Franklin Electric - Q4 2017

Transcript

Operator (participant)

Good day, ladies and gentlemen, and welcome to the Franklin Electric fourth quarter and fiscal year 2017 earnings conference call. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be followed at that time. If anyone should require assistance at any time during the conference, please press star, then zero, on your touch-tone telephone. As a reminder, this conference call is being recorded. I would now like to turn the conference over to Mr. John Haines, Chief Financial Officer. Sir, you may begin.

John Haines (CFO)

Thank you, Brian, and welcome everyone to Franklin Electric's fourth quarter and fiscal year 2017 earnings conference call. With me today are Gregg Sengstack, our Chairman and CEO, and Robert Stone, our Senior Vice President and President of our International Water Systems Unit. On today's call, Gregg will review our fourth quarter and full-year business results, and I'll review our fourth quarter and full-year financial results. When I'm through, we'll have some time for questions and answers. Before we begin, let me remind you that as we conduct this call, we will be making forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are subject to various risks and uncertainties, many of which could cause actual results to differ materially from such forward-looking statements.

A discussion of these factors may be found in the company's annual report on Form 10-K and in today's earnings release. All forward-looking statements made during this call are based on information currently available, and except as required by law, the company assumes no obligation to update any forward-looking statements. With that, I'll turn the call over to our Chairman and CEO, Gregg Sengstack.

Gregg Sengstack (CEO)

Thank you, John. Our fourth quarter unfolded pretty much as we had anticipated. In the U.S. and Canada water systems business, Pioneer brand dewatering pump sales remained strong, more than double the fourth quarter of last year, driven by recovery in the market for oil and gas, as well as the expansion of our business into other end markets. Backlog in the business is strong. Revenue from other surface pumps, as well as groundwater pumps, declined for a couple of reasons. End market demand appears to be flat. We elected to reduce promotional activity to smooth demand, and our distribution business, focusing on their working capital, reduced purchases from our manufacturing business. Compared to a very strong finish of 2016, U.S. and Canada water revenues were lower. Outside the U.S. and Canada, we had single-digit revenue growth in Europe, Africa, and Asia.

Our business in Turkey continues to do well, and while small, our business in India grew nicely. However, in each of these end markets, we saw margin contraction due to rising input costs. After several years of strong growth in sales and profits, for the last three quarters, our business in Brazil has had lower quarter-over-quarter sales and profits. Favorable market conditions have been replaced by weak demand and margin compression, particularly this last quarter. Brazil is an important market for us. It has the second-largest underground aquifer in the world. At the same time, our team is adjusting the cost structure to address the current realities of the market. Our fueling systems business turned in another record quarter. Our business outside the U.S. was very strong. Revenue in China doubled. Revenue in every other international market grew double digits except for India.

While we continue to be bullish on a long-term business in India, the market to retrofit fuel transport trucks for stage one vapor recovery has yet to materialize. We decided to cut our losses and shut down our Wadcorpp JV that produces this product line. At the same time, we are beginning to move some fueling system production into our water systems factory located in Gujarat. Fueling revenue in the U.S. and Canada declined 2%. Gains in pumps and fuel management were more than offset by a decline in containment and dispensing product lines. Our U.S. distribution business lost money in the quarter. The groundwater distribution business is seasonal. That fact, combined with additional integration, logistics, and promotional costs, led to the expected loss. No one wants to have a loss, particularly in a recent acquisition.

However, the 2017 pro forma operating income margin of the distribution segment was 3%. Our leadership team has a line of sight to move into the post-integration range of 4%-6% as we originally guided. As we close the books on 2017, I want to take a moment to reflect upon the year. We made a strategic decision to create a new company, Headwater, as an investment vehicle to acquire groundwater distributors in the U.S. We saw this as an opportunity to both maintain access to this market, move us closer to the end user, the contractor, and to make money. For the year, even with all the disruptions, our distribution business was profitable, and our manufacturing profitability in this important end market improved as well.

