Earnings Call Transcript - FELE Q1 2021

Operator, Operator

Good morning, everyone, and welcome to the Franklin Electric first quarter 2021 sales and earnings conference call. I will now hand it over to your host, Mr. John Haines, Chief Financial Officer.

John Haines, CFO

Thank you, Stacy, and welcome, everyone, to Franklin Electric's First Quarter 2021 Earnings Conference Call. With me today is Gregg Sengstack, our Chairperson and CEO. On today's call, Gregg will review our first quarter business highlights, and I will review our first quarter financial results in more detail. When I'm through, we will have some time for questions and answers. Before we begin, let me remind you that as we conduct this call, we will be making forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are subject to various risks and uncertainties, many of which could cause actual results to differ materially from such forward-looking statements. A discussion of these factors may be found in the company's annual report on Form 10-K and in today's earnings release. All forward-looking statements made during this call are based on information currently available, and except as required by law, the company assumes no obligation to update any forward-looking statements. With that, I will now turn the call over to our Chairperson and CEO, Gregg Sengstack.

Gregg Sengstack, CEO

Thank you, John. Thank you all for joining us. We're very happy with our first quarter results. We see the momentum that was building in the back half of last year continuing and presenting us with robust demand environments for most of the end markets we serve. Our financial results in just about every measure were records for any first quarter in our history, including net sales, gross profit, operating income, net income, and earnings per share. Our strategy to grow as a global provider of water and fuel systems through geographic expansion and product line extensions, leveraging our global platform and competency in system design, continued to produce strong results as expected. During the first quarter, we continued to expand our water treatment adjacency in water systems, and the distribution segment achieved tremendous organic growth. Our Water Systems business had a record quarter, generating overall revenue growth of 20% and organic revenue growth of 18%. We see multiple signs of demand strength in the Water Systems end markets, including a strong housing market, the global recovery of commodity prices, drier weather, and robust demand in developing regions. Our Water Systems revenues also grew by over 3% from price actions realized in the quarter, which were necessary given the significant raw material inflation we continue to experience. Although our dewatering equipment sales declined by about 4% in the quarter, sequentially, this decline is much lower than what we had experienced in 2020, due in part to greater international demand. Although still a headwind, foreign currency exchange translation was a lesser impact on our top line than it has been in recent memory at just over 2%. In the U.S., strong housing and agricultural demand, combined with continued dry weather drove a 24% increase in groundwater pumping systems revenue in the quarter. Overall, organic growth in the U.S. Water Systems was 11%. Outside of the U.S., organic Water Systems growth was 26%, led by our businesses in Latin America, the Middle East, and Asia Pacific, all of which continued to see pandemic recovery demand, with notable strength in Brazil, Turkey, and Thailand. Our U.S. distribution business had an exceptional first quarter. Favorable weather in most of the U.S., pent-up demand for well equipment, and the Gicon acquisition we made at the end of last year were all factors that drove overall first quarter revenue growth of 58% and 31% organic revenue growth. Revenue growth in distribution was broad-based across all geographies and product lines. The lowest revenue increase in any one of our legacy distribution businesses in the first quarter was 23% over the first quarter last year. Gicon started the year strong and benefited in the quarter from the winter storm in Texas that caused multiple equipment failures and replacements in that state. The Gicon integration is going well, and we've already completed the combination of two branches with those from our legacy businesses. Overall, our distribution customers are experiencing some product shortages, notably, pipe and well gauging. That puts a buy forward and demand on some of these products. As a result of these revenue achievements, our distribution business made money in the first quarter for the first time in its history, reversing the $2.2 million loss from the first quarter of 2020 to $2 million of operating income in this year's first quarter. Our Fueling Systems business picked up momentum in the first quarter, growing revenue by 3% overall and 1% organically, a meaningful sequential improvement from the overall fourth quarter 2020 decline of 15%. The fueling growth is being led by end markets outside of North America, notably, Europe, with the Middle East and Africa were up 30%, and Latin America was up 19%. Sales in the U.S. and Canada were flat to last year's first quarter, and sales in China declined by about 19%. Despite the pandemic-related slowdown in new filling station builds, we believe major marketers continue to see filling stations as good investments and expressed their intention to ramp up builds in 2021. We also believe environmental challenges like corrosion of underground storage tanks caused by alternative fuels create new opportunities, especially in developing regions where liquid fuel consumption is increasing and greater environmental protection is necessary. Even with 3% revenue growth, Fueling Systems achieved a record first quarter operating income of $14.9 million and an operating income margin of 26.2% because of price achievement and fixed cost leverage. Due to better first quarter earnings and the April 1 '21 completion of the acquisition of Puronics, we're raising our full year 2021 revenue estimates to be in the range of $1.45 billion to $1.48 billion and full year 2021 earnings per share before restructuring expenses to be in the range of $2.80 to $3. We're raising our financial guidance, we have assumed there will be no worsening impacts from the global pandemic, and we will continue to offset raw material cost inflation with price. I will now turn the call back over to John.

