Franklin Electric (NASDAQ:FELE) Q3 2020 Earnings Call

0:00 Ladies and gentlemen, thank you for standing by and welcome to Franklin Electric Reports 3rd Quarter 2020 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 assistance during the conference, Please press star then zero on your touch-tone cell phone. As a reminder, this conference call is being recorded. I would now like to turn the conference over to your host, Mr. John Haynes, our Chief Financial Officer. Please go ahead.

0:44 Thank you, Ludi, and welcome everyone to Franklin Electric's third quarter 2020 earnings conference call. With me today is Greg Singstack, our Chairman and CEO. On today's call, Greg will review our third quarter business results and the impacts our company is experiencing from the global pandemic, and I will review our third 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 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.

1:43 All forward-looking statements made during this call are based on information currently available and accepted as required by law The company assumes no obligation to update any forward-looking statements. With that, I will now turn the call over to our chairman and CEO, Greg Singstad.

2:03 Thank you, John. Thank you all for joining us. As I noted in our press release, I am consistently impressed with how our company and my 5,500 colleagues are dealing with the pandemic. Our global product supply leadership and facilities teams continue to do a great job maintaining protocols to keep our people safe. We continue to follow the guidelines of health authorities around the globe, including the CDC and national, state, and local government requirements. Even with these new protocols, guidelines, and requirements, our operating performance continues to improve both sequentially and year over year. With the benefit of price, mix, and thoughtful expense control, the recovery in our third quarter revenue drove record consolidated operating income and earnings, earnings per share, for any quarter in our history.

2:55 Water system's product demand strengthened through the quarter, driving double-digit organic growth outside the U.S. and excluding our large dewatering pumps in the U.S. as well. While our business in Brazil and Turkey experienced the strongest organic growth, driven in part by price increases to offset inflation, Generally, our business was strong in all end markets with the exception of the Middle East and North Africa. Large dewatering pump sales are stable, albeit at depressed levels given a lack of demand by pump rental customers. Our fueling systems business is recovering slowly. Outside of China, revenue is down 7% in the quarter. In the US and Canada, fueling declined 5% compared to the third quarter last year.

3:41 Our business in China improved slightly Our U.S. distribution business continues to perform well. Demand is strong. While it is dry in the western U.S., which is generally favorable for our groundwater manufacturing and distribution businesses, it has been wetter than average east of the Mississippi. However, overall sales gains are uniform across the country, except for the upper Midwest, where we have seen strong post-lockdown recovery and share gains. Although we continue to experience some challenges in our supply chain, our product availability continues to improve. Across the company, we continue to make progress on reducing working capital, driving record free cash flow.

4:27 Turning to the fourth quarter, we see groundwater demand remaining strong in the U.S., both for our manufacturing and distribution segments. As a result of the second quarter lockdowns and generally favorable weather conditions, contractor backlogs are significant for this time of the year. We also see the plumbing HVAC business as steady, with good end market demand and channel inventories recovering. We expect largely watering pump demand to be steady. Outside the U.S., except for the Middle East and North Africa, demand is solid. Outside of China, we expect our fueling systems business to see a small sequential improvement. Gasoline consumption in the U.S., where we have good data, is getting closer to pre-pandemic levels. We expect that outside the U.S., consumption rates are growing as well.

5:14 In China, our visibility into the funding of government mandated programs has always been a challenge. We remain optimistic that with the recovery of the Chinese economy, we will see some additional double wall pipe upgrades and installation of a meaningful number of fuel vapor monitoring systems and gas stations. However, we do not currently see that happening this year. Overall, with the continued drag of lower dewatering pump sales, We are forecasting fourth quarter water systems revenue down mid single digits, fueling systems revenue down around 10%, and distribution revenue up around 10%. With our improved overall operating performance, we believe our fourth quarter operating earnings will be up 10% to 15% over the fourth quarter last year. So we are increasing our annual guidance for earnings per share from a midpoint of $1.82 to a midpoint of $2.12.

6:06 Also, with our strong free cash flow performance, We are increasing our estimate of annual free cash flow to 170% of net income. I will now turn the call back over to John. John.

