Franklin Electric - Q3 2013

Transcript

Operator (participant)

Good day, ladies and gentlemen, and welcome to the Franklin Electric Third Quarter 2013 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. If anyone should require operator assistance during the conference, 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 introduce your host for today's conference, Mr. Jeff Fleeger, Treasurer. Mr. Fleeger, please begin.

Jeff Fleeger (Treasurer)

Thank you, Janine, and welcome everybody to Franklin Electric's Third Quarter 2013 Earnings Conference Call. With me today are Scott Trumbull, our Chairman and CEO; John Haines, our CFO; Robert Stone, senior vice president and President of International Water Systems; and Gregg Sengstack, President and COO. On today's call, Scott will review our third quarter and year-to-date business results, and then John will review our third quarter and year-to-date 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 any 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. Also, our press release in this call contains non-GAAP financial measures that include but are not limited to: earnings after non-GAAP adjustments, fully diluted earnings per share after non-GAAP adjustments or adjusted EPS, operating income after non-GAAP adjustments, and percent operating income to net sales after non-GAAP adjustments. The company believes that these measures help investors understand underlying trends in the company's business more easily. The differences between these measures and the most comparable GAAP measures are reconciled in the tables in our earnings release. All forward-looking statements made during this call are based on information currently available, and except as required by law, the company assumes no obligation to update any forward-looking statements. With that, I will now turn the call over to our chairman and CEO. Scott?

Scott Trumbull (Chairman and CEO)

Thanks, Jeff. We're pleased to report that our sales and earnings per share were the highest for any third quarter in the company's history. Our global sales of Pioneer branded mobility dewatering systems and Little Giant branded wastewater pumps increased by more than 25% during the quarter. In addition, we continue to achieve high single-digit organic sales growth for both water and fueling products in developing regions. This growth more than offset a decline in groundwater pump shipments. Recall that during the third quarter of 2012, drought conditions prevailed across much of North America, resulting in unusually strong demand for our groundwater pumping equipment.

So on balance, Water Systems achieved 5% organic sales growth during the quarter after excluding the impact of foreign translation, which, along with ongoing productivity improvements and expense controls, enabled us to increase our earnings per share after non-GAAP adjustments by 9% and increase our operating income margin after non-GAAP adjustments by 60 basis points to 14.8%. Our water sales in the U.S. and Canada represented 42% of our consolidated sales and grew by 5% compared to the third quarter prior year. As I mentioned, our sales of groundwater pumping equipment in North America declined during the quarter, but this decline was more than offset with rapidly growing demand for our mobile dewatering pumps and for our residential and light commercial wastewater pumps. We believe we'll continue to achieve solid sales gains for these product lines in North America through the fourth quarter.

However, we are concerned that our groundwater pumping equipment distributors in North America may be entering the seasonally slow fourth quarter with somewhat higher-than-normal inventories. Our water sales in the Asia-Pacific region represented 5% of our consolidated sales and declined organically by 16% compared to the third quarter prior year. This decrease was driven principally by a fall-off in sales orders from our customers in Southeast Asia. During the first half of this year, our sales in Southeast Asia grew organically by 38% compared to the prior year. Several of our large distributors in the region curtailed orders during the third quarter in order to adjust inventories. So in spite of the third quarter decline, our year-to-date Southeast Asia sales are up 21%. Our water sales in Europe represented 7% of our consolidated sales and grew organically by 8% compared to the third quarter prior year.

We experienced solid sales increases across all regions of Europe, with our sales to Eastern Europe growing most rapidly. We had particularly strong demand in Europe for our 4-inch groundwater pumps and motors that are used in residential and light commercial applications, as well as in smaller irrigation and municipal applications. Our European sales also benefited from expanded distribution for our E-Techbranded line of stainless steel pumps. This is particularly encouraging because in the next few months we'll be expanding this product line to include a complete line of vertical multi-stage pumps used for pressure boosting in commercial buildings and industrial applications. We also achieved solid sales growth in Europe with our Pioneer line of mobility dewatering equipment. As I've mentioned in previous quarterly calls, we're in the process of starting up a Pioneer pump rental business in the U.K.