John Haines, CFO

Thanks, Gregg. Our fully diluted earnings per share were a record for any first quarter in the company's history at $0.59 for the first quarter of 2021 versus $0.23 for the first quarter of 2020. First quarter EPS before the impact of restructuring expenses was also $0.59 compared to 2020 first quarter EPS before restructuring of $0.24. Restructuring expenses in the first quarter of 2021 were $0.2 million and were related to various manufacturing realignment activities in the water and distribution segments and had no impact on earnings per share in the first quarter of 2021. Restructuring expenses in the first quarter of 2020 were $0.9 million and were primarily related to various manufacturing realignment activities in the water segment and resulted in a $0.01 impact on earnings per share in the first quarter of 2020. First quarter 2021 sales were $333 million compared to 2020 first quarter sales of $266.8 million. The sales increase from acquisition-related sales was $23.5 million. Sales revenue decreased by $2.9 million or about 1% in the first quarter of 2021 due to foreign currency translation. Water Systems sales in the U.S. and Canada were up about 21% compared to the first quarter of 2020 due to volume, price, and acquisition-related sales. In the first quarter of 2021, sales from businesses acquired since the first quarter of 2020 were $7.2 million. Sales of groundwater pumping equipment increased by about 24%. Sales of surface pumping equipment increased by about 10% versus the first quarter of 2020 due to strong end market demand, in part due to lower sales last year due to the pandemic. These increases were offset by lower sales of dewatering equipment, which were down by about 8% due to lower sales in the rental channel. Water Systems sales in markets outside the U.S. and Canada increased by 20% overall. Foreign currency translation decreased sales by 6%. Outside the U.S. and Canada, water systems organic sales increased by 26%, driven by higher sales in all regions of the world, Latin America, Asia Pacific, Europe, Middle East, and Africa markets. Water Systems operating income was $31.3 million in the first quarter of 2021 compared to $18.8 million in the first quarter of 2020 driven by price realization, product sales mix, and cost management. Distribution sales were a record at $95.7 million in the first quarter of 2021 versus first quarter 2020 sales of $60.4 million. In the first quarter of 2021, sales from businesses acquired since the first quarter of 2020 were $16.3 million. The distribution segment organic sales increased 31% compared to the first quarter of 2020. Revenue growth was driven by broad-based demand in all regions and product categories, the Gicon acquisition, and some customer purchase pull forward in the Texas winter storm. The distribution segment operating income was a record for any first quarter at $2 million, compared to a loss of $2.2 million in the first quarter of 2020. Fueling System sales in the United States and Canada increased by about 1% compared to the first quarter of 2020. The increase was due to higher demand for pumping and fuel management systems. Outside the U.S. and Canada, Fueling Systems revenues increased by about 7%, driven by higher sales in Latin America and EMEA. Fueling Systems operating income was a record for any first quarter at $14.9 million compared to $12.1 million in the first quarter of 2020, driven by price realization and cost management. The company's consolidated gross profit was $115.5 million for the first quarter of 2021, an increase from the first quarter of 2020 gross profit of $90.3 million. The gross profit as a percentage of net sales was 34.7% in the first quarter of 2021 versus 33.9% in the first quarter of 2020 and improved by 80 basis points, primarily due to better price realization, product sales mix, and cost management. Selling, general, and administrative expenses were $81.6 million in the first quarter of 2021 compared to $75.6 million in the first quarter of 2020. SG&A expenses from acquired businesses were $4.9 million. Excluding acquisitions, SG&A expenses were higher by about 1%, primarily due to variable compensation expense, partially offset by foreign currency translation. The effective tax rate for the first quarter of 2021 was about 14% compared to 19% in the first quarter last year due to larger net favorable discrete events, which include tax benefits from share-based compensation and a deferred tax benefit from a tax selection made in a foreign jurisdiction. The tax rate as a percent of pretax earnings for the balance of 2021 is projected to be about 20% before discrete adjustments. As Gregg mentioned, the company is raising its guidance for full year earnings per share before restructuring expenses to $2.80 to $3, basically on the strength of the first quarter results and the recently announced water treatment acquisitions. We expect revenue in the $1.45 billion to $1.48 billion range, and our free cash flow conversion will be 115% or better for the full year 2021. Although end market demand for most of our products remains strong, ongoing impact from the pandemic, global raw material, and component availability and cost are key factors potentially impacting the balance of 2021 results. The company ended the first quarter of 2021 with a cash balance of $118.3 million and generated a record $5.4 million of net cash flows from operations during the first quarter of 2021 versus a negative $4.7 million in the first quarter of 2020. The increase was primarily due to higher net income and lower net working capital requirements. The company's total incremental borrowing capacity was about $645 million at the end of the first quarter 2021. Yesterday, the company announced a quarterly cash dividend of $0.175 that will be paid on May 20 to shareholders of record on May 6. The company purchased 14,000 shares for about $1.1 million of its common stock in the open market during the first quarter of 2021. At the end of the first quarter, the total remaining authorized shares that may be repurchased is about 919,000. This concludes our prepared remarks, and we'd now like to turn the call over for questions.

