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Edited Transcript of FELE earnings conference call or presentation 24-Jul-18 1:00pm GMT

Q2 2018 Franklin Electric Co Inc Earnings Call

BLUFFTON Sep 4, 2018 (Thomson StreetEvents) -- Edited Transcript of Franklin Electric Co Inc earnings conference call or presentation Tuesday, July 24, 2018 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Gregg C. Sengstack

Franklin Electric Co., Inc. - Chairman & CEO

* John J. Haines

Franklin Electric Co., Inc. - VP, CFO & Principal Accounting Officer

* Robert J. Stone

Franklin Electric Co., Inc. - Senior VP & President of International Water Systems

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Conference Call Participants

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* Edward James Marshall

Sidoti & Company, LLC - Research Analyst

* Matt J. Summerville

D.A. Davidson & Co., Research Division - Senior Analyst

* Michael Patrick Halloran

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* Ryan Michael Connors

Boenning and Scattergood, Inc., Research Division - MD & Senior Analyst of Water and Environment

* Walter Scott Liptak

Seaport Global Securities LLC, Research Division - MD & Senior Industrials Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Franklin Electric Reports Second Quarter 2018 Sales and Earning Conference Call. (Operator Instructions)

As a reminder, this call will be recorded. I would now like to introduce your host for today's conference, Mr. John Haines, Chief Financial Officer. You may begin.

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John J. Haines, Franklin Electric Co., Inc. - VP, CFO & Principal Accounting Officer [2]

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Thank you, Catherine. And welcome, everyone, to Franklin Electric's Second Quarter 2018 Earnings Conference Call.

With me today are Gregg Sengstack, our Chairman and Chief Executive Officer; and Robert Stone; our Senior Vice President and President of our International Water Systems unit.

On today's call, Gregg will review our second quarter business results, and I will review our second quarter financial results. When we're through, we'll 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 Chairman and CEO, Gregg Sengstack.

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Gregg C. Sengstack, Franklin Electric Co., Inc. - Chairman & CEO [3]

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Thank you, John. Overall, our second quarter results were strong. Our Water Systems units in the U.S. and Canada grew organically by about 12%, and our Fueling Systems organic revenue growth was 18%.

In Distribution, we continued to see revenue growth momentum, and overall results met our expectations for the quarter.

Our operating income grew by almost 20%, and our earnings per share before restructuring expenses and the nonoperational gain we realized in the second quarter last year grew by 12%.

Our second quarter results were, however, held back by considerable weakness in 2 key International Water Systems end markets, Asia-Pacific and Brazil, whose combined revenue declined over 20% versus the second quarter last year.

We estimate that this decline resulted in our second quarter earnings per share being about $0.07 lower than we had expected.

Despite the International Water market weakness, with the strength of our other businesses we're maintaining our full year earnings per share guidance.

In the U.S. and Canada Water Systems business, Pioneer-branded dewatering pump revenue was up 70% from last year, now in pace with the first quarter of 2018.

Groundwater pumping systems grew about 11%, with strong sales gains through our Headwater Distribution company and steady sales through the balance of our Distribution network.

Other surface pumping equipment revenue was flat. Outside the U.S., we again saw strong growth in Europe, the Middle East and Africa, which similar to Q1 grew organically at about 7%. But this growth was not enough to offset continued weak demand in Asia Pacific and Brazil.

In Asia Pacific, our sales in Korea declined due to an overall slowdown in the economic environment and strong first quarter sales. And in Thailand, sales were adversely impacted by declines in government funding from water-related projects and by weather.

In Brazil, the impact of a prolonged trucking strike in the second quarter significantly hurt our ability to deliver product to our customers.

Our Fueling Systems team delivered another record quarter. Revenue in the U.S. and Canada market was up 7%, as the team continues to gain traction with major marketers in the North America market.

Internationally, revenues were up over 40%. China continues to be the key growth engine as the country's mandated multiyear upgrade to the underground piping systems in retail gas stations is well underway.

As I mentioned last quarter, we expect this upgrade to add significant revenue and income to our Fueling business over the next several years.

Further, some provinces are choosing to extend their upgrades beyond piping systems to pumping and leak detection systems as well.

Outside of China, International revenue growth of our Fueling Systems business exceeded 10%.

Turning to our Distribution segment, Headwater. Second quarter revenue grew organically by 6%. The Headwater leadership team has nearly recovered all the lost revenue related to products purchased from former groundwater pumps suppliers.

Through the first 6 months of 2018, Headwater performance is on plan.

