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#Good day, ladies and gentlemen, and welcome to the Franklin Electric Second Quarter 2017 Earnings Conference Call.
(Operator Instructions) As a reminder, today's conference is being recorded.
I would now like to turn the call over to Mr.
<UNK> <UNK>, Chief Financial Officer.
Sir, you may begin.
Thank you, Chelsea, and welcome, everyone, to Franklin Electric's Second Quarter 2017 Earnings Conference Call.
With me today are <UNK> <UNK>, our Chairman and Chief Executive Officer; and <UNK> <UNK>, Senior Vice President and President of our International Water Systems unit.
On today's call, <UNK> will review our second quarter business results, and then I will review our second quarter 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'll 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 will now turn the call over to our Chairman and Chief Executive Officer, <UNK> <UNK>.
Thank you, <UNK>.
We're pleased with the overall performance of our company in the second quarter in which we achieved solid organic growth in both our Water and Fueling Systems segments.
In the U.S. and Canada Water Systems business, we had organic growth in all 3 product lines: groundwater, surface and dewatering.
While a little delayed due to record rains in the West, groundwater pumping equipment sales strengthened throughout the quarter as weather generally turned hotter and drier across many regions.
Surface pumping equipment sales continued to show steady single-digit sales growth, and dewatering equipment sales and backlog continued to accelerate, with strengthening demand in domestic gas field service as well as international markets.
Outside the U.S. and Canada, the story was mixed.
Sales in Asia Pacific were down 10% as the drought in Southeast Asia has ended.
In Brazil, the political turmoil, economic malaise finally caught up to our business and we saw a similar sales decline.
The rest of Latin America was basically flat.
While business in Europe, the Middle East and Africa was generally up, our revenues remain below plan due to lack of orders coming from the Gulf states.
Our Fueling Systems business had another strong quarter on the top line.
However, margins were down due to mix, both product and geography.
The U.S. and Canada markets continued to do well.
As I mentioned last quarter, we continue to gain share with major marketers and see increased customer traffic on our Site Builder and FFS PRO University platforms.
Outside the U.S. and Canada, fueling sales have improved across Europe, Africa and Asia.
Our business in China is strong, as a national initiative to replace existing underground piping systems with more environmentally safe double wall piping systems is accelerating.
Our new U.S. distributions segment had a good initial quarter.
While we estimate pro forma sales were down a couple of points due to weak weather-related demand in the West, margins were better than planned as cost synergies were realized ahead of schedule.
The multi-quarter back-office integration of the acquired entities is on schedule.
Looking forward, we are raising our annual guidance by $0.10 based on the following: first, the $0.06 gain on our previously held equity investments was not entirely in our original guidance; second, about 10% of our sales is in euros, and overall, half of our manufacturing business revenue is outside the U.S. Therefore, the dollar's decline generally should lift our reported results.
Most importantly, however, we see strengthening demand across many markets, while at the same time, remaining cautious about the timing of recoveries in the Southeast Asia, the Gulf and the Brazilian end markets.
I will now turn it back ---+ the call back over to <UNK>.
Thanks, <UNK>.
Our fully diluted earnings per share were $0.64 for the second quarter of 2017 versus $0.50 for the second quarter of 2016, an increase of 28%.
Second quarter 2017 sales were $305.3 million, an increase of 21% compared to 2016 second quarter sales of $252.1 million.
Water Systems sales were $203.4 million in the second quarter 2017, an increase of $8.8 million or about 5% versus the second quarter 2016 sales of $194.6 million.
Water Systems sales decreased by about $1.8 million or about 1% in the quarter due to foreign currency translation.
Water Systems organic sales were up about 6% compared to the second quarter 2016.
Water Systems sales in the United States and Canada were up about 10% compared to the prior year second quarter.
Sales of dewatering equipment increased by 25% in the second quarter when compared to the prior year, resulting from the continued diversification of customers, new channel development and international sales of the Pioneer branded equipment.
