Franklin Electric - Q4 2014

Transcript

Operator (participant)

Good day, ladies and gentlemen, and welcome to the Franklin Electric fourth quarter and fiscal 2014 sales and earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. If anyone should require operator assistance, please press star, then the zero key, on your touch-tone telephone. As a reminder, this conference is being recorded. I would now like to introduce your host for today's conference, Jeffery Taylor. Treasurer, sir, you may begin.

Jeffery L. Taylor (CFO, Retired VP)

Okay, thank you, Sam. We hope everybody enjoyed the music on that short break. And, welcome everyone to Franklin Electric's fourth quarter 2014 earnings conference call. With me today are Gregg Sengstack, our CEO. John Haines, our CFO. Robert Stone, senior vice president and president of International Water Systems. On today's call, Gregg will review our fourth quarter and full-year business results, and then John will review our fourth quarter and full-year 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.

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 helps 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 Franklin Electric's website. With that, I will now turn the call over to our CEO, Gregg Sengstack.

Gregg Sengstack (Member Board of Directors)

Thank you, Jeff. During the fourth quarter, the company achieved record sales. Our adjusted earnings per share exceeded last year's fourth quarter adjusted earnings per share, which were the highest recorded earnings for any fourth quarter in the company's history, despite an estimated $0.02 EPS headwind due to foreign currency translation in the fourth quarter 2014. Continued strength in our fueling business and a lower effective tax rate offset Water Systems' results, which were below our expectations. Water Systems' margins were impacted, principally by higher material costs both year-over-year and sequentially, and higher marketing and selling costs in our U.S. commercial business. During the fourth quarter, Water Systems' sales in the U.S. and Canada, which were 36% of consolidated sales, increased by about 6% compared to the prior year. Sales of surface water pumping equipment grew by 15% in the fourth quarter. U.S.

Canada sales of Pioneer branded mobile pumping equipment increased by over 10% in the fourth quarter of 2014 compared to the prior year. As I mentioned last quarter, the contribution margin of Pioneer sales deteriorated year-over-year as we outsourced production and took other actions to assure timely customer deliveries during this period of rapid sales growth. These sales increases were partially offset by a 2% decline in the sales of groundwater pumping equipment, an improvement from the 16% decline we experienced in the third quarter. This small decline was primarily due to two factors. The first was weak demand for agricultural irrigation pumps due to weather and depressed crop prices, and the second due to uneven order patterns as a result of our previously announced groundwater distribution footprint change.

You may recall that we implemented this distribution change west of the Rockies and east of the Mississippi during the third quarter of 2014. We have announced further changes in the central region of the country, which will take effect at the end of March 2015. We have been pleased thus far with the distribution transition. Business levels have steadily increased through 2014. During the fourth quarter, while we incurred heavier-than-normal promotional costs, our market share in the U.S. groundwater business equaled the record level achieved in the fourth quarter of 2012. Turning to our international water business, in the fourth quarter, our Water Systems teams in developing regions continued to deliver solid performance. Water Systems sales in Latin America, which were about 16% of consolidated sales for the fourth quarter, increased 19%, excluding ex acquisitions and the impact of foreign currency translation.

In spite of the weak Brazilian economy, our organic Water Systems sales in Brazil grew 23% in the quarter due to dry weather, the introduction of new products, and share gain. Our distribution outlets in Chile and Colombia continued to contribute to increased sales in those markets as well. Water Systems sales in the Middle East and Africa, which were about 11% of consolidated sales, were down 2% compared to the fourth quarter of 2013. However, excluding the impact of foreign currency translation, sales increased by about 6% compared to the fourth quarter of 2013, driven in part by a recovery of our South African business and our business in Turkey continuing to post record results driven by strong sales of groundwater pumping equipment.

Excluding acquisitions in foreign currency translation, Asia Pacific sales increased by about 7% compared to the fourth quarter prior year, driven by an improvement in our business in Australia. In Europe, our sales bounced back nicely from a weak third quarter, increasing by 15% before the impact of foreign currency translation as compared to the fourth quarter of 2013. Sales were up 2% across the Franklin branded Water Systems products, and its Pioneer branded mobile pumping equipment product sales doubled in the fourth quarter. Turning now to our fueling business. The fueling business team had a great year, turning in another record quarter ahead of expectations and guidance, with sales growing 11% and earnings growing by 10% compared to the fourth quarter prior year. Fueling systems grew across most product lines in all regions of the globe except the Middle East and Africa.