During the first week of July, we announced 2 acquisitions. The first acquisition was a product line of battery testing and monitoring equipment used in a variety of industries, including telecom, data center and electric utilities. This product line will be added to our grid solutions business, expanding our remote monitoring technology and capabilities. This product line has about $8 million in annual sales.

The second acquisition, Industrias Rotor Pump, positions Franklin as a leading pump company in Argentina. Franklin has been a supplier of rotor pump for more than 3 decades, and while Argentina has a volatile economy, there's a stable and growing pump industry supporting a large agricultural markets.

Industrias Rotor Pump has about $21 million of annual sales.

As we look forward to the back half of 2018, we remain encouraged by the momentum we have in our North America Water Systems end markets and the global performance of Fueling Systems. We expect our 2018 results for both business segments to be above our original expectations and offset the lower results in the water end markets of Asia Pacific and Brazil. And we believe announced pricing actions will offset estimated inflation and tariffs in the second half of 2018. Therefore, our earnings per share guidance range is unchanged at $2.27 to $2.37 per share for this year.

I will now turn the call over to John to discuss the numbers in more detail. John?

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John J. Haines, Franklin Electric Co., Inc. - VP, CFO & Principal Accounting Officer [4]

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Thanks, Gregg. Our fully diluted earnings per share were $0.64 for the second quarter of 2018 versus $0.64 for the second quarter of 2017.

Restructuring expenses were $0.6 million and have a $0.01 impact on the earnings per share in the second quarter of 2018.

Second quarter 2018 sales were $344 million compared to 2017 second quarter sales of $305.3 million, an increase of 13%. The sales increase was from acquired distribution entities as well as organic sales of about 9%.

Foreign currency translation did not have a material impact on consolidated sales in the second quarter.

Water Systems sales were $210.4 million in the second quarter 2018 versus the second quarter of 2017 sales of $198.3 million. Water Systems sales decreased about 1% in the quarter due to foreign currency translation.

Water Systems organic sales increased about 7% compared to the second quarter of 2017.

Water Systems operating income was $32.3 million in the second quarter of 2018 compared to $32.8 million in the second quarter of 2017. The decline in operating income was due to lower revenue in Asia Pacific and Brazil, higher raw material costs and product sales mix shifts.

Fueling Systems sales were $74.1 million in the second quarter 2018 versus the second quarter 2017 sales of $61 million. Fueling Systems sales increased by about 3% due to foreign currency translation.

Fueling Systems organic sales were up about 18% compared to the second quarter of 2017.

Fueling Systems operating income was $18.9 million in the second quarter of 2018 compared to $14.9 million in the second quarter of 2017. The increase in operating income is primarily related to higher sales.

Distribution sales were $79.5 million in the second quarter 2018 versus second quarter 2017 sales of $59.1 million.

Sales from businesses acquired since the second quarter of 2017 were $16.6 million.

The Distribution segment organic sales increased about 6% compared to the second quarter of 2017.

The Distribution segment operating income was $4 million in the second quarter of 2018 compared to $3.7 million in the second quarter of 2017. The increase in operating income is primarily related to the inclusion of more acquired entities, higher sales, partially offset by higher operating expenses.

The company's consolidated gross profit was $116.1 million for the second quarter of 2018, an increase from the second quarter of 2017 gross profit of $102.8 million.

The gross profit as a percentage of net sales was 33.7% in both the second quarters of 2018 and 2017. The gross profit increase was primarily due to higher sales.

In the second quarter, we believe achieved price actually -- basically offsets inflation. In the back half of the year, we expect there to be about 250 to 300 basis points of achieved price in part due to announced pricing actions and that this achieved price will offset assumed inflation, including tariffs.

Selling, general and administrative expenses were $75 million in the second quarter of 2018 compared to $68.2 million in the second quarter of the prior year. The increase in SG&A expenses from acquired businesses was $3.3 million.

Excluding the acquired entities, the company's SG&A expenses in the second quarter of 2018 were $71.7 million, an increase of about 5% from the second quarter of 2017, driven in part by an increase in research and development spending.

As a reminder, the company's second quarter 2017 earnings include a gain on the previously held equity investments in the 3 distribution entities acquired in the second quarter of 2017. This gain included in other income in the company's income system represented about $4.8 million of pretax earnings or about $0.06 of earnings per share last year.

Consistent with our previous guidance, the company believes the full year 2018 effective tax rate will be about 15% on pretax earnings.

In the second quarter, the effective tax rate was about 19%, primarily due to the lower tax rate in the U.S. The second quarter of 2017 tax rate was also about 19%, primarily due to discrete tax benefits realized in that quarter.