We now have six rental depots open, with a seventh scheduled to open in the first quarter next year. This venture's not scheduled to reach break-even for several months yet, but it is starting to have an impact on our overall European sales growth rate. Our water systems sales in the Middle East and Africa represented 13% of our consolidated sales during the quarter and grew organically by 18% compared to the third quarter prior year. Our strongest organic sales growth was in the Sub-Saharan Africa area, with sales in South Africa, Botswana, and Namibia growing organically in excess of 25%. During the fourth quarter, we'll be opening a new distribution center in Zambia, which will put us in a position to tap the accelerating growth for our ag irrigation and mine dewatering pumping systems in that and neighboring countries as we move into 2014.

Our sales to the Gulf region, the Near East, and North Africa grew organically by 12% compared to the third quarter prior year, driven primarily by growing demand for Franklin pumping equipment used in large agricultural irrigation projects. Our strategy of selling Impo branded pumps and motors to the price-sensitive market segments and Franklin branded products to customers seeking longer life and higher efficiency in the Middle East and African market area is also facilitating our growth. Our water sales in Latin America represented 12% of our consolidated sales and grew organically by 8% compared to the third quarter prior year. Our team in Brazil continued to generate most of our organic sales gain in Latin America during the quarter. Our organic sales growth in Brazil was 23% in the third quarter compared to the prior year.

The new factory we're building in Brazil, which will provide the capacity for continued growth in this dynamic market, is proceeding on budget and on schedule and should be in production early in the second quarter next year. This strong performance in Brazil was partially offset by reduced sales in Venezuela due to the difficulty that our distributors in that country are having obtaining U.S. dollars to pay for the importation of Franklin pumps and motors. Late in the third quarter, we opened a new distribution center in Bogotá, Colombia, which will continue our growth in that market during 2014. Fueling systems represented 21% of our sales and grew organically by 1% compared to the third quarter prior year. Fueling sales in developing regions grew organically by about 8% during the quarter.

Our fueling sales in Latin America grew by 30%, and our sales in China grew by 25% during the third quarter. Filling station owners in these regions are continuing to migrate to the Franklin pressure pumping system in order to accommodate larger stations, pump at higher speeds, and reduce installation and maintenance costs. We also are achieving strong sales gain for fuel management dispensing systems in these regions. Our developing region fueling sales growth in Latin America and China was partially offset by a decline of sales in India. Starting in the third quarter last year and ending in the second quarter 2013, the company had shipped large tender orders to two of the major Indian oil companies. While we anticipate additional tender orders, if these do not develop, we'll continue to face negative comparisons for fueling shipments in India over the next few quarters.

Our fueling sales in the U.S. and Canada grew by 6% during the quarter, with all of the sales growth coming from the Flex-Ing acquisition. Our pumping and fuel management product lines in the U.S. and Canada grew by 4% compared to the prior year, but this was offset by a decline in our dispensing product line. The dispensing product line declined due to the previously announced EPA decision to no longer require station owners in several states to have in-station vapor recovery systems. We believe that over the next two years, this decision will ultimately result in reducing our overall fueling system sales by about 2% and will be far more than offset by new product launches as well as organic growth in other markets and product lines.

Turning to our outlook for the fourth quarter, we expect that during the fourth quarter of 2013, our water systems sales will improve by 5%-8%, and our adjusted operating income will improve by 4%-7% versus the fourth quarter of 2012. The operating income is expected to grow at a slower rate than sales due to an anticipated unfavorable sales mix shift during the fourth quarter of 2013. Additionally, we estimate that our fueling systems sales and adjusted operating income will grow by 4%-7% compared to the fourth quarter prior year. Overall, we're expecting our consolidated fourth quarter sales to grow by 5%-8% and our adjusted EPS to grow by 4%-7% compared to the fourth quarter 2012.

