Franklin Electric Co Inc (FELE) 2007 Q3 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to the Franklin Electric Company third quarter 2007 earnings release. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (OPERATOR INSTRUCTIONS). As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Mike Butchko, Treasurer for Franklin Electric. Thank you, Mr. Butchko, you may begin.

Thank you, Rob, and welcome to Franklin Electric's third quarter 2007 earnings conference call. With me today are Scott Trumbull, our Chairman and CEO; Tom Strupp, our CFO, and Gregg Sengstack, our Senior Vice President of Franklin Electric, President of Asia-Pacific Water Systems and Fueling. On today's call, Scott will review the key issues confronting our company this year and our prospects as we end 2007 and move into 2008. Tom will review the third quarter and year-to-date financials. When Tom is through, we will allow some time for questions and answers.

Before we begin, let me remind you that any forward-looking statements contained herein, including those relating to the company's financial results, business goals, and sales growth involve risks and uncertainties, including but not limited to risks and uncertainties with respect to general economic and currency conditions, various conditions specific to the company's business and industry, weather conditions, new housing starts, market demand, competitive factors, changes in distribution channels, supply constraints, technology factors, litigation, government, and regulatory actions, the company's accounting policies, future trends, and other risks which are detailed in the company's security and exchange commission filings, included in item 1A and part 1 of the Company's annual report on form 10-K for the fiscal year ending December 30, 2006, exhibit 99.1 attached thereto, and in item 1A of Part 2 of the company's quarterly reports on form 10-Q.

These risks and uncertainties may cause actual results to differ materially from those indicated by the forward-looking statements. All forward-looking statements made herein are based on information currently available and the company assumes no obligation to update any forward-looking statements. I will now turn the call over to our Chairman and CEO, Scott Trumbull.

Thank you, Mike. Good afternoon. As we remain attentive to the decline in our earnings this year, we are also confident that the factors causing the decline are acute, not chronic, and that the actions we are taking this year will result in a return to solid earnings growth in 2008. My comments this afternoon will focus on our basis for this confidence.

We are achieving strong sales and earnings growth in both our Fueling and International Water Systems end markets. Together, these end markets represent 53% of our total revenues. This year, our Fueling sales are up organically by 28% and up 48% overall. Our International Water sales are up 11% organically and 22% overall. Our sales in developing regions are driving this organic growth. Operating earnings from fueling and international water have grown more rapidly than sales. So in Fueling and international Water, which together represent 53% of our total revenue, our performance has been very good. For reasons that I will discuss in a moment, we have strong momentum in both these markets and expect sustained growth through 2008.

However, our growth in these areas in 2007 has been masked by reduced sales and earnings in the U.S. and Canadian Water Systems market. As those of you who follow the company know, in 2004 we made an important strategic decision. That is to sell our Water Systems products in the U.S. and Canada, primarily through distributors as opposed to large pump OEMs, and to enter the pump business ourselves. We made this decision because we determined that our sales and earnings from a complete line of Water Systems products sold to distributors would grow to exceed the sales and earnings we could achieve from selling only submersible motors to a highly concentrated group of large pump OEMs.

In the course of implementing this decision, we entered into a settlement agreement with the two largest pump OEMs, which ensured that we would supply them with Franklin motors until January 1, 2007. When that agreement expired on January 1st, we discontinued supplying these two OEMs. As a result, our sales in the U.S. and Canada to these two accounts declined by $30 million during the third quarter, and by $82 million year-to-date. Our fourth quarter 2007 sales comparison will also be penalized by about $30 million, representing our sales to the two OEMs during the fourth quarter of 2006.

For reasons that we anticipated, we are not fully offsetting these declines in 2007 with organic sales increases to distributors and other customers in the U.S. and Canada. The primary reason is, during 2006 the two large pump OEMs stockpiled a significant quantity of Franklin motors that they could liquidate during 2007 after we discontinued supply. Throughout 2006, we advised investors in each of our quarterly earnings releases about our concerns regarding this motor stockpile and its potential impact on 2007 results. We estimate that the stockpiling increased our sales by approximately 250,000 motors or 35 to $40 million in 2006.

In addition, we believe our sales this year have been negatively impacted by a similar amount as the stockpile has been liquidated and our competitors have continued to supply distributors and contractors with Franklin motors. So as we had anticipated, in 2007, we are running against artificially high prior-year comparisons, and we are delayed in realizing the significant sales growth opportunity as our competitors sell our motors from their inventory. An additional issue this year has been weak overall Water Systems industry demand in the United States and Canada. Based on trade association data, we estimate that industry unit volume is off 12 to 13%, due principally to the downturn in new housing starts.

We are encouraged that in spite of these headwinds, our Water Systems sales to distributors and other customers in the U.S. and Canada are growing at an annualized rate of 40 to $45 million in 2007. And our sales growth to these customers accelerated in the third quarter. During the third quarter, we've started picking up increased anecdotal evidence from our field sales organization that the remaining stockpile is now being allocated among distributor customers. As we look to 2008, we believe our sales to distributors and other customers will continue to grow organically, with this growth fueled by several factors.

