Earnings Call Transcript - FELE Q3 2023

Operator, Operator

Good day, and welcome to the Franklin Electric Reports Third Quarter 2023 Sales and Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to Vice President of Investor Relations, Sandy Statzer. Please go ahead.

Sandy Statzer, Vice President of Investor Relations

Thank you, Abigail, and welcome everyone to Franklin Electric's third quarter 2023 earnings conference call. With me today is Gregg Sengstack, our Chairperson and Chief Executive Officer; and Jeff Taylor, our Vice President and Chief Financial Officer. On today's call, Gregg will review our third quarter business highlights, then Jeff will provide an overview of our financial performance. We will then take questions. 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 will 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 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 Gregg.

Gregg Sengstack, Chairperson and CEO

Thank you, Sandy. The third quarter, which is seasonally one of our strongest periods, was a solid quarter, but more challenging than we had anticipated with the results reflecting additional commodity price pressure in our distribution business and further destocking impacting demand during the quarter. Our Fueling business was most impacted by destocking as well as by marketers delaying new station build projects. Conversely, with our product line breadth and geographic reach, our Water Systems business set third quarter records for sales and operating income, with continued strength in large dewatering systems more than offsetting product lines impacted by inventory rightsizing and destocking. While underlying demand in our core markets remains solid with higher interest rates and trading costs, customers are more sensitive to inventory levels. With improved lead times and delivery performance, we have higher confidence in the availability of products when they need them as well. As a result, just like us, they are reducing inventory levels. Despite these external factors, the team executed well and focused on delivering for our customers. Disciplined cost management allowed us to maintain healthy operating margins in our manufacturing businesses, while Distribution delivered a solid operating margin in a market challenged by the deflation of commodity products. We generated strong cash flow in the period and year-to-date. Our cash flow improved by approximately $190 million as compared to last year. We accelerated shipments and converted backlog during the quarter, decreasing inventory by $31 million and reducing our backlog by $44 million sequentially. I'm incredibly proud of the Franklin team for their commitment to driving operational excellence. A little more color on our segments. Water Systems delivered year-over-year revenue growth on top of a strong third quarter 2022, with sales increasing by 1% on a reported basis and 5% excluding the impact of foreign currency translation and operating income increasing by 16%, both third quarter records. This growth was driven by robust sales of our large dewatering pumps, principally in the U.S., and year-over-year growth in the Latin America and EMEA regions. Internationally, sales of our groundwater products were also strong; however, unfavorable foreign exchange along with unfavorable weather and destocking in the U.S. that I previously mentioned offset these strong results. We believe underlying end market demand for surface pumping and groundwater equipment remains healthy. We recently participated in the Annual WEFTEC Conference in Chicago, where customer feedback supported our belief in this healthy demand environment. Overall, Water Systems operating margin was strong and increased by 230 basis points over the prior-year quarter. These results reflect leverage from sales growth, gross margin expansion, and focused cost management. Fueling Systems' reported revenue and operating income decreased by 14% and 10%, respectively, compared to the prior-year period, lapping a tough year-over-year comparison of record revenue and operating income for any quarter in Franklin's history. Our Fueling results were driven by lower volume as inventory destocking continued in this market. Higher interest rates along with labor constraints caused delays in new station builds as well. Fueling Systems' third quarter operating margin was 33.2%, an increase of 150 basis points compared to the prior-year period, driven by continued demand for high-margin products, including critical asset monitoring, fuel management systems, and grid solution products along with disciplined cost management by the Fueling team globally. We expect that broader macroeconomic factors, including higher interest rates and availability of construction labor, will continue to weigh on the timing of new station builds into 2024. Nevertheless, we continue to focus on and invest in our relationships with our convenience marketers and providing them with innovative products and systems. We continue to invest in our Grid Solutions product line as well, where the underlying demand for our grid products remains robust. There's a well-documented stress on the electrical grid that's driving accelerated investment in our critical asset monitoring products. Distribution sales decreased by 2% from the prior-year period, driven by lower commodity pricing, primarily pipes, and continued wetter-than-expected weather delaying contractor installations across much of the United States. In addition, the industry is continuing to work through some destocking and channel inventory as supply chains improve. This segment has delivered an operating margin of 5.7%, which is 410 basis points below last year's record third quarter operating margin, which benefited from a strong 2022 inflationary environment. During the quarter, we also made key investments to expand on-site inventory for large contractors. We now have over 400 OSI containers deployed across the country, an integral part of our strategy to better serve our customers by making products available when and where our customers need them. As we look forward with our focus on products and systems that move and monitor water, fuel, and electricity, we're confident of the underlying demand in our core markets. We're also cognizant of the impact that increased interest rates are having on end markets we serve as well as a transitory impact of weather-related delays, and inventory normalization that we and others are experiencing, all of which spurred an inflection of demand during the quarter and continue to pose some headwinds. As a result, we are revising our full year 2023 guidance. We now expect 2023 full year sales to be in the range of $2.05 billion to $2.15 billion, and earnings per share to be in the range of $4.07 to $4.17. With that, I will now turn the call over to Jeff for the financial highlights.

