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Edited Transcript of FELE earnings conference call or presentation 29-Oct-19 1:00pm GMT

Q3 2019 Franklin Electric Co Inc Earnings Call

BLUFFTON Nov 1, 2019 (Thomson StreetEvents) -- Edited Transcript of Franklin Electric Co Inc earnings conference call or presentation Tuesday, October 29, 2019 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, President & CEO

* John J. Haines

Franklin Electric Co., Inc. - VP & CFO

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Conference Call Participants

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* Edward James Marshall

Sidoti & Company, LLC - Senior Equity Research Analyst

* 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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Ladies and gentlemen, thank you for standing by, and welcome to the Franklin Electric Third Quarter 2019 Earnings Call. (Operator Instructions) Please be advised that today's conference is being recorded. (Operator Instructions)

I would now like to hand the conference over to your speaker today, John Haines, Chief Financial Officer. Thank you. Please go ahead, sir.

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

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Thank you, Ashley, and welcome, everyone, to Franklin Electric's third quarter 2019 earnings conference call. With me today is Gregg Sengstack, our Chairman and CEO. On today's call, Gregg will review our third quarter business results, and I will review our third quarter financial results. When I'm 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 risk 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, President & CEO [3]

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Thank you, John. Our third quarter earnings were a record for any third quarter in the company's history. Our earnings per share grew 14% from the third quarter of 2018. Our improvement in earnings was led by our Distribution segment, which grew operating income by over 70% as a result of more favorable weather conditions in much of the United States and acquisitions.

Our free cash flow after capital expenditures is about 65% higher through the first 3 quarters of this year versus the same period of 2018. Despite these earnings and cash generation improvements, organic sales growth was below expectations in our Water and Fueling Systems businesses.

In the U.S. and Canada Water Systems business, groundwater pump sales were up about 1%. Sales of groundwater equipment through the professional distribution channel were up 7% overall due to increases in transfers to the Headwater segment and down 3% to third-party distributors. Large dewatering pump sales were up 2% due to continued strength in rental equipment end markets. Backlog in this product line is down from the second quarter, primarily due to expanding manufacturing capacity. Sales of other categories of service pumps were down mid-single digits coming off a strong second quarter.

Moving outside the U.S., our Water Systems business grew organically mid-single digits in Latin America and EMEA. In Latin America, sales were flat in Mexico, and up in Brazil and increased more significantly in the Southern Cone. While Europe continues to be slow, our business in the Near and Middle East as well as Africa improved meaningfully. You may recall that last year, the Turkish lira devalued significantly, impacting our business there.

Our Fueling Systems business delivered another record quarter. Sales were up again, up double digits in the U.S. and Canada. This was offset by an approximate 20% year-over-year decline in business in China.

In the rest of the world, we saw declines in EMEA, Latin America and Australia, offset by growth in India and Southeast Asia.

Turning to Distribution. With a more normalized weather pattern in the U.S. and stronger execution from our new branch structure in the West, the water team delivered organic growth of 2% and with earnings from the acquisitions early this year, record results for the quarter. That brings me to our outlook for the fourth quarter. I will start with Distribution.

As expected, the business improved in Q3 and we expect the fourth quarter to see a similar improvement over last year as well. We expect modest growth in our U.S. groundwater and surface pump lines being offset by a tough comparison to last year for a large dewatering pump line.

Outside the U.S., we expect modest organic growth somewhat offset by currency translation. Our U.S. fueling business should continue to deliver strong growth. And while we expect our business in China to recover some from Q3, we do not expect it to reach the level of last year's Q4. So we expect overall fueling organic growth to be modestly positive.

Based on our third quarter results and our current view of our end markets, we expect our fourth quarter to be similar to last year in both revenue and earnings. This will result in full year 2019 earnings per share before restructuring at the low end of our current guidance.

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 [4]

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Thank you, Gregg. Our fully diluted earnings per share were $0.72 for the third quarter of 2019 versus $0.63 for the third quarter of 2018. Third quarter EPS before the impact of restructuring expenses was $0.73 compared to 2018 third quarter EPS before restructuring of $0.64.

Restructuring expenses in the third quarter of 2019 were $0.4 million and were related to various manufacturing and distribution realignment activities and resulted in a $0.01 impact on earnings per share in the third quarter of 2019.

Restructuring expenses in the third quarter of 2018 were $0.3 million related to branch consolidations and other assets after rationalizations in the distribution segment and resulted in a $0.01 impact on earnings per share in the third quarter of 2018.

Third quarter 2019 sales were $348.4 million compared to 2018 third quarter sales of $341.9 million, an increase of 2%. Sales revenue decreased by $5.8 million or about 2% in the third quarter of 2019 due to foreign currency translation, and we estimate this revenue decline lowered our earnings per share in the third quarter by about $0.02 versus the third quarter of 2018.