Outside the U.S., water systems revenue grew, but profitability suffered across the globe, principally in Asia-Pacific and Brazil, where demand was weak and input costs continued to rise. Our fueling business delivered another record year, driven by converting customer specifications to Franklin products, market growth, and the strength of our business in China. In both our water and fueling businesses, we continue to turn out an increasing number of innovative new products to address customer needs. So as we turn to 2018, in our water systems business, we currently expect to see revenue growth in the 4%-5% range. We have taken pricing actions to offset the inflation that we are seeing, such as we expect water systems operating income to increase double digits. In our fueling systems business, we currently expect a year like 2017, with sales and operating income growth in the high single digits.

In addition, I want to point out that the upgrade of underground piping systems in China, which is currently accelerating, may provide additional growth. With our product offering reset, we expect our distribution business to see organic sales growth with a modest expansion in operating income margin. Please note that the distribution segment will have greater seasonality in reported revenue and earnings than our water systems businesses. We continue to look at acquisitions in our core markets and adjacencies but remain disciplined around the multiples of cash flow that we're willing to pay. Overall, we're very optimistic about 2018 and expect our earnings per share before restructuring charges to be between $2.16-$2.28 for the full year. I will now turn the call over to John to discuss the numbers in more detail. John?

John Haines (CFO)

Thank you, Gregg. Our fully diluted earnings per share were $0.17 for the fourth quarter of 2017 versus $0.37 for the fourth quarter of 2016. In the fourth quarter of 2017, the company incurred $0.04 of restructuring expenses and $0.21 of tax expenses related to the U.S. Tax Cuts and Jobs Act of 2017. So before the impact of restructuring and the U.S. Tax Cuts and Jobs Act of 2017, we were able to grow our fourth quarter earnings per share by about 14%, primarily related to the fueling systems performance and discrete tax benefits unrelated to the new tax law in the United States. I'll say a bit more about the new tax law in the U.S. in a couple of minutes. Fourth quarter 2017 sales were $288.2 million compared to 2016 fourth quarter sales of $239.6 million, an increase of 20% primarily from acquisitions.

Organic sales increased about 2% when excluding the impact of foreign currency translation. Water systems sales were $181.5 million in the fourth quarter 2017 versus the fourth quarter 2016 sales of $177.8 million, an increase of 2%. Water systems organic sales were about 1% in the quarter when you exclude the impact of foreign currency translation. Water systems sales in the U.S. and Canada declined by about 3% compared to the fourth quarter 2016. Sales of Pioneer-branded dewatering equipment increased by about 80% in the fourth quarter when compared to the prior year, resulting from the continued diversification of customers and strengthening in the U.S. oil and gas end markets. Sales of groundwater pumping equipment decreased by about 9% on weaker residential and agricultural system sales, lower sales to Headwater, and due to a difficult sales comparison in the fourth quarter of 2016.

Sales of other surface pumping equipment decreased by about 4%, primarily in irrigation and agricultural-related products. Water systems sales in markets outside the United States and Canada increased by about 6% overall. The impact of foreign currency translation increased sales by about 2%. International water systems sales were led by improved sales in Europe, the Middle East, Africa, and Asia-Pacific, but were offset by lower sales in Latin America when compared to the fourth quarter of 2016. Sales in Brazil declined by about 8% in the quarter. Water systems operating income was $19.5 million in the fourth quarter of 2017, down $3.1 million versus the fourth quarter of 2016. Water systems operating income before restructuring was $20.6 million in the fourth quarter of 2017, down $2.2 million, or about 10% versus the fourth quarter of 2016.

