Franklin Electric Co Inc (FELE) 2008 Q3 法說會逐字稿

Greetings ladies and gentlemen and welcome to the Franklin Electric Co. third quarter 2008 earnings release. (OPERATOR INSTRUCTIONS) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mike Butchko, Treasurer for Franklin Electric Co.

Thank you, and welcome to Franklin Electric's third quarter 2008 earnings conference call. With me today are Scott Trumbull our Chairman and CEO; John Haines, our CFO; Robert Stone, Senior Vice President of America's Water; and Greg Sengstack, Senior Vice President of our Fueling and Asia Pac business units. On today's call Scott will review our third quarter results and discuss the key issues confronting our Company for the balance of 2008 and into 2009. John will review our third quarter financials. When John 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 Securities and Exchange Commission filings included in item 1A of part one of the Company's annual report on Form 10(K) for the fiscal year ending December 29, 2007, exhibit 99.1 attached thereto and in item 1A of part two 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.

Thank you, Mike. We are pleased to report record third quarter sales, earnings and EPS. Earnings this quarter were the highest of any quarter in the Company's history. The performance of our fueling segment exceeded our expectations. Sales grew by over 90% and operating income grew by over 270% versus third quarter prior year. Most of the growth was driven by fueling sales in California as filling station owners installed vapor control and monitoring systems in accordance with the California Air Resources Board mandate. We estimate that the California conversion is now between 35 and 40% complete and that the sales surge from the mandate will wind down in the latter part of 2009.

In the meantime our fueling management team is moving to expand our sales base outside California in order to partially offset the impact of the surge winding down. We are encouraged that a number of countries outside the United States have either implemented vapor control initiatives or are actively considering them. These include China and India. We are modifying our vapor control and fuel management product lines to meet the specific needs of customers in these and other developing markets.

Also in mid 2009 we will introduce a line of vapor control and petroleum dispensing products for the European market. As we sell more Franklin vapor control systems in California and elsewhere in the world we are building a large installed base of nozzles and hanging hardware that we recognize has a limited useful life due to handling wear, tear and damage. As we move into 2009 and '010 we anticipate developing a 10 million to $15 million per year replacement business that will continue growing as our installed base grows and ages. Our water system sales for the quarter grew by $21 million or 16%. Acquisitions accounted for $15.5 million of the $21 million overall growth. Water system sales in international markets represented 47% of our total water sales and grew by 24% overall and 6% organically. Water sales in the U.S. and Canada represented 53% of the total and grew by 10% overall and were up about 3% organically. In general our water system sales to the agricultural and commercial markets grew at high single digits rates while our sales for residential applications were flat. The weakness in residential sales was due to the housing recession in the U.S. and portions of western Europe.

The major issue for the Company during the third quarter was the 380 basis points decline in water systems operating margins versus the prior year. This decline came after a 480 basis points increase in water margins during the second quarter. There were three factors that were primarily responsible for this decline.

First, as we have discussed during previous conference calls we entered 2008 with water systems inventory levels in our North American plants that were too high. During the second half of this year we are focused on improving liquidity and inventory turns across the Company and especially in our North American water plants. As a result of this focus by the end of the third quarter inventories in our North American water systems plants were 26% lower this year than the same period last year, while our year to date sales volume out of our North American facilities is running about 10% higher. Reducing inventory in this fashion has required reducing facility utilization rates. We plan to continue curtailing production and inventories through the end of this year so that we will enter 2009 in a position to move utilization rates back up. Operating at lower utilization rates in order to reduces inventories has resulted in a 150 basis points reduction in operating margin.

The second factor impacting water systems margin in the third quarter was that operating expenses of acquired business units not included in the third quarter of 2007 have increased SG&A costs as a percentage of sales buy about 100 basis points.