Water Systems sales were $199.8 million in the third quarter of 2019 versus the third quarter 2018 sales of $199.3 million. In the third quarter of 2019, sales from businesses acquired since the third quarter of 2018 were $2.3 million. Water Systems sales decreased about 2% in the quarter due to foreign currency translation. Water Systems organic sales increased by about 2% compared to the third quarter of 2018.

Water Systems operating income was $28.4 million in the third quarter of 2019 and the third quarter of 2018. During the third quarter, the company acquired First Sales, LLC, a manufacturer of water treatment and filtration equipment for the residential and commercial markets. First Sales, which has about $14 million in annual revenues, creates an operating platform in the highly fragmented water treatment space and provides synergies with our core groundwater customers and channels in North America.

Fueling Systems sales were $78.1 million in the third quarter 2019 compared to third quarter 2018 sales of $77.8 million and were a record for any third quarter. Fueling Systems sales decreased about 1% in the quarter due to foreign currency translation. Fueling Systems organic sales increased about 2% compared to the third quarter of 2018. Fueling Systems operating income was a record for any third quarter at $21.6 million compared to $20.9 million in the third quarter of 2018. Fueling Systems operating income was higher in the quarter due to favorable product sales mix.

Distribution sales were $87 million in the third quarter of 2019 versus third quarter 2018 sales of $78 million. In the third quarter of 2019, sales from businesses acquired since the third quarter of 2018 were $7.3 million. The Distribution segment sales grew about 2% organically compared to the third quarter of 2018.

The Distribution segment operating income was $5.9 million in the third quarter of 2019 compared to $3.1 million in the third quarter of 2018. Distribution's operating income was higher in the third quarter due to higher sales volumes and acquisitions.

The company's consolidated gross profit was $117.6 million for the third quarter of 2019, an increase from the third quarter of 2018 gross profit of $113 million. The gross profit increase was primarily due to higher Fueling Systems and Distribution sales. Gross profit as a percent of net sales was 33.8% in the third quarter of 2019 versus 33% in the third quarter of 2018.

Selling, general and administrative expenses were $74.5 million in the third quarter of 2019 compared to $72.5 million in the third quarter of 2018. SG&A expenses from acquired businesses were $1.5 million. The company's SG&A expenses in the third quarter of 2019 declined by about $1.7 million due to the effect of foreign currency translation.

During the first quarter of 2019, the company changed the management reporting for certain transfers of manufactured products between the Water and Fueling segments. This change was made to better align the production of certain products by reportable segment and sales to third-party customers. To consistently compare 2019 results to the prior year, certain 2018 net sales and operating income reclassifications were made. These reclassifications resulted in lowering third quarter 2018 results of Fueling Systems and increasing third quarter 2018 results of Water Systems net sales by about $1 million and operating income was unchanged versus what was reported in this period last year. There is no impact on the company's previously reported consolidated financial statement.

During the third quarter of 2019, the company recognized about $2.1 million of foreign exchange transaction gains below the operating income line. Virtually all of this gain was driven by the 36% weakening of the Argentinian peso during the quarter. The company had some hedge protection against the significant strengthening of the Argentinian peso.

In the third quarter of 2019, our effective tax rate net of discrete events was about 20% higher than the third quarter 2018 effective tax rate of about 16%. The higher tax rate resulted in about $1.6 million of incremental income tax expense had the third quarter 2018 rate been in effect. The higher tax rate negatively impacts earnings per share by about $0.04. 20% is a reasonable estimate for the full year 2019 effective tax rate.

The company ended the third quarter of 2019 with a cash balance of $47.8 million, which was $11.4 million lower than at the end of 2018. Cash decreased primarily due to acquisitions and debt repayments. The company had $79.1 million in borrowings on its revolving debt facilities at the end of the third quarter of 2019 and $89.1 million borrowing at the end of the third quarter 2018.

As of January 1, 2019, the company adopted the new lease standard and has recognized additional operating liabilities of about $25 million for its outstanding operating leases with corresponding right-of-use assets of the same amount. The impact of this new accounting standard is noncash in nature and does not affect the company's cash position.

The company does not consider the impact of this standard to be material to the consolidated

(technical difficulty)

or to the cash flows. Cash from operations through the first 3 quarters of 2019 was about $90 million or 119% of net income compared to $60 million or 74% of net income for the same period of 2018. Our free cash flow -- cash from operations less capital expenditures is about $75 million and about 65% higher through the first 3 quarters of this year compared to the same period of 2018. This improvement in cash flow is primarily due to a reduction in working capital requirements as the company focuses on improvements in customer and vendor terms. The company did not purchase any shares of its common stock in the open market during the third quarter 2019. At the end of the third quarter 2019, the total remaining authorized shares that may be repurchased is about 1.3 million.