First, with the stockpile diminished, we'll be no longer competing against our owner motors. This will open an estimated 35 to $40 million sales opportunity in motors. This amount represents the estimated value of Franklin Motors that were supplied to the market this year from our competitor's stockpile and in addition we will have opportunity to sell the pumps that go with those motors. Our competitors will retain a portion of this business by selling pumps with their new motor. But all of our market rental as well as 50 years of experience with contractors gives us confidence that a significant amount of this sales opportunity will come our way. Second, we've achieved an important increase in our distribution footprint in several key regions of country during the back half of this year and this will result in increased sales in 2008.

Third, during 2007, we've introduced a series of new pump products that improve and expand our product line. These products are being well received by our growing distributor and water well contractor customer base and will lead the sales growth in 2008. Fourth, our quick pack and subdrive product lines, are leading a paradigm shift in the industry, as Electric moves to a drive as the means of removing water pressure from a well. We are leading this shift and our drive product lines are growing rapidly as the change accelerates. For all these reasons, that is the opportunity in 2008 to sell motors and related pump products that were supplied out of the stockpile in 2007, our expanded distributor footprint, our broader product line, and growth of our constant pressure drive business, for these reasons, we anticipate that our sales to distributors and other customers in the U.S. and Canada will continue growing at the 40 to $50 million better or pace in 2008.

Since we will no longer be running against the stockpile inflated 2006 sales comparisons, in 2008, these incremental sales will positively impact the bottom and -- at the top and bottom line as organic growth. In addition, as we look to 2008, we are confident in our ability to continue delivering 20% organic growth in our fueling business.

Fueling represents about 21% of our total sales and grew organically by 29% in the third quarter and 28% year-to-date. Looking forward to 2008 and '09, we believe our growth in this business will continue as the California Air Resources Board has required that all filling stations in the state install upgraded vapor recovery systems by mid-2009 and a phased implementation of vapor monitoring systems through third quarter 2010. There are about 11,000 stations in California that remain to be retrofitted over this time frame. To date, we supply the only approved vapor recovery system for the California retrofit market, although we believe that one other competitor may be approved. These systems sell for $18,000 to $20,000 a piece.

Additionally, we continue to work with the California Air Resources Board on the certification of our vapor monitoring system, a separate system component that's also required by the regulatory mandate. We expect to be one of only two approved suppliers of these systems in California. These monitoring systems sell for $8,000 to $15,000 a piece. So over the next 36 months, we anticipate that 11,000 California station owners will spent about $28,000 each to purchase vapor control and monitoring systems. This represents a $300 million-plus market opportunity for Franklin and is the reason why we would conservatively project ongoing 20% organic growth in this business.

Over the past five years, we've built a significant growing and profitable business selling our Water Systems products in developing regions of the world. We've targeted these regions because the primary demand for Water Systems products is growing more rapidly in developing regions than in the United States, Canada, and western Europe. We've also found that in most cases, the indigenous competition is relatively weak and the Franklin brand is well-recognized and highly regarded by local Water Systems, distributors, and contractors. Since 2002, our sales in developing regions have grown from $38 million to an annualized rate of $145 million today.

2007 year-to-date, our sales in developing regions are up 11% organically and 35% in total versus prior year. We are aggressively expanding our distribution network in these regions and selling a broader line of Water Systems products through this network. We expect to achieve high single digit or low double digit organic sales growth in developing regions in 2008. We recognize that as we return to organic sales growth in 2008, a key issue will be how much of this growth will contribute to the bottom line. One consideration will be the extent to which we achieve fixed cost leverage.

In the recent past, we've expanded our sales, marketing, and engineering organizations to execute our strategy of selling a more complex product line to a more diverse customer base. As a result, we've increased fixed costs at a rate faster than our sales growth. Our total fixed costs, which include SG&A, depreciation and amortization, and manufacturing fixed spending has grown as a percentage of sales by 220 basis points over the past 12 months. At this point, we have the organization and cost structure in place to execute our strategy and future increases will be only incremental and relate primarily to inflation.

In 2008, our fixed spending as a percentage of sales is budgeted to decline by about 200 basis points versus the 2007 level, exclusive of acquisitions. While we recognize that because of the stockpile and weak industry conditions, 2007 would be a difficult year, we elected to go forward with a number of strategic new product development and facilities initiatives which would detract from earnings during the year, but lead to improved earnings in 2008 and beyond.

During 2007, we will introduce new pump designs that will replace and upgrade about 80% of our U.S. and Canadian ground water pump product lines. This activity has not only required to increase development and start-up costs, but also resulted in increased inventory since we must carry both the new and old SKUs as we convert each individual customer to the new design. These new designs have the dual advantage of being more durable and efficient for our customers, while also reducing our manufacturing cycle times and costs. We expect to have largely competed -- completed the transition from the incumbent designs to the new designs by mid-first quarter 2008.

We're also building a new 100,000-square foot pump manufacturing facility in Linares, Mexico, adjacent to our Linares Motor Plant, which will produce these new designs as well as other pump products. We're incurring the design engineering, training, and start-up costs this year and will have the plant operational during the first quarter of 2008. In our Fueling business, we made the decision to shut down three satellite manufacturing locations in 2007 and consolidate these operations in our recently-expanded Madison, Wisconsin facility, again incurring, engineering, training, severance, and start-up costs this year with reduced costs following in 2008.

