Earnings Call Transcript - FELE Q2 2023

Operator, Operator

Hello and thank you for standing by. Welcome to the Franklin Electric Reports Second 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. It is now my pleasure to introduce Vice President of Finance and Investor Relations, Sandy Statzer.

Sandy Statzer, Vice President of Finance and Investor Relations

Thank you, Andrew, and welcome, everyone, to Franklin Electric's Second Quarter 2023 Earnings Conference Call. With me today is Gregg Sengstack, our Chairperson and our Chief Executive Officer; and Jeff Taylor, our Vice President and Chief Financial Officer. On today's call, Gregg will review our second 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 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 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 Sengstack.

Gregg Sengstack, CEO

Thank you, Sandy. The Franklin team delivered another strong quarter of performance, which included record sales and earnings per share results for any quarter in Franklin's history. These record top line results were driven by our Water Systems and Distribution segments. Throughout the quarter, we saw solid demand continue across our core end markets and geographic regions, even as each business continued to face weather-related headwinds. Strong execution and disciplined expense management by our global teams enabled us to deliver solid margins in all of our businesses. This is especially notable in our Fueling Systems segment, which reported second quarter record operating income and year-over-year operating income growth on lower year-over-year sales. The second fiscal quarter is the start of the busy season for our core northern hemisphere markets, and when we typically build inventories to meet demand. However, as the performance of our supply base continues to improve, during the quarter, we focused on reducing inventories to more normalized levels. This operational focus and agility allowed us to accelerate shipments and convert backlog, sequentially decreasing inventory by $26 million, reducing our backlog to $186 million. As a result, our year-to-date cash flow improved by $105 million over the prior year. We still have some work ahead of us, but we continue to make progress on our commitments to improve our cash flow generation. Turning to our segments. Water Systems delivered record sales and operating income for any quarter in its history with revenues and operating income each increasing approximately 4% driven by robust sales of our large dewatering pumps and year-over-year growth in other surface pump products. Our groundwater business was solid despite being negatively impacted by wetter weather in the US and other regions than previous few years and our intentional reduction of intersegment sales. As our lead times are improving, we are reducing transfers to our Headwater Distribution segment to right-size their inventory of our products. We expect that other customers are rightsizing their inventories as well. We believe these weather and destocking headwinds to be transitory and we continue to see healthy end market demand across our business. For example, in our water treatment business, our direct sales to consumers this quarter were up about 10% sequentially as we're lapping the housing market slowdown that started last summer. Overall, Water Systems reported an operating margin of 16%, flat year-over-year as leverage from sales growth was offset by the mix impact from large dewatering pump volumes. Fueling Systems reported a revenue decrease of 7% compared to the prior year period, while delivering strong operating margins and record second quarter operating income. Half of the sales decrease was due to us exiting our tank manufacturing business located in the United Kingdom. Fueling Systems' record second quarter operating margin of 33.2% and an increase of 290 basis points compared to the prior year period was driven by robust demand for our higher-margin critical asset monitoring, fuel management systems and grid solution products. During the quarter, we experienced further supply chain improvements, though chip and certain component availability continues to be a challenge. While we understand that major convenience store market or customers are not reducing their planned build program, some programs have slowed such that it appears that several planned 2023 new-to-industry builds are now likely to be completed in early 2024. We expect that higher interest rates, weather and the availability of construction labor have all had an impact on the timing of these new builds. We believe we are gaining market share in fuel management systems and continue to build momentum with convenience store marketers. Further, the well-documented stress in the electrical grid is driving investment in our grid solution critical asset monitoring products. This investment appears to be accelerated. Distribution revenue increased 1% from the prior year period despite unfavorable weather impacting the start of contractor installations. Commodity pricing is continuing to decline and customer inventory is trending to more normalized levels. Operating income decreased about 24%, primarily driven by lower commodity prices. The segment delivered an operating margin of 9.2%, a historically strong margin of 300 basis points below last year's record operating margin, which was aided by last year's strong inflationary environment. More importantly, the operating margin increased sequentially by 590 basis points, reflecting a normal seasonal pickup in the second quarter. The team remains focused on executing our strategy to grow and leverage the foundation we built in the Distribution business over the last several years. Our balanced capital allocation strategy remains unchanged. We evaluate each opportunity on its economic and strategic merits and continue to return capital to shareholders through dividends and share repurchases, invest in our business and explore M&A opportunities. While we are mindful of the macroeconomic pressures that continue to persist and the transitory issues of weather and the impact of channel inventory rightsizing across all three of our reporting segments, we are optimistic about the underlying demand in our core markets. Our second quarter results keeps us on track with the full year 2023 guidance, which was raised last quarter. As a result, we are reaffirming our 2023 full year sales and EPS guidance range of $2.15 billion to $2.25 billion in revenue and $4.25 to $4.45 in earnings per share respectively. Before turning the call over to Jeff, I'd like to mention our 2023 sustainability report, which was just published in June and has expanded from previous years. This year's sustainability report provides an update on the progress we have made on several ESG initiatives as well as areas of focus for the next few years. I'm proud of the progress we have made in our ESG performance as reflected in this year's sustainability report, but as I said earlier, we have more work to do. With that, I will now turn the call over to Jeff for the financial highlights.

Jeff Taylor, CFO

Thanks, Gregg, and good morning, everyone. Overall, it was a record second quarter for Franklin Electric. We established new quarterly records for consolidated sales and earnings per share. Second quarter 2023 consolidated sales were a record $569.1 million, a year-over-year increase of 3% despite the 2% headwind due to foreign currency translation. Our fully diluted earnings per share were $1.27 for the second quarter 2023 versus $1.26 for the second quarter of 2022. Water Systems sales in the US and Canada were up 4% compared to the second quarter of 2022 due to price and volume. Foreign currency translation decreased Canadian sales by 1%. The sales growth in the US and Canada was led by sales of large dewatering equipment, which increased approximately 100%. Wet weather across most of the US in the first half of the year and some destocking in the US pro channel led to lower sales of groundwater pumping equipment. Water Systems sales in markets outside the US and Canada were up 3%. Foreign currency translation decreased sales outside the US and Canada by 10%. Sales increases in EMEA and Latin America more than offset slightly lower sales in the Asia Pacific markets. Water Systems' operating income was $50.8 million in the second quarter of 2023, up $1.8 million or 4% versus the second quarter of 2022. Operating income margin was 15.8%, flat compared to last year. The increase in operating income was primarily due to higher sales. Distribution's second quarter sales were a record $193.1 million versus second quarter 2022 sales of $191.1 million, a 1% increase. The Distribution segment's operating income was $17.8 million for the second quarter, a year-over-year decrease of $5.5 million. Operating income margin was 9.2% of sales in the second quarter of 2023 versus 12.2% in the prior year. The Distribution segment was negatively impacted by wetter weather consistent with our prior comments relating to Water Systems. Income was also negatively impacted by margin compression from lower pricing on commodity-based products sold through the business. Fueling Systems' sales were $80.4 million in 2023 versus second quarter 2022 sales of $86.0 million, a 7% decrease. Fueling Systems' sales in the US and Canada decreased 6% compared to the second quarter of 2022 due to lower demand from destocking and channel inventory as supply availability and lead times improved. We experienced growth in our fuel management systems and pumping systems as well as our grid solutions business. Outside the US and Canada, Fueling Systems' revenues decreased 8%, primarily due to the divestiture of the tank business in 2022 and lower sales in the Asia Pacific region. Fueling Systems' operating income was $26.7 million, a second quarter record, compared to $26.1 million in the second quarter of 2022. The second quarter 2023 operating income margin was 33.2% compared to 30.3% of net sales in the prior year. Operating income and margin increased primarily due to price realization, favorable product and geographic sales mix shift and disciplined expense management. Franklin Electric's consolidated gross profit was $188.5 million for the second quarter of 2023, down slightly from last year's second quarter gross profit of $189.3 million. The gross profit as a percentage of net sales was 33.1% in the second quarter 2023 versus 34.3% in the prior year. Gross profit margin was negatively impacted by weather and margin compression from unfavorable pricing of commodity-based products sold through the business. Selling, general and administrative or SG&A expense was $107.4 million in the second quarter of 2023 compared to $108.3 million in the second quarter of 2022. The decrease in SG&A expense was largely due to disciplined expense management, including lower spending in marketing and advertising in the quarter. SG&A cost as a percent of net sales decreased to 18.9% in the second quarter of 2023 from 19.7% in the second quarter of 2022. Consolidated operating income was $80.9 million in the second quarter of 2023, down $0.1 million or less than 1% from $81.0 million in the second quarter 2022 despite an unfavorable foreign exchange translational headwind of approximately $1 million. Second quarter 2023 operating income margin was 14.2% versus 14.7% of net sales in the second quarter of 2022. The decrease in operating income and operating margin was primarily due to the decrease in operating income from the Distribution segment. Other nonoperating expenses were higher in the second quarter of 2023 compared to the prior year. First, interest expense was higher due to higher interest rates. Next, foreign exchange losses were higher primarily due to the stronger US dollar and our operations outside the US, particularly in Turkey and Argentina. The effective tax rate was 19% for the quarter compared to 22% in the prior year quarter. We generated approximately $43 million of operating cash flow in the first half of 2023 compared to using or negative $62 million in operating cash flow in the first half 2022, an improvement of $105 million. In 2021 and 2022, we invested in higher levels of working capital to support our growth. In 2023, we expect working capital to continue to return to more normal levels, leading to improved cash flows. The company purchased approximately 9,000 shares of common stock in the open market for about $0.9 million during the second quarter of 2023. At the end of the second quarter of 2023, the remaining share repurchase authorization is approximately 1.1 million shares. Yesterday, the company announced a quarterly cash dividend of $0.225 that will be paid on August 17 to shareholders of record as of August 3. This concludes our prepared remarks. We'll now turn the call back over to Andrew for questions.

Operator, Operator

Thank you. Our first question comes from the line of Matt Summerville with D.A. Davidson.

Matt Summerville, Analyst

Thanks. A couple of questions. Can you maybe just put a finer point on what you saw from a destocking standpoint? When in the quarter it started? If you're still seeing a lingering impact into the third quarter? And maybe is there a way to quantify how much of an impact it had on Q2? So maybe just start there and then I have a follow-up.

Gregg Sengstack, CEO

Matt, this is Greg, and I believe Jeff will provide some additional insights. It's challenging for us to analyze the situation fully due to the years of dry weather we've experienced, along with the housing slowdown that began last summer. In terms of sales and groundwater, we have the clearest perspective in the United States. We noted that Headwater sales increased by 1%, and actual units saw a slightly higher increase, although the value of the commodities we sold, like pipe or wire, was lower in terms of dollars. This business is a useful indicator for us; despite the sales, we intentionally reduced our transfers into the business by about $10 million to decrease inventory. This represents around 40% of our sales from that channel, allowing for some extrapolation. This trend persisted throughout the quarter. I cannot provide finer details, but Jeff may offer a different perspective.

Jeff Taylor, CFO

I don't have an exact figure to quantify the amount of destocking. As Gregg mentioned, it's challenging to distinguish how much was due to weather versus how much was caused by destocking. What I can share is that we are observing improvements in the supply chain. Our delivery times to our customers have improved in the second quarter, and our delivery times from our suppliers have also improved. We believe others are experiencing similar trends, which is allowing them to normalize or adjust their inventory levels. This has definitely had an impact. Additionally, higher interest rates are influencing this situation, as people are becoming aware that the cost of holding inventory is greater today than it was a year ago. Consequently, we are also looking to reduce our inventory levels. We believe this trend is more pronounced in fueling than on the water side, as they have encountered some delays with new industry installations. However, it's difficult to distinguish the impact of weather compared to destocking. We think these effects are temporary and expect some impact to carry over into Q3, though it is still hard to quantify at this time.

Matt Summerville, Analyst

Got it. And then as a follow-up, can you talk about what price realization looks like on a year-over-year basis for Franklin Electric, and if there's a material difference in the businesses and one of the things I'm trying to get at is how much did lower commodity pass-through way on the Distribution segment. And then maybe, Jeff, if you can comment on what you expect free cash conversion to look like for Franklin in '23? Thank you guys.

Jeff Taylor, CFO

Certainly, Matt. Regarding pricing realization on a year-over-year basis, excluding the commodity aspect of Headwater, we are observing mid-single digit pricing overall, with water systems experiencing mid to high single digits currently. We anticipated that as the year progresses, price increases would occur less frequently and become more stable, returning to the normal pricing environment we have seen in the past. We expect these rates to continue contracting as we move forward and have lapped last year's price increases. On the Headwater side, non-commodity products such as pumps, motors, controls, and drives are achieving good price realization, consistent with the mid-single digit pricing in water systems. However, the commodity products are experiencing price decreases, contributing significantly to the margin compression seen in Headwater's business in the first half of the year. The Fueling business is witnessing low to mid-single digit pricing, and overall, there is a positive outlook on pricing at this time. For free cash flow conversion, our target remains at 100% based on our current outlook for the remainder of the year, and we expect to exceed that by a reasonable margin as we enter the latter half of the year, traditionally when we generate robust cash flow. In Q2, we reported strong free cash flow, both compared to the previous year and sequentially. Therefore, we anticipate a typical recovery with strong free cash flow generation in the latter part of the year.

Matt Summerville, Analyst

Understood. Thanks, guys.

Operator, Operator

Thank you. One moment please for our next question. And our next question comes from the line of Mike Halloran with Baird.

Michael Halloran, Analyst

Hey, good morning, everyone.

Gregg Sengstack, CEO

Hey, Mike.

Michael Halloran, Analyst

I have a couple of questions. First, I believe this relates to part of Matt's initial question. When I hear your comments about lead times normalizing alongside a destock in the quarter, it makes sense together. However, you're also mentioning a healthy backlog level in the current environment. Could you help clarify how these elements fit together? It seems contradictory at first glance, but I'm interested in understanding how they align beneath the surface.

Gregg Sengstack, CEO

Mike, there are several factors to consider. In the second quarter, as we enter the season, we're facing a tougher comparison to last year due to the weather. Additionally, our customers are using up their current stock. Meanwhile, our large pump business is progressing well as we are addressing our backlog, with a significant amount of it related to large pumps that will be delivered over the coming months. Some of these deliveries are even extending into 2024, providing us with good visibility, unlike our short-cycle business. As we approach Q3, which has traditionally been our largest revenue quarter, we are now seeing Q3 becoming slightly larger than Q2 due to our expanded distribution business. In California, there has been a lot of rain leading to increased use of surface water, but that's just one small market. We've also seen strong performance in Northern Latin America, Europe, Southern Africa, and Asia appears to be improving. While our short-cycle business indicates caution, our team is confident about the latter half of the year.

Michael Halloran, Analyst

That's helpful. Oh, go ahead. Sorry. Sorry, Jeff.

Jeff Taylor, CFO

No, I wanted to add that Gregg mentioned our large pumps, which have a longer order cycle compared to our short-cycle business. A significant portion of the backlog increase was due to our past dues, and we made considerable progress this quarter in addressing those past dues. While some of the decrease was related to large pumps, a substantial amount was also from the short-cycle business. We are very satisfied with how the backlog is developing in this environment, and as I mentioned, we are making great strides in reducing past dues, which are nearing what we consider a normal level for us. We are, once again, pleased with that.

Michael Halloran, Analyst

That makes sense, Jeff. Thanks for that. And then second question relates to something I think, Gregg, you touched on that briefly. Just how to think about what seasonality now looks like to your business? I understand the Headwater piece probably a little bit more sequential improvement. But obviously, you pointed out a bunch of things going on in 2Q from a destock perspective, weather perspective that maybe changes how that cadencing looks from 2Q to 3Q. So more on the water side cumulatively. But any help you can give to how you think that should play out as we look through the back half of the year, how it compares to normal seasonality any kind of context would be great.

Jeff Taylor, CFO

Yes. So obviously, the middle part of the year is generally the strong season for us in the Northern Hemisphere, it's the drilling season and the groundwater business. And so, those are going to be our strongest periods of time. Every year is a little different. And so you kind of take it year by year. I would say Gregg can confirm or correct me if I'm wrong, but I mean, typically, historically, maybe Q2 has been a little bit of a stronger quarter for us, but in the last couple of years, we've certainly seen that strength continue into Q3. And I think this year, in particular, with the wet weather that we saw in the first half of the year, I mean the US was really much wetter this year than the prior couple of years that we've seen in the first half of the year, and I think that's going to, hopefully, we see things dry up here, and I think we've started to see that already. And that will lead to some pickup in activity in the back half of the year. And then I would say the other thing that can impact that seasonality and it's a little early to be talking about fourth quarter and the end of the year. But certainly, how long the season goes into the fourth quarter. And so if winter weather kind of holds off and we have a long season, that obviously will play into the full year seasonality.

Michael Halloran, Analyst

Thanks, gentlemen. I appreciate it.

Jeff Taylor, CFO

Thank you.

Gregg Sengstack, CEO

Thank you, Mike.

Operator, Operator

Thank you. One moment please for our next question. And our next question comes from the line of Walt Liptak with Seaport Research.

Walter Liptak, Analyst

Hey, good morning, guys. You're answering the question, but I wanted to ask it in a different way. With the guidance maintained for 2023 and the weaker second quarter, what are your key assumptions for maintaining that guidance?

Jeff Taylor, CFO

Yes, Walt, I would say that our outlook really hasn't changed materially for the full year. Obviously, we're maintaining our full year guidance. And so from that perspective, really little to no change from the last quarter. I'll echo a couple of points that I made last quarter. I mean we are expecting to see more of a return to normal in 2023 versus what we saw in '21 and '22. We see inflation continuing to moderate. We see generally organic growth in kind of mid-single digits, certainly depending on our business and our region. And then obviously, if we get that kind of growth, we get good leverage on it flow through for our bottom line results as well. We expect supply chain is going to continue to improve. And our base demand has been very solid and very, very healthy. We have a high component of replacement demand in our core business, and that's generally very stable. And so that plays into our outlook and our view for the rest of the year. We continue to see FX translation continuing to be a headwind. It was about 2% in the second quarter. We would generally view it to be about 1% to 2%. We have started to see some areas where the dollar is stabilizing and starting maybe even to weaken versus a couple of currencies. On the macro level, we're not economists. We're not, I would say, predicting where the economy is going, but I don't think we see a recession built into our outlook. I think we see the economy continuing to kind of move along at the current level through the end of the year and into 2024.

Walter Liptak, Analyst

Okay. Great. And with the destocking issue and maybe the timing issue that you just spoke about in the previous question, is some of that related to the agricultural irrigation markets. And I wonder what kind of visibility you have into things firming up in the third quarter.

Jeff Taylor, CFO

Yes. In our business, the agricultural segment performed relatively well, showing a positive year-over-year change, although it was modest at low single-digit growth. We did not observe significant gains in the agricultural sector. However, we have seen stronger performance in the residential area, including both our core water business and water treatment. It's worth noting that water treatment tends to be more sensitive or exposed to the residential market compared to the core water business.

Walter Liptak, Analyst

Okay. Great. Okay. Thank you.

Gregg Sengstack, CEO

Thank you, Walt.

Operator, Operator

I would now like to hand the call back over to CEO, Gregg Sengstack, for any closing remarks.

Gregg Sengstack, CEO

Thank you for joining us this morning for our conference call. We look forward to speaking to you after the end of the Q3 with our results. Have a good week.

Operator, Operator

Ladies and gentlemen, this concludes today's conference call. Thank you for participating, and you may now disconnect.