On October 22, the company announced a quarterly cash dividend of $0.145 per share. The dividends will be paid November 15 to shareholders of record on November 1.

This concludes our prepared remarks. So we would 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 your first question comes from Edward Marshall with Sidoti & Company.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [2]

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So I'm looking at Headwater. On a sequential basis, so from Q2 '19, revenue is about the same. Was there something in the mix? Or was there something structurally that changed within your Headwater division that had a much better drop-through relative to Q2 of this year?

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

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Yes. Ed, a couple of things on Headwater. We were hurt in the first half of the year on the top line by the weather, as we've talked about. It was a much more moderate weather environment really across the country in the third quarter. Our business in the Southeast part of the United States, especially the Drillers Services, Inc. (sic) [Drillers Service, Inc.] business had a really nice quarter. The drop-through though, the benefit that we saw in the operating income, was really in the businesses that are on the -- in the Western part of the United States, the Western Hydro and 2M acquisitions. Remember that last year, those were the businesses that were going through a lot of the branch restructuring and rationalizations. We closed some branches. We combined some branches. We otherwise rationalized some assets there.

And despite the fact that, that business had a decline in revenue, they had a really meaningful improvement in their operating income. So those 2 businesses combined had almost a 60% increase year-over-year in third quarter operating income. So it wasn't due really to a lot of top line benefit there, but it was due to a lot of these cost and restructuring efforts.

And then that, combined with the strength of DSI in the Southeast and combined with the acquisition we did this year, a company called Milan in Michigan, those were all the main drivers for the improved operating results at the Distribution segment.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [4]

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Got it. And if you took the cost last year, why did we see the impact in Q3 and not Q2? I'm just trying to understand that.

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

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Yes, you've got to again look at this. We were going through some changes. And so there's some stabilization. There's some margin pickup. Q2 was -- people were still recovering from a very weak Q1. I think pricing was just a little bit more aggressive out there. So we saw some stability in margins. We again saw some better execution and we saw some lower fixed costs as well.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [6]

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So the structural changes is now, I won't call it permanent but are more normalizing as we move forward and this is kind of a margin that we should anticipate on a go-forward?

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

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These are the kinds of margins we would expect in the season, which would be Q2, Q3. And then keep in mind, Q4, Q1, which is the low season, is when we get delevered and why we think we're going to have an improvement year-over-year to last year's Q4. Q4 and Q1, our quarters where we're either marginally profitable or marginally lose money.

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Edward James Marshall, Sidoti & Company, LLC - Senior Equity Research Analyst [8]

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Got it. Okay. So looking off to the fueling business, I think, John, you cautioned us last quarter to not get comfortable in the high 20s, the mid-20s is more of the range, but the run rate continued. What's going on? Is it continuing to be the positive mix in North America? And how does that look for the balance of the year and into 2020?

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John J. Haines, Franklin Electric Co., Inc. - VP & CFO [9]

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Yes. The OI margin, really, 2 things. It is positive sales mix. So our sales in the U.S. and Canada of fuel management systems continues to be very strong and we have a very nice margin profile on those products. The second thing that I've mentioned in the past is the business does a really good job of leveraging its fixed cost. So there's not a ton of SG&A add or other fixed cost to add. As the business continues to grow its top line to that, leverage is helpful there as well.

The caution remains around a mix shift away from maybe some of the more favorable profitability products. Geography mix also matters. So in quarters where we might see big spikes in revenue in some of the developing world markets, that can impact our margin profile as well. So it was a good -- it was not a great growth quarter, organic growth quarter for Fueling mainly because of China. But from an earnings perspective, it continues to be very strong.

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

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Okay, good. And then the foreign exchange gain below operating income. It looks like there's a change on the balance sheet. Did you sell something? Or what's going on there, the $2.1 million?

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Gregg C. Sengstack, Franklin Electric Co., Inc. - Chairman, President & CEO [11]

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No. The $2.1 million is a gain that is primarily driven by the hyperinflation accounting in Argentina. So the reason we benefit from that, Ed, is that the hyperinflation accounting rules require us to separate our assets into monetary versus nonmonetary assets and liabilities. Our net position in Argentina is a net monetary liability. So that's unusual. And the big portion of that is driven by deferred tax liability. It's unusual in a sense that many other companies have net asset position, not net liability position.

So when the Argentinian peso weakens to the U.S. dollar, which it did significantly in this quarter and has year-to-date, we will recognize gains. So that's the rationale for why we have that significant gain in the third quarter. It had -- there was a big movement in advance of this past weekend's election in the third quarter in the peso to the U.S. dollar.