Finally, early in 2007, we made the decision that in the United States and Canada Water Systems market this year, we would err on the side of carrying too much inventory rather than too little. We were not certain of the size of our competitor's stockpile or of the impact that housing starts would have on industry sales, but under no circumstance did we want contractors or distributors to be forced to try a competitor's motor because of our lack of availability. As a result, through the back half of this year, we are operating our North American manufacturing plants at a reduced utilization rate to realign inventory. As we go into 2008, with the stockpile no longer a factor, we have clearer visibility of demand and will be more successful scheduling and level loading our factories.

Another key issue will be the pricing environment, particularly in the United States and Canada Water Systems market. Because of the weak market conditions this year, and our rapid share gains with distributors, our competitors have responded with unusually heavy price promotional activity in 2007. This activity has occurred at the same time that the pump and motor industries worldwide have experienced heavy cost inflation. Material costs are about 50% of the manufacturing costs of pumps and motors. The major material cost elements include copper, steel, stainless steel, and freight. In the past year, prices for all these inputs have increased significantly. Against this backdrop, promotional pricing activity takes a particularly heavy toll on margins.

We estimate that cost increases in excess of price increases have reduced our overall gross profit margins by about 200 basis points this year. The only good news is that our competitors should be feeling the same pain since steel, stainless steel, copper, and freight have gone up for everyone. We believe that distributors and contractors understand the cost pressures that their pump and motor suppliers are facing and they will be prepared to accept inflation-justified price increases during the first quarter of 2008.

While we believe it would be rationale for our competitors to lead or follow these increases, we recognize that competitive market price behavior is difficult to predict. So while we are naturally concerned by the earnings decline we are experiencing this year and we remain uncertain regarding the pricing environment in the United States and Canada Water Systems market, for the reasons I have enumerated, we are confident that we are taking the right steps to restore earnings growth in 2008 and beyond.

Now Tom Strupp, our CFO, will provide some color on our financial performance during the quarter and year-to-date.

Thank you, Scott. Further to Scott's comments, third quarter sales for 2007 for the company were a record $165.3 million, an increase of about 6%, with solid growth in International Water Systems sales outside the United States and Canada, and significant organic and total growth from the Fueling business. The Healy Systems and Pump Brands acquisitions increased overall sales by about 12% during the quarter, and foreign exchange changes increased sales an additional 2%. Third quarter sales exclusive of acquisitions and foreign exchange declined by 8% from the same period a year ago. The company sales' volume of 4 inch submersible water well motors in the United States and Canada was reduced due to the continued inventory liquidation by several large integrated pump OEMs that began in the first quarter of 2007. This factor was further compounded with continuing weakness and the water well industry being off in the high single digits as indicated from trade association data for the third quarter, compared to 2006.

We are encouraged by the underlying expansion of our Water Systems' pump product lines being sold to distributors and other customers in the United States and Canada. Operating margins for the consolidated business declined to 11.8% in the third quarter compared to 16.4% during last year's third quarter. Gross profit for the company was down $5.4 million or above 10% from the third quarter 2006. The company's overall third quarter gross profit rate was 29.0% of sales versus 34.2% in the prior year.

Global water systems gross profit declined by about $7.5 million or 16% versus the third quarter of 2006. Water Systems' gross profit in international markets continued to grow at a faster rate than sales; however, this growth was offset by gross profit declines in the U.S. and Canada Water Systems' market. In the United States and Canada, 2006 gross profits benefited from unusually high sales of submersible motors to large pump OEMs as they built their stockpile.

The loss of gross profit on sales of submersible motors to these OEMs in 2007 was partially offset by increased gross profit on sales of Water Systems' products to distributors and other customers throughout North America. The global Water Systems' gross profit rate declined 540 basis points in the third quarter of 2007 compared to the third quarter of 2006. The gross profit rate decline pertains directly to sales in the United States and Canada market, having three principal causal factors. First, approximately one-third of the gross profit rate decline was attributable to product mix changes.

Pumps have become a higher percent of sales and they generally carry a somewhat lower gross profit margin than submersible motors. Approximately one-third was attributed to fixed cost coverage as the company's North American submersible motor plants operated at lower capacity utilization rates during the third quarter of 2007 compared to last year. The remaining third was due to increased costs of material and freight net of realized market price increases. There continues to be an unusual amount of promotional pricing in the United States and Canada Water Systems market as competitors react to the company's growing pump market position and the weak overall industry conditions this year.

Fueling Systems' gross profit increased by $3 million for the quarter or 43% versus the third quarter of 2006. Fueling Systems' gross profit rate declined modestly during the quarter due to an unusually high mix of international tender sales during the third quarter of 2007. Selling and administrative expenses in the third quarter of 2007 decreased as a percent of sales to 17.1% from 17.8% for the same period last year. The company's overall selling and administrative expense for the third quarter of 2007 increased by $0.4 million over the same period in the prior year. Acquisitions increased selling and administrative expenses in the third quarter of 2007 compared to last year by about $2.6 million. The incremental acquisition expenses were largely offset by reduced spending in the base business operations.

Interest expense increased by $1.2 million during the quarter versus the same period in the prior year as the company's debt has increased for the funding of our 2007 acquisitions, Pump Brands, Inc. in South Africa and the Canadian Pump division of Monarch industry and increases in working capital during the year. During the third quarter of 2007, the company continued to execute its global manufacturing realignment program.

