Franklin Electric Co Inc (FELE) 2010 Q3 法說會逐字稿

Good day ladies and gentlemen and welcome to Franklin Electric 2010 earnings conference call. (Operator Instructions). I would like to hand the conference over to Mr. Patrick Davis, Treasurer. Sir, you may begin.

Thank you. And welcome to Franklin Electric's third quarter 2010 earnings conference call. With me today are Scott Trumbull our Chairman and CEO, John Haines, our CFO, Robert Stone, SVP of Americas Water, and Gregg Sengstack, SVP of Fueling and International Water. On today's call, Scott will review our quarterly and year-to-date business results and John will review our quarterly and year-to-date financial results. When John is through, we will have some time for questions and answers.

Before we begin, let me remind you that any forward looking statements contained herein including those relating to market conditions or the Company's financial results, expense reductions, profit margin, inventory levels, foreign currency translation rates, liquidity expectations, business goals and sales growth, involve risks and uncertainties.

These risks and uncertainties include but are not limited 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 and future trends and other risks which are detailed in the Company's FCC filings and are included in item 1A of part 1 of the Company's annual report on form 10K for the fiscal year ending January 2, 2010, exhibit 99-1 attached thereto and in item 1A of part two of the Company's quarterly reports on form 10Q.

These risks and uncertainties may cause actual results to differ materially from those indicated by any 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, Patrick. On balance, we were pleased with our operational performance during the third quarter. Our organic consolidated sales growth was 12% and earnings per share before restructuring charges increased by 33% to $0.53 which was reduced by $0.01 per share due to transaction expenses for our most recently announced PetroTechnik acquisition. Our water business represented 80% of our sales during the quarter and increased by 11% compared to the prior year. All of the growth was organic.

Our water system sales in the U.S. and Canada were particularly strong during the quarter growing by 16%. Our sales of ground water pumping systems for U.S. and Canadian residential applications increased by about 19% driven by ongoing share gains. Our sales of large ground water pumping systems for industrial and irrigation applications in the U.S. and Canadian market grew by a healthy 27% during the quarter as we believe farms spending for our products increased despite relatively wet weather in several important ag irrigation regions of the country.

Our Water System sales in the developing markets of Latin America, Asia Pacific and Southern Africa represent 30% of our total water sales during the quarter and grew by 11% compared to the prior year. Our water system sales in Europe, Middle East and North Africa were flat in U.S. dollars for the quarter compared to prior year. But grew by about 10% in local currency. All in all, we viewed this as a solid sales quarter for our global water businesses particularly given the general economic conditions in the U.S. and western Europe. Our water operating income before restructuring grew by 10% to $22.5 million which was the highest third quarter operating income level for our water business in the Company's history. After rising sharply throughout the year, water operating income margins declined by 20 basis points during the quarter.

There were two primary causes for this decline in operation margins. Both of which, should be mitigated as we enter 2011. First, we have sales incentive programs with nearly all of our Water Systems distributors that pay out at year end if the distributor achieves the annual sales growth targets. Last year during the second half we began lowering our estimates of the cost of these programs because it became clear that due to the recession, most of our distributors were not going to achieve their targets.

This year it is likely that most of our distributors will meet or exceed their targets so we are increasing our estimates of these costs. As a result, during the third quarter 2010, the estimated cost for year-end sales incentive payments increased as a percentage of gross sales by 180 basis points compared to the third quarter prior year. Second, water systems raw material costs as a percentage of gross sales increased by 180 basis points compared to the third quarter prior year.

Many of the components that we purchased are made of commodity materials such as copper, stainless steel and plastic resins. Our costs for many of these components are increasing because of inflation and the underlying commodity. As a result we have announced price increases in most of our global water businesses that will become affective early next year and are anticipated to offset these cost increases.

Our fueling business provided 20% of our total sales during the quarter and performed very well. Our overall fueling sales increased by 25% compared to the third quarter prior year. Fueling equipment sales in the U.S. and Canada represented about 65% of our total fueling sales during the quarter and grew by 8%. This growth was led by increases in the sales of our new electronic fuel management system product line.

International fueling sales represented about 35% of this segment sales and increased by 73% compared to the third quarter prior year. Excluding the PetroTechnik acquisition, our international fueling sales increased by a healthy 41%. This strong international fueling growth was not an anomaly as our year to date international fueling sales are up 43%.