6:17 Thanks, Greg. Our fully diluted earnings per share were a record for any quarter in the company's history at 82 cents for the third quarter of 2020 versus 72 cents for the third quarter of 2019. Third quarter EPS before the impact of restructuring expenses was 83 cents, compared to 2019 third quarter EPS before restructuring of 73 cents. Restructuring expenses in the third quarter of 2020 were 0.4 million and were related to various manufacturing realignment activities in the water system segment and resulted in a one cent impact on earnings per share in the third quarter of 2020. Restructuring expenses in the third quarter of 2019 were also 0.4 million related to various manufacturing realignment activities in the water system segment and also resulted in a one cent impact on earnings per share in the third quarter of 2019. Third quarter 2020 sales were 351.2 million compared to 2019 third quarter sales of 348.4 million, an increase of 1%. Sales revenue decreased by 10.4 million were about 3% in the third quarter of 2020 due to foreign currency translation.

7:44 Water system sales in the United States and Canada were flat compared to the third quarter of 2019. Sales of groundwater pumping equipment increased by about 17%, and sales of surface pumping equipment increased by about 8% versus the third quarter of 2019 due to strong end market demand. These increases were offset by lower sales of dewatering equipment, which were down by about 54% due to lower sales in the rental channel. Water systems sales in markets outside the U.S. and Canada increased by 3% overall. Foreign currency translation decreased sales by 12%. Outside the U.S. and Canada, water systems organic sales increased by 15%.

8:34 primarily driven by higher sales in all three major geographic regions, Latin America, Europe, the Middle East, and Africa, and the Asia-Pacific market. Water systems operating income was $36.6 million in the third quarter of 2020 compared to $28.4 million in the third quarter of 2019 driven by price realization, product sales mix, and cost management. Dealing system sales in the U.S. and Canada decreased by about 5% compared to the third quarter of 2019. The decrease was in all product lines and due to declining demand for new filling stations. Outside the U.S.

9:19 and Canada, dealing systems revenues declined by about 27%, driven by lower sales in Asia Pacific, primarily China. In the third quarter, outside of China, Global fueling system sales were down about 7%, an improvement from being down about 20% in the second quarter. In China, fueling system sales improved sequentially. They continue to be less than half of last year's sales. Fueling systems operating income was 18.9 million in the third quarter of 2020, compared to 21.6 million in the third quarter of 2019. Driven almost entirely by lower revenue.

10:07 Distribution sales were a record at 98 million in the third quarter of 2020 versus third quarter 2019 sales of 87 million. The distribution segment organic sales increased 13% compared to the third quarter of 2019. Favorable weather conditions versus the third quarter last year contributed to the revenue growth. The distribution segment operating income was $6.4 million in the third quarter of 2020 compared to $5.9 million in the third quarter of 2019. Operating income growth did not keep pace with sales growth primarily due to unfavorable product sales mix and higher personnel costs in the quarter.

10:53 The company's consolidated gross profit was $124.3 million for the third quarter of 2020 An increase from the third quarter of 2019 gross profit of $117.6 million. The gross profit as a percentage of net sales was 35.4% in the third quarter of 2020 versus 33.8% in the third quarter of 2019 and improved primarily due to better price realization and product sales net. Selling, general and administrative or SG&A expenses were $75.5 million in the third quarter of 2020 compared to $74.5 million in the third quarter of 2019.

11:40 SG&A expenses were higher primarily due to variable compensation expense partially offset by foreign currency translation. In the third quarter of 2020, our effective tax rate net of discrete events was about 17% down from about 20% in the third quarter of 2019 due to the net result of favorable discrete events. Our 2020 effective tax rate net of discrete events should be between 18% and 20% and consistent with our original financial guidance. The company ended the third quarter of 2020 with a cash balance of $114.5 million and generated $118.5 million of free cash flow from continuing operations during the nine months of 2020 versus free cash flow in the first nine months of 2019 of $75.5 million.

12:41 The company's total incremental borrowing capacity was $532 million on September 30, 2020. Yesterday, The company announced a quarterly cash dividend of 15.5 cents that will be paid November 19th to shareholders of record on November 5th. The company made no purchases of its common stock in the open market during the third quarter of 2020. At the end of the third quarter of 2020, the total remaining authorized shares that may be repurchased is about 934,000. This concludes our prepared remarks, and we'd like to now turn the call over for questions.

13:31 Ladies and gentlemen, if you have a question at this time, please press the star, then the number one key on your touch-tone telephone. If your question has been answered or wish to remove yourself from the queue, please press the pound key. Our first question comes from the line of Mike Halloran from Baird. Your line is open.

14:02 Hey, morning, gentlemen. Good morning, Mike. So let's just make sure I understand the trends in the fourth quarter on the water side and how you're thinking about sustainability here. If I hear the prepared remarks correctly, it sounds like the underlying dynamics in the third quarter are going to be mirrored in the fourth quarter. But could you give some granularity on how you're thinking about some of the sustainability of those pieces, kind of excluding what weather looks like, with a real focus on maybe the ag market as well as the other groundwater markets?