As part of Phase II, the company just announced the phased relocation of the Little Rock, Arkansas Water Systems pump manufacturing to the new pump plant in Linares, Mexico, over the next several months. The new Tri-seal and Series 5 4-in submersible and VersaJet product lines will be in production in Linares during the first quarter of 2008. The mission of the Little Rock facility will now be centered on becoming a world class distribution hub for Water Systems product shipments to the company's growing North American customer base. Restructuring expenses year-to-date 2007 were approximately $1.9 million on a pretax basis and reduced EPS by approximately $0.05 per share. Full-year 2007 restructuring expenses are estimated to be $4.0 million, again pretax, and will include severance and other employee expenses as well as manufacturing equipment relocation costs.

The company's effective income tax rate in the third quarter of 2007 was 33.8% compared to 35.0% in the prior year. The tax rate decrease in the third quarter is attributable to one-time adjustments to the tax provision primarily for announced income tax rate reductions in Germany. Cash flows generated by operating activities in the third quarter of 2007 were $26.6 million, with approximately $10 million resulting from a reduction in accounts receivable working capital. Cash flows used for investing activities in the third quarter were $23.3 million and were used primarily for the acquisition of the Pump Division of Monarch Industries. While cash flows from financing activities were essentially flat in the third quarter, the company did issue $40 million of long-term fixed rate debt with a coupon of 5.79%.

Proceeds were used to pay off floating rate debt outstanding at the time. As a result, the company ended the third quarter with $60 million of cash on the balance sheet, $150 million of ten-year fixed rate debt, with a coupon of 5.79% and no outstanding borrowings on its $120 million revolving credit agreement. The company repurchased 186,000 shares of its common stock for $8.1 million in the second quarter of 2007 and had no repurchase activity in the third quarter of 2007.

This now conclude ours prepared remarks on the third quarter 2007 results. We would now like to open it up for questions.

Thank you. (OPERATOR INSTRUCTIONS). Our first question comes from the line of Matt Summerville with KeyBanc. Please proceed with your question.

A couple questions. First, I guess all things considered that you went through, Scott, how much should your spend go down next year in '08 compared to '07, around new product development, product launch costs, engineering, all that? Is there a more concrete way to quantify that and I guess how we think about SG&A going forward now?

We indicated that while our fixed spending overall, which includes SG&A, manufacturing fixed, and depreciation was up in the last 12 months as a percentage of sales, I think it went from 29.1% to 31.3%, 220 basis points, our plan is to reduce that percentage by about 200 basis points in 2008. So that's about as much guidance as I can give you on that.

Okay. Your discussion around fueling, looking for 20% growth or more, it sounded like, '08 versus '07, I guess. As you think about your capacity in that business, doesn't your capacity contemplate significantly higher growth than that? I guess I'm trying to understand if that's a pretty conservative viewpoint?

I think it is a conservative viewpoint. The issue for us will be the timing of the demand surge as it pertains to this California mandate, which by the way isn't the only thing driving the demand for our fueling business. But that is obviously a major factor over the next 24 to 36 months. In the past, we have seen mandated capital investments for filling station operators, for instance, the tank change that occurred at the end of the 90s, where they had to go to double walled tanks. What typically happens is the station operators will put off the capital expenditure as long as they can and do it near the end of the conversion date. So that certainly won't -- not everybody is going to do it in the last month. That's not going to happen.

But we don't know for sure what the timing will be of the demand surge. Whether it will occur kind of evenly over 2008, really pick up in the back half of 2008, and what have you. Our -- we are gearing up to supply this demand surge and we're structuring our facilities and capacity to respond to it, even if it occurs fairly intensively late in the game. We're going to be prepared to supply a significant share of this total gain. I don't think it's going to come all at the -- in the last six months or anything like that, but we don't know for sure how that demand surge is going to come to us over the course of 2008 and the early part of 2009 and into the back half of 2009.

Outside of California, can you kind of walk through what other states either are considering legislation or have passed legislation? Kind of what is the outlook for Fueling in the U.S. outside of California? And then when you look across into the international piece of the business, maybe you can give a little more color on the kinds of growth rates you're seeing in places like China and India and how you expect that to play out over the next year or two?

In response to the question on Fueling, I'm going to ask Gregg Sengstack,, who is with us today and who is President of our Fueling Business to comment on that.

Hey, Matt.

Hey.

I would respond in the United States outside of California, there's already been a mandated change in the state of Texas, which is pretty much behind us. So that'll be a replacement market. What I'll call the NESCOM states, the states in the Northeast, New England states that are all subject to vapor recovery, I think these people are looking at whether they should do something similar to Texas and that is to swap out their incompatible systems that exist today with ORVR compatible systems and that would be mandated state by state, whether they're making their state implementation plans with the EPA or not. So that's something that will come -- unfold in the next couple of years.

Outside the United States, obviously, there are huge opportunities, particularly in China and India, for example. In China they have mandated that they have recovery go into the Beijing area in advance of the Olympics. I would say that they've got a lot to get done if they're going to do that before the Olympics, but that may be the kickoff for a general move within China. There's also been a mandate in the Shanghai area by 2010 and also in the Guangzhou area by 2010 with the balance of the stations by 2015.

In India I do not know the formal mandate, but because of the high temperature conditions in India and a large amount of evaporative loss issue in India, the Indian oil companies are voluntarily putting in paper recovery to deal with the evaporative loss as well as to deal with the safety around the station because they have full-time attendants and the inhalation of the BOC and benzene. So we're seeing opportunities in both those markets.