The decline in operating income is primarily related to higher raw material and freight costs, product sales mix-shifts, and lower revenue in Brazil. Fueling systems sales were $67.9 million in the fourth quarter of 2017 versus the fourth quarter of 2016 sales of $61.8 million, or about 10% higher. Fueling system organic sales were about 7% when excluding the impact of foreign currency translation. Fueling systems sales in the U.S. and Canada declined about 2% compared to the fourth quarter of 2016. The decrease was in piping and dispensing products. Outside the U.S. and Canada, fueling systems revenues grew by about 26%, led by strong sales in China, Southeast Asia, and Europe. Fueling systems operating income was $17 million in the fourth quarter of 2017 compared to $15.4 million in the fourth quarter of 2016.

Fueling systems operating income before restructuring was $18.6 million in the fourth quarter of 2017 compared to $15.5 million in the fourth quarter of 2016. Distribution segment sales were $49.5 million in the fourth quarter of 2017. We estimate that fourth quarter distribution sales declined by about 11% from the fourth quarter of 2016, primarily driven by supply chain disruptions and weak end market conditions in the west and southeast regions of the United States. The distribution segment recorded an operating loss of $2 million in the fourth quarter of 2017. The company's consolidated gross profit was $94.6 million for the fourth quarter, an increase from the fourth quarter of 2016 gross profit of $81 million. The gross profit increase was primarily due to higher sales.

The gross profit as a percent of net sales was 32.8% in the fourth quarter of 2017 versus 33.8% during the fourth quarter of 2016. The decline in gross profit margin percentage is primarily due to product and geographic sales mix-shift and higher raw material costs in water systems. Selling general and administrative expenses were $69.4 million in the fourth quarter of 2017 compared to $55.5 million in the fourth quarter of the prior year. The increase in SG&A expenses from acquired businesses was $16.3 million. Excluding the acquired entities, the company's SG&A expenses in the fourth quarter of 2017 were $53.1 million, or about 4% lower than the 2016 fourth quarter. Restructuring expenses for the fourth quarter of 2017 were $2.7 million and reduced fully diluted earnings per share by approximately $0.04.

During the fourth quarter of 2017, the company approved a plan to close the Wadcorpp India Private Limited joint venture and took a charge of $1.6 million. The company purchased a controlling interest in the Wadcorpp entity during the third quarter of 2014 and included the entity as a fully consolidated subsidiary in the fueling systems segment. As part of this action, the company will continue to sell fueling product in the Indian market while the Wadcorpp manufacturing operations will cease. The closure began in the fourth quarter of 2017 and is estimated to conclude by the end of 2018. Charges for the closure are expected to be in the range between $2 million and $4 million and will include severance expenses, asset write-offs, and other closure expenses. The balance of the fourth quarter 2017 restructuring expenses, about $1.1 million, were primarily related to continuing realignment efforts in Brazil.

Restructuring expenses in the fourth quarter of 2016 were $0.2 million. In the fourth quarter ended December 31st, 2017, the company recorded a net tax expense of $10.2 million or $0.21 per share related to the enactment of the U.S. Tax Cuts and Jobs Act of 2017. This expense was primarily derived from the recognition of a U.S. tax liability for the deemed repatriation of foreign earnings, partially offset by the revaluation of other deferred tax liabilities. In 2018, the company estimates its effective tax rate will be 13%-17%, or about 10 percentage points lower than the effective tax rate of 25% in 2017, which includes the $10.2 million one-time charge in the fourth quarter. The lower tax rate in 2018 is primarily the result of the U.S. Tax Cuts and Jobs Act of 2017.

The company ended 2017 with a cash balance of about $67 million versus about $104 million at the end of 2016, down primarily due to acquisitions and increased working capital. Inventory levels at the end of 2017 were $312 million versus the prior year in 2016 of $203 million. About $65 million of the inventory increase is due to the distribution segment acquisitions. The company had $67 million in borrowing on its revolving debt facilities at the end of the year and no borrowing at the end of 2016. These borrowings were primarily to fund the distribution acquisitions made during the year and for working capital needs. The company did not purchase any shares of its common stock in the open market during fourth quarter of 2017. As of the end of the fourth quarter of 2017, the total remaining authorized shares that may be repurchased is about 2.2 million.