The strong performance is primarily the result of the growing need for filling station infrastructure in developing regions where the number of vehicles on the road is increasing rapidly. This underlying growth rate is being enhanced by the global shift away from suction pumping systems in gas stations to pressure pumping. The pressure pumping system for gas station was developed by Franklin Electric and we remain the global leader in this technology.

Because our bullish outlook for fueling sales in international markets we were particularly pleased to be able to announce the closing of the PetroTechnik acquisition in September. As previously announced, the PetroTechnik acquisition will double our international fueling sales and significantly increase our distribution network in Europe, Latin America and Asia. This will give us a larger platform for selling our entire fueling product line in these markets including PetroTechnik about half of our Fueling System sales will be international.

Fueling operating income before restructuring increased by 65% during the quarter compared to the third quarter prior year. Excluding the transaction cost associated with the PetroTechnik accusation, fueling operating income before restructuring was up 77%. Fueling operating income margins before restructuring increased by 460 basis points compared to the third quarter prior year and increased by 600 basis points if you exclude the PetroTechnik transaction costs. Because PetroTechnik outsources the manufacturing of their major product lines their operating income margins have historically been lower by the margins achieved by our Fueling Systems traditional product lines.

So initially, the PetroTechnik acquisition will be dilutive to our margin percentages. However, we believe the acquisition will be accretive to our EPS during the first year of ownership. Over the next 18 months, we expect to achieve synergies that will move PetroTechnik's margins closer to those of our base fueling business.

Turning to our outlook for the fourth quarter, we believe that at current exchange rates are consolidated sales will increase by 15% to 20% compared to prior year and that consolidated earnings per share will be flat to up modestly. Year on year Water System sales are expected to grow by 6% to 8% during the fourth quarter as share increases in North America and demand growth in developing regions more than offset negative translation affects. However, we are currently forecasting that water systems operating income before restructuring charges will decline by 5% to 10% compared to the fourth quarter prior year.

Given our improved sales performance in 2010 for the full year, year-end sales growth incentive payments to distributors are expected to be up significantly as will year-end incentive payments to employees. Raw material costs are also expected to increase as a percentage of sales compared to the prior year. As I mentioned earlier, price increases are being implemented in most global Water Systems markets over the next 90 days in order to offset these anticipated cost increases.

Fourth quarter Fueling System sales are expected to grow by 50% to 60% compared to the prior year. Excluding the PetroTechnik acquisition Fueling System sales are expected to be up 15% to 20%. Fourth quarter Fueling Systems operating income is expected to grow by 30% to 35% compared the prior year.

So on balance, we believe the full year 2010 will prove to be a solid year of recovery as the Company and our markets emerge from the recession. We expect full year sales to grow by 12% to 14%, an EPS before restructuring and the second quarter legal settlements are anticipated to increase by 46% to 50%. I would like now to turn the call over to John Haines our CFO to add a little more color on the third quarter results.

Thank you, Scott and good afternoon. Our fully diluted earnings per share were $0.52 for the third quarter 2010. An increase of 41% compared to 2009 third quarter earnings per share of %0.37. Earnings per share before restructuring charges were $0.53 an increase of 33% compared to the prior year. Third quarter 2010 sales were $188.4 million, an increase of 13% compared to 2009 third quarter sales of $166 million.

Water systems revenues increased by $15.4 million or about 11% overall from the third quarter of 2009. All of the growth was organic. Sales increased in all major market areas with the most significant improvements in the United States, Brazil, China and the [OSION] region. Foreign exchange reduced Water System sales by about $100,000 in the quarter.

Fueling System sales were $35.5 million, an increase by 25% during the third quarter of 2010 compared to the same period in the prior year. Excluding the PetroTechnik acquisition, third quarter sales were $33.1 million and grew by about 16% with about 8% growth in the United States and Canada and about 41% growth in the rest of the world. With particular strengths in Europe and Asia Pacific.

On September 3rd, 2010, Franklin Fueling Systems purchased all the outstanding stock of PetroTechnik Limited for about $15 million dollars and was paid for with cash on hand. PetroTechnik's most recent consolidated annual sales were approximately $40 million US. The Company expects the acquisition to be accretive to earnings per share but dilutive to operating income margins in its first year. The Company's consolidated gross profit was $59.3 million for the third quarter of 2010 up $9 million from $50.3 million in the third quarter of 2009.