In developing regions, our strongest growth continued to come from filling station owners continuing to invest in Franklin pressure pumping systems for delivering fuel to the dispensers, as well as our vapor control and leak detection systems. While on the subject of developing regions, as I mentioned last quarter, we continue to be convinced that over the next decade, most of the world's growth in demand for our water and fueling products will increasingly occur in developing regions. Certainly, the results this quarter support our premise. Therefore, we will continue to focus on acquisition opportunities in those regions. Of the three acquisitions we completed in 2014, integration of Bombas Leão, a Brazilian company acquired in June, is proceeding on plan, and during the fourth quarter, Leão brand pump sales were the highest in that company's history. The Leão business was modestly accretive in the fourth quarter.

The two acquisitions that we completed in India during the third quarter, while smaller than Leão, are also meeting expectations, and we believe that after the initial integration costs are behind us, these acquisitions will be accretive to earnings during 2015. While the strengthening US dollar will mute these results, our overall sales in developing regions now stands at 42% of our consolidated revenue and grew by 16% versus the fourth quarter last year. Turning now to our outlook. As we head into 2015, both the strong US dollar and the reduction in oil and gas drilling activity in the United States are having a negative impact on our global sales volume. We estimate that if the US dollar stays at current levels, the translation effect will reduce our global sales and earnings by about 6% in 2015, and reduced drilling activity will result in another 3% decline versus 2014.

With the additional steps we have taken to reset our U.S. groundwater business, we anticipate demand to be uneven and promotions to be heavier than normal until the market settles down, probably mid-year, when we anticipate a bounce back in our U.S. water sales during the peak selling season as our new distribution network becomes fully functional. On the other hand, we are implementing price increases across most of our global water and fueling markets that will have a favorable impact on margins after they become effective. In addition, we are forecasting another strong year for our fueling business as global investment in filling station infrastructure continues to expand with particular growth in demand for Franklin pressure pumping and vapor recovery systems. Turning now to the first quarter and considering the factors outlined above, we believe it'll be our toughest comparison of 2014.

We are anticipating low single-digit growth in Water Systems sales, but a low- to mid-single-digit % decline in Water Systems adjusted operating earnings. The earnings decline is attributable to the translation effect of the strong pricing actions that I mentioned earlier. We estimate that our fueling system sales and adjusted operating earnings will grow in the first quarter of 2015 by 8%-10%, representing a record first quarter performance for this segment of our business. Overall, we expect first quarter 2015 adjusted earnings per share to be flat, to down $0.02 when compared to the record 2014 first quarter adjusted earnings per share of $0.35. I would like now to turn the call over to John Haines, our CFO. John?

Jeffery L. Taylor (CFO, Retired VP)

Thank you, Gregg. Our fully diluted earnings per share, as reported, were $0.06 for the fourth quarter of 2014 versus $0.27 for the fourth quarter of 2013. As we note in the tables in the earnings release, the company adjusts the as-reported GAAP operating income and earnings per share for items that 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 fourth quarter of 2014 were $17.6 million and included $15.1 million in restructuring costs, primarily for the European manufacturing realignment that the company announced on July 1st, 2014, and $2.5 million of other non-GAAP expenses, primarily for acquisition-related costs. The fourth quarter 2014 non-GAAP adjustments had an EPS impact of $0.25, a reduction in the reported EPS.

After considering these non-GAAP items, fourth quarter 2014 adjusted EPS is $0.31, which is up 3% to the $0.30 adjusted EPS the company reported in the fourth quarter of 2013. It is worth noting that the company estimated its fourth quarter 2014 adjusted earnings per share was negatively impacted by $0.02 due to the translation impacts of foreign exchange. As Gregg noted, we saw a significant strengthening of the U.S. dollar versus many key currencies which we do business in, including the euro, Brazilian reais, South African rand, and Turkish lira during the quarter. This strengthening causes the earnings of these units to be translated back to fewer U.S. dollars. Consolidated net sales in the fourth quarter of 2014 were $253.8 million, an increase of $24.1 million, or about 10% compared to the fourth quarter of 2013 sales of $229.7 million.