Operator, Operator

Our first question comes from Mike Halloran from Baird.

Michael Halloran, Analyst

So a handful of questions here. First, maybe you could just talk a little bit about underlying supply chain trends? How you're looking at pricing? And how you think price cost balances out for the remainder of the year?

Gregg Sengstack, CEO

Mike, it's Gregg. On the supply chain, it continues to be a challenge. We continue to have challenges around the globe, and the team is responding admirably through the challenges that are in front of us to keep the supply chain moving. We're seeing the same challenges in all the headline commodities and semiconductors, so I don't think there's anything new on that front. It continues to be a daily battle on that side. As for the cost, input, and price realization, I'll turn that over to John.

John Haines, CFO

Yes. So Mike, we saw very significant input raw material inflation in our manufacturing entities in the first quarter. I'll quantify that as twice as high on a percentage basis as any first quarter in the last five years. So we are going to respond to that with price actions. This is mostly in the Water Systems segment, although it will impact fueling as well. So we will respond to that with incremental price actions later this quarter in the U.S. and Europe, specifically. And then when we look at the inflation price on an output basis, that was all on an input basis. When you look at it on an output basis through cost of goods sold, because you know the input stuff gets hung up on the balance sheet for a period and then flows into the cost of goods sold. When you look at it on an output basis, we maintained the spread of price or inflation in the first quarter. However, that spread measured in basis points is lower than what it has been for the last four quarters and it was lower than what it was in the first quarter of 2020. So we knew this was coming at us. We took price actions late last year, earlier this year, in anticipation of that. We saw even more in the first quarter than we had expected in our annual operating plan, and we are now going to respond to that with additional price action. Our guidance assumes that we will continue to maintain this positive spread of price or inflation for the balance of the year despite the fact that it is narrowing in the first quarter.

Michael Halloran, Analyst

So that's helpful. And just to clarify maybe Gregg's comments. I know you mentioned that Headwater was seeing some product shortages. It felt like non-Franklin Electric water product shortages. Are you seeing any shortages of supply chain pressures that are impacting your ability to put content into the market in fueling or water or is that comment just limited to Headwater?

Gregg Sengstack, CEO

We're experiencing challenges across the manufacturing sector. My earlier comments were directed at the global issues we're facing with suppliers who may temporarily shut down due to COVID and part availability. We're expediting many products and components, and we're also managing the transportation of containers stuck off the port of LA. Essentially, the same issues you're reading about in the news are affecting us as well.

Michael Halloran, Analyst

So in guidance, from a top line perspective. Maybe you could just walk through what's embedded in it, are you assuming pretty normal sequentials from here an improvement, deceleration in any specific markets? Any markets where you think there was some pull forward in the short term? Or do you think that there's a lot of more backlog that still needs to be let out? Just some context on what the underlying thoughts are within the guidance.

John Haines, CFO

Yes. In our manufacturing operations, the backlog remains very robust. In fact, it is approximately twice as large at the end of the first quarter of 2021 compared to the same period last year. We anticipate strong organic growth in both the water and distribution segments going forward. However, we are cautious about expecting the same level of organic growth we experienced in the first quarter. We also announced an acquisition in water treatment on April 1, and this is included in our guidance. There are many opportunities and favorable conditions ahead, but the challenges mentioned by Gregg, along with the accompanying inflation, are making us take a moment to assess the situation further in the second quarter regarding manufacturing. In distribution, there's still significant underlying demand. While I don't expect the same 31% organic growth we saw in the first quarter to persist throughout the year, we do anticipate solid double-digit organic growth for distribution for the remainder of the year. Additionally, while the issues we face are not unique to our water segment, the supply challenges are beginning to impact them, and we will need to monitor how that affects their revenue. Nonetheless, Headwater and Gicon are both experiencing considerable momentum, and we expect strong performance from them for the rest of the year.

Gregg Sengstack, CEO

Mike, on the fueling side, we have observed a significant rebound. We only began to notice a slowdown outside of Asia Pacific due to the pandemic in the first quarter of last year. The results outside North America, excluding China, are strong. In China, our initiatives regarding organization diagnostics are still on hold, but we anticipate progress. In the U.S. market, growth has been flat. However, there is optimism about a rebound in station builds in the U.S. One constraint we face is the critical supply of resin for fiberglass tanks, which could delay the availability for deliveries. Although we haven't felt this impact yet, we are aware of limited availability of underground tanks moving forward, which could potentially lower revenue. Nevertheless, we maintain a strong outlook for the fueling business in the U.S.

Operator, Operator

Your next question comes from Walter Liptak from Seaport.

Walter Liptak, Analyst

I wanted to stick with the discussion about the distribution segment. And congratulations on getting the $2 million of profit. And you guys have made a lot of progress with it. But I wonder what does that imply for the full year profits that you've turned the corner in the first quarter with profitability? And then you've owned this business for a while. And I'm just wondering why first quarters tend to be losses, is it like an overhead absorption thing? Are there front-loaded costs for the year or something that runs through distribution?

Gregg Sengstack, CEO

We expect strong organic growth in Headwater for the full year, aiming for operating income margins of 4% to 6%. Historically, we haven't consistently hit those margins, but we're confident we will be in the middle of that range or better in 2021. Aside from some supply concerns regarding certain products, the business has significant momentum right now. Regarding the first quarter, it's mainly seasonal rather than driven by accounting issues. In the U.S., this is the lowest season because the ground is frozen, preventing access to necessary work sites. This seasonal impact has typically led to lower revenue, and as a result, we lose leverage on our fixed cost base. Fortunately, we experienced the opposite in the first quarter of 2021, which significantly contributed to our top line growth and the fixed cost leverage that enhances profitability.

Walter Liptak, Analyst

Okay. Great. Okay. All right. But for the full year, you're thinking in that range of 4% to 6% operating profit margins?

Gregg Sengstack, CEO

Yes, sir.

Walter Liptak, Analyst

I wanted to ask about the profitability in the Fueling Systems business. You mentioned the strong $14.9 million in profit due to mix. Could you elaborate on whether the profit from the mix or the cost management was more significant this quarter? Also, do you believe some of that profitability is sustainable for the remainder of the year?

Gregg Sengstack, CEO

Yes. Fueling Systems, as we mentioned before, have effectively managed their fixed cost base and SG&A expenses, which allows for greater flexibility compared to the water systems segment. They did a commendable job in 2020 of reducing those fixed costs, and even though it's gradually returning, we are committed to supporting the international growth we are experiencing. In the first quarter, we observed this trend continuing, with incremental margins being exceptionally strong. This is attributed to the business not needing to significantly increase fixed costs as their revenue grows. This is the key aspect of their success. Additionally, they successfully implemented pricing strategies, contributing to profitability across all our segments in the first quarter.

Operator, Operator

Your next question comes from Matt Summerville from D.A. Davidson.

Matt Summerville, Analyst

A couple of questions. First, I want to make sure I'm clear. What was the magnitude of uplift you saw maybe from the Texas weather situation as well as the buy ahead you referenced in the quarter?

Gregg Sengstack, CEO

Yes. We think both of those things, Matt, were in the $6 million range in total, $6 million to $7 million.

John Haines, CFO

About half and half, Matt, about half from Texas, about half of the buy ahead.

Matt Summerville, Analyst

Perfect. Can you explain what led to the buy ahead? Additionally, what is your overall assessment of channel inventories at this time?

Gregg Sengstack, CEO

When contractors need piping to install pumping systems, they will purchase pipe, especially when supply is tight. It's essential because without pipe, they cannot perform installations. While other products are also necessary, pipe becomes critical during events like the hurricane that occurred in Texas, leading to increased purchases. Currently, due to general supply constraints, I don't believe there is much channel inventory available. Our working capital in the distribution business at Headwater has actually declined over the past year. Therefore, what customers are purchasing is primarily being utilized, except potentially for some forward buys on pipe products.

Matt Summerville, Analyst

And then as a follow-up, with respect to North America groundwater in one of your comments, I think it was mentioned that it was up 24%. Can you attempt to parse out kind of what you're seeing in residential versus agricultural around that 24% number?

John Haines, CFO

Yes, the residential segment has increased even more than that, while agricultural products were up about 11%. In North America, when we focus on specific agricultural product categories, they showed an 11% increase. The growth in the residential product categories was even more pronounced.