And, third, because the Company's sales and earnings performance through September 2008, our significantly better than through September 2007, additional expenses for incentive compensation were incurred which increased SG&A expenses as a percentage of sales by about 100 basis points. During the fourth quarter of this year we expect to finalize our plans for a major facility consolidation initiative in North America. The initiative will involve a phased move of approximately 500,000 man hours of production activity from older and higher cost facilities to our new world class plant complex in Linares, Mexico. This consolidation will increase our Linares production output by about 60%. All of this volume can be accommodated by the existing plant footprint and with only incremental additions to the fixed cost structure. Based on our estimates now we expect this move will reduce our labor costs by about $7 million and will also reduce our fixed manufacturing costs as we fully utilize the Linares operations and reduce capacity in overhead elsewhere.

We expect the moves to be complete by the end of the second quarter 2009. At that point with the lean initiatives that we are implementing in Linares we expect to still have space for moving a significant amount of additional business into this low cost plant complex. We expect to complete our planning for this consolidation over the next 60 days and will announce the anticipated scope of these moves at that time. While we are pleased to report record third quarter earnings we are mindful of the challenges we anticipate in the fourth quarter. We foresee declining general economic conditions impacting our sales rate. As mentioned we will continue to reduce water systems inventories which will lower capacity utilization rates and we expect our international sales and earnings growth to be negatively impacted by the strengthening dollar. While we face these head winds in the fourth quarter we will continue to benefit from strong growth in our fueling business. As a result we are maintaining our overall sales growth guidance of 25 to 30% for the full year.

We are also confirming the guidance we have provided throughout the year that our fixed spending leverage for the full year will meet or exceed 220 basis points. Note that through the third quarter of 2008 our year to date fixed spending leverage was favorable by about 360 basis points. We expect our fixed spending leverage to decline in the fourth quarter due to expenses associated with the major consolidation into Linares, and the prospect of slowing sales volume due to the deteriorating economic climate. As we look to 2009 we anticipate achieving earnings improvement in our water systems business. While during the first half of 2008 we experienced unprecedented inflation in the cost of key raw materials such as steel and copper, in recent months we've seen a very rapid decline in the cost of these and other materials. These declines will start to be reflected in our cost structure during the first half of next year. In addition we anticipate increasing facility utilization rates and reaping the benefits of consolidating North American production in our lowest cost facilities.

I'll now turn the call over to John Haines our CFO, who will provide some additional information regarding the company's liquidity and financial position. John?

Thank you, Scott. Our cash and equivalent balances on hand were $60.8 million at the end of the third quarter of 2008, versus $59.6 million of cash equivalents and investments at the end of the third quarter 2007. Our net debt as a percent of total capital was 23%. The recent financial uncertainty has not impacted the liquidity of the Company and we believe our existing bank and financing arrangements are sufficient to fully support our operating needs. Our bank revolver debt has $120 million limit of which had $40 million outstanding at the end of the third quarter. Our revolver financing agreement is in place until December 2011. The Company has $150 million of long-term notes at 5.79% with no principal payments due until 2015. We are operating well within all of our existing covenant restrictions and believe we have strong bank and private placement partners behind all of our debt obligations. The Company did not repurchase any shares in common stock in the third quarter of 2008 and on Friday, October 24, 2008, the Board of Directors of Franklin Electric declared a $0.125 dividends payable on the outstanding shares of common stock on November 20, 2008, to share owners of record on November 6, 2008. These comments conclude our formal remarks, and we would like to now open the call for questions.

(OPERATOR INSTRUCTIONS) Our first question is from Mike Schneider with Robert W. Baird.

Thank you and good afternoon. Maybe first we can start with fueling. I'm wondering if you can give us an update on any orders you may have already secured in Korea, Spain, the U.K. or some of these other emerging markets for your fueling systems?

Mike, Gregg Sengstack will respond to that.

Mike, as Scott commented, the equipment requirements in Europe are fundamentally different than equipment requirements in the United States due to nozzle design and local preference and certification requirements. So we have limited sales in western Europe. We are seeing interest in Korea, although with the current uncertainty that's going on in the world economic markets, Korea has been particularly hard hit so we're not sure how that's going to develop at this time.