The incremental impact of sales from acquired businesses was $10.4 million, or about 4%. Sales revenue decreased by $10 million, or about 4%, in the fourth quarter of 2014 due to foreign currency translation. As I said, the translation effect reduced our adjusted earnings per share by about $0.02 in the fourth quarter. The sales change in the fourth quarter of 2014, excluding acquisitions and foreign currency translation, was 10%. Water Systems sales were $196.7 million in the fourth quarter of 2014, an increase of $18.3 million, or about 10% versus the fourth quarter 2013 sales of $178.4 million. Sales from businesses acquired since the fourth quarter of 2013 were $10.4 million, or about 6%. Water Systems sales were reduced by $8.9 million, or about 5% of the quarter, due to foreign currency translation. Water Systems sales growth, excluding acquisitions and foreign currency translation, was about 9%.

Water Systems operating income after non-GAAP adjustments was $21 million in the fourth quarter, a decrease of about 20% versus the fourth quarter of 2013. The fourth quarter operating income margin after non-GAAP adjustments was 10.7%, down 390 basis points from 14.6% in the fourth quarter of 2013. Water Systems adjusted operating income margin declined primarily due to increases in raw material costs, including steel and purchase components, and higher selling and marketing expenses for customer incentives supporting sales in the U.S. and Canada Water Systems units. To a lesser extent, and not as significant as in the third quarter of 2014, a sales mix shift also contributed to lower overall margins. During the fourth quarter of 2014, groundwater pumping equipment sales were about 62% of total Water Systems sales, while in the fourth quarter of 2013, they were about 65%.

Water Systems margins also declined in the quarter due to lower margins from recently acquired units still being integrated. Fueling system sales represented 22% of consolidated sales and were $57.1 million in the fourth quarter of 2014, an increase of $5.8 million, or about 11%, versus the fourth quarter 2013 sales of $51.3 million. Fueling system sales decreased by $1.1 million, or about 2%, in the quarter due to foreign currency translation. Excluding the impact of foreign currency translation, fueling system sales increased about 13% compared to the fourth quarter of 2013. During the fourth quarter, fueling systems shipped about $2 million of equipment to India to partially fill a large customer order, excluding the impact of these India sales, fueling systems sales grew by about 10%. Sales growth was broad-based across most product lines and regions of the world. Pardon me.

Fueling Systems operating income after non-GAAP adjustments was $13 million in the fourth quarter of 2014 compared to $11.8 million after non-GAAP adjustments in the fourth quarter of 2013, an increase of about 10%. Fourth quarter operating income margin after non-GAAP adjustments was 22.8%, flat to the fourth quarter. The increase in dollars was primarily driven by higher sales volume. The company's consolidated gross profit was $77.8 million for the fourth quarter of 2014, an increase of $1.8 million, or about 2%, from the fourth quarter of 2013 gross profit of $76 million. Gross profit as a percent of net sales was 30.6% in the fourth quarter of 2014, down from 250 basis points versus 33.1% during the fourth quarter of 2013. The previously discussed items in the Water Systems segment contributed significantly to the lower gross profit margin in the quarter.

Selling, general, and administrative expenses were $60.1 million in the fourth quarter of 2014 compared to $52.3 million in the fourth quarter of the prior year, an increase of $7.8 million, or about 15%. The increase in SG&A expenses from acquired businesses was $2.5 million. Excluding the acquisitions, the company's overall SG&A expenses in the fourth quarter of 2014 increased by $5.3 million, or 10%, to prior year fourth quarter. The remaining increases in SG&A were primarily driven by higher commission, sales, marketing, and selling-related costs in support of higher sales and increases in research, development, and engineering expenses. The tax rate for the full year 2014 was 21%, and in 2013 was 25.9%. The tax rate declined in 2014 from the tax rate for 2013 primarily due to a reversal of deferred tax liabilities associated with earnings of certain foreign subsidiaries, which have been realigned within the company.