The company ended the second quarter of 2018 with a cash balance of $70 million, which was about $3 million higher than at the end of 2017. The cash balance increase is attributable to higher borrowings and cash generated from operations of about $5 million, an improvement of $17 million compared to the first half of the prior year when cash used in operations was about $12 million.

The company had $134 million in borrowing on its revolving debt facilities at the end of the second quarter of 2018 and $67 million in borrowing at year-end 2017. These borrowings were primarily to fund acquisitions and working capital needs.

The company purchased about 46,000 shares of its common stock for approximately $2 million in the open market during the second quarter of 2018. As of the end of the second quarter 2018, the total remaining authorized shares that may be repurchased is about $1.9 million.

Yesterday, the company announced a quarterly cash dividend of $0.12, consistent with the previous quarterly dividend amount. The dividend will be payable August 16 to shareholders of record on August 2.

This concludes our prepared remarks. And we'd now like to turn the call over for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from Mike Halloran with Baird.

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Michael Patrick Halloran, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [2]

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So let's just start on the guidance and just make sure I understand the puts and takes here. On the Brazil and China weakness, is the expectation that the run rate you saw in the second quarter that, that continues into the second half of the year at this point?

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John J. Haines, Franklin Electric Co., Inc. - VP, CFO & Principal Accounting Officer [3]

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No, Mike. First of all, it's Brazil and specific markets within Asia Pacific, one of which is China. Yes, it's Thailand and Korea. So no, our expectation is that we will not fully recover the miss in the second quarter. Having said that, we do think that there will be some recovery sequentially over the levels we saw. So for example, in Korea, part of the issue in Korea is that our customers there are very sensitive to the overall economic environment to the strength of the U.S. dollar. We had a very strong first quarter in Korea. So you tend to see in that market some ebb and flow, up and down a bit. We expect that we'll get some recovery in the back half in Korea. In Brazil, as you've read about and we mentioned here this morning, this trucker strike was very impactful in the quarter. There certainly will be some recovery from that trucking strike. We're not sure if we'll fully recover what we lost in the second quarter. But we kind of compared it a bit, Mike, to a major snowstorm when things kind of shut down for a while and then there's a period of recovery. The issue is we just didn't see that recovery in the second quarter. Now the other thing that's on our mind in Brazil, of course, is there's a presidential election coming there. There's still a highly unsettled political environment and economic environment there. And those are part of our caution for the second half of the year.

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Michael Patrick Halloran, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [4]

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No, that makes sense. On the positive side, the strength you're seeing in the other pieces. On the water side North America, certainly, it feels like broad-based strength through the portfolio there. Any change in the underlying trajectory there? Anything in the second quarter that you don't look at as sustainable? It doesn't feel that way but just want to understand the trend going into the third quarter, particularly relative to any pricing actions, if you're seeing any impact from that?

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Gregg C. Sengstack, Franklin Electric Co., Inc. - Chairman & CEO [5]

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Yes, Mike, we agree with your observation. We see the dewatering business continue to be strong on the back of just the strong economy, strong oil prices. Although we are systemically moving away from the well, we're seeing broad-based demand for dewatering pumps, which we think will continue through the end of 2018 and beyond. The water business -- the groundwater business, I'd say it's steady. The weather conditions have been kind of mixed. We've had -- wet in the Southeast. It's been moderate in other parts of the country. You've -- some recent articles about crop prices actually going down a little bit because of favorable weather conditions getting bigger crop yield. And we see kind of, again, in the South, mid-South and Texas has been dry, well documented. We're seeing some good demand for our larger pumps there. But then you go to California and the Valley, business is kind of okay. We're not as big in the Valley because there's more line-shaft turbine. We're growing that business with Headwater. But the California market, I'd say, has been maybe a little down. So the overall market in groundwater has been kind of flattish. But we don't see any reason that's going to deteriorate. We may actually see a little bit of acceleration in the back half. And I'd say the rest of our pumping business, as you pointed out, it's been pretty steady in North America. I'd also point out that in Europe and Middle East and Africa we again posted 7%, Robert. The team there continues to do well. And has -- it has been a pretty steady business. And that's actually been an environment, Robert, where it's been not the world's best kind of weather or climate backdrop.

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Michael Patrick Halloran, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [6]

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All right. Makes sense. And then last one from my side. Just could you comment on the price cost side, inflation capture with pricing actions and how you're thinking about that going into the back half?

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Gregg C. Sengstack, Franklin Electric Co., Inc. - Chairman & CEO [7]

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Yes, so we've taken pricing action across the North American business units and fueling unit. And John can give you some more detail about our approach and where we see that falling out. John?

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John J. Haines, Franklin Electric Co., Inc. - VP, CFO & Principal Accounting Officer [8]

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Yes, Mike. In the quarter -- in the second quarter, we think we were basically breakeven on price inflation, all in the neighborhood of 200 basis points. So we have some nice price achievement, sequential improvement in both Fueling and in Water Systems. But we're also starting to feel higher inflationary pressure. So in total in the quarter, we think that we basically achieved price to offset inflation. As we look at the back half of the year, we have even higher sequential inflation expectations. We also now have this new factor of tariffs on certain goods that we're bringing in from other countries. So those are bad items, of course, from an inflation perspective. And as Gregg points out, we have announced price in our Water Systems business. We have price in Pioneer, we have price in Fueling, all of which are going to be back -- the back half impactful. So our view right now is that we'll see price inflation somewhere in the 250 to 300 basis point range. There's the possibility we could achieve more price than inflation. But how much of this sticks, the mix of business, individual customer impacts, there's a 1,000 variables that will come into play here. But that's our view of it right now.

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Operator [9]

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And our next question comes from Edward Marshall with Sidoti & Co.

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Edward James Marshall, Sidoti & Company, LLC - Research Analyst [10]

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So I just wanted a follow-up on that pricing discussion. You talk -- typically you get 200 and 300 basis points a year, if I'm not mistaken. Are you saying there's an additional 250 to 300 basis points of pricing that you're going to get in the second half in addition to your typical pricing increases?

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John J. Haines, Franklin Electric Co., Inc. - VP, CFO & Principal Accounting Officer [11]

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Well, no. What we're saying is that when we analyze inflation, inflation factors, Ed, and we analyze our announced or already-in-effect price actions and those that'll come into effect in the second half and we boil all that down, what we're saying is that in the back half of the year we think inflation will be in the 250 to 300 basis point range over the prior year period. And we think that pricing will be in that same range. So we're -- our current expectation is we're basically going to be neutral on price inflation in the second half like we were in the first half. So what -- just for the first part of your question, we have not seen if you look over the last couple of years or 8 quarters or so necessarily reached enough to get into that full 200 basis points. We try to get price every year for sure. But that's obviously impacted by the competitive environment that we're selling our products in. So 200 is not about a -- a bad outcome from our perspective for the second quarter. But given the inflation, the tariffs that are coming in, it has to be better than that in the second half. And we think the actions that we have taken and or planned will get us that.

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Edward James Marshall, Sidoti & Company, LLC - Research Analyst [12]

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Got it. And looking at Headwater, looks they've had a pretty good quarter. You pointed out the acquired sales in the quarter. I'm wondering if you can talk about maybe the profit contribution from Valley Farms. If you're not willing to give a direct number, could you talk about maybe was it at the average, below the average or above the average?

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John J. Haines, Franklin Electric Co., Inc. - VP, CFO & Principal Accounting Officer [13]

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Yes, we prefer not to talk about those individual entities profitability, Ed. But we can tell you that Valley Farms is above the average. Valley Farms is a strong market player in the markets that they compete in. They have large branches, so Valley Farms is generally above the average.

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Edward James Marshall, Sidoti & Company, LLC - Research Analyst [14]

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Got it. And then, I can't help but notice the acquisitions that you've most recently made, the 2 that was announced, fueling and 1 in water, weren't distribution. I just want to kind of check in with you, make sure that there's not a change in your strategy that you anticipate continuing to build out the Headwater segment that you put in place. And any comments you'd like to put around that as well.

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Gregg C. Sengstack, Franklin Electric Co., Inc. - Chairman & CEO [15]

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Sure. These 2 acquisitions are absolutely consistent with Franklin's global strategy of geographic expansion and product line extensions. And the geographic expansion, us getting a further position in Argentina we saw as key. We've been talking to the owners of this company -- I joined Franklin 30 years ago. We were doing business with them. At one point, they're going to have an event -- a family event. It was not clear of succession. We see this as just a natural extension of both the distribution reach and then the ability also to enter a market as a manufacturer, which Industrias Rotor Pump does both. So we see that as just a natural extension to our Latin American strategy and our global strategy around geographic expansion. With respect to the Midtronics product line acquisition, back to almost now 20 years ago, we acquired a company called INCON in the state of Maine. That was the platform for our EVO fuel management system. The people that started INCON actually started in the electric utility space with a product that monitored the transformer load tap changer and also circuit breakers. We took that technology -- they took that technology into the fueling space. We've added to that. We've developed that platform. We've used that platform, the electronic platform, back in the utility space with circuit breaker monitoring. And so we see this kind of back and forth in these highly regulated spaces the ability to have monitoring equipment. And we're learning from this, and we think that there'll be some natural extensions into our water space as well. So they both clearly fit our overall company strategy. We're not abandoning by any means our strategy of increasing our distribution footprint in the U.S. groundwater market, where we have a significant position, and we've a significant commitment to the overall industry.

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Operator [16]

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Our next question comes from Ryan Connors with Boeing and Scattergood.

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Ryan Michael Connors, Boenning and Scattergood, Inc., Research Division - MD & Senior Analyst of Water and Environment [17]

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Guys, I wanted to just -- since you're on the topic of distribution, stick on that for a second as it relates to -- where -- can you just update us on where we are on with the core business, the initial acquired entities in terms of -- obviously, we had some probability pressures early or the latter part of last year that pressured the stock. And where are we in terms of that stabilization process with the line cards and the personnel? And are we kind of where we need to be? Everything's steady as she goes now? Or are there still -- are we still kind of in a mode of getting things where they need to be?

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Gregg C. Sengstack, Franklin Electric Co., Inc. - Chairman & CEO [18]

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Sure, Ryan. I'll answer that as a series of follow-ons to your question. So to start off, let's go back a year ago. We announced the acquisition of these 3 entities, and we're beginning to integrate them as a Headwater company. There was an election by 3 large pump suppliers, groundwater pumps suppliers to no longer support Headwater. That all started to impact principally third quarter, then more dramatically, as you pointed out, fourth quarter revenues as we needed to replace that line card, as you pointed out. We have 9 additional pump companies that have been added to the line card to replace the product lines. They're those companies that left us had, including Franklin as one of those, to the line card. Franklin is really just a piece of it. There were other pump suppliers that stepped up to support Headwater. We then came into the first part of this year and got our feet underneath us and began to drive sales growth. As we mentioned, in this quarter we had organic growth. Some of that has been consciously by increasing the sale of complementary products. You may recall that pumps are about 30% of what these distributors sell. They sell a number of other items, accessories, drop pipe, wire, driller mud, drill bits and so on. So there's been a conscious effort to increase the sale of these other product lines as well. We have slowed down the integration. We're moving on to the one ERP solution. That ERP solution we initially thought was going to occur in the back half of last year. We had the -- we realized that we were more on the bleeding edge than leading edge on this new cloud solution from a well-established software company. We have work with them, and now we have worked out almost all of the changes -- we believe all the changes. So we are expecting to do that further integration the back half of this year. That's going to allow us to get better scale and visibility and operate the company more efficiently, particularly in the supply chain area. So we see that as a net positive as well. So we're actually now looking at some challenges of space constraints. Some of our branches just physically aren't large enough to support what we see as being a growing business. And so, we'll be looking at opportunities to expand our footprint on a go-forward basis, particularly in the West. It is kind -- it's kind West of the Rockies. So we are -- where we want to be on running the business, the back office is about 6 months -- actually maybe 12 months late on getting everything on one platform. And from a standpoint of growth, we posted pretty good numbers in Q2.

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Ryan Michael Connors, Boenning and Scattergood, Inc., Research Division - MD & Senior Analyst of Water and Environment [19]

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Okay, so it sounds like if I can just kind of summarize that, that there was some predictable kind of headaches in integration and getting this thing on the ground. But it sounds like now you feel like where you want to be. And now we're into kind of a growth mode going forward. Is that kind of the right way to think about it?

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Gregg C. Sengstack, Franklin Electric Co., Inc. - Chairman & CEO [20]

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That's a nice summary.

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Ryan Michael Connors, Boenning and Scattergood, Inc., Research Division - MD & Senior Analyst of Water and Environment [21]

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Okay. And then, yes, so the one -- you covered this APAC thing pretty well. But there was one comment you made in your prepared remarks and in your press release that I didn't hear you expand on it. And it was that you're starting the strong 1Q sales, so implying some kind of a pull forward in 1Q that it negatively impacted 2Q. Can you kind of expand on that? I mean is that some kind of channel thing? Or is that a pricing buy ahead? Or what's going on with that?

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John J. Haines, Franklin Electric Co., Inc. - VP, CFO & Principal Accounting Officer [22]

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This is specific to the Korea market, the Korean end market, which had some nuances, and Robert is going to give you some more background.

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Robert J. Stone, Franklin Electric Co., Inc. - Senior VP & President of International Water Systems [23]

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Ryan, yes, so as John mentioned earlier as well, the Korean market -- Korean's are very sensitive to U.S. dollar currency moves. And they will bet a little bit in terms of where the currency is going, and we had some strong demand in Q1. We also -- that was partly driven by a new product we offered there, which was a small, highly reliable variable frequency drive for constant pressure systems. We had lost some share there. That product took off really well for us. In fact, we actually sold out there, and that's how we drove some of our Q1 success. And Q2, again, we get to sort of an accordion effect with inventory there, fairly long supply chain to deliver to Korea. And they have held off on some purchases. They've told us and we know too that we weren't able to get some shipments out right at the end of the quarter. So that's going to come back in Q3.

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Ryan Michael Connors, Boenning and Scattergood, Inc., Research Division - MD & Senior Analyst of Water and Environment [24]

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Got it. That's helpful. And then my last one, more of a housekeeping, I guess, since John is the only one we haven't talked to. Just on the tax rate, it seems like it came in a little higher than at least we had been expecting, John. Can you give us an update on how we should be -- what kind of number should we be thinking about there in terms of the tax rate going forward?

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John J. Haines, Franklin Electric Co., Inc. - VP, CFO & Principal Accounting Officer [25]

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Yes, Ryan, we had in the first quarter, you'll recall, some very significant discrete items in our tax rate that drove it actually favorable in the first quarter. So what we're saying is on a full year basis it'll be 15%. But what, of course, that means is in the back half of the year it's going to be more in the high teens, low 20s kind of range, which is where it was in the second quarter. So the exchange that we're seeing here is that although we have a favorable rate in the United States because of the new tax law we're losing discrete tax benefits, it's not because of that law just because there are fewer tax -- discrete tax benefits to take globally. So you see a tendency and offset of that. And that's why in the second quarter we had kind of a 19% tax rate in both years. But the way we got to that was very different. This year it was about the new tax law in the United States and the statutory rates being lower. Last year, it was about some discrete tax benefits that we realized in the second quarter that drove that rate down. So 15% for the full year, and what you'll see is something closer to 20% for the back half of the year.

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Operator [26]

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And our next question comes from Matt Summerville with D.A. Davidson.

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Matt J. Summerville, D.A. Davidson & Co., Research Division - Senior Analyst [27]

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A couple of questions. Maybe, Gregg, what's your assessment in terms of channel inventories in the Groundwater business in North America? I believe coming out of Q1 you'd indicated your own inventories were running a bit high. If you just look at the balance sheet, it looks like you maybe have been able to reduce some excess there. But maybe talk about what the game plan is for inventories for the remainder of the year?

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Gregg C. Sengstack, Franklin Electric Co., Inc. - Chairman & CEO [28]

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Sure, Matt. Two separate points here. One is that within the channel we would say inventory levels are normal. We don't have any reason to believe that they're exceptionally high or low. I don't think that the tariffs, which would increase -- which the specific product tariffs which would impact the consumer channel have really had a meaningful impact on buy ahead in Q2 to our knowledge. So I'd say inventory generally in the channel looks to be normal, and that would include the groundwater channel where we have some visibility with our own distribution company. With our own business, the manufacturing business, we are moving forward with some intentional, thoughtful management of our supply chain to squeeze out inventory within the supply chain now that things have been settling down, particularly the North America market with respect to having forward integrated distribution. So I think you're going to see more systemic decrease in inventory without impact to service levels within Franklin.

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Matt J. Summerville, D.A. Davidson & Co., Research Division - Senior Analyst [29]

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With respect to agriculture, and this is primarily obviously a North American comment. With recognizing -- I recognized that a big piece of this is nondiscretionary in nature in terms of purchases. But those that are discretionary, is there any concern on your part that trade and tariff issues, i.e, perhaps maybe a lot less soybeans and other crops being exported, crop price falling, all that stuff, are you worried that the discretionary side of ag really gets hit here in the back half of the year?

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Gregg C. Sengstack, Franklin Electric Co., Inc. - Chairman & CEO [30]

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Matt, to your point, we have a much bigger nondiscretionary piece of our business replacement than, say, maybe -- the guys I use as an example would be the pivot guys. It's one thing to [elect] and defer to expand your irrigation, it's another to stop irrigating that what you already have. We don't -- we have not had a major discussion internally about the impact of trade tariffs depressing prices and then having farmers elect not to replant for next year. And for this year, again, the weather patterns have been kind of normal, neutral. So they've been wet Southeast, kind of favorable in parts of the country. It's been dry in the Texas Panhandle area. That's been good for us. But other parts of the country from the residential side of it, we see as being kind of relatively flattish demand. So the short answer to your question is, we're not seeing it that way. But we think weather probably has as much or more of an influence than say the tariffs would have.

I think the tariffs would probably be more longer, longer term. I don't know that you necessarily, Matt, would see tariff impact on a short-term basis. It's going to take a while for markets to react and supply chains to react, and it might be a little bit longer term.

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Matt J. Summerville, D.A. Davidson & Co., Research Division - Senior Analyst [31]

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That makes sense. And then I just -- with respect to, I mean, the fueling business in North America, I don't have it in front of me how many quarters you've been posting well above kind of mid-single digit or better organic sales growth, but it's been sustained for quite a while here. Can you talk about how much of that is being driven by, I'm going to call it, a cycle in North America versus how much is being driven by market share and/or pricing?

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John J. Haines, Franklin Electric Co., Inc. - VP, CFO & Principal Accounting Officer [32]

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Okay, well, in the Fueling channel, there's really no kind of market share data readily available. It's -- we have to build it through anecdotal. I would say this, you go back in the late 1990s, there was a massive upgrade of all the underground tanks in the U.S. market. That is now 20-years old. Those stations are now effectively 20 years since they've been refreshed, so maybe they've done some refreshing in between. I think we're generally seeing a secular upgrade of equipment. You're seeing consolidation. Major marketers are buying up more of the single-store operators or single-operator stores and upgrading as they're expanding their footprints generally in these minimarket bases, adding a lot of features that are drawing people into the stores. And they're looking to upgrade their forecourts. So that's generally good for us. There are new regulations on the books that station owners have to do more tightness around their -- the containment sumps and more inspections. And we suspect those inspections are going to identify more leaks which we're going to have to be repaired, and that's going to be kind of a multiyear initiative. EMV, which has been pushed out, has probably actually delayed some construction. So that's -- and that would also delay some of our upgrades as well. And getting back to market share, I mean, we're -- we have a state-of-the-art fuel management system. We -- there is -- we are not the market leader in size, but we are working hard to become the market leader. And so there we are clearly seeing some share wins with some significant marketers. And that's been pretty steady over the last several years, and that's why I think you're seeing the strong growth as well. And that -- with that, we can pull along other product lines. So we see actually kind of a secular trend. We see some additional regulatory trends, and we see that we are doing well, with our new technology getting some market share as well.

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Matt J. Summerville, D.A. Davidson & Co., Research Division - Senior Analyst [33]

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And then I might as well throw one last one in there just maybe for Robert. In terms of Brazil, if we just remove the noise from the trucker strike to the extent that's possible, what is your feeling around how the underlying business is performing, not only just from an end-market demand standpoint but your own market share? And I guess, politically, economically, when does that business in your mind start to turn the corner meaningfully? Is that a 2019, 2020 sort of thing? Or do we see some of that in the back half of '18?

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Robert J. Stone, Franklin Electric Co., Inc. - Senior VP & President of International Water Systems [34]

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Back half of '18 is really going to depend on what happens with the election. And I think given the timing of the election in October, there's not going to be a lot of impact in 2018. So we'd be really looking at 2019. We've -- over the past several years, we've been gaining share in the markets. What we're seeing now is just a depression in the overall demand, partly driven by -- mainly driven by political uncertainty in Brazil at this time. The weather hadn't really been a factor. We're at a seasonably slow period in the Southern Hemisphere. That should start to turn around next quarter. Yes. And we've been expanding our products and our reach as well in Brazil. So the business -- the underlying business we've been growing. We've just been hammered by horrible economic conditions. You would expect that the Brazilian economy generally would also start to pick up with an increase in commodity prices, but that hasn't really translated to any additional spending in the economy.

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Operator [35]

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And our next question comes from Walter Liptak with Seaport Global.

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Walter Scott Liptak, Seaport Global Securities LLC, Research Division - MD & Senior Industrials Analyst [36]

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Wanted to do a follow-up on the last one about Fueling Systems in North America. And my understanding is this is a project-based business. So I wonder if you can just address the visibility that you're seeing on North America -- I guess U.S. projects, especially with the regulations coming up this fall. And is this high single-digit revenue growth? It sounds like you're saying that that's sustainable. But I wonder if it's -- if it could accelerate from here, the projects that are building.

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Gregg C. Sengstack, Franklin Electric Co., Inc. - Chairman & CEO [37]

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Walter, a fair question. We have some visibility because as we talk to major marketers they will share with us to some level of detail their build schedules. And that's why we remain bullish on the business -- the fueling business globally, in China and North America more specifically, is that we do see good build schedules by major marketers who use our products. The regulation you're talking about impacting this fall, I think that as you've seen -- similar to what we've seen in the past is that there actually tends to be a carryover. And so we think this is going to be kind of more of a several year situation where people are going to be continuing to test products on a more regular basis, spill buckets and tank sumps and the like, and have different solutions for monitoring. And that generally will be good for us on a longer-term basis. But it's difficult for us to get into specific numbers about is it going to accelerate from here, de-accelerate. As I said, EMV is a factor. The fact that it was pushed out may have maybe actually slow things down. So that would be a potential positive for us as well. But right now, the team is feeling very good about the North American -- particularly the U.S. market.

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Walter Scott Liptak, Seaport Global Securities LLC, Research Division - MD & Senior Industrials Analyst [38]

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Okay, all right. Great. And with fueling systems in China, I wanted to ask about the channel there. And maybe if you can help us understand how these systems are put in places, the inventory that goes in and then the work goes into a project? Or is this something where it's project based, so you've got visibility going out? And I guess, the concern here is that somehow tariffs might impact the demand or maybe there was kind of a pull forward in front of tariffs.

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Gregg C. Sengstack, Franklin Electric Co., Inc. - Chairman & CEO [39]

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Sure, Walter. It's a fair question or a fair series of questions. So what's going on is that -- in China is that based on the national mandate and regulations that are on the books the individual provinces are beginning to put in these upgraded systems. For Franklin Electric, most of our production for these systems is in China. So it's not based or reliant on our U.S. production. Therefore, we're not -- if there's this quid pro quo or tit-for-tat-type tariff activity, that should not impact materially the business in China. The other production we're using to support China is coming out of Europe. So we feel pretty good on that front. The speed at which these conversions occur are really driven by the provinces of the state-owned oil companies as well as the private sector oil companies. And again, we have visibility to some extent, but my experience in China has been things turn on pretty quickly, and you get -- you don't get a whole lot of warning. And it -- we also see where it tends to be back half calendar year loaded. And so we saw this acceleration in the Q4 of 2017, which gave us confidence about the 2018 numbers. But they have continued to come in a little stronger than our plan, and we see that carrying into '19 and beyond because there are literally tens of thousands of gas stations that need to be upgraded across the entire country.

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Walter Scott Liptak, Seaport Global Securities LLC, Research Division - MD & Senior Industrials Analyst [40]

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Okay, all right, sounds good. And then a last one. I didn't see a foreign currency impact overall on top line. And with the strengthening dollar, I wonder if the benefit that you've been getting starts to turn negative, and how does that impact profitability?

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Gregg C. Sengstack, Franklin Electric Co., Inc. - Chairman & CEO [41]

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Yes, on the Water Systems and Fueling Systems on a consolidated basis, Walter, it was basically negative. It was less than 1% in the quarter. However, when you look at it on a segment basis, in Water Systems foreign currency was negative in the quarter about 1%. And in Fueling Systems, it was positive, i.e., additive, to the top line in the quarter. So as we look out, we can't predict these obviously. But the ones that are proving to be very volatile are the riyals; the Turkish lira has lost a significant amount of value versus the dollar. But the euro is kind of hanging in there and may strengthening a bit. So those are the key currencies that we look at. But on a year-to-date basis, it hasn't really been a factor, and we'll see what happens in the second half.

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John J. Haines, Franklin Electric Co., Inc. - VP, CFO & Principal Accounting Officer [42]

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Walter, I'd like to add to that is that when you look at a couple of these high -- or these currencies that have move significantly, for example, in Turkey, our Turkish business there also exports. And they pretty much -- and when they export, they price in dollars. And within Turkey, they manage their pricing very effectively because much of their input cost is in euros and dollars, so they're able to manage their margins by adjusting pricing rather rapidly. A similar situation to -- in -- for example, in Mexico and in Argentina, which is considered to be a hyperinflation country, essentially the price -- stock price in dollars at the time. And then we have to be either collecting in cash or being very aggressive on the receivable side so that we don't see a deterioration in the margin because of the depreciation of the currency. So in these currencies that we've seen some significant weakness, we generally are able to take some pricing actions to manage -- again, manage the margins overall and the business overall.

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Operator [43]

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I'm showing no further questions at this time. I'd like to turn the call back over to Mr. Gregg Sengstack for any closing remarks.

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Gregg C. Sengstack, Franklin Electric Co., Inc. - Chairman & CEO [44]

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Again, we thank you for listening to us and asking your questions on this conference call. We look forward to speaking to you after the quarter 3 end.

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Operator [45]

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