This concludes our prepared remarks. We'd now like to turn the call over for questions.

Operator (participant)

Thank you. Ladies and gentlemen, if you have a question at this time, please press star, then the one key on your touch-tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Once again, if you have a question, press star and one. Our first question comes from the line of Edward Marshall from Sidoti & Company. Sir, your line is now open.

Edward Marshall (Senior Equity Research Analyst)

Hey, Gregg. John, how are you this morning?

John Haines (CFO)

Hey, good morning, Ed.

Edward Marshall (Senior Equity Research Analyst)

Good morning. I'm curious on the distribution side. I'm wondering, did you potentially lose share in those regions because the OEM wasn't able to supply the channel fast enough?

Gregg Sengstack (CEO)

Yeah. I mean, we had some disruptions. Yeah. Ed, in Q3 and Q4, once we were cut off by a couple of OEMs, and we had to go and get other OEMs reestablished. And so, yes, at that time, we lost some share, and then we got the new supplies at best. We haven't fully recovered that share, but that's where we're seeing some opportunity going into 2018.

Edward Marshall (Senior Equity Research Analyst)

Got it. And I thought a big portion of that increased supplier was coming from Franklin OEMs themselves. And looking at the revenues in the two businesses, groundwater and distribution, as it relates to the U.S., I'm not seeing the restocking that I might have thought that I would see. Can you kind of clear that up for me?

Gregg Sengstack (CEO)

Sure. No, there was clear pass-through between Franklin Manufacturing and the Headwater Distribution Company in the last six months. What we're looking at was more of the disruption on the pump lines that Franklin is not deep well submersible pumps, but other pump lines, surface pump lines, is where we were looking to gain traction to replace product lines that Franklin Electric frankly doesn't have.

John Haines (CFO)

Yeah. The other way just to think about that, our sales, or our transfers, I guess, is what you should call them, between our manufacturing business in the United States and Headwater were down 11% in the fourth quarter. Part of that is because the fourth quarter of 2016 was a pretty strong quarter before we owned the Headwater companies. The other part of it, as Gregg pointed out, is there was really not an economic benefit to do that and just to transfer inventory or sell inventory to them and then have them not do anything with that in terms of selling it on to their end markets. So instead of doing that and taking what would be a working capital penalty, if you will, in Headwater, we didn't make those sales, and that was part of the decline.

Edward Marshall (Senior Equity Research Analyst)

Got it. And I shouldn't infer from what you're saying here today that there's an issue obtaining certain suppliers or anything. It's just a matter of timing. They just haven't gotten the product to you.

John Haines (CFO)

Yeah. It was more the latter because we picked up nine pump companies in the last 6-7 months, and we're a new customer, and we're looking for a lot of products. We're looking for training. They had to get out with our people. So it's just that natural friction that occurs in switching vendors on pretty short notice.

Edward Marshall (Senior Equity Research Analyst)

Got it. And the fourth quarter unprofitability in the segment, first, is that typical for that business line? And second, was there loss of potentially rebate activity due to the loss of certain suppliers?

Gregg Sengstack (CEO)

I would say that there's as much gain in rebate activity from new suppliers as there was potential loss from old suppliers. I don't have the exact numbers. John may be able to expand upon that. This is a business where we knew that you'd see losses in the winter months. And so this is not, as I said, this was not my prepared remarks. This is not unexpected for this business.

Edward Marshall (Senior Equity Research Analyst)

Got it. When I look at the guidance for next year in 2018, I guess any one-time items or are there acquisitions baked into that line that's all other EPS growth? Or is that a clean number?