Jeff Taylor, Vice President and CFO

Thanks, Gregg, and good morning, everyone. Overall, as Gregg said, it was a solid quarter for Franklin Electric, despite the challenging operating conditions. We established new quarterly records in the Water segment, while the results were below our expectations in the Fueling and Distribution segments. Third quarter 2023 consolidated sales were $538.4 million, a year-over-year decrease of 2%. Excluding the impact of foreign currency translation, sales were flat compared to last year. Our fully diluted earnings per share were $1.23 for the third quarter 2023 versus $1.24 for the third quarter 2022. Water Systems sales in the U.S. and Canada were down 1% compared to the third quarter 2022, primarily due to lower sales of groundwater equipment resulting from channel destocking and wet weather across much of the U.S., which was largely offset by higher sales of our large dewatering equipment. Water Systems sales in markets outside the U.S. and Canada were up 4%. Foreign currency translation decreased sales outside the U.S. and Canada by 11%. Sales increases in Latin America and the EMEA region more than offset lower sales in the Asia Pacific markets. Water Systems operating income was a record $52.7 million in the third quarter of 2023, up $7.2 million or 16% versus the third quarter of 2022. Operating income margin was 17.8%, up 230 basis points compared to last year. The increase in operating income was primarily due to the leverage from sales growth, gross margin expansion, and cost management. Distribution's third quarter sales were $189.2 million versus the third quarter 2022 sales of $193.2 million, a 2% decrease. The Distribution segment's operating income was $10.7 million for the third quarter, a year-over-year decrease of $8.3 million. Operating income margin was 5.7% of sales in the third quarter 2023 versus 9.8% in the prior year. The Distribution segment's income was negatively impacted by wetter weather, consistent with our prior comments, and margin compression from lower pricing on commodity-based products sold through the business. Fueling Systems sales were $77.7 million in the third quarter of 2023 versus third quarter 2022 sales of $90.2 million, a 14% decrease. As a reminder, the current year represents a tough comparison for the business as third quarter 2022 Fueling Systems' sales represented an all-time quarterly record. Fueling System sales in the U.S. and Canada decreased 14% compared to the third quarter 2022 due to lower demand from destocking and channel inventory, while supply availability and lead times improved. However, we experienced growth in our fuel pumping systems as well as our grid solutions business during the quarter. Outside the U.S. and Canada, Fueling System sales decreased 20% due primarily to the divestiture of the tank business in 2022 and lower sales in the Asia Pacific region. Fueling Systems operating income was $25.8 million in the third quarter of 2023 compared to $28.6 million in the third quarter of 2022. The third quarter 2023 operating income margin was 33.2% compared to 31.7% of net sales in the prior year. Operating income decreased primarily due to lower sales while the margin percentage increased due to a favorable product mix, gross margin expansion, and cost management. Franklin Electric's consolidated gross profit was $186.3 million for the third quarter 2023 down from last year's third quarter gross profit of $190.6 million. The gross profit as a percentage of net sales was 34.6% in the third quarter of 2023 versus 34.5% in the prior year. Selling, general, and administrative expenses, or SG&A, were $107.7 million in the third quarter of 2023 compared to $109.4 million in the third quarter of 2022. The decrease in SG&A expense was largely due to lower incentive-based compensation expenses and cost management in the quarter. SG&A cost as a percent of net sales was 20.0% in the third quarter of 2023 and in line with the prior-year quarter. Consolidated operating income was $78.1 million in the third quarter of 2023, down $1.9 million or 2% from $80.0 million in the third quarter of 2022, due to lower sales and an unfavorable foreign exchange translational headwind. The third quarter 2023 operating income margin was 14.5%, flat to the third quarter of 2022. The effective tax rate was 20% for the quarter compared to 18.5% in the prior-year quarter. We generated approximately $198 million of operating cash flow in the first nine months of 2023 compared to $7 million of operating cash flow in the first nine months of 2022, an improvement of $191 million. In 2021 and 2022, we invested in higher levels of working capital to support our growth. In 2023, working capital has returned to more normal levels, leading to improved cash flows. The company purchased approximately 56,000 shares of common stock in the open market for about $5 million during the third quarter of 2023. At the end of the third quarter 2023, the remaining share repurchase authorization is approximately 1.1 million shares. And yesterday, the company announced a quarterly cash dividend of $0.225 that will be paid on November 16 to shareholders of record as of November 2. This concludes our prepared remarks. We will now turn the call back over to Abigail for questions.

Operator, Operator

Thank you. At this time, we'll conduct the question-and-answer session. Our first question comes from Matt Summerville with D.A. Davidson. Your line is open.

Matt Summerville, Analyst

Thanks. A couple of questions. Just maybe first with respect to Water Systems' margins, 17.8%, that's the highest level you guys have delivered, I believe, in three years. I think the last time you were up in that zip code was the third quarter of 2020. Can you talk about the factors a little bit more that drove that kind of performance and how you think about sustainability net of normal seasonal factors that impact the business? And then I have a follow-up.

Jeff Taylor, Vice President and CFO

Yeah, good morning, Matt. Thanks for the question. Water Systems had, as you pointed out, really strong operating margins in the quarter, and they had record sales and record operating income. So that business certainly performed very well. And I think it's a diverse business and a global business, and we had strength in different parts of the business. But overall, we had strong top-line, very good cost management, and very good delivery of products during the quarter. We are seeing a little bit of an improvement on our gross margin line as commodity prices like copper and steel slowly retreat, and that's providing a little bit of flow through on the margin line as well, as well as just overall good mix in the business. I think the second part of your question was regarding seasonality?

Matt Summerville, Analyst

Yeah, just how we should think about the go-forward cadence and the sustainability? 2Q and 3Q are typically your stronger margin quarters. Is 17.8% kind of the new go-forward way to think about based on the commodity price environment where margins should be during the seasonally high period? And then, similarly, how should we think about an appropriate level in the seasonally lower period? And then, I have a follow-up.

Jeff Taylor, Vice President and CFO

Yeah. Matt, we typically guide Water Systems operating margins in the 15% to 17% range. And so, I think 17.8% was very strong. They had a really solid strong quarter. It's a record third quarter for them. Seasonally, the business does slowdown in the fourth quarter and the first quarter, and we expect to see that normal seasonality coming through. And typically, there will be a little bit of a margin impact as you get lower leverage on fixed costs and lower volumes during those couple of slower quarters for us. So, we would expect to see that happen. But I think normal operating margins are very strong right now, but in that 15% to 17% range on a go-forward basis.

Gregg Sengstack, Chairperson and CEO

Yeah. Matt, you may recall, when we think about that, that's of course on an annual basis, we are guiding for a 15% to 17% range. But you may recall back in the Halcyon days of '12 and '13, we had much more centric in groundwater that had margins above that. But we've done a lot also with our international operations and then also the cost structure of our large pumping systems to improve margins there by standardizing some of the production for high runners in our Wilburton, Oklahoma plant. So that's also aided us in structurally improving our margins, what you've noted over the last several years. So, we're not necessarily stating a specific target; we want to deliver and then talk about it. So, we certainly are directionally moving in the right way. But we want to make sure we can prove it out over a period of a couple of years rather than just talking about a one-time improvement. But clearly, we're at a different margin profile than we were a couple of years back.

Matt Summerville, Analyst

Got it. And then just maybe to flip over to the negative aspects impacting the business, you talk about destocking, you talk about project push-outs. Gregg, you've done this for a number of decades. So, drawing on your experience, how long do you think kind of the downcycle can persist as it pertains to the destocking sort of phenomenon as well as what you're seeing on the project side in both Water and Fueling? Thank you.

Gregg Sengstack, Chairperson and CEO

Yeah, Matt, with my experience, I tend to get smarter over time. I thought we were past this phase after Q2, but with the interest rates and lead times affecting both us and our customers, it seems we're back to pre-COVID conditions. People are reassessing their inventories and deciding they don't need to stock up, preferring to let manufacturers handle it. In our case, we are leaning on our suppliers and saying we'd rather have them manage the inventory upstream. I believe we might be navigating through this until the end of the year. Specifically for pipes, which comprise a significant part of our Distribution business, availability was extremely restricted during the pandemic, but now it's flooded the market, which might complicate things into year-end. However, I think the discipline of maintaining higher interest rates will benefit us as we enter 2024 compared to our competitors in Distribution. Regarding project timelines, we’re keeping close contact with key players in the Fueling business who have indicated that their build schedules, while typically on track, are being delayed. In conversations with contracting companies in late July or August, they expressed difficulties in finding labor for project execution, suggesting everything has slowed down a bit. I anticipate the Fueling business will gradually improve in 2024, making comparisons easier in the latter half of the year. Additionally, with our large pumping systems, we are increasingly exposed to rental customers like URIs and Sunbelts. We had setbacks in that area during the oil price drops in 2014 and 2015 and again around 2019 or 2020. However, we've diversified our customer base significantly and are gaining recognition from leading brands. While rental fleet customers might be catching up, which could contribute to this slowdown, we perceive underlying strength in the U.S. industrial economy and positive feedback from events like WEFTEC, indicating we can maneuver through these challenges. It may be slow in the upcoming quarters as we adapt to the new normal, but we feel well-prepared. In the groundwater sector, after experiencing a couple of very dry years—remember the record droughts in California—we then saw record rainfall, which is favorable in the long term but has impacted short-term demand. This year has been more typical, but we also faced weather-related challenges on the East Coast and Midwest in the third quarter, which affected demand. We've navigated through these cycles, and I believe we will come off a more normal year next year, leading to manageable comparisons. Moreover, we are noticing improvements in South America, although Europe may face difficulties during the winter and Asia has its own challenges. I expect to see advancements as we recover. That may have been a lengthy response, but I aimed to provide a thorough answer.

Matt Summerville, Analyst

Perfect. Appreciate it, Gregg. Thank you.

Gregg Sengstack, Chairperson and CEO

Sure, Matt.

Operator, Operator

Thank you. I'm showing no further questions at this time. I would like to turn the call back to Gregg Sengstack for closing remarks.

Gregg Sengstack, Chairperson and CEO

We appreciate you following the company and joining us today on our call. We look forward to speaking to you after the first year with our full year results. And everybody have a great week. Thank you for joining us.

Operator, Operator

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.