Q3 2023 Franklin Electric Co Inc Earnings Call

Participants

Gregg C. Sengstack; Chairman & CEO; Franklin Electric Co., Inc.

Jeffery L. Taylor; VP & CFO; Franklin Electric Co., Inc.

Sandy Statzer

Matt J. Summerville; MD & Senior Research Analyst; D.A. Davidson & Co., Research Division

Presentation

Operator

Good day, and welcome to the Franklin Electric Reports Third Quarter 2023 Sales and Earnings Conference Call. (Operator Instructions) please be advised that today's conference is being recorded.
I would now like to hand the conference over to Vice President of Investor Relations, Sandy Statzer. Please go ahead.

Sandy Statzer

Thank you, Abigail, and welcome, everyone, to Franklin Electric's Third Quarter 2023 Earnings Conference Call. With me today is Gregg Sengstack, our Chair person and Chief Executive Officer; and Jeff Taylor, our Vice President and Chief Financial Officer.
On today's call, Gregg will review our third quarter business highlights, then Jeff will provide an overview of our financial performance. We will then take questions. Before we begin, let me remind you that as we conduct this call, we will be making forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are subject to various risks and uncertainties, many of which will cause actual results to differ materially from such forward-looking statements.
A discussion of these factors may be found in the company's annual report on Form 10-K and today's earnings release. All forward-looking statements made during this call are based on information currently available and except as required by law, the company assumes no obligation to update any forward-looking statements.
With that, I will now turn the call over to Gregg.

Gregg C. Sengstack

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

Jeffery L. Taylor

Thanks, Gregg, and good morning, everyone. Overall, as Gregg said, it was a solid quarter for Franklin Electric despite the challenging operating conditions. We established new quarterly records in the Water segment, while results were below our expectations in the Fueling and Distribution segments. Third quarter 2023 consolidated sales were $538.4 million, a year-over-year decrease of 2%. Excluding the impact of foreign currency translation, sales were flat compared to last year. Our fully diluted earnings per share were $1.23 for the third quarter 2023 versus $1.24 for the third quarter of 2022. Water Systems sales in the U.S. and Canada were down 1% compared to the third quarter of 2022, primarily due to lower sales of groundwater equipment resulting from channel destocking and wet weather across much of the U.S., which was largely offset by higher sales of our large dewatering equipment. Water Systems sales in markets outside the U.S. and Canada were up 4%.
Foreign currency translation decreased sales outside the U.S. and Canada by 11%. Sales increases in Latin America and the EMEA region more than offset lower sales in the Asia Pacific markets. Water Systems operating income was a record $52.7 million in the third quarter of 2023, up $7.2 million or 16% versus the third quarter of 2022. Operating income margin was 17.8%, up 230 basis points compared to last year. The increase in operating income was primarily due to leverage from sales growth, gross margin expansion and cost management. Distribution's third quarter sales were $189.2 million versus the third quarter 2022 sales of $193.2 million, a 2% decrease.
The Distribution segment's operating income was $10.7 million for the third quarter, a year-over-year decrease of $8.3 million. Operating income margin was 5.7% of sales in the third quarter 2023 versus 9.8% in the prior year. The Distribution segment's income was negatively impacted by wetter weather, consistent with our prior comments and margin compression from lower pricing on commodity-based products sold through the business. Fueling Systems sales were $77.7 million in the third quarter of 2023 versus third quarter 2022 sales of $90.2 million, a 14% decrease. As a reminder, the current year represents a tough comparison for the business' third quarter 2022 Fueling Systems sales represented an all-time quarterly record.
Fueling Systems sales in the U.S. and Canada decreased 14% compared to the third quarter of 2022 due to lower demand from destocking and channel inventory to supply availability and lead times improve. However, we experienced growth in our fuel pumping systems as well as our Grid Solutions business during the quarter. Outside the U.S. and Canada, Fueling Systems sales decreased 20% due primarily to the divestiture of the tank business in 2022 and lower sales in the Asia Pacific region. Fueling Systems operating income was $25.8 million in the third quarter of 2023 compared to $28.6 million in the third quarter of 2022. The third quarter 2023 operating income margin was 33.2% compared to 31.7% of net sales in the prior year.
Operating income decreased primarily due to lower sales, while the margin percentage increased due to a favorable product mix, gross margin expansion and cost management. Franklin Electric's consolidated gross profit was $186.3 million for the third quarter of 2023, down from last year's third quarter gross profit of $190.6 million. The gross profit as a percentage of net sales was 34.6% in the third quarter of 2023 versus 34.5% in the prior year. Selling, general and administrative expenses or SG&A were $107.7 million in the third quarter of 2023 compared to $109.4 million in the third quarter of 2022.
The decrease in SG&A expense was largely due to lower incentive-based compensation expenses and cost management in the quarter. SG&A cost as a percent of net sales was 20.0% in the third quarter of 2023 and in line with prior year quarter. Consolidated operating income was $78.1 million in the third quarter of 2023, down $1.9 million or 2% from $80.0 million in the third quarter of 2022, due to lower sales and an unfavorable foreign exchange translational headwind. The third quarter 2023 operating income margin was 14.5%, flat to the third quarter of 2022. The effective tax rate was 20% for the quarter compared to 18.5% in the prior year quarter. We generated approximately $198 million of operating cash flow in the first 9 months of 2023 compared to $7 million of operating cash flow in the first 9 months of 2022, an improvement of $191 million.
In 2021 and 2022, we invested in higher levels of working capital to support our growth. In 2023, working capital has returned to more normal levels, leading to improved cash flows. The company purchased approximately 56,000 shares of common stock in the open market for about $5 million during the third quarter of 2023. At the end of the third quarter 2023, the remaining share repurchase authorization is approximately 1.1 million shares. And yesterday, the company announced a quarterly cash dividend of $0.225 that will be paid November 16 to shareholders of record as of November 2. This concludes our prepared remarks. We will now turn the call back over to Abigail for questions.

Question and Answer Session

Operator

(Operator Instructions) Our first question comes from Matt Summerville with D.A. Davidson.

Matt J. Summerville

A couple of questions. Just maybe first with respect to Water Systems margins, 17.8%, that's the highest level you guys have delivered, I believe, in 3 years. I think the last time you were up in that the ZIP code was the third quarter of 2020. Can you talk about the factors a little bit more that drove that kind of performance and how you think about sustainability net of normal seasonal factors that impact the business? And then I have a follow-up.

Jeffery L. Taylor

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

Matt J. Summerville

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

Jeffery L. Taylor

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

Gregg C. Sengstack

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

Matt J. Summerville

Got it. And then just maybe to flip over to kind of the negative things impacting the business. You talked about destocking, you talked about project pushouts. Gregg, you done this for a number of decades. So drawing on your experience, how long do you think kind of the down cycle can persist as it pertains to the destocking sort of phenomenon as well as what you're seeing on the project side in both Water and Fueling.

Gregg C. Sengstack

Yes, Matt, you think with my experience, I get smarter over time. And -- we -- I would say, I was -- I thought we were kind of through this and through Q2. But I think with the interest rate and just with the ability of lead times, including our owns and our customers, that we're back to the pre-COVID normal and people who were looking at -- we are seasonal in Northern Hemisphere. And so I think that customers are saying, look, I don't need to take the stock. I don't need to carry the stock. I'll let the manufacturers (inaudible).
And then even in our case, our own distribution being more reliant on us as a supplier because the supply about 1/3 of the product, saying, look, I'd rather have a carried upstream. So there's a -- so I think that we're kind of getting through that maybe through the end of the year, certainly, the pipe, which is a large portion of the Distribution business, as a plastic resident also steel pipe and that availability was acutely tight through the pandemic and then it came out and applaud. And so that's, I think, maybe exacerbated the situation probably into year-end. But here, again, I think that the discipline of having higher interest rates will help us coming into '24 relative to our competitors in Distribution.
Relative to the push-outs, I think here again, we continue to stay in close contact with major marketers of the Fueling business and they said we have these build programs, and they normally hit their build progress, and just seemingly things came -- went to the (inaudible) sort of pushed to the right. I talked to some contracting companies in late July or I think it was early August, and they talked about how they still were kind of having trouble getting help to build out projects. So I think that since everything kind of slowed down a little bit. I think that we'll see the Fueling business kind of steadily get better in '24. It will be an easier comp in the back half certainly.
The other thing is with our large pumping systems, we've had a large exposure to the rental customers (inaudible) and others in the world. And back in '14 to '15 when oil prices collapsed, we took it on a chin on that business. We saw that slow down again, I think it was '19 or '20, but we've done a lot to diversify the customer base. We've got a growing recognition for the Pioneer brand. So while we expected the rental fleet customers are now kind of catching up and maybe that part of it is going to slow that, given the underlying strength in the industrial economy, generally the United States and kind of the positive comments, WefTec and other conferences, we're feeling -- we can carry through that. It may be a little slow there again next couple of quarters as we kind of get adjusted to a new norm, but then we're feeling we're well positioned there in that space.
And then finally, in the groundwater space, we came off of a really dry couple of years. And remember, California record droughts and then we got record rain and lots of water, which overall is a good thing. But certainly, in the short term for us, it impacts demand and so now we have more -- maybe a more normal year. We certainly got hit with weather on the East Coast in the third quarter as well as kind of in the Midwest, it was a decent rain quarter. So it just didn't drive a lot of demand. So we've kind of cycled through that. And so I expect that's -- we'll be coming off of a normal year, maybe for next year, so it will be a little bit of an easier comp in that respect.
And then outside the United States, we're seeing some (inaudible) in South America. I think Europe is going to be kind of tough through the summer -- I mean, through the winter a little as they kind of get through their post-COVID situation. And Asia has been challenging for us and I think that Asia is (inaudible) challenging [pros] as well, we'll likely see improvement off the bottom. So that's a very long-winded answer to your question, but I thought I'd give you a comprehensive response.

Operator

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

Gregg C. Sengstack

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

Operator

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