowing them to really normalize or right-size their inventory levels. You know, that certainly has an impact.

I also think that, you know, higher interest rates are playing a role here. People are realizing that the cost of carrying inventory is higher today than it was a year ago, because of that, they're also looking to, you know, pull down those inventory levels. Obviously, it was, you know, we think it's a little more prevalent in fueling than we've seen on the water side, as the, you know, as they've had some delays in starts on those new to industry installations. Hard to separate the effect between, you know, weather and destocking. We do believe it's transitory. I do think that we'll see some impact carry over into Q3. Once again, hard to quantify what that is at this time.

Matt Summerville (MD and Senior Research Analyst)

Got it. As a follow-up, can you talk about what price realization looked like on a year-over-year basis for Franklin Electric, and if there's a material difference in the businesses? One of the things I'm trying to get at is, you know, how much did lower commodity pass through weigh on the Distribution segment? Maybe, Jeff, if you can comment on what you expect free cash conversion to look like for Franklin in 2023. Thank you, guys.

Jeff Taylor (VP and CFO)

Yeah, certainly, Matt. I would say that pricing realization that we're seeing on a year-over-year basis, take the commodity piece out of Headwater for this comment. you know, I think we're seeing mid-single digits, generally, pricing across the board, and that's, you know, water is kind of high- mid to high single digits at this point in time. You know, we've talked about that we expect that as we progress through the year, with price increases being less frequent this year, and being more stable, more of a return to normal pricing environment that we've seen in the past, that those will, you know, that those will continue to contract as we move through the year, and we lap those price increases from last year.

On the Headwater side, on the, on the non-commodity products, so the pumps, the motors, the controls, and drives, those type of products, you know, they're seeing good price realization. Still seeing, you know, something consistent with what Water Systems is in mid-single digits pricing. But on the commodity product side, they're seeing, you know, price decreases, and that's really what's driving a big part of the margin compression that Headwater is seeing in their business in the first half of this year. You know, the fueling business is seeing kind of low to mid single digits pricing. Everybody's positive on pricing at this point in time. For free cash flow conversion, our target, you know, is and continues to be 100%.

You know, based on our current view for the rest of the year, we expect that we'll be able to exceed that and, you know, by a reasonable amount as we go through the back half of the year. We typically generate very strong cash flow in the back half of the year. We turned the quarter in Q2. As you know, we had very strong free cash flow in the quarter, and certainly compared to the prior year and sequentially as well. We expect to see, you know, pretty normal recovery of cash, strong free cash flow generation in the back half of the year.

Matt Summerville (MD and Senior Research Analyst)

Understood. Thank you. Thanks, guys.

Operator (participant)

One moment, please, for our next question. Our next question comes from the line of Mike Halloran with Baird.

Mike Halloran (Senior Research Analyst)

Hey, good morning, everyone.

Gregg Sengstack (Chairperson and CEO)

Hey, Mike.

Mike Halloran (Senior Research Analyst)

A couple questions here. First, you know, I think probably goes with part of Matt's first question a little bit. You know, when I hear what you're saying, which is lead times are normalizing, but you had a destock in the quarter, those two kind of make sense. At the same time, you're talking about a pretty healthy backlog level as you look in the environment. Maybe you can just find a way to rectify those for me. They seem contradictory on the surface, but obviously, it's what you're seeing below the surface. Would love to understand how those all fit together.

Gregg Sengstack (Chairperson and CEO)

Yeah, Mike, a couple of things are going on. To your point is that, again, you know, the Q2, I think as people are coming into the season, both the compared to prior year, a little bit a tougher comp from the standpoint of weather. Also, I think people are just kind of burning through what they have on hand, you know, our customers. We're seeing that. At the same time, you know, our large pump business, you know, that's a different business, and that, you know, we work off of backlog. There's a, you know, a meaningful portion of our quote, backlog, which relates to large pumps, which are going to be delivered over a series of months. We're even seeing now some POs going to 2024.

We have good visibility on that, which is, you know, different than our short cycle business. The short cycle business is more, you know, as we go into, you know, Q3, which, you know, it used to be Q2 is our largest revenue quarter as a manufacturer. Now, it's with a more meaningful distribution business, Q3 tends to be a, maybe a little bit bigger than Q2. We just, you know, we're in that part of the season. Yeah, You know, California has been, you got a lot of rain, so they're using a lot of surface water. That's, you know, one micro market. We had decent results in Northern Latin America. Europe did well, Southern Africa did well. Asia looks like it's coming back.

We have a sense that's where we have, you know, a sense it's a short cycle business, but our people are confident right now at in the back half of the year.

Jeff Taylor (VP and CFO)

Yeah.

Mike Halloran (Senior Research Analyst)

That's helpful.

Jeff Taylor (VP and CFO)

Thank you.

Mike Halloran (Senior Research Analyst)

Oh, go ahead, sorry. Sorry, Jeff.

Jeff Taylor (VP and CFO)

I was going to say that the comment I would add there is, you know, Greg talked about our large pumps and the, you know, they're more of a longer order cycle versus our short cycle business. A big part of the decrease we saw in our backlog was in our past dues, we've made great progress in the quarter catching up on past dues. You know, some of the decrease was on the large pumps, but a big chunk of it was also in the short cycle business. We're very pleased with, you know, how we're seeing the backlog in this environment, and we're making, like I said, great progress in terms of reducing past dues.