Sales of other surface pumping equipment increased by 8% in part due to wet weather conditions in the upper Midwest and Canada.
Sales of groundwater pumping equipment increased about 5%.
Water Systems sales in markets outside the United States and Canada overall declined by about 1%, due primarily to the impact of foreign currency translation.
International Water Systems sales were led by improved sales in Europe, the Middle East and Africa, but were offset by lower sales volumes in the Latin American and Asia Pacific markets in the quarter compared to last year.
Water Systems operating income was $32.8 million in the second quarter 2017, up $1.3 million or 4% versus the second quarter 2016, and operating income margin was 16.1% compared to the 16.2% in the second quarter of 2016.
Fueling Systems sales were $61.4 million in the second quarter of 2017, an increase of $3.9 million or about 7% versus the second quarter of 2016 sales of $57.5 million.
Fueling Systems sales decreased by $0.7 million or about 1% in the quarter due to foreign currency translation.
Fueling Systems organic sales increased about 8% compared to the second quarter of 2016.
Fueling Systems operating income was $14.9 million in the second quarter of 2017, down $0.6 million or about 4% compared to $15.5 million in the second quarter of 2016, and the second quarter operating income margin was 24.3%, a decrease of 270 basis points from the 27% of net sales in the second quarter of 2016.
The decline in operating income was primarily due to adverse product and geography sales mix shifts.
As <UNK> pointed out, we were happy with the first reported quarter from the new distribution entity and segment.
Sales were $59.1 million in the second quarter 2017.
On a pro forma basis, we estimate this is about a 2% decline from the second quarter of 2016, primarily driven by adverse weather conditions in the western portion of the United States.
Distribution operating income was $3.7 million in the second quarter of 2017, and the second quarter operating income margin was 6.3%.
As we had described in our first quarter 2017 earnings conference call, we are now reporting interest segment sales and the related elimination of sales and operating income for the transfer of products between our reporting segments.
These eliminations primarily relate to sales from the Water Systems segment to the Distribution segment.
For the second quarter 2017, the total sales elimination for intersegment transfers is $18.6 million, and the total operating income elimination is $3.3 million.
The intersegment elimination of operating income effectively defers the operating income on sales from Water Systems to Distribution in our consolidated financial results until such time as the transferred product is sold from the Distribution segment to its end third-party customer.
This deferral of operating income or the elimination will be greatest during the first 6 to 12 months following the acquisition, as pre-acquisition inventory held in distribution entities is sold and post-acquisition inventory increases to an optimal level to support our customers.
The company's consolidated gross profit was $102.8 million for the second quarter of 2017, an increase of $12.1 million or about 13% from the second quarter of 2016 gross profit of $90.7 million.
The gross profit as a percent of net sales was 33.7% in the second quarter of 2017, and decreased about 230 basis points versus 36% during the second quarter of 2016.
The gross profit increase was primarily due to higher sales.
The decline in gross profit margin percentage is primarily due to lower gross profit margin of the new Distribution segment, which will have lower overall profit margins in our legacy Water and Fueling Systems segments.
Excluding the new Distribution segment, gross profit margin was 34.5%, and declined primarily due to higher raw material and other direct variable expenses, including freight.
Selling, general and administrative expenses were $68.3 million in the second quarter of 2017 compared to $58 million in the second quarter of the prior year, an increase of $10.3 million or about 18%.
The increase in SG&A expenses from acquired businesses were $13 million.
Excluding the acquired entities, the company's SG&A expenses in the second quarter of 2017 decreased by $2.7 million or about 5%.
Overall, the lower SG&A spending outside the acquired entities is due to lower advertising and promotion, engineering and engineering project costs and certain variable employee benefit costs.
The company's second quarter 2017 earnings included gains on the previously held equity investments in the 3 Distribution entities as indicated in the announcement made on April 10 regarding the acquisition of the controlling interest of these entities.
This gain, included in Other income in the company's income statement, was about $4.8 million or about $0.06 of earnings per share.