The realignment of certain foreign entities resulted in their unremitted earnings indefinitely reinvested. The effect of tax rate differs from the statutory rate primarily due to the indefinite reinvestment of foreign earnings tax at rates below U.S. statutory rate, as well as recognition of foreign tax credit. The company has the ability to indefinitely reinvest these foreign earnings based on the earnings and cash projections of its other operations, as well as cash on hand and available credit. The full year 2015 rate is estimated to be about 24%. The company ended the fourth quarter of 2014 with a cash balance of $59.1 million, which was $75.5 million lower than at the end of 2013. The cash balance decrease is primarily attributable to increased working capital needs and completed acquisitions.

The company had no borrowings on its revolving debt facilities at the end of the fourth quarter of 2014 or at the end of the fourth quarter of 2013. The company purchased about 40,000 shares of its common stock for approximately $1.4 million in the open market during the fourth quarter of 2014. This brings our total share repurchases in 2014 to about 243,000. Total remaining authorized shares that may be repurchased is about 870,000 shares. This concludes our prepared remarks, and we would now like to turn the call over for questions.

Gregg Sengstack (Member Board of Directors)

Thank you. Ladies and gentlemen, if you have a question at this time, please press star then the one key on your touch-tone cell phone. 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 opened.

Joseph Radigan (Principal and Senior Portfolio Manager)

Thank you. Good morning, guys.

John J. Haines (Board Member)

Good morning.

Joseph Radigan (Principal and Senior Portfolio Manager)

First, on pricing. On average, what was the magnitude of the list price increases that you've passed, and then what's the timing of when those go into effect?

John J. Haines (Board Member)

There's a big span around that average, Joe, depending on the market, the international market, the product, the currency environment, the raw material inflation environment. Generally, we would say that our price increases are between 250 and 300 basis points.

Joseph Radigan (Principal and Senior Portfolio Manager)

Okay. Has that already gone into effect, John, or is that at the end of the—what's the timing around that?

John J. Haines (Board Member)

Some have gone into effect and some have not. What we generally do is try to raise prices, Joe, only once a year. So there's quite a bit of thinking about, "Okay, what is the right timing for that?" Some of our units raise prices in December. Some of our units won't raise price until this month or later in the quarter in advance of the strong northern hemisphere selling season.

Joseph Radigan (Principal and Senior Portfolio Manager)

Okay. And then for the water in terms of the water margin, you mentioned that was impacted by increased customer incentives. Is that related to the annual purchase targets of your customers, or is that something else that you're talking about?

John J. Haines (Board Member)

So, Joe, as we are continuing to reset our distribution in the North American market, we are into heavy activity around promotions of the products. And so it's more related to that than to year-end buys or targets to year-end buys, which would be carried as inventory, and net sales. It would be netted out in sales, not down in SG&A.

Joseph Radigan (Principal and Senior Portfolio Manager)

Okay. And then so on a and sticking with margin, on a sequential basis, it sounds like revenue is going to be down modestly, sequentially fourth quarter to first quarter, but operating income and operating margin is going to be up on a sequential basis. I know there's a lot there's a lot of moving parts here between mix, raw materials, acquisition revenue, the higher customer incentives. In terms of those buckets, I mean, what's going to change to where you're going to see an increase in margin on a sequential basis in water?

John J. Haines (Board Member)

Joe, what we said for the water side was that we believe that the growth will be in the low to mid single digits after considering everything, FX and the acquisitions and everything else. We do think that sequentially, our margins or our operating income in water will improve, but we think it will be down versus the first quarter of 2014, mainly because of many of these same factors. Now, the mix shift, which was a smaller factor in the fourth quarter, is difficult to predict, but we know the distribution reset in the U.S. will continue. We know that - excuse me - we're going to have to get past these raw material increases and let these price increases that we have just discussed start to take effect.

Generally, we see sequentially that our water operating income will improve, but it'll still be below the first quarter last year.

Joseph Radigan (Principal and Senior Portfolio Manager)

Okay. And then you mentioned share. What did the industry in North America grow? I think you've given that number in the past from industry data. I'm just trying to. It sounds like you're pretty comfortable that you're maintaining share even in the midst of this whole reset. So can you give some data or color around that?