Europe is a market we currently are not involved in. Europe already has about the same number of gas stations as the United States that are vapor recovery, somewhere in that 50,000 station range and I don't -- our VR initiative in Europe, I do see continued vapor recovery needs in Europe and I do see that expanding.

Okay, great. That's helpful. I'll get back in queue. Thanks.

Matt? Matt?

Our next question comes from the line of Michael Schneider with Robert Baird.

Just to finish up, though, on Matt's question, he asked about the international side and the developing region side, as I mentioned in my comments, our sales in regions over the last five years have grown from about $40 million to an annualized rate currently of $145 million. We talk about developing regions, we're talking about Latin American, eastern Europe, Middle East and North Africa, Southern Africa, and Asia-Pacific. So from over those five years, 38 to $145 million. Of that about 45% of that growth has been by acquisition and 55% has been organic. Mike, we're on to you.

Good afternoon, guys.

Good afternoon.

Hi, Mike.

Maybe first we can just start with the concept of the 35 -- I believe you said 35 to $40 million you expect to recover in 2008 as a result of basically not competing against your own motors, did I hear that correctly, Scott?

Yes.

So I'm trying to reconcile, and I may be mixing two topics here, but the pump business roughly did about $60 million last year and I believe the goal going into the year was to double that business to to roughly $120 million, but it sounds like that goal has now been at least scaled back to 35 to $40 million rather than --

No, what that 35 to $40 million is the -- this year, we estimate that the motor sales value of the -- the value of the motors that were sold out of the stockpile, and again, this is our estimate, we estimated that at 250,000 units or that would have a sales value of 35 to $40 million of motors. Okay? In other words, the value of those motors that went out of the stockpile, most of them -- pumps attached, but leaving the pumps out of it, the value of those motors, we estimate to be 35 to $40 million. So as we look to next year, what we're seeing is that customers who bought 35 to $40 million worth of Franklin motors are going to need -- will want to buy pumps and motors again next year, and will have the opportunity to supply those motors and oh, by the way, also with a pump attached.

My point was, so we're looking at next year being able to address this opportunity while this year it was foreclosed from us because somebody else supplied those motors out of their inventory. And acknowledging that the 35 to 40 actually is a larger opportunity because there are an opportunity to also sell the pumps that go with those, we recognized that we won't get all that opportunity. That certainly our competitors will retain some of that as -- with their pumps and their new motor. But our expectation is that we'll get a significant share of that next year, just based on our -- what we see going on in the market. In addition, I pointed to the fact that we'll have the -- a broader distribution footprint, which will enhance our sales next year, we'll have a broader product line over the course of the full year, which will enhance our sales, and we're also experiencing good sales growth with our drive and control product line. And all of that, I indicated, would add up to, we anticipate, 40 to $50 million of sales growth in the U.S. and Canada next year and that that will show up organic growth next year because we won't have the headwinds of the stockpile liquidation in the prior-year numbers. Is that clear?

Yes. Okay, thank you for that. That second data point is what I want to then also try to reconcile. In your release and in your prepared comments, you said that the growth of sales to distributors has now reached a rate of 40 to $45 million this year. That's an annualized rate. That is pumps, motors, and controls, all products?

Yes.

So with that in mind again, if you were looking to grow the pump business $60 million this year and the growth to distributors is 40 to $45 million for all three products, does that mean that you've tempered your pump forecast for the year just given the market conditions, or again am I mixing apples and oranges here?

We have tempered our forecast. Our dollar forecast, yes. Compared to where we were as we went into the beginning of this year.

Okay and is that -- can you then maybe attribute the rationale is it market-related, is it the dynamics of just the competitive environment now?

It's market related and it's as we entered this year, we were not -- we didn't have as clear a picture of the size of the stockpile.

Okay. And then so looking into '08, then, do you -- can you give us a sense of what your expectations were for pump market share and what you think you can achieve now in '07 or '08 or however you've analyzed this?

Our pump market share has continued to grow rapidly. As I mentioned, I thought that we were either number one or number two in the industry and I believe that is true, as far as pumps alone are concerned. As a total supplier to the Water Systems distribution channel, we clearly are the largest supplier to the Water Systems distribution channel. But we haven't, Mike, disclosed precise market share numbers and I'm not going to, for competitive reasons, get into that on the call here.

Okay. Then just given some of the gross margin or margin topics we've talked about, you're adding 200 basis points back or I guess recovering 200 basis points of the fixed costs. Is that assuming in effect that you get back the one-third that was lost to materials and freight and deflation and then the other one-third of materials -- or manufacturing under absorption?

No. That -- the fixed costs that we're talking about are SG&A, depreciation and amortization, and manufacturing fixed costs, which really is plant supervision and the maintenance department. In other words, people that are not involved in manufacturing -- directly manufacturing the product. All costs that are direct costs are not in that calculation. So we're going to spread those fixed costs and get -- pick up 200 basis points on those alone. That would not include any assumptions that we've made about freight going up or down or copper or steel or what have you and our ability to recover those with price. Okay?

Okay. Then just ruling down SG&A, that was clearly the swing factor in the upside to my model this quarter. Amazingly, it looks like you took $3 million out of SG&A just sequentially. Can you talk about where that money came out of and just break it down in rough buckets for us, because -- and if that level's sustainable?