Past dues are almost getting back to what we would say is a norm, you know, a normal level for us. We're once again, pleased with that.

Mike Halloran (Senior Research Analyst)

Well, that makes sense, Jeff. Thanks for that add on. Second question relates to something I think, Gregg, you touched on there briefly. Just how to think about what seasonality now looks like to your business? I understand the Headwater piece, probably a little bit more sequential improvement. Obviously, you've pointed out a bunch of things going on in Q2 from a destock perspective, weather perspective, that maybe changes how that cadencing looks from Q2 to Q3. More on the weather, on the water side, cumulatively. Any help you can give to how you think that should play out as we look through the back half of the year, how it compares to normal seasonality, any kind of context would be great.

Jeff Taylor (VP and CFO)

Yeah. You know, obviously, the middle part of the year is generally the strong season for us. In the Northern Hemisphere, it's the drilling season in the groundwater business, you know, those are gonna be our strongest periods of time. Every year is a little different, you know, you kind of take it year by year. I would say, Gregg can confirm or correct me if I'm wrong, but I think typically, historically, maybe Q2 has been a little bit of a stronger quarter for us.

In the last couple of years, you know, we've certainly seen that strength continue into Q3, and I think this year, in particular, with, you know, the wet weather that we saw in the first half of the year, I mean, the US was really much wetter this year than the prior couple of years that we've seen in the first half of the year. I think that's gonna, you know, Hopefully, we see things dry up here, and I think we've started to see that already. And that'll lead to you know, some pickup in activity in the back half of the year.

I would say the other thing that can impact that seasonality. It's a little early to be talking about Q4 and the end of the year. Certainly, you know, how long the season goes into, you know, into the Q4. If winter weather kinda holds off and we have a long season, that'll obviously play into the full year seasonality.

Mike Halloran (Senior Research Analyst)

Thanks, gentlemen. Appreciate it.

Jeff Taylor (VP and CFO)

Thank you.

Gregg Sengstack (Chairperson and CEO)

Thank you, Mike.

Operator (participant)

Thank you. One moment, please, for our next question. Our next question comes from the line of Walt Liptak with Seaport Research.

Walt Liptak (Senior Research Analyst)

Hey, good morning, guys. You know, you know, You're answering the question, but I wanted to ask it in a different way. You know, with the guidance maintained for 2023 and the weaker Q2, you know, what are your key assumptions for maintaining that guidance?

Jeff Taylor (VP and CFO)

Yeah, Walt, I would say that, you know, our outlook really hasn't changed materially for the full year. Obviously, we're maintaining our full-year guidance. From that perspective, really little to no change from the last quarter. I'll echo a couple of points that I made last quarter. I mean, we are expecting to see, you know, more of a return to normal in 2023 versus what we saw in 2021 and 2022. We see inflation continuing to moderate. We see, you know, generally organic growth in kind of mid-single digits, certainly depending on our business and our region. You know, obviously, if we get that kind of growth, we get good leverage on it and flow through for our bottom line results as well.

We expect supply chain is gonna continue to improve, and our base demand has been very solid and very, very healthy. You know, we have a high component of replacement demand in our core business, and that's generally very stable. You know, that plays into our outlook and our view for the rest of the year. We continue to see FX translation continuing to be a headwind. It's about 2% in the Q2. We would generally view it to be about 1%-2%. We have started to see, you know, some areas where the dollar is stabilizing and starting maybe even to weaken versus a couple of currencies. On the macro level, we're not economists.

We're, you know, we're not, I would say, predicting, where the economy is going, but I don't think we see a recession built into our outlook. I think we see, you know, the economy, continuing to kind of move along, at the current level through the end of the year and into 2024.

Walt Liptak (Senior Research Analyst)

Okay, great. With the, you know, the destocking issue and maybe the timing issue that you just spoke about in the previous question, is some of that related to the agricultural irrigation markets? I wonder, you know, you know, what kind of visibility you have into things firming up in the Q3?

Jeff Taylor (VP and CFO)

Yeah. For our business, we saw the ag side kinda hold up. It was positive on a year-over-year basis, but kinda, you know, low single digits. So we didn't see as much on the, on the ag side. You know, I would say that, you know, we've seen a little more on the residential, the resi side, in both our base water business, but also at water treatment. We've talked about how the water treatment has a little more exposure or sensitivity on the resi side than the base water business does.

Walt Liptak (Senior Research Analyst)

Okay, great. Okay, thank you.

Jeff Taylor (VP and CFO)

Thank you, Walt.

Operator (participant)

Thank you. I would now like to hand the call back over to CEO, Greg Sengstack, for any closing remarks.

Gregg Sengstack (Chairperson and CEO)

Thank you for joining us this morning for our conference call. We look forward to speaking to you after the end of the Q3 with our results. Have a good week.

Operator (participant)

Ladies and gentlemen, this concludes today's conference call. Thank you for participating, and you may now disconnect.