And are there any proposals actually with time lines associated with them right now that you're aware of in any of these emerging countries?

Certainly in China there's a big opportunity over the next couple of years in both the Shanghai area and the Guangzhou, Shenzen area. Those are mandates that were put in place several years ago much like with Beijing with the Olympics and Shanghai and Guangzhou areas you have both the Asian games and the World Expo are coming up here in the next year so that's going to be a big opportunity for us. Korea does have a deadline out, I believe it's down two years from now. So that will be an opportunity it's a question you were asking about specifically orders right now in hand. We would expect India now that the price of oil has come down, we would expect India to come back on line although there's nothing formal at this point in India. We do see pockets in other areas of the world where there's interest in trying out systems on a test basis.

Gregg, have you seen any impact in California from the financial mess we're in either on the ability of station owners to get credit to retrofit the stations and then I guess as well marketing margins for the station owners have plummeted as well, just curious if this has had an impact on the roll out?

I've made two observations, one is that relative to the overall revenue of the stations, observations, the amount of money we are at a talking about here in the upgrade, we are talking in the tens of thousands of dollars, less than $100,000 can be financed over a period of years. I know there are several finance companies that are pursuing that business actively. I cannot comment on the current or last few weeks in that regard. And overall marketers margins while overall prices of file are declining, you could think that marketers margins would narrow, in fact in the near time prices are still a little sticky so they could possibly benefit from the decline in fuel prices in the near term.

Okay. Then just margins within fueling, Greg, 31.5% this quarter, it was up basically 7-points sequentially. I guess I'll accident same question as last quarter which is if you look at the incremental margins they were enormous, would you expect margins to as the peak really hits in full force to continue to leap at these type of rates.

Well, I think you have to look, Mike as you point out sequentially we had a large increase in sales we are getting the benefit of great operating leverage and you have to look at how you think this is going to roll-out over the next nine to 12 months and our operating margins are being -- our utilization refractory is being fully reflected now.

Have you been able to keep up production rates with demand at this point or is lead time stretching for you?

We have no delay in deliveries.

I'll get back in line. Thank you, again,.

The next question is from Ned Borland, Next Generation Equity Research.

Good afternoon, just going to the water side of the business here, what is your target for inventory and how far down are you trying to get it? I mean, if you are 26% lower now, I mean what do you expect to exit the year at?

Well, Ned, this is John Haines. On a consolidated basis the target we set for ourselves is basically to get our inventory, all inventory down to about the same levels we ended last year at which is the $155 million to $160 million range. And we set that target there because we said if we could increase our sales by 25% or 30% or in that range and keep our inventories effectively flat that's going to be a very significant step forward in terms of our Company managing inventories. So the 26% that we referenced in this release is really just talking about the inventories for certain facilities in our North American water systems segment. So that's the goal that we had set for the year and kind of how we came up with it.

Okay. And then the roughly 140 basis points of fixed cost leverage that you are going to get back this quarter are we looking at that as mostly a cost of goods sold hit or is some of that in SG&A as well?

It's in both. I think the best way to say it is the factors that we pointed to in this release, the underutilization of our facilities in an effort to lower inventories, the SG&A coming from our Schneider acquisition in Brazil earlier this year and then the additional SG&A related to commissions and incentive compensation which we really didn't have much of unfortunately in 2007 all of those factors that we pointed to in the third quarter of 2008 will be present and continue to be a drag on earnings in the fourth quarter of 2008.

Okay. And then can you comment on the pricing environment in water? I mean you've got housing in the gutter here and raw materials have slid a little bit. I mean, is there any pressure by some of these distributors to maybe concede a little on price?

Yes. This is Robert, Stone, by the way who is ahead of our Americas Water systems business.

We have seen some discounting this year, Ned, but it hasn't been anything like what we saw last year. What we say in the market is that distributors, though at this time are fairly full of inventory and contractors are not taking on inventory reflecting their concerns about the sale of that inventory, but we haven't had the same level of discounting as we've seen in 2007.