14:42 Sure, Mike. So if you look at our North American business, to your point, what we're seeing is that effectively, you know, much of Q2 kind of pushed out to Q3, Q4, and it's been a good climate for our business and both in the residential and ag space for the groundwater business and then we've also seen a nice recovery in the plumbing HVAC business and we just feel that given the information we get from our distribution side of our business which is more focused on groundwater that there's good backlog with contractors and as long as the weather is reasonable and contractors can continue to get out in the field that unlike Prior years, we've seen more of a slowdown in Q4. We think this is going to carry a little bit more in a Q4.

15:30 Outside of the United States, you go around the globe, with the exception, again, of North Africa and Saudi, we're impacted by lower oil prices. We're seeing generally good demand in Latin America, Africa, Europe steady, Asia steady. We're just seeing good water demand across those end markets as we move into the last quarter of the year.

15:56 So could maybe touch on what the inventory levels look like through the channel, both within the water segment as well as in the distribution. And then any thoughts on an early buy this year and whether there's enough out there for some of your customers to try to pull ahead and get some rebates?

16:16 Well, with business being basically strong, people have got plenty to do and they're plenty busy. I can't really comment to the early buy side. I would just say generally inventory is good, maybe even a little bit skinny because the supply chains for ourselves and others, because we see multiple suppliers for our headwater distribution company, supply chains struggled actually in the third quarter, maybe not as much in the second quarter, but you still had to struggle as people started ramping up their supply chains. And so we saw even in our own case in Franklin, towards the back half of September, We were struggling getting some components from key suppliers. We seem to be over that hump now, but I wouldn't think that inventories are particularly robust. People tend to go for cash in these situations whenever you have a shock to the system, so I would not think that inventory levels are particularly robust in the channel.

17:13 That makes sense. And then last one, really strong cash generation, really good cash position. I'm guessing not much has changed, but love some thoughts on how you're looking at the M&A landscape out there, what the optionality looks like, and any cast usage priorities, excluding the obvious, which is invest in yourself first.

17:33 Yeah, Mike, our view toward M&A really hasn't changed. We have some transactions that we continue to look at, so the pipeline, I'm not sure I would say it's really robust, but we've got We're getting looks, and we'll see where some of those may take us here. But that continues to be our priority, as you know, is accretive acquisitions. And from there, we'll go. And we're not really particular. If it's a good opportunity, it's a good opportunity. That may be in water. It may be in fueling. It may be in distribution. It may be outside the U.S., in the U.S. The cash generation is really coming, as you can see, from the working capital improvements that we've made largely around the corporation.

18:25 Our working capital ratio is down to 29% at the end of the quarter, which is an important performance measure for the leadership team here. And it's almost 400 basis points better than where we were last year at this time. You know, kudos to the team for the great improvements they've made there, as Greg points out, in not a particularly easy supply chain kind of environment in the third quarter.

18:56 Great. Thanks, guys. Appreciate the time. And our next question comes from the line of Ryan Connors from Benning and Scottergood. Your line is open.

19:13 Great. Thanks for taking my question, and congrats on the great results. What a difference six months makes, huh?

19:19 Thank you, Ryan. Good morning, Ryan.

19:21 A really remarkable bounce back. So I wanted to talk a little bit about fueling, and particularly to start with on the margin side. I mean, obviously, you know, there's some top-line headwinds there, but the margin's, you know, holding up really well. So can you drill down that a little more than you did, John, and why? A, what's driving that and what's enabling that? And B, what are the different scenarios for margins from here? If we get a top-line bump, is there actually upside to that? And if we do get a leg down at some point, you know, can we continue to hold the line on margins there in fueling?

19:57 Yeah, so kind of two factors at work there, Ryan. The first one is we have nice price realization in fueling in the quarter in February. in the neighborhood of 350 plus basis points. So the business has done a nice job at managing its supply chain, matching increases in inflation that's coming at us, and then going into the market and getting a price. So that's a big impact. The other thing that this business has done really well at is controlled their SG&A expenses, understood that 2020 was going to be kind of a A flat-ish year and now a down year because of the pandemic and really held the line on SG&A increases.

20:46 So, as you know, I always get a little uncomfortable when we try to get talked up on fueling OI margins. You know, 27.6% is pretty healthy. Sequentially, it's up. It's just about even with where we were in the third quarter of 2019. So product mix matters, geography mix matters, and I just don't think I would get too fired up beyond that mid-20 range for very long for fueling systems. Now, as we look forward and we capitalize on some of these opportunities in China, which are just great, other developing world opportunities continue to hopefully see station builds come back in the U.S.

21:36 Some of those SG&A costs are going to come back. There's no question about it. Some of the comp, variable comp, those kind of things are going to come back. But overall, I would point to price, and the SG&A is the main contributors to that, and the leadership team there is doing a really nice job of managing those factors.

21:57 Okay. Now, obviously, the election impacts many businesses, but it's hard to imagine a business that's more impacted than fueling. I mean, you've got two very different visions there of kind of the path forward in terms of electric vehicles and so forth. So, obviously, we can come back three months from now and talk about it a little more definitively, know what the landscape is. But what's your broad view on the risks and opportunities there as you – Thank you, Ryan. A couple observations. With respect to the U.S. market, much of our growth is coming from innovation.

22:58 and solving customer pain points so they can operate their systems safely with the lowest total cost of ownership. And demand, for example, we just started shipping some corrosion control systems for underground diesel storage tanks where the problem with corrosion from low sulfur diesel, which is going to become a bigger problem worldwide as we go to low sulfur diesel, which is a good thing. You go to low sulfur diesel, it's better for the environment, but it's going to create some corrosion challenges and we have a solution for that. So that's That's an example of a product that's not being driven by regulation. It's being driven by, again, the station operators looking for lowest total cost of ownership. Also, I would keep in mind that within the United States or even outside the United States, a vehicle sold today that's a liquid-fueled vehicle is most likely going to be on the road for 20 years. So while there's no question there's going to be a conversion to EV vehicles over time, no question it's going to come in the developing regions first. but there's a long build out and if you look at various data around energy consumption across the globe without massive conversion to some type of solar wind and so on is that we're going to need energy from all sources and liquid fuels are really a great way to move vehicles around, aircraft around and so that's going to be a part of the energy solution for decades.

24:26 and so we just see the fueling business, our growth rates actually inside the United States have often exceeded our growth rates outside the United States as we see major marketers consolidating the smaller stores and building out new stores and as they get more sophisticated stores they like our equipment. Outside the United States, which would not be so impacted by the U.S. elections, again, some of the environmental initiatives that you're looking at in China and India around the gas stations are some really simple solutions that can really help with cleaning up the environment. Stage 2 vapor recovery, which was started in China and then has subsided, but now they want to put in in-station diagnostics to confirm that these Stage 2 systems are working correctly, and that will be good for the environment to do that.

25:12 Similarly in India, where we know there are real air pollution problems, again, as long as you have liquid fuel vehicles, These vapor recovery systems are a very effective way to capture a significant amount of DOC. So we see these as being, as long as we have liquid fuels in the world, and we're going to have those for decades, we see our systems being relevant. We're seeing it as being a good driver of growth for our fuel business.

25:39 Got it. That's really great commentary. Thanks, Greg. And my last one was... I apologize if I missed this. You were a little choppy toward the end of your answer to the last question. When you talked about M&A and acquisitions, it seems like distribution has really gotten its legs under it and is in a good place here. The growing pain has passed and that business is really doing well, but yet it's still smallish in the overall mix. Is that a particular area where you would be looking to maybe build more Through acquisition, I know that space needs to consolidate anyway.

26:17 Yeah, Ryan, it is. You know, we're going to be thoughtful and patient and, you know, a couple more comments. You know, we don't see anybody else out there kind of consolidating this space. We've done several acquisitions, so we think we know the ins and outs and the key factors when it comes to valuation, evaluating these kind of entities. So, yeah, there's going to be more opportunities, and we're going to be thoughtful and consider those. We think about geographic presence and where certain parts of the country it might be better to own a platform there that we don't have. So the short answer is yes, and we'll consider opportunities as they come at us and be very thoughtful in how we execute those.

27:09 Super. Well, thanks. I appreciate your time. Thank you, Ryan. Thank you. Our next question comes from the line of Matt Somerville from DA Davidson. Your line is open.

27:23 Thanks. Hey, guys. With respect to the two pieces of the business that are pretty soft for you right now, first with the watering, where do you think Pioneer's business comes in from a revenue standpoint in 2020? and do you have an initial preliminary sort of view on how that might shape up in 21?

27:47 Yeah, you know, 2020, Matt, 60-ish, 65 million top line there. We're doing our work right now on 2021. I'm a little hesitant to share something there, but... As you know, a big impact, this equipment is sold to rental houses and then in the U.S. anyway, they put those out on rent to O&G activity, including fracking activity. So I think that there's differing views on that, but we're not real bullish on that, at least in North America at the moment.