Correspondingly the gross profit margin increased to 31.5% for the third quarter of 2010 from 30.3% from the third quarter of 2009. During the third quarter of 2010 consolidated SG & A expenses increased by $5.8 million or about 17% compared to the third quarter 2009 primarily as a result of higher commissions, sales, marketing and compensation related costs. SG & A expenses associated with the acquisition of PetroTechnik were $1 million of which were $0.5 million were costs to complete the transaction.

Restructuring expenses for the third quarter of 2010 were $0.2 million and reduced diluted earnings per share by approximately $0.01. Restructuring expenses include severance costs, asset write downs and manufacturing equipment relocation costs. The company is currently exploring additional restructuring opportunities and will provide investors an estimate of future charges when the plans are definitive. Therefore, for the consolidated entity, operating income before restructuring expenses was $19.6 million up 19% from prior year.

Operating income margin before restructuring charges was 10.3% of sales in the third quarter of 2010 up 100 basis points from the 9.3% of sales from the same period in 2009. The effective tax rate for the third quarter was 32.5% before (inaudible) events and we believe that remains a reasonable estimate for the fourth quarter as well. The company ended the third quarter 2010 with cash on hand of about $122 million dollars compared to about $87 million dollars of cash on hand at the end of the third quarter 2009.

The company generated $69.1 million in cash from operations during the first nine months of 2010 versus $88.3 million in the first nine months of 2009. During the first nine months of 2009 the company reduced inventories by about $40 million as sales were declining due to recessionary market conditions. During the first nine month of 2010 inventories have increased by $2.4 million as sales before PetroTechnik have grown by $55 million or 11% compared to the prior year.

The company purchased approximately $4.4 million or about 158,000 shares of company stock pursuant to it's authorized stock repurchase program during the first nine months of 2010. The company had no outstanding balance on its revolving debt agreement at the end of the third quarter of 2010 or at the end of the year 2009. Finally, on October 29, 2010 the board of directors of Franklin Electric declared a quarterly cash dividend of $0.13 per share payable November 24th, 2010 to the share owners of record on November 11th, 2010. This concludes our prepared remarks. We would like now to open the call up for questions.

Thank you, Sir. (Operator Instructions). Our first question comes from Mike Howard from Robert W. Baird.

Good afternoon gentleman. I just want to focus on the margin side on the water business to start out here. Specifically trying to drive to what you guys think the sustainable run rate coming out of this quarter is. Obviously you can probably balance out the commodity costs when you drive into next year but I'm assuming that the incentive related uptick versus last year is probably going to be embedded in your numbers on a go-forward basis depending on the quarter. Is that a fair way to think about it.

Yes, there have been -- our sales incentive programs with our distributors have not -- the programs themselves have not changed in structure or base pay out amount over -- base payout opportunity over several years. So, what we are seeing is not a inflation in our incentive programs, it's just that last year people were beating their targets. This year, -- or last year people were well below their targets and this year they are exceeding their targets. Anything going in to next year we would assume people will hit their targets and their actual sales incentive payments over the full year, 2011 would be somewhat lower than they are this year. That would be our assumption going in to the year next year.

In other words a more normalized viewpoint on that side in the commodities is called 180 basis point drag. Assuming you can get the price increasing, you are looking at something in the mid 16-type margin is a more representative range or are there other things in there that you think on a go forward basis wouldn't be sustainable?

Well, the variables are the degree operating leverage that we achieve which is a function of our sales, our pricing and our material cost inflation and if we get operating leverage next year on the basis of fixed cost control and our sales improve then I think we have an opportunity to continue moving our margins up.

And then on that -- on one of those variables, the price cost variables, could you talk about what kind of assumption relative to 3Q you're expecting in the next quarter. Are you expecting a comparable drag on the water margins 4Q versus 3Q or does that price cost curve shift around a little bit?

Well, we won't get any benefit from the price moves that we're making in water until either very late in the fourth quarter or really early first quarter next year. So, there's not going to be a price effect that will play through in the fourth quarter.

So, I know the price is probably going to be a little bit more static but on cost side. Are your costs going to be any higher in the fourth quarter relative to the third quarter as that gap widens a little bit in the fourth quarter and then normalizes more in the first?

I believe it would be safe to say that it will widen a little bit. The costs will widen, the cost gap will widen a little bit more in the fourth quarter.

Yes, Mike, the raw material costs increases are going to continue to flow through in the fourth quarter. There will be additional estimates for the deductions that we've talked about that will hit in the fourth quarter. So Scott's right, I think that's a safe assumption there will be additional deterioration in the fourth quarter.