The company ended the second quarter of 2017 with a cash balance of about $55 million versus about $104 million at the end of 2016, down primarily due to acquisitions and increased working capital needs.
Inventory levels at the end of the second quarter of 2017 were $297 million versus year end 2016 of $203 million.
About $60 million of the inventory increase is due to the Distribution segment acquisitions.
The company realized discrete income tax benefits related to the onetime gain on the acquisition of the controlling interest in Distribution entities and the expiration of uncertain tax positions in foreign jurisdictions in the second quarter of 2017, which lowered the consolidated effective tax rate to about 19%.
The effective tax rate in the second quarter of 2016 was about 25%.
The company believes 25% is a reasonable estimate of the effective income tax rate for the remainder of 2017.
The company had $113 million in borrowings on its revolving debt facilities at the end of Q2 2017, and no borrowings at year end 2016.
These borrowings were primarily to fund the distribution acquisitions made in the quarter and for seasonal working capital needs.
The company did not purchase any shares of its common stock in the open market during the second quarter of 2017.
As of the end of the second quarter 2017, the total remaining authorized shares that may be repurchased is about 2.2 million.
Yesterday, the Franklin Electric Board of Directors declared a quarterly cash dividend of $0.1075 per share payable August 17 to shareholders of record on August 3, 2017.
This concludes our prepared remarks and we would now like to turn the call over for questions.
(Operator Instructions) And our first question comes from the line of Nish Damodara with <UNK> Baird.
This is actually Mike.
We must have had our lines crossed up.
So a couple of questions.
First, maybe just some initial thoughts on the Distribution side.
How that integration is going so far.
The comments were that it's ahead of expectation.
Maybe just a little bit more on what you've done so far and kind of what the next steps are.
Sure, Mike.
Initially, obviously, we've got costs out that were not going to be ---+ private ownership costs out of business.
We're on 4 separate ---+ actually, 3 separate platforms right now from an ERP point of view.
So we wanted to get some level of reporting across the platforms into the corporate office in Denver.
We're working on standardizing the operations platform, standardizing logistics, getting all the employee benefit plans in line.
Just the typical things you'll do when you're integrating an acquisition.
In this case, though, we're integrating them into each other as opposed to into Franklin.
So those processes are all underway.
So we look at being on a standard platform in ERP system, say, within 12 months.
We're looking to having all the benefit plans lined up by the end of the year.
And we look to getting greater visibility to the inventory levels because this is all about managing inventory and working capital and so our operation team is doing that as we speak.
So those are the kinds of activities.
And the cost out was really on the side of kind of the owner costs that you'd see typically in a private business, rationalizing those on a relatively quick basis so that we could get it to a running operating expense on a go-forward basis.
That makes sense.
The margins were certainly an encouraging start there.
Any thoughts on the channel now that you've had in the fold for a few months.
What do your channel partners, the customer base saying at this point.
Any worries on the competitive side yet.
Well, I think you see the range of responses that we talked about in our earlier call.
I mean, you see a range of response from, okay, we see there's a new owner and the same face is calling on me, so nothing has changed from that point of view, to more of a wait-and-see attitude.
We'd say that, generally, if you look at the first half of the year, buying patterns of all Franklin Electric's manufacturing customers are pretty much similar to prior years.
We've had a couple situations where we've had suppliers to Headwater choose not to continue to supply.
That's opened up other opportunities for us.
Some with other suppliers, which we're pursuing and have pursued.
So kind of, I think, the normal start of activity and not much different than what we described at our last call.
Okay.
That makes sense.
And then strong water trends in North America in the quarter, any sense for inventory through the channel.
Probably in a pretty fair spot at this point.
Last one from me then on the dewatering side.
Good to see that turning the corner.
What are the thoughts on sustainability on that side.
Yes, we're really pleased with the level of backlog and, touch wood, it's been doing really nice.
We're seeing it, again, across both the gas field service.
And I think after a couple of years of not buying much capital equipment, there's a need for new pumps, there's a need for repair parts, which is good for us.
So that's going well.
We're seeing ---+ we've increased our reach within the North American market and other channels, and then internationally, the business has picked up.
So we're encouraged.
But one quarter does not a trend make for the backlog has been lengthening out and we're very optimistic with that business.
And our next question comes from the line of <UNK> <UNK> with Sidoti & Company.
Just wanted to follow up with that distribution margin for a second.
First, I wanted to see if that's a clean number.
Was there any step up in inventory adjustments from the consolidation.
But secondly, as you've discussed outperforming expectations, I'm curious, is this sustainable or did you over earn in the quarter.
Okay.
So are you saying ---+ just to kind of read between the lines here, are you're saying it's a low signal-digit margin in a normalized kind of unseasonally strong quarter.
Got it.
<UNK>, I apologize, I missed what you said on the tax rate in your prepared remarks.
Could you ---+ could I ask you to repeat that.
Got it.
And the cash flow quarter ---+ generally 2Q is a really good free cash flow quarter.
This is kind of not stacking up to the prior few.
I'm curious, is this recognition of cash with the inventory adjustments for Water to Distribution.
Is that the right way to think about maybe what happened on the cash for the quarter.
No, I don't think those adjustments that you're referring to had really had a big impact on the cash flow at all.
When you look at our cash flow statement, what you see is kind of the change in receivables and inventories.
The pieces are a little bit different, but they're basically about the same as they were last year.
Our accounts payable accrued expenses are much lower this year than they were last year.
Some of that's just timing of inventory receipts, timing of other compensation payments that we make throughout the year.
The other part of this is some of our tax liabilities.
To get some of these discrete tax benefits that we take, we have tax liabilities that then those liabilities go away once we take that benefit.
So that's part of what we see below ---+ or not below the line, but in the other section of that cash flow section.
As <UNK> pointed out, I think our biggest opportunity is inventory management, not only in Distribution, but in our Water Systems and Fueling Systems segments as well.
And we continue to push on better working capital and inventory management.
And our next question comes from the line of <UNK> <UNK> with Boenning and Scattergood.
I had a question on the Distribution side, and I recognize this is a issue you can't talk too much about.
But in terms of the pipeline and your strategy there on the forward integration, just still trying to get an idea of whether Headwaters was more of a one-off and a situation that opportunistically made sense.
Or whether this is something that you're really going to push to ---+ we should expect that business to grow through further acquisition going forward.
Can you just give us an update on your thinking there, <UNK>.
Yes, sure, <UNK>.
Thanks for the question.
You look at it, again ---+ when we talk about Headwater, these first 3 significant distributors all had transition challenges from 1 generation to the next.
And 5 of the 6 leaders, I'd point out, were all over the age of 65 and looking for an exit strategy.
So it was important for us to have stability there.
And so you look at that as being a starting point.
That said, we have had several people contact us.
We are evaluating this model as we go.
The first job for the team, I made it very clear with [D] and his team, is we need to get these businesses integrated and hit the ROIC numbers that we modeled.
Based on that performance, we'd be encouraged to do more.
And so we're going to see how this unfolds.
We think it's a very interesting additive strategy to our manufacturing plan in a market we know very, very well where there are a number of privately held companies, where there's not necessarily a logical successor or whether there's a capital in the family to create a transaction.
So we see this as being a new platform.
We see it as being a platform that needs to prove itself out.
We're confident it will do that.
And as it does that, we will look at other opportunities.
Okay.
That's helpful.
And then my other one was, I may have missed it, but I didn't hear you say too much about ag in general in terms of the quarter and the outlook and the order board there.
Can you just give us an update on that particular market.
Yes, <UNK>.
We ---+ the big story in the United States, as we talked about U.S. and Canada, was on the dewatering side and then surface.
Groundwater was up 5% within that.
We didn't really see a lot of increase in ag.
Ag was pretty flat to slightly down.