The -- I don't believe that we're going to sustain at the same level of SG&A spending in going forward that we had in the third quarter. It's just a variety of accruals and accounting entries that enabled that to be down somewhat. Not really accounting entries, but some of the accruals that we had were a little bit lower than they were in the prior year. This quarter is always the lowest quarter for us as far as spending as a percentage of sales are concerned. We came in for the quarter at around $28 million and we're going to be a little bit higher than that in the fourth quarter.

In dollars?

In dollars.

Okay, that makes sense. And the accruals, did you, for example, reverse out any of the warranty accruals or the incentive compensation accruals for the year?

We may have reversed out some accruals. But they were not the major factors driving the percentage decline in operating expense.

Okay. Then just in terms of seasonality, with all the dynamics of this market, we've somewhat lost touch with the seasonality. Would you expect us to return in the fourth quarter to the typical seasonality where you're down sequentially in earnings, just generally speaking?

Yes. The fourth quarter, normally, is down versus the third quarter and the second quarter. Frequently, in the fourth quarter, there is a surge in sales at the end of the quarter as customers try to reach year end rebate levels. The levels are progressive and so the more you buy, the better your rebate, and if customers are close to an incremental rebate level, they may stretch at the end of the fourth quarter to hit that. This year because the industry's been off, we're not certain how much of that will occur.

So we're anticipating that, yes, sequentially the fourth quarter will be down and the fourth quarter may also be off a little bit. Again, this is not something that I'm certain of, but it's something that should be considered. The fourth quarter could be off this year because there will be less buy-up activity in December than there has been in prior year fourth quarters.

And there was with a big pre-buy in the last fourth quarter by the integrated OEMs, correct?

Well, there was a, as I mentioned, $30 million of purchases of motors in the fourth quarter last year by the OEMs.

Okay. Then along those lines, gross margins, again, sequentially, you're talking about recovering a lot of these fixed costs heading into 2008, does any of that start in Q4 or again -- or at this 29% gross margin level, does that seem at least in the range, at least, for the fourth quarter until we get some relief into '08?

Mike, I indicated that the key issue -- one of the key issues for us is the pricing environment and the degree to which we'll be looking at promotional pricing during the quarter. The good news is that we have not seen list price reductions. What we've seen are one-off promotions, which have the same affect to the bottom line, but at least they're not permanent. So going into the fourth quarter, the question for us that will determine to some extent -- to a large extent our gross profit level will be the degree to which there is promotional pricing activity over and above what normally occurs. For that reason, I'm reluctant to get too specific as far as guidance is concerned, because if I can't control that.

Although, a year ago, just for comparison's sake, you wouldn't have been discounting in Q4 of last year knowing what you know about what your largest customers were doing with stockpiling, correct?

Right.

Okay, so -- okay. So year over year that makes a difference. And then just finally before I -- apologize for monopolizing time here. The European market itself and the growth you'reenjoying over there in the submersibles business, have you seen any impact, there's been a lot of articles including cover stories in the Wall Street Journal about the European housing market rolling over. Have you seen any impact of that and what are you anticipating in '08 given the trends there?

So far we have not seen a significant impact there. I think one thing that's important to point out is in Europe where here in North America or the U.S. and Canada, quite a significant percentage of our products go into residential applications. They're 4" and they're out there in individual farms and vacation homes and places where people are outside the municipal water system and have their own wells.

In Europe, a much higher percentage of our sales are larger pumps that go into agricultural, industrial, municipal, and commercial applications and so the mix is different in our susceptibility to a housing decline in Europe is different than it is here. But having said that, we haven't seen a material impact to our business as a result of housing in Europe yet. It seems that weather seems to be a bigger factor over there in a really dry season particularly in southern Europe will move the needle quite a bit. But we're having a decent year in our European business and our volumes overall have been about where we had anticipated them to be.

Okay. I'll get back in line. Thank you.

Our next question is from the line of Ned Borland with Next Generation. Please proceed with your question.

Good afternoon, guys. Just a quick question here on utilization. The inventory build here, what is that costing you in terms of utilization at your plants and how quickly do you think you can get through that?

Well, again, I think perhaps the best way to respond to that is to go back to this issue of fixed cost coverage and leverage. As I mentioned, the combination of us increasing our fixed spending this year and at the same time suffering a material reduction in volume because of the inventory liquidation, the impact that that's had playing through year on year numbers, the double whammy of selling it last year and not selling it this year, that has driven up our fixed costs as a percentage of sales over the last 12 months by 220 basis points. And as we look out, because those fixed costs are going to level off and our sales are going to start showing up as organic sales because we're not going to be running against the big negative numbers anymore, as we move into the first quarter of next year, we are targeting to bring that back down by 200 basis points as we go through the year.

We certainly have -- the capacity utilization -- we have tremendous flexibility around the amount of capacity that we can bring through our facilities. On the upside and -- so there won't be any issue of responding to surges in demand. The issue is how do we cover fixed costs in those facilities? That's probably the best way to look at it. Or it's the clearest guidance we could give you on that.

Okay. Well, just sort of a follow up on that and one of the previous questions on SG&A, should we be thinking in '08 a 17% of sales rate is sustainable?

Ned, I think you need to look at the year-to-date run rate this year at 20% and factor in a component of the improvement in fixed cost SG&A that Scott mentioned, the 200 basis points. A significant component of that would apply to SG&A, yes.

Okay. Thanks.

Work off the year-to-date rate.

Okay.

We have a follow-up question from the line of Matt Summerville with KeyBanc.

So, Scott, I guess, when we think about this overhang and what you're hearing in the market, in terms of duration, how much do we have left? And now that we're pretty much through October, do you think it's fully resolved?

Well, the amount that we have left -- what we're -- I'd have to say that we just had our national sales meeting, which I sat through the whole thing and in the meeting, we asked our salespeople, each individual territory manager, talking account by account, distributor by distributor, to identify the degree to which our competitors' pumps are still being sold with Franklin motors. And the bottom line of that survey -- and again, these guys are out there in the market and have no reason to be anything other than completely accurate in their projections as best they can, we're still seeing 50 to 70% depending on the markets of what's going off the distributor shelves being -- of the competitor's products that are going off the distributor's shelves, still having a Franklin motor on it.

Now having said that, we are also picking up increased data points where distributors are telling us that they can -- they'll no longer be able to get one of our competitor's brands with a Franklin motor. Or a state -- there are several states where our competitors have now indicated that they will only be able to supply Farradyne product, no longer will they be able to supply Franklin product. And so we're seeing more and more instances and getting more and more calls from distributors and contractors who are saying, hey, I can't get my product anymore with a Franklin motor. Let's talk about me getting started or accelerating my use of Franklin pumps in order to ensure that I continue to get the Franklin motor.

So we're seeing more and more incidences of that showing up in the market. So I think there's still product in inventory, but I think that they're starting to run out and they're starting to allocate it among customers and that it will become less and less a factor, certainly, as we go through the fourth quarter and as we go into next year. I think they'll continue to hold some in inventory to supply customers who they think they have a chance to convert, but who are -- remain absolutely committed to a Franklin motor and so they'll increasingly try to allocate the product around those kind of customers.

Okay. And then in terms of -- I think you mentioned that the North American Water Systems industry was down 12% year-to-date. I was wondering, first, do you have a figure on the third quarter and then can you talk about your North American volume in context of that and then whether or not the magnitude of pricing degradation you saw in Q3 was equivalent to what you saw in the first six months?

Okay. The industry was down probably high single digits in the third quarter. On the back of a strong September. When we talk about the industry, we're talking about shipments from the pump companies to the distributors, because our only data point on industry shipments is trade association data, which measures the shipments of selected products from the pump companies to the distributors. And sales in the month of September were up significantly, primarily driven because of price promotions, which were occurring in September, which the distributors knew would go away on October 1.

So whether or not that represents a permanent increase in demand or just a bulge in inventory remains to be seen, but having said that, demand was down in the third quarter by less than it was in the prior quarters this year. There was, from our perspective, somewhat less price promotional activity in the third quarter than there was in the first and second quarter of this year. Not altogether surprising because the third quarter -- the price promotional activity kind of trends down under any circumstance in the third quarter because distributors are not that interested in stocking up because we're going into the slow season at this point.

Whereas in the first quarter and the second quarter, promotional activity can result in getting more product on the shelf. But there was more in the third quarter this year than there was in the third quarter last year, significantly, although sequentially it was down somewhat. And how that will play through in the fourth quarter remains to be seen. Did that respond to your questions?

Yes. I guess the other one that I lobbed in there was just, all right, if the market was down high single, how much do you think your North American motor volume was down? I'm trying to put this in context of your utilization rates and trying to build that picture.

Okay. Our North American pump and motor combination pump motor products -- when I talk about the market being down, what I'm doing is really talking about the bellwether product is the pump motor, 4 inch pump motor assembly, which is the bellwether product in the industry. That was down high single digits in the quarter and our pump motor business was up dramatically. I'm not going to give you a precise number, but it was -- it wasn't quite double, but it was up at a very high rate in the -- in the quarter.

Okay. Then just, Tom, maybe can you talk about what your thoughts are on share repurchase going forward? Maybe given that the stock's sitting here below 40, why not get more aggressive?

Well, we're certainly going to deploy our cash, looking at a number of strategic options, including acquisitions as we go forward, and those decisions will play out as we have our options that we consider going forward and, yes, that would be a possibility, but we're not going to provide specific guidance in that area in terms of what to expect.

And then maybe just one more comment on SG&A. As we move into '08, product development costs, engineering spend coming down, is that part of the 200 bips, Scott? And then just to clarify in the third quarter the sequential decline, was that related to maybe some of the spend here? I guess I'm trying to understand as well why it was down so much, because I don't think just accrual reversals would have done that.

Certainly, the front part of 2007 had a heavier spend for the new product development projects that we have spoken about and that would be a factor, as well as the third quarter of 2007 -- excuse me, 2006 having a somewhat higher spend versus the third quarter of 2007. So it's really a combination of those and some of the accrual activity that was mentioned. But really part of it, I think, because what we're referencing here is sequential, the -- part of the -- what makes it look like such an extraordinary decline is that in the first quarter, our SG&A was around $29 million. The second quarter it bounced up to around $32 million. The third quarter it went back to 28.

The unusual number was the $32 million in the second quarter. And we will not go back to $32 million. But it wasn't that the third quarter was so much dramatically lower, it was that the second quarter was pretty high. And now as we're kind of providing some guidance in the fourth quarter, it'll be -- it will certainly be higher than it was in the third quarter, but also certainly lower than it was in the second quarter.