Thank you for that. Just switching gears on the last question on the ground water sales side in the U.S., Canada region is very strong seems to be above what your competitors are doing that right now. Can you talk a little bit about what is driving that strength and what is driving the market share gains?

I believe that our basic strategy is really starting to pay off. And, that is that we have focused on lining up the strongest distributors in the country to represent us in the market and from a service perspective we've had a much stronger focus on the contractor than our competitors because we are just more focused on this market than our competitors and it's resulting in share gains across our end markets. So I think that's what's happened.

We know from industry data that on the clean water side the overall industry in the third quarter was only up modestly. Between 1% and 2%. And we know that our sales were up sharply more than that. So it isn't because there's been some, unfortunately, it is not because there has been some dramatic up tick in the market itself. It's been an indication that our people are being more effective in the marketplace.

Great, I appreciate the time.

Thank you. Our next question comes from Joe Radigan KeyBanc Capital Markets .

Hey, guys. A couple questions. Scott you talked about clean water business. Can you talk to the gray water business. How did that perform in the quarter?

Well, from a sales perspective, our, again, and speaking in terms of share and the industry volume was up sharply in the quarter year on year. That is some sewage, affluent and utility pump sales were up sharply, industry wide in the quarter, 24%. That comes, however, on the heels of a 30% decline in the third quarter the prior year. And it appears like a big increase but it's really only partially closing the gap on third quarter 2008 shipments and our sales were up in units materially more than that. Roughly twice that rate.

Okay, in terms of the sales incentive programs, do you expect to see a return to a more normal end of year activity where the distributors are stocking up to reach their bogies or are they on coarse to meet them without having to do that and I guess in correlation there, have you seen or do you expect to see pre buying activity given the price increases and the run up in raws. Did you benefit at all in the third quarter from either one of those and do you expect to benefit in the fourth quarter?

We probably will not see very much activity on the part of distributors to purchase more in the fourth quarter in order to hit targets because for the most part, our distributor basis is in a pretty good position to hit their targets without extraordinary purchases. On the other hand, in several of our markets our price increases are taking effect right around year-end and there could be some pre buying in anticipation of those price increases. It's a little early to see it right now but I, generally we see that.

Okay.

Did that answer your question?

Yes, thanks. Then, how's the season started off in the southern hemisphere? Are you seeing normal pre season inventory builds there? Can you give us an early read on that market?

As John mentioned in his comments one of our strongest sales growth regions in the third quarter was Brazil where our sales were up sharply.

One thing I would comment on there, Joe, too, this is Robert Stone. The business in Brazil in particular is a different mix of product and the seasonality of that business is not quite the same as it is for the ground water pumping business. But we've had a good start also helped by currency which has been strong from Brazil translated to U.S. dollars this year although we're facing a bit of a headwind in the fourth quarter because it's not nearly as favorable in the fourth quarter as it was earlier this year.

Our sales in Brazil and our sales in Southern Africa were both up sharply in the third quarter. Our sales in Australia were not -- were actually down a little bit because of -- primarily because of the weather. Australia had been in a long period of drought that ended this summer up here in the northern hemisphere so there's been quite of bit of water in Australia which has affected our sales there.

Okay, and then just one on the fueling side. Obviously, I mean I heard what you said about the international growth but I think you were expecting China to slow in the back half of the year. Have you seen that at all? Can you give some geographic color on what you are seeing there and is there anything near term that we should be thinking about either on the vapor management guide or is it really now just that steady conversion to pressure from suction and then infrastructure build out of the fueling stations.

I'm going to let Gregg Sengstack, who runs that segment of our business, respond to that.

Joe, in the case of China, while we are seeing some slowing in the vapor recovery after some strong sales in the Shanghai region in southern China, we are seeing strong growth in other product lines as Scott eluded to with this general infrastructure build out in the country so in the areas of fuel management and areas in the piping and fuel pumping systems and everything that relates to new station installs. We are seeing good demand there so it's been able to soften the slowing of the vapor recovery that we're experiencing in the back half.

Okay, great, thanks guys.

Thank you, our next question comes from Paul Mammola from Sidoti & Company .

Hi, good afternoon everyone.

Hi, Paul.

On the pricing side, it seems like your taking share given some of the numbers you've given but, are competitors acting in step with you in terms of pricing in North America?