Recall that during the second half of this year, we've been investing in an unusually large number of startup projects that are reducing our profits but are scheduled to turn around as we enter 2014 and start contributing to our profit growth. These projects include the startup of our U.K.-based rental business, the startup of our artificial lift business, the opening of five new distribution centers around the world, a 16% increase in R&D and E spending in the company, and the construction of our new factory in Brazil. In addition, during the fourth quarter of this year and early in the first quarter next year, we are announcing price increases in many of our largest markets around the world. These increases will cover product lines that represent about 70% of our total sales and will average about 3%. I'll now turn the call over to our CFO, John Haines. John?

John Haines (CFO)

Thank you, Scott. Our fully diluted earnings per share were $0.51 for the third quarter of 2013 versus $0.46 for the third quarter of 2012. As we note in the tables and 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 third quarter of 2013 were $0.9 million and included $0.8 million in restructuring costs, of which $0.6 million related to relocation costs for the new corporate headquarters and engineering center in Fort Wayne, Indiana, that the company occupied during the third quarter, and $0.1 million in other legal and advisory costs related to potential acquisitions.

These non-GAAP expenses were offset by an adjustment for $1.6 million due to the reversal of a reserve for legal claims held by Franklin Fueling Systems to receive the favorable ruling on a lawsuit during the quarter. This adjustment was reflected in the selling, general, and administrative expenses on the company's consolidated income statement. In total, then, third quarter 2013 non-GAAP adjustments resulted in a decrease of operating income of $0.7 million and a decrease of EPS of about $0.01. There were no non-GAAP EPS adjustments in the third quarter of 2012. So after considering these non-GAAP items, third quarter 2013 adjusted EPS is $0.50, which is 9% higher than the $0.46 adjusted EPS the company reported in the third quarter of 2012. Overall, the 2013 third quarter revenue, gross profit, operating income, net income, and earnings per share were records for any third quarter in the company's history.

Water Systems sales were $197.9 million in the third quarter of 2013, an increase of $8.1 million or about 4% versus the third quarter of 2012 sales of $189.8 million. Sales from businesses acquired since the third quarter of 2012 were $2.3 million or 1%. Water Systems sales were reduced by $4.4 million or about 2% in the quarter due to foreign currency translation. Water Systems sales growth, excluding acquisitions and foreign currency translation, was about 5%. Water Systems operating income after non-GAAP adjustments was $36.8 million in the third quarter of 2013, an increase of 4% versus the third quarter of 2012. The third quarter operating income margin after non-GAAP adjustments was 18.6%, flat compared to the third quarter of 2012.

Fueling systems sales were $51.9 million in the third quarter of 2013, an increase of $4.1 million or about 9% versus the third quarter of 2012 sales of $47.8 million. Sales from businesses acquired since the third quarter of 2012 were $3 million or about 6%. Fueling systems sales were increased by $0.7 million or about 1% in the quarter due to foreign currency translation. Fueling systems sales growth, excluding acquisitions in foreign currency translation, was about 1%. Fueling systems operating income after non-GAAP adjustments was $12.5 million in the third quarter of 2013 compared to $11.4 million after non-GAAP adjustments in the third quarter of 2012, an increase of about 10%. The third quarter operating income margin after non-GAAP adjustments was 24.1%, an increase by 30 basis points compared to 23.8% of net sales in the third quarter of 2012.

Operating income margin after non-GAAP adjustments increased in fueling systems primarily due to fixed cost leverage on higher sales and lower raw material costs. The company's consolidated gross profit was $87 million for the third quarter of 2013, an increase of $4.4 million or about 5% from the third quarter of 2012 gross profit of $82.6 million. The gross profit as a percentage of net sales was 34.8% in both the third quarter of 2013 and the third quarter of 2012. Selling, general, and administrative expenses were $48.4 million in the third quarter of 2013 compared to $49 million from the third quarter of prior year, a decrease of $0.6 million or about 1%. In the third quarter of 2013, increases in SG&A attributable to acquisitions were $0.7 million.