Okay. Great. That clarifies it. Thanks a lot.

Our final question of the day comes from the line of Brad Schatz with Snyder Capital.

Good afternoon, guys.

Yes, Brad.

I just wanted to clarify a couple of things. When you talk about the -- I'm sorry to ask another question on the expense side, but with the consolidation you announced the first part of the fourth quarter for some of your Fueling Systems satellite offices, is that incremental to the expense reductions, the 200 basis points that you're planning for for 2008?

No, that's -- that would be part of it. Although, we will also have what will work out to be direct cost reductions as a result of that. We will have, because we have consolidated the Healy operation, the Phil-Tite operation, and the extrusion operations for our pipe business, all of those going out of stand-alone facilities into -- or Satellite facilities into Madison, that will give us an opportunity to reduce fixed costs, which is part of the 200-basis point reduction. But in addition, the pipe product line that we were buying, we had our equipment in an outsider vendor who was supplying that pipe product line to us as a variable cost. They were charging us for that. When we move that into Madison and produce it ourselves, we're going to find a material cost reduction as well, which will help us out as a result of that move. So it's in the 200 basis point reduction, but will also have some additional benefit that will flow through as a result of the change that's outside of the 200 basis point reduction.

Okay. So these expense reductions the consolidation of the Fueling system satellite offices, as well as the -- I believe you have talked previously, when you entered the year you were looking for some expense reductions because of the Shiloh Springs facilities and the layoffs at those facilities. Is there a way to think of -- and I assume this is all pro forma for the acquisitions and the incremental SG&A from Monarch and from Pump Brands, which would be included in this 200-basis point reduction?

I'm sorry, please repeat your question.

I guess with the moving pieces, with the acquisitions of Pump Brands and the acquisitions of Monarch, there is some incremental SG&A that's going to consolidate into the business. And I believe in the past that you've spoken about some expense reduction, some head count reductions at your motor facility and also at your pump facility in moving the manufacturing down to Linares, correct? correct?

Yes.

I'm just -- is the 200 basis points you're discussing, does that fully encompass all of these changes to the different pieces of the business? Is that sort of pro forma for everything, all the moving parts?

It is pro forma for the SG&A, the manufacturing fixed, and the depreciation and amortization on all of the businesses that are currently part of the business, including Pump Brands and Monarch.

Okay. And just one last --

But it does not include the savings that we get, for instance, if we have moved, as we have over the course of this year, if we have moved manufacturing to [Silum] and replaced direct labor in Silum with direct labor in Linares, or as we move forward next year, having curtailed pump production in Little Rock, replacing Little Rock direct labor with direct labor in Linares, that savings, because of the difference between $18 to $20 an hour labor and $2 an hour labor, $2.50 that savings is not included in this -- in that calculation.

Okay. So that savings is still incremental?

Yes.

And just one last question and I'll follow up with you guys a little bit later. You've outlined over the past three quarters very well the impacts from -- let's call it this year's change in the product mix with the motors versus the pumps and some of the aspects that are taking place in the Water Systems. Is there a way to think about the revenue dollar leverage? Is it fair to say that the revenue dollar leverage that you would have received in motors as you work through the inventory adjustment going into 2008, if you're able to achieve the same kinds of rates that within motors, within Fueling Systems that the incremental margins -- is it right to think of the same historic margins you received previously?

We talked about this in the press release, but as our mix of business has changed and we are selling more pumps and the Pump portion of the business becomes a higher percentage of our overall business, that mix affect that because pumps generally carry a lower gross profit margin than motors, they're somewhat less capital intensive, but they carry a lower gross profit margin than motors, then as pumps grow, the gross profit margin will be down and we're saying of the 520-basis point or so reduction that we've incurred this year in gross profit margin, about a third of it you'd call structural due to the affect of just the mix shift. And about a third of it pertains to fixed cost coverage and the subjects that we've discussed and about a third of it pertains to prices relative to direct cost and the price per direct cost contribution margin squeeze that we've incurred this year.

Right.

Okay?

I'm sorry. I guess what I'm asking, I understand that the product mix shift in the pumps, maybe I can check with you later, but I just want to understand, when you talk about the incremental business, the inventory overhang, you will be competing for that business because you were previously competing against yourselves. Within the motor segment of the PMA market that you're going to be addressing, is there any reason to think that the historical margins, the operating margins you received in motors would be any different in 2008 if you were able to achieve that business than it was in 2005 or 2004? Just in the motor segment.

Most of that 35 to $40 million opportunity is -- that reflects the motors that we sold to OEMs in 2006, the 250,000 motors that we think went into the stockpile and the value of those was 35 to $40 million. As we have an opportunity to address those in the marketplace in 2008, for the most part we will be selling motors attached to pumped or pumps attached to motors. And the key to answering your question will be what will the market price be of the PMA -- of the pump motor assembly, because the price of the motor will be buried in that and the issue there will be what kind of a pricing environment will we face as we sell those products in the market as pumps next year.

Okay.

So as motors they should be the same price. The issue will be as PMAs, how will they come through in the marketplaces next year as far as margins are concerned? Do you understand?

I do. Thank you.

Gentlemen. We are out of time for today's conference. I would like to turn the floor back over to you for any closing comments.

Thank you for participating in our call and we'll look forward to having a discussion with you at the end of next quarter.

This concludes today's teleconference. You may disconnect your lines at this time.