Excuse me, I just would make a point that the margin decline that we saw in water really did have to do with the three issues that we pointed to, the utilization, the year on year effect of the acquired companies and specifically Schneider down in Brazil as a very diverse, large marketing infrastructure, and that has increased our SG&A as a percentage of sales, and the accruals for compensation related expenses. Price versus cost has actually been pretty good so far this year. We have fully covered the extraordinary inflation that we have seen in the cost of raw materials during the first half. And while they are coming down, the way our purchasing agreements work and just the way the costs flow through inventory and eventually get on to our P&L, we really won't see the benefit of these declining costs until next year, until the first part of next year. So in spite of that the sales price relationship has not really been a factor in the margin deterioration that we experienced in the third quarter.

Okay. And then finally, the lack of share repurchase, you're building a good level of cash here. Are you still hunting for acquisitions and is that going to be the focus of cash going forward?

Well, in this climate with, as we all know, uncertainty regarding our end markets, I do think our business is perhaps less volatile than many industry's but nevertheless we have to be mindful that any projections in this climate are subject to a much wider standard deviation than they have in the past. and I just am hesitant to see us increase the leverage ratios or go out any further than necessary on our revolver. And so we are going to be fairly conservative. But we are not going to completely pull in our horns. If with see an opportunity for a strategic acquisition we will pursue that and then work on financing it in a way that doesn't put the Company in jeopardy at all.

Okay. Thank you.

The next question is from Paul Mammola with Sidoti & Company.

Good afternoon, guys, is there a lump-sum cost estimate for the move down to Linares and will that be taken as a restructuring expense in the fourth quarter?

There is, Paul, this is John Haines, there is and a portion of it may be taken in the fourth quarter as we indicated we are still planning this out. We are still trying to make sure we have all these costs identified and properly categorized. But we do expect to take some restructuring charge in the fourth quarter related to these moves. And our intention is to provide our investors a little bit more disclosure on that, understanding of that within the next 60 days or so.

Good enough. Given the state of credit right now is there any concern for aging receivables or uncollectible accounts at this point?

Yes, our receivables are up as you probably saw, Paul, but as we tear through those, we don't really see any significant customer concerns. Our percent of receivables that are past due has remained fairly constant through the course of this year. So it is something that our credit team watches very closely. It's something we are on high alert for but so far we've not seen any real significant increase in past-due receivables or have any specific customers that we have concern about.

Okay. That's good. And any comments or color on the high thrust market and what a domestic recession would mean for the higher margin products for you guys?

Well, the -- we have had a competitor who has indicated that they intend to launch a high thrust motor, or a family of high thrust motors. They initially were to have launched those products in early 2008 and to our knowledge they are still not available in any significant quantities and trade rumors have it that they really won't available until 2009 now. So we really haven't seen much additional competitive impact in that market up to now. As far as the -- also up till now the commercial and agricultural markets which are characterized by the use of higher horsepower motors have been the strong point for our business not only in the Americas but also elsewhere in international markets. And the residential market which is characterized by the smaller pumps, jet pumps, 4-inch submersible, sub sewage pumps, those product lines have been most negatively impacted by the housing recession. And right now I think it's too early to tell how those, the ag and the commercial markets that rely on our larger motors and pumps are going to be affected. We haven't, we are coming into at least in the northern hemisphere a seasonally down period, anyway so we would expect our sales to fall off. We haven't really seen our sales of those products fall off by a greater degree than we would normally expect due to seasonality up to this point but we are certainly mindful of the risks.

Just as a reminder there as well Paul remember that in these high thrust products they are generally sold separately, the pump and the motor, right, so our customers have a choice of between the pump and the motor in how they acquire and install this, so we've had competition as you know on the high thrust side for a long time and for most of these commercial and agriculture applications it's going to be a real, much greater risk for that installer to want to install a new motor there for the commercial application given the, given the downside potential that could come from a failure.

Okay. Great. Thanks for your time.