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Operator [12]

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(Operator Instructions) And your 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 [13]

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I wanted to ask about the trends that you're seeing in Fueling Systems in North America. It sounds like the market's pretty robust and it should continue. I wonder what kind of project funnel you've got looking into 2020 and if you think these kind of growth rates can continue.

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Gregg C. Sengstack, Franklin Electric Co., Inc. - Chairman, President & CEO [14]

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You know, Walter, we haven't gone out with 2020 guidance. I'll just say broadly, with capital, it's relatively inexpensive. And you're seeing, I think, a secular move by major marketers to acquire and upgrade large networks of stations, and I think that's driving some of the underlying growth. You're seeing that through us, I think Dover and Ford have both reported and they had, I think, something north of 10% growth as well, and I think theirs was driven by North America.

So the market's robust. We're all seeing these investments. These major marketers are seeing the returns by making these upgrades to stores. A lot of these stores were upgraded or the 4 courts were upgraded over 20 years ago when the last major tank regs came out. So it's kind of maybe a natural secular time in the marketplace.

And then Franklin is doing well with getting wins and getting market share gains on some of our fuel management system technology, which we mentioned earlier is what's resulting in some of the margin improvement in North America as well. So as long as we continue to see, I think, a relatively favorable capital environment, there is some upgrade for the EMV initiative for dispensers. You could argue that helps us. You could also argue that hurts us because of where the dollars go. But we've all seen some pretty nice lift here in the North American market.

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Walter Scott Liptak, Seaport Global Securities LLC, Research Division - MD & Senior Industrials Analyst [15]

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Okay. Great. And the China market. This seems to be slowing a little bit sooner than we thought and maybe a little bit more dramatically. Was it the same issue that was -- that you talked about last quarter for underground? Or was there something else that was going on this quarter to slow sales in China?

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Gregg C. Sengstack, Franklin Electric Co., Inc. - Chairman, President & CEO [16]

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Again, 2 factors seem to be affecting our business in China. One is, it's your comment, I think things are getting done a little faster and with a little bit more for the independent marketers, not the state-owned enterprises, a little bit more with local product than we anticipated. The second factor is, I mentioned I believe last quarter that the scale of capital that the major -- the state-owned enterprises are allocating to station upgrades has been shrunk or shrunken, I guess. And so what we're seeing is that the station owners or the state-owned enterprise stations are only investing in the underground piping systems and not so much in fuel management or fuel pumping and some of the other product we were capturing as well.

So a couple of factors there have slowed it down. The third factor is, is that we are recognizing their 70th year here at the end of the month and the end of the quarter. So there was some slowdown. We know that impact several initiatives. There was a slowdown for several weeks in construction. We think that's what's going to come back a little bit in Q4.

The thing we're looking for in China now is that as the piping initiatives kind of winds its way down is we're looking at in-station diagnostics as being the next wave for the Chinese state-owned enterprises and other stations to be upgraded so that there can be a continuous monitoring of the vapor recovery systems. And we see that as being the next kind of multiyear initiative and we expect to see some traction there. We just don't know if it's going to be early 2020 or later in the year. So we're having one kind of declining revenue source. We should have a lift in other revenue source. How they crossover is not yet clear for us.

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Walter Scott Liptak, Seaport Global Securities LLC, Research Division - MD & Senior Industrials Analyst [17]

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Okay, got it. If I could switch over to water. The groundwater business is weak. I wonder if you could just review with the submarket and how that tends to trend in the fourth quarter. I think it's still relatively slow. And thinking about 2020, could there be a pickup, kind of a reversion, back from the tough year this year?

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

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Sure. So well, 2 things. One is that, to your point, it's been pretty slow. I'd say it's generally kind of flattish. Our sales to third-party distribution, because we don't have visibility of their inventories other than anecdotally for the year, up 1% or 2%. But for the quarter, we're down a couple of percent.

Our best visibility is on our own distribution out the door sales, which are down year-to-date, but were up in the quarter a couple of percent. And I'd say that Headwater's footprint is more Western-based. And so that's where we had the toughest situation with California just in kind of the -- the West and some of the Midwest. The Southeast been relatively dry. We've done relatively well there.

Looking at 2020, if we have another 125-year events for a year, wettest year on record, I would expect results to be similar. But if we have a more normalized weather year, that will be, of course, it should be a positive driver for us.

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Operator [19]

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I am showing no further questions at this time. I will now turn the call back to Gregg Sengstack.

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

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Again, we thank you all for joining us for our third quarter conference call. We look forward to speaking to you in the New Year for our fourth quarter and year-end annual results. You all have a good week.

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Operator [21]

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