Most of the benefit we saw in groundwater in the U.S. and Canada was related to residential systems.
So we ---+ now, some of this may be the way inventory is built in the channel and then runs down, but the second quarter was not a particularly strong ag quarter for Franklin.
And our next question comes from the line of <UNK> <UNK> with Seaport Global.
Just ---+ sorry if I missed this, but in the Water Systems side, I think we were targeting 5% to 7% growth for the full year, even with the slower start in Q1.
Just looking at first half results now and the tougher comps in the second half, is that still what we're targeting.
Or was there a change within the guidance on some of those underlying assumptions.
<UNK>, the ---+ we still think we're going to be able to hit the lower end of that (inaudible) lower end of that.
We did have a slow start.
It's principally offshore.
<UNK> <UNK> is here, he can give you a little travelogue around the world of how the first half unfolded and kind of ---+ and how we're looking at the second half in our international markets because that will be the driver of the achievement of that original guidance.
<UNK>.
Sure.
A very mixed bag around the globe.
Southeast Asia for us was off.
<UNK>, I think, mentioned in his comments about the weather change.
There going forward, that looks to be a continued headwind for us.
Europe is mixed, gets some help at times from currency.
Brazil is ---+ and South America generally are struggling economically.
So we think we're going to have some continued challenge there as well.
Some bright spots, though, we were actually up in a couple of areas, including Africa and parts of the Middle East, Near East, we're a little bit better than last year.
Southeast Asia, if I go back to that, was also a very tough comp against prior year.
So probably our forecast would say that the back half of the year, we're going to be about ---+ we're going to be not as bad off in Southeast Asia in the back half of the year as we were in the first half.
Okay.
Thanks for the color there.
And then on Headwaters, the profitability was great to see in Q2.
I had thought we were targeting sort of 4% to 6% margins, 2018 and beyond.
And 2017 was going to be about breakeven.
Have you changed the thinking there, where we could be or should be above that for the remainder of the year.
Or are you thinking there could be some offset that still keeps us flat.
Any thought there.
Yes, <UNK>, I'll take the second portion of your question first, and you're exactly right, top-line synergies are tough.
And you think about acquisitions, often you think about integrating them into your existing base business.
Here we're creating a new platform.
And so these synergies we're looking for in the top line are really kind of across these different distribution businesses.
Some of which have specialties in areas like turf or commercial or water treatment, and others didn't have those types of expertise.
That's where we see some nice cross-synergies.
I don't want to put a number on it, to your point, because there's a few that can be elusive.
We're optimistic that there's quite a bit of opportunity on the top line.
With respect to OpEx synergies, I'll turn the call over to <UNK> who will do that ---+ take you through that math to the degree that we have visibility to it.
<UNK>.
Yes, <UNK>, one of the challenges of trying to give some targets on any kind of synergies, so you have top line, as <UNK> is describing.
You also have sourcing, potential for sourcing synergies, OpEx synergies.
We're dealing with a historical basis here that where companies were run in a very different way than the way we're going to run these companies.
So it's a little bit hard for us to capture a range of numbers and say, okay, here's what we think they are.
That's why we're going to stick with the 4% to 6%.
The 4% to 6% operating income margin, we think, is the way to think about the profitability of this.
There are some synergy assumptions in that, as <UNK> said, so far, so good on those synergy assumptions.
But I don't want to get out in front of ourselves here until we get through a few quarters of operating this entity and kind of get some history of our own behind us, where we can really understand the cost base, really understand the sourcing processes, as an example, and establish a better baseline that is a Franklin baseline.
And not one that we're relying on kind of what the past was, which was ---+ could have been anything, really.
So the 4% to 6% is, I think, an appropriate guidance measure right now in profitability for that segment, and that's what we'll stick to for the moment.
On price realization.
Yes.
I would expect Fueling price realization to be ahead of Water, yes.
Thank you for joining us on this second quarter conference call.
We look forward to speaking with you at the end of our third quarter.
Have a good day.