John J. Haines (Board Member)

Yeah. Our sense is that it grew a couple%. Again, we had weakness that's been well-reported around the ag space, but the residential, where we have probably better numbers, I'd say, grew a couple%. But I'd say the ag business overall was off for the year. Again, you got to remember we had a couple years of really strong drought in large parts of the country. And while the drought continued in California, through the center of the country, the growing areas of the country, the heavy ag areas, there just wasn't a call for a lot of replacement products. So our industry numbers are more tilted to the residential side, and there we could say it was a couple% growth.

Joseph Radigan (Principal and Senior Portfolio Manager)

Okay. And then last question for me. In terms of Pioneer, that grew over 10% in North America versus a pretty tough comp, I think. How should we think about, and it sounds like you're making some headway there in Europe as well. How should we think about the growth trajectory of that dewatering business in 2015?

John J. Haines (Board Member)

Yeah. As we look at it, Pioneer is going to be the product line that is most impacted by the decline in oil prices. A large portion of the Pioneer product line goes into rental fleets and is used out in the oil fields for transfer of water. And so that is going to be the headwind that we've called out related to the oil and gas pricing. So while we're making progress around the world and generally outside of the rental fleet space, the headwind of the oil and gas reduction far outweighs that. Robert, would you like to add to the?

Robert Stone (SVP and President of International Water Systems)

No, I think you've covered it, Gregg. The issue is, Joe, is that our customers that have rental fleets have seen a lot of equipment come back from the oil and gas areas, the upstream development because of gas prices now or oil prices, I'm sorry. Until that turns around, we're going to have a rather soft time, especially in North America. For Pioneer, having said that, we think with the outsourcing we did last year, that impacted margins. We ought to be able to improve margins slightly in Pioneer, even on lower volume, as we go forward.

Joseph Radigan (Principal and Senior Portfolio Manager)

Okay. That's helpful. Thank you very much.

Operator (participant)

Thank you. Our next question comes from Ryan O'Donnell of Robert W. Baird. Your line is now opened.

Ryan Smith (Managing Director)

Good morning, guys. This is Ryan on for Mike.

John J. Haines (Board Member)

Hey, Ryan.

Speaker 9

Hey, Ryan. Good morning.

Ryan Smith (Managing Director)

Could you just provide a little more color on kind of what you're seeing competitively here in the U.S. and how the new distribution changes in the central U.S. kind of play into this?

John J. Haines (Board Member)

Well, anytime you go through a change in your customer base, you're just going to have a lumpy, uneven order pattern as you got to remember, the distributors we're bringing on are maybe selling off other inventory that they were carrying. Distributors that we were supplying are also then rebalancing their inventory. So it's been a little bumpy. In the center of the country, we just saw that we weren't getting the support that we were looking for, hoping for, from our large former national distributor. Our former distributor is national and has a national footprint. So we decided to make some changes there. So it's going to continue to be bumpy. We expect for the next couple quarters until the season kicks in and the market is reset.

Ryan Smith (Managing Director)

Okay. Great. And then I know you guys mentioned kind of elevated inventory levels, particularly in ag last quarter, and kind of expected that to last a few quarters. Can you just provide an update there and how we look into 2015?

John J. Haines (Board Member)

Yeah. Again, this is anecdotal information, feedback from the field. We'd say that when you get into the center of the country, particularly you get into West Texas, which is a heavy user of groundwater submersible pumping systems, that there's pretty big inventory in the field there because of market conditions, because of competitive nature, a lot of products on the shelf. If you go out to the West, where it's been dry, there's been pretty good throughput. If you go out to the East, I'd just say, generally speaking, the East is probably pretty balanced. Again, the Northeast is under a lot of snow. Last year, other parts of the country were under a lot of snow. But we'd say that outside of maybe the West Texas and central region, inventory levels look to be fairly normal.

Ryan Smith (Managing Director)

Okay. And then lastly from me, on the coal-bed methane opportunity, obviously a small piece, but just curious how that's playing given kind of the oil and gas price declines that we're seeing. Any update there?

John J. Haines (Board Member)

Yeah. To your point, with low gas prices, the new wells and new holes have obviously declined. And therefore, what we're doing is, while we continue to look to develop and to sell our products in the North American market - and we have traction here in North America - we have turned our focus to China, India, Indonesia, and Turkey. Gas prices are higher. The needs are acute. The interest while again, we're selling units in the orders of ones and twos and fives and tens, but it is low. I mean, we're not getting a lot of dollar volume out of this, but we think that those are markets that are going to be much more active going forward just because gas isn't something you can easily transport around the world like oil. So that's the focus.

Ryan Smith (Managing Director)

All right. Thanks, guys.

Operator (participant)

Thank you. Our next question comes from David Rose of Wedbush Securities. Your line is now opened.

James Kim (Managing Director)

Good morning, y'all. This is actually James Kim calling in for David.

John J. Haines (Board Member)

Hey, James. How are you?

James Kim (Managing Director)

Good. Good. So clarification on the higher selling and marketing costs. I mean, obviously, you stated it was mainly due to the distributor reset. And just want to clarify that you expect a similar level of spending increase in the first half as a result of you continuing your efforts resetting your distribution in the central region?

John J. Haines (Board Member)

Well, again, I think the reset in the central region would be smaller in overall dollar volume than the actions we took west of the Rockies, east of the Mississippi. We expect also that generally, these heavier promotional activities will begin to abate. We're prepared to do it. We're going to do what it takes to maintain our position in the marketplace. But I would expect that over time, that it's going to become sequentially less of an impact.

James Kim (Managing Director)

Okay. And so the higher expense was mainly impacted by the distributor reset, right? There wasn't anything else?

John J. Haines (Board Member)

Yeah. It was focused particularly in the U.S., what we call pro-channel market.

James Kim (Managing Director)

Okay. On the water systems margins, obviously, you've got a headwind from freight cost, lower margin acquisitions, and also the distributor reset. But you've also got some benefits coming from bringing production of your Pioneer pumps in-house. And as you talked about in your script, benefits from European restructuring. So based on those, what should we kind of expect going forward or sort of a normalized level of margins for water systems? I know we've been talking about kind of 2013 levels being sort of the normalized levels, excluding all these headwinds. But is that still the case, or would you expect that, given acquisitions and all these other factors, that our expectations might be a little bit lower now?

John J. Haines (Board Member)

James, what I would say is what we've discussed in the past is that our water segment in total is basically a 16%-18% OI margin segment. In 2013, it was 17.1%. It dropped in 2014 to about 15%. When we have favorable mix, higher concentrations of groundwater pumping equipment, you'll see that margin go beyond that. And when we have unfavorable mix, you'll see it start to drop below that kind of 16% entry point. So what we would say is our expectation for 2015 is to get back in that range. We, as Gregg said, think that the unsettledness, this shockiness that's going on in the U.S. market with the distributor reset ought to play its way out over the first couple quarters. We cannot predict weather. Of course, we feel very good about most of our international units in terms of what they're doing.

We have the price increases. So we see margin rebound in 2015 for sure, and we would expect to see ourselves back in that historic range where water has performed.

James Kim (Managing Director)

Okay. And another question on your expectations for Pioneer and deliquification. Obviously, with oil prices and the market dynamics now, you're expecting those businesses to be impacted. But does the lower oil prices, John, you and I talked about this following the last quarter too, but does that affect your fueling business at all? And have you seen any of that in the quarter?

John J. Haines (Board Member)

I mean, I would make the following observation. Lower oil prices will increase the demand for oil for use in passenger vehicles and other vehicles that use fuel, either gasoline or diesel. So that would generally play well to expansion or more rapid expansion of infrastructure, which would be good for the business, keeping in mind that the fueling business is not one that turns on and turns off. You have to plan gas stations and construction. But I'd say that lower oil prices would generally be a positive for fueling at the market.

James Kim (Managing Director)

Okay. And is that something you've been seeing yet, or is it too early to say at this point?

John J. Haines (Board Member)

We don't have industry data that we could turn to to say that has a measurable impact. Again, you think about the prices dropped rather dramatically in the last several months. And so if you're going to see increased demand for use of vehicles, particularly outside the United States and developing world, people moving to the middle class, higher standard of living, opportunity to own a vehicle, and to use fuel, it'll be, I think, a natural outcome. But I wouldn't expect it to be measured in months, more measured in quarters.