28:36 The good news is that the business continues to pick up traction internationally, really good applications for mining, the watering applications, other types of things like that. And we see some traction in Latin America, Australia. We see some traction in Southern Africa with this product. So it's much smaller, of course, than kind of the bulk that's in the U.S., but There are some positives in this product line as well, and we'll continue to try to push that.

29:09 Just sticking with that theme, if I recall correctly, your dewatering business, I think, was down like 50% in the fourth quarter of 2019. And if I heard you guys correct in your prepared remarks, you're thinking – Water is going to be down kind of mid-single digits in Q4, unless I didn't hear you correctly. So I guess I'm maybe a little surprised that you're anticipating water to be down in Q4. Can you expand on that?

29:42 Yeah, I think the key thing, Matt, is just seasonally, as you know, we're going into the fourth quarter. As Greg pointed out, we saw a really nice quarter in both groundwater and surface pumping in the U.S. Groundwater was up 17 and surface was up 8. Some of that surface is recovery of the stocking we believe that was happening in the second quarter. That's going to trail off, right? As seasonally we get into the winter months, that's going to start to decline. And then groundwater is really, you know, it's difficult to predict. As Greg said, right now the The weather conditions have been in our favor, at least in this country. We definitely think that there's this resurgence of demand that's coming out of the second quarter when a lot of areas were suppressed. A lot of that's going to depend on contractors being able to get out there and do the work.

30:47 We're still hearing a lot of positive things from our distributors in the headwater business. We're hearing positive things that There's more work than there is time. So that's a tailwind for the fourth quarter, but there's lots of puts and takes, and we don't expect dewatering to change that much. In the second quarter, dewatering was down 70%. It was down 54%. Now the comps get easier, but as I said, we're not expecting much out of that product group in the fourth quarter.

31:20 Got it. And then over to fueling, the other piece of the business that is kind of soft for you guys. Where do you think China fueling comes in from a top-line standpoint in 20? And similar to my dewatering question, how should we be thinking about the next wave of environmental-related stuff, the ISD sort of revenue? How should we think about that in the context of 2021 at this point?

31:49 Yeah, the top line number for 2020, Matt, 17 to 20, somewhere in that range, 17 to 19. We keep kind of inching it down a bit here. In terms of looking forward, again, a little hesitant to give too much on 21 just yet, but the reality is that these environmental mandates in China are real. There's lots of volume, and it's competitive for sure, but our product and our technical solution fits with what is needed there. So we continue to be optimistic.

32:35 I think 2020, or we think 2020, was a highly unsettled year in China with the pandemic and floods and other issues there. I think generally our view is that it will stabilize and we'll see more volume traction in 2021 in China for our fueling systems vision.

32:55 Got it. And then just last real quick, you mentioned the price realization in fueling. Can you give the same figure for your water business? Thanks, John.

33:04 Yeah, in water, it was a nice quarter as well. Now, some of that, as Greg pointed out, is our developing region, some of our developing region businesses Price on spot rate. So, as effect starts to go up and they go get more price. In water systems, we're in the two and a quarter to kind of 250 range. And in distribution, we're in the half a point to a full point kind of range of price realization. And for a year to date through the three quarters, water in the 200 basis point range and fueling in the 300 basis point range. So, You know, it's been a nice, it's been a good year, and the teams have done a nice job at getting price to stick.

33:52 Great.

33:53 Thank you, guys.

33:54 Thanks, man. And ladies and gentlemen, to ask a question, seem to press a star, then the number one on your telephone keypad.

34:26 Ludi, I think we're ready to wrap up the call with some final comments here from Mr. Sangstack. I thank you. I will now turn the call over to Mr. Greg Sangstack for the closing remarks.

34:40 Thank you, Ludi. Before we end this call, I would like to call your attention to the 2020 Franklin Electric Sustainability Report that will be issued today and available for download on our website. While this report is our first public disclosure of some important environmental and social measurements, principles of sustainability are the foundational tenants of Franklin Electric's culture and have long contributed to our success. A commitment to safety, ethical compliance with established policies, care for the well-being of our employees, and a history of innovation, environmental protection, continuous improvement, and lean manufacturing practices. Thank you for joining us this morning. We look forward to your joining us on our conference call following our fourth quarter earnings release.

35:27 Take care and stay safe. Ladies and gentlemen, this concludes today's conference call. Thank you for participating. Have a wonderful day.