SG&A expenses in the third quarter of 2013 were offset by an adjustment for the reversal of a reserve for legal claims established in prior years that were favorably resolved in the third quarter. As I previously mentioned, this benefit is considered a non-GAAP adjustment. The tax rate as a percentage of pre-tax earnings for the third quarter of 2013 was about 28%, flat to the third quarter of 2012, which we also believe is a reasonable estimate for the full year 2013 rate before discrete events. The company currently estimates that total non-GAAP adjustments to full year earnings in 2013 will net to approximately $0.5 million-$1 million, resulting primarily from restructuring activities related to the flexing acquisition, the relocation of the company's headquarters, and other miscellaneous manufacturing realignments in North America and certain international locations, offset by the reversal of the legal reserves we previously discussed.

The company will continue to provide quarterly reconciliations and explanations of all non-GAAP related items. The company ended the third quarter of 2013 with a cash balance of $118.1 million, which was $14.8 million higher than the end of 2012. The cash balance increased primarily as a result of normal seasonal cash fluctuations, decreases in prepaid income and other taxes, and proceeds from debt, offset by additions to property, plant, and equipment of approximately $51 million. The company had no outstanding balance on its revolving debt agreement at the end of the third quarter of 2013 or 2012. Finally, on Friday, October 25th, the board of directors of the company declared a quarterly cash dividend in the amount of $0.0775 per share for outstanding shares of common stock on November 21st, 2013, with a record date of November 7th, 2013.

This concludes our prepared remarks, and we'd now like to open the call up for questions.

Operator (participant)

Thank you. Ladies and gentlemen, if you would like to ask a question, please press the star, then the number one key on your touch-tone telephone. If your question is answered or you wish to remove yourself from the queue, you may press the pound key. And the first question is from Matt Somerville of KeyBanc. Please go ahead.

Joe Radigan (VP and Senior Equity Research Analyst)

Good morning, guys. This is Joe on for Matt. How much were your ag-related sales down year-over-year in the quarter, and then what sort of decline does your fourth quarter guidance assume? And if you have it, what were they up last year just to give some context? I'm just trying to get an idea of the mix headwind that you're facing in the water business.

Scott Trumbull (Chairman and CEO)

Yeah. Our sales were down high single, low double digits in North America in irrigation groundwater-related shipments in the third quarter. Last year, they were up. I don't have the precise number on my tongue, but it was approximately 20%. It was a significant increase last year. Most of the west of the Rockies continued to be pretty dry this year. We had solid shipments west of the Rockies comparable to last year in that region. But if you look at a drought map, east of the Rockies went from being very dry last year to, especially during much of the ag season, very wet, particularly in the Southeast. So our sales hit was pretty geographically confined to regions east of the Rockies and especially in the Southeast region of the United States.

On the other hand, for the same reason that our sales of groundwater pumps were down, our sales of wastewater pumps and dewatering pumps, as I mentioned, were up 25% during the quarter. There tends to be a little bit of a natural hedge. On the other hand, our margins are somewhat higher on groundwater pumping equipment than they are on wastewater and mobile dewatering pumps.

Joe Radigan (VP and Senior Equity Research Analyst)

Okay. And then given that commentary, Scott, is your concern around channel inventory more isolated to those eastern distributors as opposed to the distributors out west? And are you seeing more aggressive discounting activity due to that concern in the industry?

Scott Trumbull (Chairman and CEO)

The first question, the answer is yes. We think that our inventory, we don't have hard data on distributor inventory levels, although our salespeople are in our distributors all the time. So it's all based on subjective observation. But we would say that our inventories with our distributors west of the Rockies are, we believe, generally in line with anticipated sales levels. And our inventories with distributors, particularly in the Southeast, are probably heavy.

Joe Radigan (VP and Senior Equity Research Analyst)

Okay. And then how are they positioned in terms of their annual sales incentive targets this year compared to last year? I mean, how could that impact selling? Could that be a driver to drive sales later in the year, or are they is that a non?