James Kim (Managing Director)

Okay. And my last question on tax rates. I know you guys talked about a lot of tax planning you guys have been doing to benefit from that. Is the expected tax rate for 2015 still in the 25%-27% range?

John J. Haines (Board Member)

Yeah. It's about 24 now. Change is what we've guided to. So we did a lot of these realignments and subsidiary realignments in the fourth quarter. We got a big benefit from that in the fourth quarter. Some of that will continue into 2015, but not nearly as much as what we saw in the fourth quarter. So we think right now a 24% effective rate for 2015 to states. Yes. We'll update quarterly if that changes.

James Kim (Managing Director)

Okay. Thank you for your time.

John J. Haines (Board Member)

Thank you.

Operator (participant)

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

Edward Marshall (VP Economic Analysis & Strategic Planning)

Morning, Gregg. Morning, John. Sorry to make you talk back there. It sounds like you're suffering pretty bad.

John J. Haines (Board Member)

I'm sorry to put you through that pain. Yeah. Everybody else on the call.

Joseph Radigan (Principal and Senior Portfolio Manager)

I wanted to look at the order book for a second, if I could, when we look at the spring and the summer kind of agriculture season as we move into that season. I just kind of want to get an understanding or sense from you how that might be shaping up, especially if we've had a wetter North American winter. I think that with acreage planted declining into 2015, I just wanted to get your sense as to what you expect that order book and maybe how it's developing so far this year.

John J. Haines (Board Member)

Yeah. In our business, it's all about availability. The reason it's all about availability is that our visibility in order book is days and weeks out. It's not really months out outside of the Pioneer business, which typically operates from a backlog. So it's more again, we talk to our contractors. We talk to our distributors. We get their feedback. And based on that is how we then can give you some guidance as to how we see the business unfolding. And that's why we have limited our guidance to a quarterly basis. With all that said, with 8 feet of snow up in Boston, when that snow melts, there's going to be a lot of need for dewatering, some pump activity. That would generally be good for our Little Giant branded product lines and for our SSE line or some sewage effluent lines.

I'd say potentially similar kind of to last year where we had a lot of snow but more in the middle of the country. With respect to crop prices and ag in general, obviously, the irrigation companies are confronted with a much larger decline because people are not necessarily putting in new systems. I can understand that when crop prices are down. Farmers are looking to hold off on putting in new systems. But they got to continue to service their existing systems. We were pleased to see that after a very soft third quarter and the ag business down 16%, that we saw our fourth quarter, while down, rebounded really fairly strongly from the third quarter to only down 2% in the ag space.

So I think that, again, supports the idea that we have that 80% ± of our products are replacement products or are used in replacement situations, emergency replacements. And so we think that, generally speaking, we should have another decent year. But to John's point earlier, and I pointed out with our Brazilian business, when you have a dry market like we were seeing in Brazil, up 23% year-over-year. When it's dry, people need pumps, and they need water. And so we have a dry year. It can push that number way up. If we have another damp year like we had in 2014, it'll be muted.

Edward Marshall (VP Economic Analysis & Strategic Planning)

Okay. I wanted to talk about maybe the distribution conversion a little bit further, if I could. I'm just curious, what's creating the dislocation? I mean, it's a small part of your business, I think, that you're converting. I originally thought that you had mentioned that you would destock with one distributor in particular and then restock with another. Are you having to displace another manufacturer? Are there other salesforce of the salesforce of that distributor, are they accepting your product instead of the other manufacturers? Is it a matter of educating? I mean, these questions specifically come to mind as you talk about maybe higher selling expenses. I'm just kind of curious as to how the acceptance of the product line is going so far within that distributor.

John J. Haines (Board Member)

Sure. We'll go back. In early last year, about this time last year, we made the decision to change our distribution footprint west of the Rockies and east of the Mississippi. And that change actually didn't occur. We announced it early in the year. It didn't occur until the third quarter. And so at that time, we're bringing on new distribution. And our prior relationship with our prior distributor is no longer buying after July 15th in those regions. Now, our products are well known in the marketplace. And the distributors that we brought back on were distributors that handled our products in the past. So there's not a lack of familiarity with the product. But when you're in a market that's soft, particularly in the ag business, as we've discussed, you're going to have incentives. You're going to use incentives to encourage people to switch.

People have loyalty to the product. They also have relationships with distributors. And so you're going to work hard to get those new relationships started. So when the contractor's driving their truck down the road, that they turn into the distributor that carries your product as compared to the distributor that used to carry your product. So you have those frictions and switching costs that you're going to incur. It is true that the additional step we're taking here in the first quarter of this year is of a smaller, it impacts a smaller dollar volume than the one we took last year. And so it'll be, in that respect, smaller. But still, you're encouraging people to change who they pick up your product from. And that takes additional effort and focus.

Edward Marshall (VP Economic Analysis & Strategic Planning)

Then I guess finally, if I could, we talked a bit about the acquisition pipeline. I guess you have kind of another 30% of Pioneer to acquire in 1Q2015. As I look at the business, and you've said yourself that it's showing some signs of weakness, how does that develop from here? You bring an additional 30% of the business onto the balance sheet. What are your plans for further acquisitions this year? Just kind of if you can help me out there.

John J. Haines (Board Member)

Yeah. Sure. I mean, the Pioneer 30%, as you point out, that's a commitment that's been made. It was formulaic. The closing will occur here on that piece in the next couple of weeks or months. With respect to our pipeline, again, this is a situation in our business where many of the businesses we acquire we've known the owners of the businesses for many years. We want to let them know that as their needs change, as their plans their family businesses typically change, as they look at their own needs and their financial plans, we want them to give us a call. When they give us a call is not always on our schedule. It's on their schedule. So there are deals that come across the transom of companies we may not be as familiar with.

And then there are the deals that are down the fairway for us, is the terminology we use. And those we stay in contact with owners. And if the owner's view changes, then there's potentially an acquisition to be made. But the timing is difficult. So we continue to see a lot of activity. We're interested in doing more deals. We have the low leverage. We have the capability of doing them. But timing's always unpredictable.

Edward Marshall (VP Economic Analysis & Strategic Planning)

Okay. Maybe if I could squeeze one more in it. I know I've asked a few, but. And I look at in your prepared remarks, you talked about raw material costs being higher. And you mentioned steel. And I'm just kind of curious because if you look at the steel indices, I mean, the steel prices have come down really significantly this year. And I'm just kind of what specifically are you buying? And especially as we're seeing a lot of imports of steel into the U.S., I mean, that's pressuring the prices. So is it a special alloy that you're buying that goes into the pumps, or what's causing the higher raw material prices?

John J. Haines (Board Member)

Yeah. The primary steel that we're buying it is rolled steel, stainless steel, the magnetic steel that's used for the laminations in our product. And when we look at our major components of purchases kind of from the May timeframe up through really October, we saw a very consistent trend of higher prices to the previous year's average. The good news is that we started to see that turnover in the last couple of months and go lower. Now, the one commodity we have seen lower and consistently lower is copper, which is a good thing for us. But when you think about how that flows through our cost of goods sold and the way our inventories turn, that increase that we saw over the summer months, a good portion of that came home in the cost of goods sold in the fourth quarter.

And that really is what drove some of these negative price variances and the lower gross profit and lower operating income margins in water. Another area is on purchased components, right? So we've seen some inflation in Chinese purchased components. We've seen some inflation in major suppliers in Brazil that we buy finished product from, finished motors or other finished components from. So all of that is contributing to this. And again, a little bit in front of our price increases. And I think the one positive is that when we look at all this on an input basis, we're starting to see it turn the other direction.

Edward Marshall (VP Economic Analysis & Strategic Planning)

Okay. Great, guys. Thanks very much.

John J. Haines (Board Member)

Thank you.

Gregg Sengstack (Member Board of Directors)

Thank you. At this time, I'm not showing any further questions. I'd like to turn the call back to management for any closing comments.

John J. Haines (Board Member)

Again, thank you for listening to our fourth quarter earnings call. We look forward to speaking to you after the first quarter. Have a good day.

Operator (participant)

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone, have a wonderful day.