Well, we have not experienced price erosion over the course of the year in North America and our distributor customers have told us that others of our competitors are announcing price increases for either later this year or early next year. So, it appears that this run up in raw material costs is being, putting pressure on not only us but other people in the industry and since it's commodity based and these commodities are not commodities that it's easy for us to hedge because we don't buy much of the commodities themselves we buy products made out of the commodities. For those reasons, it'll float through everybody's P and L in a similar fashion so I think everybody's under the same kind of cost pressures that we are.

Okay, I guess I was coming at it from the angle that maybe someone would use that as an opportunity to try and steal some volume from you guys but maybe the commodity pressure is just too much. So that's fair enough. Is it still the case that the contribution margin from an international pump motor assembly is the same as one sold from North America?

I respond to that by saying they are similar. Our prices vary to different customers in North America and outside North America. But if you added them all up and compared them, the PMA prices outside of U.S. and Canada and in the international markets I believe the contribution margins would be similar.

Okay, finally, where are you capacity utilization wise in North America right now?

Well, our capacity utilization varies over the course of the year. And coming into the fourth quarter is the time of year where our utilization rates fall way down. Our sales volume starts to decline and we just produced less to keep control of inventories and have more days off throughout the fourth quarter so as we go in to the fourth quarter, we have a lot of capacity that we can bring on stream if market conditions required it.

At peak -- it's -- given our kind of industry, Ned, we can always add a -- excuse me, Paul, given our kind of industry we can, capacity is very flexible because we always add a shift. Most of our plants are producing at a two shift schedule now and so we have a lot of room for added capacity by adding shifts.

Okay, that's helpful. I guess I was curious if utilization in north America is the driving factor in any further restructuring or is there some other opportunistic angle that you're coming from.

Paul, we have -- as I've mentioned this previously, our people in Linares, Mexico, which is our largest North American facility, have done a really nice job of leaning out that plant and as a result we still have physical space in that plant to accommodate 200,000 to 300,000 additional man hours of production. Usually we save about ten dollars or more per man hour when we moved production to Linares. So, the answer is we still have a nice cost reduction opportunity in our Linares factory.

It will take us a while. We are very careful when we move production because of the risk of having the quality problem and causing problems for our customers and we won't do that. So when we do move production we move it methodically and so I'd actually say in 2011 we wouldn't have any benefit from this opportunity. In fact we may even have some added cost because we carry some redundant costs during the time that we're transitioning production but we would see a substantial gain as we go in to 2012 from filling up our Linares factory.

Okay and flexing Linares up by 200,000 to 300,000 man hours is around 60%, right, 40% to 60% if I remember correctly?

Well, we're currently running over a million man hours in Linares.

Okay. Alright, thanks Scott. Thanks for your time.

Thank you. Our next question comes from Ned Borland from Hudson Securities.

Morning guys. First just a question on water. Given your comments on the agricultural market and given the farming environment now. Would you expect your mix to perhaps move a little bit or improve a little bit heading to subsequent quarters and then to 2011?

Well, we were very pleased last quarter with our industrial and irrigation submersible sales being up 25%. We know that there are heavy irrigation regions of the country that were relatively wet in the quarter and so, for us to get that kind of sales increase, that's very encouraging. We do know that -- I think that the dynamic is -- I think that there are ultimate customers -- the farmers have more cash and are in a position to justify capital expenditures that will produce their productivity and irrigation does that.

And offset by what happens with the weather. We never know what for sure is going to happen with the weather. So we think, again, that our strong distributor base is representing us well in the market. Our customer service organizations doing a good job on after sale service for the installers in this segment and we are optimistic that we will continue to see better than average growth in this area. It's a higher value added business for us.

Okay. And then, switching over to fueling, can you just give us some color on exactly the distribution over in Europe that PetroTechnik unlocks for you?

Ned, PetroTechnik has been established in Europe for well over two decades and has a strong distribution network of their own which will be complimentary to ours in the region.

Okay. And then just sort of the margin question with the outsourcing that PetroTechnik does. What is your time line for kind of improving that in the effects on the margins.

As Scott made mention in his remarks, our look is over the next 18 months to have a steady improvement in the operating margins of PetroTechnik as we assimilated the Franklin operation.

Okay. Thanks.

This concludes our question and answer session for today. I would now like to hand the conference back over to Mr. Scott Trumbull for closing remarks.

Thank you for your attention. This ends our call.

Ladies and gentlemen, thank you for participating in today's conference. This concludes our program for today. You may all disconnect and have a wonderful day.