Gregg C. Sengstack; Chairman & CEO; Franklin Electric Co., Inc.
Jeffery L. Taylor; VP & CFO; Franklin Electric Co., Inc.
Matt J. Summerville; MD & Senior Research Analyst; D.A. Davidson & Co., Research Division
Michael Patrick Halloran; Associate Director of Research & Senior Research Analyst; Robert W. Baird & Co. Incorporated, Research Division
Walter Scott Liptak; MD & Senior Industrials Analyst; Seaport Research Partners
Hello, and thank you for standing by. Welcome to the Franklin Electric Reports Second Quarter 2023 Sales and Earnings Conference Call. (Operator Instructions). 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.
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 C. Sengstack
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 commitment 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 U.S. 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 rightsize 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. 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 3 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.
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.
Jeffery L. Taylor
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 U.S. 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 U.S. and Canada was led by sales of large dewatering equipment, which increased approximately 100%. Wet weather across most of the U.S. in the first half of the year and some destocking in the U.S. pro channel led to lower sales of groundwater pumping equipment. Water Systems sales in markets outside the U.S. and Canada were up 3%. Foreign currency translation decreased sales outside the U.S. 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 U.S. 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 U.S. 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 U.S. dollar and our operations outside the U.S., 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.
Question and Answer Session
(Operator Instructions) And our first question comes from the line of Matt Summerville with D.A. Davidson.
Matt J. Summerville
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 C. Sengstack
Matt, this is Greg, and I'm sure Jeff will have a follow-on to this. It's a little tough for us to parse it out because of the -- look, we had a couple of years of really dry weather. We've seen the housing slowdown from last summer. So sales in the quarter and groundwater, we probably have the most visibility in the United States. You can see that the Headwater sales out the door were up 1% and actual units are up a little bit more than that because the value of the commodity piece was lower in dollars per commodity that we sold like pipe or wire. So that's our kind of best indicator is that the -- that business was actually off the door and yet we reduced our transfers by about $10 million into the business intentionally reduce their inventory. So that's a (inaudible) and let's say that that's 40% of kind of our sales from that channel. So you can maybe extrapolate from that. So it was kind of throughout the quarter. I really maybe couldn't put a finer point. Jeff may have a better -- a different point of view -- better point of view.
Jeffery L. Taylor
No, I don't have a hard number to quantify the amount of destocking. As Gregg said, it's really hard to kind of separate how much was weather related versus how much was destocking. What I can tell you is that we are seeing supply chain improve. Our delivery times to our customers have improved in the second quarter. Our delivery times from our suppliers improved in the quarter. We think that others are seeing that as well, which is allowing them to really normalize or rightsize their inventory levels. And so that certainly had an impact.
I also think that higher interest rates are playing a role here. So people are realizing that the cost of carrying inventory is higher today than it was a year ago. And because of that, we're also looking to pull down those inventory levels. Obviously, it was -- we think it's a little more prevalent in fueling than we've seen on the water side as they've had some delays in starts on those new-to-industry installations. But hard to separate the effect between weather and destocking. We do believe it's transitory. I do think that we'll see some impact carry over into Q3. Once again, hard to quantify what that is at this time.
Matt J. Summerville
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?
Jeffery L. Taylor
Yes. Certainly, Matt. So I would say that pricing realization that we're seeing on a year-over-year basis. Take the commodity piece out of Headwater for this comment, and I think we're seeing mid-single digits generally. Pricing across the board, and water is kind of mid- to high single digits at this point in time. We've talked about that we expected as we progress through the year with price increases being less frequent this year, and being more stable, more of a return to normal pricing environment that we've seen in the past that those will continue to contract as we move through the year and we've lapped those price increases from last year.
On the Headwater side, on the non-commodity products, so the pumps, the motors, the controls and drives those type of products, they're seeing good price realization, still seeing something consistent with what water systems is in mid-single digits pricing, but on the commodity product side, they're seeing price decreases, and that's really what's driving a big part of the margin compression that Headwater has seen in their business in the first half of this year. And then the Fueling business is seeing kind of low to mid-single digits pricing. So everybody is positive on pricing at this point in time.
For free cash flow conversion, our target is and continues to be 100% based on our current view for the rest of the year. We expect that we'll be able to to exceed that and -- by a reasonable amount as we go through the back half of the year, and we typically generate very strong cash flow in the back half of the year. And so we turned the quarter in Q2. As you know, we had very strong free cash flow in the quarter and certainly compared to the prior year and sequentially as well. And so we expect to see a pretty normal recovery of cash, strong free cash flow generation in the back half of the year.
And our next question comes from the line of Mike Halloran with Baird.
Michael Patrick Halloran
So a couple of questions here. First, I think probably goes with part of Matt's first question a little bit. When you think -- when I hear what you're saying, which is lead times are normalizing, but you had a destock in the quarter, and those 2 kind of makes sense. But at the same time, you're talking about a pretty healthy backlog level as you look in the environment. So maybe you can just find a way to rectify those for me. It seemed contradictory on the surface. But obviously, it's what you're seeing below the surface. So I'd love to understand how those all fit together.
Gregg C. Sengstack
Mike, a couple of things are going on. To your point, again, the second quarter, I think as people are coming into the season, both the -- compared to prior year, a little bit tougher comp from the standpoint of weather. And then also, I think people are just kind of burning through what they have on hand, our customers. So we're seeing that. At the same time, our large pump business, that's a different business and that we worked off the backlog. So there's a meaningful portion of our backlog, which relates to large pumps, which are going to be delivered over a series of months. We're even seeing now some appeals going into 2024. So we have good visibility on that, which is different than our short-cycle business. The short cycle business is more as we go into Q3, which used to be Q2 as our largest revenue quarter as a manufacturer. Now with a more meaningful distribution business, Q3 tends to be maybe a little bit bigger than Q2. So, we're in that part of the season. Yes, California has been -- you've got a lot of rain. They're using a lot of surface water, but that's one micromarket, and we have decent results in Northern Latin America. Europe did well. Southern Africa did well. Asia looks like it's coming back. So, we have a sense that's where we have said it's a short-cycle business, but our people are confident right now in the back half of the year.
Jeffery L. Taylor
No, I was going to say the comment I want to add there is Gregg talked about our large pumps and they're more of longer order cycle versus a short-cycle business. A big part of the increase we saw in our backlog was in our past dues. And so we've made great progress in the quarter in catching up on past dues. And some of the decrease was on the large pumps, but a big chunk of it was also in the short-cycle business. So we're very pleased with how we're seeing the backlog in this environment, and we're making, like I said, great progress in terms of reducing the past dues and past dues are getting -- almost getting back to what we would say is a normal level for us. So we're once again, pleased with that.
Michael Patrick Halloran
That makes sense, Jeff. And 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.
Jeffery L. Taylor
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 U.S. 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.
(Operator Instructions) Our next question comes from the line of Walt Liptak with Seaport Research.
Walter Scott Liptak
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?
Jeffery L. Taylor
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 Scott Liptak
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.
Jeffery L. Taylor
Yes. For our business, we saw the ag side kind of hold up. It was positive on a year-over-year basis, but kind of low single digits. So we didn't see as much on the ag side. I would say that more -- we've seen a little more on the residential, the resi side, in both our base water business, but also in water treatment, and we've talked about how the water treatment has a little more exposure or sensitivity on the resi side than the base water business does.
I would now like to hand the call back over to CEO, Gregg Sengstack, for any closing remarks.
Gregg C. Sengstack
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.
Ladies and gentlemen, this concludes today's conference call. Thank you for participating, and you may now disconnect.