Gregg Sengstack (CEO)

No. The 222 midpoint, the only acquisition that's in there is the Valley Farms acquisition that we did in January in Headwater, as I know you saw. And that's accretive, but it's not accretive by a significant amount. And then, as we point out, we believe our effective tax rate in 2018 that's the basis for that guidance will be about 15% or 13%-17%, the midpoint being 15%. And that, of course, includes all of the new benefits, if you will, the rate benefit of the new tax law in the United States. So that's all in there. There's no assumption of really other one-time items in that guidance.

Edward Marshall (Senior Equity Research Analyst)

Got it. Thanks very much.

Operator (participant)

Our next question comes from the line of Ryan Connors from Boenning & Scattergood. You want to start?

Ryan Connors (Managing Director)

Great. Thank you. Yeah, just first off, continuing on this discussion of the guidance, it seems like there's so many divergent moving parts here. Some things, like the water systems, up dramatically. Others down significantly. How do you get comfort, I mean, with the top-line guidance or modeling number internally in that environment? Do we expect some kind of normalization here, or how should we think about getting to the core of what the consolidated rate of growth is when we've got so many things? It seems like jumping around pretty dramatically.

Gregg Sengstack (CEO)

Yeah. Ryan, I'd say that broadly, we develop our plans. They're developed from the ground up from the business units, and then they're rolled up to a corporate number. And to your point, there have been disruptions in the North American market, and we see 2018 to be a more kind of normal year, quarter to quarter, and year-to-year growth. When you get outside the United States, we have seen weakness. Again, we've talked about this with Brazil. That one is what it's called the last quarter I talked about that we thought was going to push into 2018. Looks like it's going to even push out a little farther. I'm not saying 2019, but we just don't have visibility to when we're going to see a business in Brazil start turning north.

We do think that Asia-Pacific, which is the other business, and Robert Stone can talk about it as well, is that Asia, we had a really strong 2016 on weather. We had some of the tough comp for 2017. We see that stabilizing. So we go around the globe, and we build that up. We also build up our fueling model the same way. We did point out in my comments that we have this potential option on the China market that could come in stronger than what we had planned. And then with our distribution business, again, we did a roll-up from the various branches right up through the top. And based on having the products we have in place today, the product supply we have in place today, we went with the number we want with. So that's how we come about with 2018.

It's just that there's been some variability 2016 to 2017, and there'll be some variability 2017, 2018. Because 2018, we expect to be kind of a more "normal" year. Robert, do you want to talk about Brazil and APAC?

Robert Stone (SVP and President, International Water Systems Unit)

Sure. Yeah. As Gregg mentioned, in terms of Asia-Pacific, we had a couple of markets where we had a really strong comp. 2016, pick one market, Thailand. We came off of basically 5 years of drought in that market. That ended in 2017. It was a very wet year, unusually wet compared to unusually dry conditions. So we saw that market contract significantly. Brazil is a combination of things. The economy still sputters. You still have some political instability. That seems to be getting better. But significant competition as the market size has shrunk over the past year and a half, and we see a lot of discounting, which has put a lot of pressure on margins. And there's the lack of confidence in the distribution channel to take on inventory. So basically, everything is almost a spot price transaction in Brazil these days. That looks to get better.

We can't say when, but we're still confident that Brazil's a very good market for us and one where we continue to invest.

Ryan Connors (Managing Director)

Okay. Yeah, that's really helpful detail. Thank you. My other question just had to do with raw material costs. You did cite that repeatedly in your prepared remarks as a margin headwind, albeit maybe less of a headwind than mix. But can you just unpack that for us a little in terms of the outlook? Are raw materials going to be a headwind again in 2018? And if so, what does the price-cost dynamic look like?

Gregg Sengstack (CEO)

Yeah. Again, with raw material, we look at ground up throughout our whole supply chain network, and we build up incoming price expectations and also with our commodities as well. And John can take you through the detail how that roll-up translates into inflation 2018 and what we're doing at pricing costs, John.

John Haines (CFO)

Yeah. Ryan, when we think about raw material increases, they obviously vary by commodity groups, products around the world. But generally, we're thinking about 150-200 basis points of raw material inflation. And that's on a comparable basis, on a net sales basis. Obviously, if you did that on a raw material basis, it would be much higher. And then when we think about pricing around the entity, each business unit is a bit different, but our pricing assumptions right now going into 2018 are between 200-300 basis points. Some businesses higher than 300 basis points on a comparable basis. So all of our water businesses all of our businesses, but our water businesses probably more especially, are competing in very intense end markets. And if there's an opportunity later to get a deep price, we'll take advantage of that.

Right now, the assumptions going in are that we will be priced 200-300 basis points with something in the range on the same basis of 150-200 basis points of inflation.

Ryan Connors (Managing Director)

Got it. Now, maybe one last one, if I might. In terms of the new business, the distribution business, how does being in that part of the supply chain impact your ability to manage that price-cost relationship? I would assume that's a positive in that respect, but can you just kind of discuss that a little bit?

Gregg Sengstack (CEO)

Well, the distribution business has its own P&L, and these guys are focused on making money in their business. And so as all distribution businesses within Franklin, outside of Franklin, tend to not object too harshly to price increases from manufacturers because that inflates the value of their on-hand inventory in a positive way. It allows them to move price along into the marketplace. So to your point, generally, I mean, modest price increases are typically well received within distribution. And again, if they're reasonable, it would be passed through to the marketplace.

Ryan Connors (Managing Director)

Got it. Great. Well, thanks for your time this morning, guys.

John Haines (CFO)

Thank you, Ryan. You too.

Operator (participant)

And our next question comes from the line of Walter Liptak from Seaport Global. Sir, you're live now.

Walter Liptak (Equity Research Analyst)

Hi. Thanks. Good morning, guys.

Gregg Sengstack (CEO)

Morning.

Jeffery Taylor (Head of Investor Relations)

Morning. Just as a follow-on to the price cost, I wonder if we could get a little bit more detail on when it was that you took prices up. And you have flexibility to take prices up further throughout the year. And then just as a follow-on to that, any color on the different parts of the business in pricing and where the pressure is coming from, if there is any pressure? And I'm thinking of in oil and gas, are you able to pass along prices? And fueling systems, are you able to pass along prices, etc.?

Speaker 9

Yeah. Walter, as Gregg said, generally, in our water businesses, which is where I think there's the most pressure, there's some pressure between inflation and achieved price, we are able to get price because we're selling primarily through distribution. So business units around the world, depending on the end market, other competitive actions, generally, will take price actions between November 1st and, let's say, March 1st. They're generally centered around the end of the year. And for a lot of businesses globally, including in North America, those price increases are kind of 200-300 basis points. The fueling business performs a little bit different. It doesn't have nearly the fragmented competition base in the end market that you see perhaps on the water side.

But they basically take the same approach where they assess the inflation and then go forward with a price action that they think is necessary to grow margins. So that's kind of the view of it right now. As I said, we do have the ability, and we have in previous years. If we get into the June, July timeframe and the inflation curve ticks up or the input costs are going up in a way that are more dramatic than we had assumed, then we have the ability to go back through and raise prices. We have done that in the past. We just prefer not to do that for the benefit of our customers.

Walter Liptak (Equity Research Analyst)

Okay. Great. Thanks for that. And then if we could just turn to distribution. And I wonder if we could just take a step back and think of the distribution business, just the core business that you bought Headwater. And I wonder if we can get an idea of how the sales ended in 2017, either in a dollar or percentage. I know you said the distribution was down 11%, but maybe there was M&A that was in there too. I don't know. And then in 2018, are you thinking distribution starts to grow next year, or is there still more supply chain disruption and revenue declines in 2018?

Gregg Sengstack (CEO)

Okay. A couple of questions there. So for 2017, we had these three businesses that we acquired in the second quarter. John was giving you an indication of relative pro forma to what we knew were 2016 results. That's where we said the revenues were down in the west and southeast, some of it's weather, some of it was loss of some customers because of the product line disruption. We think that has now stabilized, and we're beginning to see where we're gaining customers with our new suppliers to Headwater. So when we talked about 2018, we will have inorganic growth because we didn't own the company in the first four months of the year, or it wasn't consolidated within Franklin in the first four months of the year or so. We'll have inorganic growth because of the acquisition of Valley. But we're expecting organic growth.

That was the guidance I was giving of mid-single digits. That would be just year-over-year. That's, again, share recovery. Let's face it, the weather in the West Coast, particularly California, was less than ideal last year for the market. If it's more kind of a "normal year," we would expect that to be a little bit of a help as well. That's our thinking around the distribution business's top line for 2018.

Walter Liptak (Equity Research Analyst)

Okay. Okay. If I could just ask another one on distribution. You've had it now for a little while. I wonder, outside of the supply chain changes, have you made investments into the business? I'm thinking of how many salespeople do you have now versus before? Are there any profit improvement programs that you can put in place to increase profitability in 2018?

Gregg Sengstack (CEO)

Absolutely. And some of those programs will create some drag. But what we're doing is we're getting the back office all on one common platform so that we have visibility across a national network that's going to allow for better supply optimization. It's going to allow for better communication on orders between Headwater and one of their largest suppliers, Franklin Electric. We are also leaning out various branches and getting them organized into a consistent model across the branches to improve productivity at the branch level and to reduce the risk of excess and obsolete, and just to have a general kind of one look and feel under the different flags within the organization. We are continuing to expand some roles for some people in management oversight, getting training, additional sales training, and incentives.

We're doing all those things to help grow the business that you would do with any business that you acquire and want to get the leverage out of assimilating them into these common platforms and have common programs.

Walter Liptak (Equity Research Analyst)

Okay. All right. Thanks for taking my questions.

Gregg Sengstack (CEO)

Sure.

Our next question comes from the line of Matt Summerville from DA Davidson. Your line's now open.

Matt Summerville (Managing Director and Senior Research Analyst)

Thanks. Good morning.

Speaker 9

Morning.

Gregg Sengstack (CEO)

Morning, Matt.

Matt Summerville (Managing Director and Senior Research Analyst)

First, can you comment on your inventory position heading into the year and how that—I mean, adjusting for the distribution businesses, I get that aspect. But if you kind of remove that from the equation, how are you feeling about your inventory position? And I guess I would imagine you want to bleed that down a little bit. How much do you need to bleed it down in your mind, Gregg?

Speaker 9

Yeah. That is a great question. We have comfortable levels of inventory going into the year. That is clear. And I think that if you look at some of our historical numbers stripping out the distribution company, as you pointed out, to see a $25 million decline in inventory in the year, I think, would be a reasonable expectation. We want to do this over time. We've now kind of moved some inventory out of our distribution business into Franklin. We're understanding better some of the relationships. We're matching demand more to market demand than to quarter-end activity, which was more the behavior of this industry in the past. And so we're going to just keep squeezing that back into the plants and then into reducing raw material acquisitions. So we'll see that inventory bleed over time. Let's put a number out there.

Let's call it $25 million at this point. We'll see where we go from there. I think that we have the opportunity to improve upon that, again, over time.

Ryan Connors (Managing Director)

I want to make sure I understand Brazil a little bit better. Can you talk about, I think you said, water overall up 4-5 organically in 2018. What is the assumption you have baked in for Brazil specifically? Can you talk about the competitive dynamics in the business? Is this a price cutting you're seeing being brought on by other local OEMs, or are Asian competitors starting to come into the market? And I guess, does it make sense to think about having more of a roll-up strategy in Brazil, or are you positioned how you need to be positioned? Thank you.

Speaker 9

My workforce is positioned pretty well. We have some growth forecasted in Brazil this coming year. The situation is that the primary price cutting is coming from domestic players. There aren't so many, but there are a handful to a dozen domestic players. Everybody is trying to find business. So they're cutting their margins to the bone. Ebara made an acquisition last year, and we could see that that business is suffering. We see that in their price cutting as well. There is definitely some incursion from outside suppliers, namely from Asia. But that hasn't been the bulk of the challenge as yet. It's been mainly domestic suppliers who are desperate for volume.

Matt Summerville (Managing Director and Senior Research Analyst)

Got it. And then just one follow-up on fueling. Gregg, you mentioned perhaps some upside to the fueling outlook in 2018, at least from a top-line standpoint. I was wondering, to the extent you can comment a little bit on what the flow-through of that business looks like. Obviously, you had very good margins in the fourth quarter. So I guess maybe top-line upside, what the read-through is to margins and maybe what inning we're in, to use a baseball analogy, with the underground piping initiative there, please.

Gregg Sengstack (CEO)

Yeah. So what's going on in China is that there is a very large initiative to upgrade the underground piping equipment to double-wall piping. Franklin has a very strong position in the double-wall piping market. We saw the business begin to pick up in 2017, accelerated in the fourth quarter. Then going into 2018, we could see it accelerate even further. Yeah. I'm always now, I hesitate. I'm putting out numbers out there, but it could be another 3-4 points of growth on the fueling business. Margins in China are reasonable. They'll be a little bit less on piping relative to our kind of contribution margins on all of our products. But we should get some decent leverage. But we're already operating this business in the mid-20s OI.

So, to say that we can get a lot of operating leverage, our pipes are expensive to move around the globe. We are increasing manufacturing in China to support the business locally. But there are other costs. So I just caution you not to do too much of a leverage calculation on the sales opportunity.

Matt Summerville (Managing Director and Senior Research Analyst)

Got it. Thanks, guys.

Operator (participant)

Once again, ladies and gentlemen, if you have a question at this time, please press star followed by the one key on your touch-tone telephone. Our next question comes from the line of Edward Marshall from Sidoti & Company. Sir, your line's now open.

Edward Marshall (Senior Equity Research Analyst)

Just a quick follow-up. I went back to the transcript from last year. It looked like 200 basis points in 2016 of price and 250 in 2017. I'm just curious. We're kind of in line with the historic ranges of price increases. Are you capturing all the raw material price inflation in that 200-300 that you're seeing, or is there additional room for upside there?

Speaker 9

The raw material inflation, as we're talking about, is the 150-200. The price to offset that that we're assuming, again, depends on the business unit, is between 200-300. Yeah. So the assumption on the raw material inflation would be basically a bottoms-up kind of roll-up looking at commodities, purchased components. There's also an assumption that goes into that relative to value improvement opportunity. So how much can we take out of those costs from a sourcing perspective? That's all in our thinking right now, or our current thinking is the way we do that. Basically, in a roll-up that happens in the November timeframe, and then we update that roll-up in the January timeframe.

Edward Marshall (Senior Equity Research Analyst)

So it seems consistent with prior years. Is this in addition to other traditional, just normal increases in pricing aside from what you're seeing on the input cost side? I mean, it just seems like it's your typical 200-300 on an annual basis kind of increase for water.

Speaker 9

Well, yeah. The price achieved in 2017 was about 200 basis points on the consolidated entity. The assumption for 2018 is to achieve something higher than that net. And that's primarily because we're expecting higher raw material inflation than we saw in 2017.

Edward Marshall (Senior Equity Research Analyst)

Okay. Thanks, guys.

Operator (participant)

I'm currently seeing no further questions. I would now like to turn it back to Gregg Sengstack, Chief Executive Officer, for any further matters.

Gregg Sengstack (CEO)

Thank you for joining our conference call today. We look forward to speaking to you after the first quarter results are out.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you've all disconnected. Everyone, have a great day.