The next question is from Matt Somerville with KeyBanc.

Hi, several questions. First, how much copper in pounds do you buy a year, Scott?

Well, Matt, we haven't disclosed that number and I'm not sure I have off the top of my head the number of pounds that we buy. It would, if you wanted an approximate number.

Sure.

2.2 to 3 million, 2.2 million to 3 million pounds, Matt.

Okay. And then getting back to California, Gregg, can you talk about thus far what kind of market share you've seen as far as Franklin on the vapor management systems? And then can you talk about whether or not you've been able to generate some success with the new ISD product you launched, I think it was a month or two ago, and then I guess similarly what your flow share is there?

Sure, Matt, I'd just say in general with the Healy vapor management system we continue to see very large market share in California. You may recall there is another system that was approved about six months ago but we continue to see very large market share with Healy. Our ISD system, the interstation diagnostics, you're talking about the electronics was approved at the beginning of the year and we are getting more traction with that. We saw more traction in the third quarter. And then we had additional product to add to the ISD that makes it a much simpler, lower cost installation particularly in stations that have issues where they have to break concrete and that's our DTU unit, that's our data transfer unit, it's a wireless solution is what we call it. We got approved for that in the middle of the third quarter. We are seeing very good interest in that product to go along with our ISD and I would say one positive surprise is that many people are choosing to use that system even though they don't have to break concrete because it just makes installation very straight forward.

Are you finding that station owners that had purchased your ISD earlier in the year are operating now to go with that additional option? Is that, am I understanding you right?

No, it would be, at the time of purchase because when you're buying the ISD system and installing it, at that point you are making a decision about how you are going to wire it and you either use existing conduit if you know that conduit is clear and pull wires through that or what you can do is you actually cut the concrete and lay new wires. And so the DTU8 unit that we had approved in August eliminates the need to eliminate concrete at the time of installation. It's not something you would retrofit to an ISD which you installed earlier in the year.

Then with respect to the water systems business I think you mentioned international core was plus six, U.S., Canada plus three. When I look at the business overall how much of that growth is price versus actual volume? And then I guess, what are you expecting in Q4 in water systems volume relative to last year? Can you remind us what kind of comparison you face there?

Matt, this is John Haines. The price versus volume as Scott said we feel good that we've got price in the quarter to offset some of the raw material cost increases as we look forward into the fourth quarter we see the residential market being very soft and at least in the northern hemisphere we are going out of season on some of the agriculture and commercial applications. So I think the short of it is is that we think the fourth quarter is going to be a tough volume quarter for us not only in the North American geography but also in certain parts of Europe as well. Would you anticipate then margins in water systems, and again I'm trying to make sure I understand also kind of the seasonality of the business because it's a little bit different now than it was a couple years ago, would you anticipate then the fourth quarter to be below water mark if you will as far as operating margins in water? Well as we've said I think that the volume that we go into the fourth quarter with is, we are concerned about and there's a lot of indicators that it could be lower. And then all of the factors that contributed to the third quarter margin are going to be in play again in the fourth quarter. So we expect that it's going to be a tough volume and a tough margin quarter.

Okay. And then with respect to the renewal of the R&D tax credit, is that aiding your tax rate in Q3 and then what do you expect it to be in Q4? And is there anything we need to worry about with regards to life LIFO in Q4?

Well, we certainly have life LIFO risk in Q4, Matt. As you know the LIFO expense that we take a product of both the prices we have at the end of the year on our key commodities and the volume of those key commodities. I think maybe the biggest or the most significant risk that we run is just a year over year change between 4Q '08 and 4Q '07. It's worth pointing out that in 4Q '07 we did not have to take additional LIFO expense, quite the opposite, we actually had some throw back of LIFO provisions. It's too soon for to us tell but that is a risk for sure for the fourth quarter '08.

And then taxes, John.

I'm sorry, ask your question again, Matt, on that?

On the R&D tax credit did that benefit your Q3 and what we should be modeling for--?