Scott Trumbull (Chairman and CEO)

No. Given the nature of our business, with at least 80% of our sales generally being emergency replacements, which are highly unpredictable in nature, we don't sell from a backlog. We sell from distributor inventories. It's difficult to predict our sales in any quarter. The fourth quarter is always the most difficult to predict because just for that reason, in North America, all of our distributors have sales levels with a discount structure that the more they buy, the larger the year-end discount. Each year, the distributors at the end of the year make a decision about what level they want to achieve that year. It's very difficult for us to look at even distributor by distributor and make that decision for them. So there is, I think, a possibility that some distributors will reach for higher sales.

That could impact our sales in the fourth quarter. In addition, we have a North American price increase announced in December, which is also likely to influence sales patterns. A lot of people buy ahead of these price increases. So how those two impact us could conceivably cause our sales forecast to be conservative. On the other hand, we've tried to take those into consideration with the outlook that we provided.

Joe Radigan (VP and Senior Equity Research Analyst)

Okay. And then if I could just get one in on fueling, how big is the headwind from that India tender business? Can you give order of magnitude kind of what the volume headwind's going to be there? And if I'm not mistaken, was that lower margin business than typical? So I mean, does that offset sort of the volume headwind that you get a margin uplift on mix?

Jeff Fleeger (Treasurer)

It does tend to be lower margin business, and it'll be $500,000-$1 million a quarter.

Joe Radigan (VP and Senior Equity Research Analyst)

Okay. Thank you.

Operator (participant)

The next question is from David Rose of Wedbush Securities. Please go ahead.

James Kennally (SVP of Investments)

Yeah. Hi. Good morning. This is actually James on for David.

Jeff Fleeger (Treasurer)

Great, James.

James Kennally (SVP of Investments)

Good morning. One question I have is, can you actually provide more color on what kind of cost-saving initiatives or expense controls you guys mentioned that you plan to implement, and what kind of improvements can we expect from that?

Scott Trumbull (Chairman and CEO)

Okay. Well, during the quarter, our fixed cost as a % just to kind of step aside, we look at our cost buckets really in two buckets. One are costs that drive our contribution margin, variable costs, which we influence by in-plant productivity, lean, and purchasing initiatives, and pricing. And then the other bucket, and we just put all other costs are basically fixed. And our fixed costs, which include SG&A spending and plant fixed costs, we feel we can just manage those by deciding what they're going to be in a quarter or in a year. And it just takes management will and judgment because they influence future growth rates. But during the quarter, you'll note that our SG&A spending as a % of sales declined and really drove most of our margin improvement during the quarter.

We always maintain pretty tight controls on fixed spending, and we have purchasing initiatives each year that represent a percentage of our total purchases globally. They're pretty much on track for this year. We have lean and continuous improvement initiatives in all of our plants, which are also on track for the year.

James Kennally (SVP of Investments)

Okay. Thank you. One more. I know you guys used to provide sort of year-over-year growth for Cerus Acquisition. Can you tell us what the contribution was from that this quarter?

Scott Trumbull (Chairman and CEO)

Yeah. Our Cerus Acquisition, first of all, of course, we acquired it late in the third quarter last year. So up to now, the year-over-year growth has been, on our income statements, difficult to say because it's all acquisition growth. Starting in the fourth quarter, we're expecting I mean, Cerus will be apples to apples, and we're expecting growth in the fourth quarter 25%-30% over prior year, with most of the growth coming in the pump distribution channel, which is the channel which is the reason we acquired them, although we are getting good growth in the HVAC distribution channel as well with that business. When you look at them, James, on a pro forma basis, so we can compare the entire third quarter of this year to the entire third quarter of 2012, Cerus's sales are up about 20%.

If you look at it on a pro forma year-to-date through the end of the third quarter, year-over-year, their sales are up about 24%. So we're pleased with that acquisition as contributing to the top-end bottom line. And as Scott said, we'll lap that in the fourth quarter.

James Kennally (SVP of Investments)

Okay. Thank you.

Operator (participant)

I would now like to turn the conference back to Mr. Scott Trumbull, Chairman and CEO, for any further remarks.

Scott Trumbull (Chairman and CEO)

Well, that'll conclude our conference call. Thank you for your interest in our company.

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 good day.