Matt Summerville, Analyst

Got it. And then just maybe two other quick ones. You mentioned I think in the water business, you took about 300 basis points of price on a year-over-year basis in Q1. A question asked earlier on the call. In order to maintain the price cost equation you referenced, John, based on where spot prices are for things like steel, copper, resin, aluminum, etc., all things you use in fairly large quantities, how much additional price do you think you need to take in that business?

John Haines, CFO

Yes. It depends on the end market, Matt, but the big thing is this inflation exceeding expectation on an input basis in the first quarter. So I think it's in the 75 to 100 basis points range or something like that, that as we see the cycle layer start to flow through in the second and third quarters, they're going to have these higher input costs in them, and we need to have more price to offset that. So that would probably be my best estimate on the Water Systems side.

Matt Summerville, Analyst

Got it. Lastly, one of you mentioned that China is down 19%. This isn't necessarily surprising, but could you provide an update on the ISD initiative? Do you think it's a non-issue for 2021, or how should we approach that?

John Haines, CFO

Yes, Matt, this is challenging. We are observing some activity, but it's perhaps less than 10% of the market activity. The difficulty we've always encountered with China is its lack of transparency. Therefore, when it will join in and how quickly it will do so is unclear to us at this moment. The regulations and demands are present, but the timing and speed of implementation are not readily apparent right now.

Operator, Operator

Your next question comes from Chris McGinnis from Sidoti & Company.

Christopher McGinnis, Analyst

Nice quarter. I was just wondering if you could talk a little bit about the Puronics acquisition, how that adds to the business? And I think that's the third acquisition since November. Can you just talk about the landscape for M&A going forward as well?

John Haines, CFO

Sure, Chris. This is the third acquisition since we entered the water treatment sector over a year ago. We see a significant opportunity in this fragmented market, which aligns well with Franklin's business model since much of the product is distributed through professional contractors like water quality dealers and plumbing contractors, as well as through our strong position in the groundwater channel. We view this as a natural and growing area for us and have been gaining insights into the requirements and key factors necessary to serve the industry. Historically, Franklin has focused on acquiring smaller companies, integrating them to achieve operational efficiencies, and learning from these industries, which enables us to grow organically. This approach is similar to what we have done in distribution, where we combined several businesses to improve operating leverage and subsequently experienced organic growth. We believe that water treatment is a crucial and rapidly growing sector in North America, and given our reach beyond North America, we anticipate that demand for water treatment will also increase globally, and we'll explore opportunities in that area as well.

Christopher McGinnis, Analyst

Great. I appreciate that. And I guess just the landscape for additional M&A going forward, is a good market as things starting to rebound, see valuations start to pick back up, maybe just any color that you can add?

John Haines, CFO

Yes, I think the pipeline is quite strong. Sellers' expectations are elevated, historically higher than Franklin's typical transactions. As Gregg pointed out, the water treatment sector, which is a key focus for us, is highly fragmented, suggesting ongoing opportunities in that space. Every deal varies, but there is a real potential for us to find prospects there. The same applies to the distribution side. Although there are fewer ideal end properties available, we have identified some. We've completed several acquisitions and can afford to be selective. We believe we have a good grasp on property valuation, and there are opportunities out there, so we are continuing to explore those types of properties as well. Overall, the M&A climate seems positive at this time. We have a solid pipeline and are reviewing several options, and we anticipate this will continue. Last year, many sellers used changes in tax law as a sign for their actions, and if the U.S. tax situation shifts as expected, we might see an increase in people looking to transact before those changes take effect. This consideration is significant for the sellers we are engaging with.

Gregg Sengstack, CEO

Chris, one additional point is that over the last several years, I think, the last ten deals for Franklin have all been in the U.S. and Canada. And that's not for lack of interest or effort outside of the U.S. and Canada. But again, for the properties we're looking for, these are family-held businesses; it needs to be the timing for the family or an event. We continue to look at growing globally and have an appetite to do transactions outside the U.S. as well. We've done many of them in the past, and I think we've done pretty good at it. So we continue to look for deals across the globe. It's just that more opportunity for us in the last couple of years has been in the U.S. and Canada.

Operator, Operator

I'm showing no further questions at this time. I would now like to turn the conference back to Mr. Gregg Sengstack.

Gregg Sengstack, CEO

Thank you, Stacy. We appreciate you joining us today and look forward to speaking to you in July with our review of our second quarter results. You all have a good week.

Operator, Operator

Ladies and gentlemen, this concludes today's conference. Thank you for your participation, and have a wonderful day. You may all disconnect.