No, I'm sorry, we'll continue to take R&D tax credit when we can but we would not say it benefited our Q3.

What tax rate should we model in the fourth quarter roughly.

I think what you've historically used is a safe bet, Matt.

Okay, thanks, I'll get back in queue.

Matt, just to clarify, the 2.2 million pounds for copper was, is accurate for a portion of our business. If you look at the overall it's 4 to 5 million pounds.

Great. Thanks, Scott.

Our last question is from Mike Schneider with Robert W. Baird.

Guys, maybe we could just get a little more color on the North American water business. Can you discuss now if there is any great discrepancy in growth between the Little Giant business and the Submersibles business?

We've seen that the, what we call our water transfer business has been harder hit by the housing recession than our water systems business. So the old Little Giant business has been hurt overall more than our ground water pumping business.

Okay. And would it be correct to assume, then, if we take North America that was up 3% organically, presumably the larger horsepower and ag applications, et cetera, were up and presumably residential especially water transfer was down, what, mid to high single digits?

No. It actually came out pretty much the way I believe we said it which was, or would, that business overall was flat.

Okay.

By that business I mean the residential business overall was flat. And directionally you're right, water transfer as I indicated might have been down somewhat and our water systems business might have been up somewhat.

Okay. Then similar question just in Europe, could you give us a sense for the international growth being up 6% maybe what the emerging markets are growing for you versus the traditional European market and what the trends have been as of late?

The European market in total was pretty flat for us with larger motors being up and small motors being flat to down a little bit. And the developing markets were up low double digits overall.

And in some of those markets, Scott, with at least the foreign crisis that are seeming to spread from the U.S. to some of these developing markets have you seen your order patterns change materially in just the last three, four weeks?

Not yet. I think we'd be really optimistic to assume that the markets are going to sate by unaffected but up until now we really haven't seen -- other than in Asia. Other than in Asia, we have seen a marked slow down in for instance Korea, a lot of the product that goes in there, all the product that we ship in there is imported and the Korean juan has fluctuated wildly and the customers have really pulled in their horns because of FX there and in other Asian markets. But up until now Latin America has stayed reasonably strong including Brazil. Our business in South Africa in local currency has done very well. So the Middle East in Northern Africa continues to be quite strong. So I'd say the only place we've really seen a marked slow down in the last three weeks has been in Asia.

How about the same question just domestically Scott, what have you seen the last three, four weeks here?

I'll let Robert respond to that, Mike.

Mike, it's been seasonally what would you really kind of expect. We had customers place good size orders through September. Now as the weather started to change that has started to slow a bit but it's really been to this point more seasonal than anything else. I think a lot of the contractors were hit by the housing earlier, much earlier especial if you look in certain areas like Florida. So that that started to affect us some time ago and the latest shenanigans haven't really haven't really had an effect.

Okay. Thank you, again.

Thank you all. That will end our call.

Excuse me, we did let, I think Matt -- I think Matt got back into queue.

Okay. Sorry. Matt?

One moment.

One more quick question, North America water as we sit here right now on a run rate basis how much is residential construction by your estimates versus ag? And then could you answer the same question for international water? Because I mean I guess what I'm trying to get at, I'm betting obviously, because ag has been good res has been bad, that mix has changed and I'm just looking for what the current run rate is?

Generally Matt, Robert Stone here, if you look I'll speak first to the international market, I've got some experience there also, the residential markets tends to be a much smaller piece of the business that we play in in ground water pumping in international markets. So it's much more commercial and agricultural and industrially driven. In North America if I look at the submersible business it is between it and the ag, industrial business, it's actually a little, it is about close to 50/50.

Fifty res versus other applications outside of res?

Yes.

Then last question, Gregg, how much of your fueling business right now would you say is international versus domestic?

You've always said the international component of fueling is in the range of 20%, 25%, in that range, and that's the area of focus of growth for us because we are seeing double-digit growth really outside of the United States and developing areas of the world.

Thanks a lot. That's all I have.

Thank you. That will end our call.

Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation