Franklin Electric Co., Inc. (NASDAQ:FELE) Q4 2023 Earnings Call Transcript

Franklin Electric Co., Inc. (NASDAQ:FELE) Q4 2023 Earnings Call Transcript February 13, 2024

Franklin Electric Co., Inc. misses on earnings expectations. Reported EPS is $0.83 EPS, expectations were $0.85. Franklin Electric Co., Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Hello, and welcome to the Franklin Electric Reports Fourth Quarter 2023 and Full Year 2023 Results 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.

Sandy Statzer: Thank you, Andrew, and welcome, everyone, to Franklin Electric’s fourth quarter and full year 2023 earnings call. With me today is Gregg Sengstack, our Chairperson and Chief Executive Officer; and Jeff Taylor, our Chief Financial Officer. On today’s call, Gregg will review our fourth quarter and full year 2023 business results, along with guidance for 2024. Jeff will provide additional detail on 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. In addition, on today’s call, non-GAAP financial measures will be used to help investors understand Franklin Electric’s ongoing business performance. A reconciliation of the non-GAAP financial measures being discussed today to the comparable GAAP financial measures is included in the Company investor presentation, which is available on our website. With that, I will now turn the call over to Gregg.

Gregg Sengstack: Thank you, Sandy, and thank you all for joining us. We delivered a solid quarter and finished 2023. From Q3 to Q4, sequentially, we experienced more of the same market conditions with wetter weather and customer destocking continuing in the U.S. and to a lesser degree, Europe, and we experienced continued commodity pricing pressure in our Distribution business. Overall, reported sales were down $16 million or 3%, mainly driven by lower volume in Fueling Systems and a $13 million negative impact from foreign exchange, partially offset by favorable pricing. Even with soft demand, we delivered solid operating margins in water and fueling for the quarter. Our manufacturing margins remained healthy throughout 2023, driven by continued cost controls.

For the full year of 2023, we delivered sales growth of 1%, driven by pricing, partially offset by negative foreign exchange and lower volumes in Fueling Systems. Operating income grew 2% due to the strong performance in Water Systems and cost management across the Company. Operating margins expanded in water and fueling with 140 basis points and 230 basis points improvements over 2022, respectively. Sales of our critical asset monitoring products within our fueling business also set a full year record. Our Distribution business was negatively impacted by commodity pricing pressure and destocking activity. Our continued focus on the management of working capital translated into strong cash flow generation in both the fourth quarter and the full year.

Our operating cash flow improved by approximately $214 million as compared to 2022, resulting in free cash flow conversion of 142%. Free cash flow conversion was well above our five-year average of 106%. We use this cash to reduce our outstanding debt by over $115 million, completed several small acquisitions, and return cash to shareholders through increased dividends and stock repurchases. Our net debt is near zero and we delivered a nice step up in our return on invested capital to 17.2%, an increase of 70 basis points. I am incredibly proud of the Franklin team for their commitment to driving operational excellence. We are proud to be named in Newsweek’s list of America’s most responsible and trustworthy companies for two consecutive years.

We were also recognized by USA Today as one of America’s Climate Leaders for 2023. Turning to our segments. For the quarter, in Water Systems, sales declined less than 1%, overcoming a 5% foreign currency headwind. Demand in the U.S. for our large dewatering products was strong, setting a quarterly record with 13% growth and full-year record growth of 63%. In the U.S., demand for groundwater pumping systems was impacted by continued unfavorable weather patterns in the Western U.S. and customer destocking. Our water treatment product lines were challenged by soft housing starts and existing home sales. Outside the U.S., Water Systems had solid demand in Latin America, while EMEA and Asia Pacific were relatively flat. Operating income margin for the quarter was 15.8%, essentially flat with the prior year.

For the full year, pricing actions and continued cost management more than offset inflationary challenges, driving an improvement in operating income margin of 16.3%, an increase of 140 basis points compared to last year. Fueling system sales and operating income decreased 23% and 20%, respectively in the fourth quarter, lapping a difficult year-over-year comparison of record fourth quarter revenue and operating income in 2022. While end market demand remains healthy, Fueling Systems was negatively impacted by the continuation of customer inventory destocking, driving lower volumes, higher interest rates, labor constraints, and permitting delays caused some new station build plans to move into 2024. Favorable price and cost containment contributed to overall Fueling Systems fourth quarter operating margin of 29.5%, an increase of 110 basis points compared to the prior year.

We continue to see strong growth for – in our critical asset monitoring products, which closed out a record year. Overall, the Fueling Systems team did an excellent job of delivering for our customers while managing costs to maintain our operating margins. The U.S. Distribution segment was impacted by normal seasonality, destocking, and continued unfavorable weather that reduced demand. Sales decreased by approximately 1% while operating income decreased by 66% due to continued commodity pricing pressure. The operating margin, income margin of 0.7% decreased 120 basis points compared to the prior year quarter. These results are a reminder that our Distribution segment is more seasonal with lower volume in Q4 as more earnings volatility than our manufacturing segments.

As mentioned last quarter, we continue to make key investments to expand on-site inventory for large contractors. Year-over-year, we have 33% more on-site inventory or OSI containers deployed across the country, which is an integral part of our strategy to better serve our customers by making products available when and where they are needed. For the year, even with the demand and margin challenges, our Distribution segment delivered 5.1% operating income. You may recall that when we established this business in 2017, we stated that the anticipated operating income of this segment would range between 5% and 7%. Over the last four years, it has averaged around the midpoint of 6%. As the business continues to mature and we are able to gain efficiencies with our footprint and technology, we look to raise our expectations for operating income.

We completed two small acquisitions in the fourth quarter. In early December, we acquired the assets of Action Manufacturing & Supply Incorporated, now part of our water treatment product line within our Water Systems segment. Action Manufacturing is a producer and wholesale distributor of residential water conditioning, filtration, and indoor, outdoor aeration systems with operations in Florida and North Carolina. Including this acquisition, our water treatment product sales are approaching $200 million a year. With a continued focus – growth focus in our Distribution segment, we also acquired a professional groundwater distributor, Water Works Pump located in Springfield, Missouri, to expand our reach in Midwest markets. We welcome our new colleagues from Action and Water Works to the Franklin family.

While we continue to invest and acquire businesses to further our strategy and growth, we also continue to maintain a conservative capital structure with a net leverage ratio near zero. We are well-positioned to execute on both organic growth and strategic acquisitions. Turning to our 2024 outlook. We anticipate 2024 to start much like 2023 ended and improve as we move through the year. Our outlook anticipates lower levels of destocking activities, normalizing weather conditions in the U.S., a reduction in large dewatering pump volume from our record 2023 performance, improved housing starts in existing home sales, and continued pricing pressure. We also anticipate continued supply chain improvements, greater confidence in lead times, lower rates of inflation, and productivity improvements.

We look for demand for our groundwater pumps to continue to benefit from a large replacement business, a favorable concentration of activity across the agricultural, industrial, and mining markets, and only modest exposure to new construction in the U.S. housing market. We foresee this demand to similarly benefit our Distribution segment. We also expect our U.S. residential specialty pumps and water treatment product lines to face fewer headwinds from exposure to new home starts and existing home sales. Outside the U.S., we expect to see Latin America and South America business improve, Europe to stabilize, and Asia Pacific business to experience meaningful recovery. In our fueling business, major marketers in the U.S. have signaled they plan to maintain their investment plans in 2024, albeit at normalized levels after several robust years.

Labor constraints are expected to ease and permit activity to return to normal. In our Distribution segment, we look to gain momentum through the year and build on our recent acquisition. Commodity pricing pressures, especially for pipe products, should stabilize as we enter 2024. With that, we are initiating 2024 guidance, with full-year sales expected to be between $2.1 billion and $2.17 billion, and diluted earnings per share, or EPS, to be between $4.22 and $4.40 per share. I’m now going to hand the call over to Jeff to review our financials in more detail. Jeff?

Jeff Taylor: Thanks, Gregg, and good day, everyone. Fourth quarter 2023 consolidated sales were $473.0 million, a year-over-year decrease of 3%. Excluding the impact of foreign currency translation, sales were basically flat to last year. Our fully diluted earnings per share were $0.82 for the fourth quarter 2023 versus $0.84 for the fourth quarter 2022. While we don’t report adjusted earnings, I do want to highlight the FX expense or foreign exchange expense below operating income related to foreign currency devaluation, primarily the Argentine Peso. The $1.1 million higher expense year-over-year would impact earnings per share by $0.02 in the quarter. Moving on Water Systems sales in the U.S. and Canada were down 6% compared to the fourth quarter 2022, primarily due to lower volumes.

The sales decline in the U.S. and Canada was primarily due to lower groundwater sales. Wet weather across parts of the U.S. 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 7%. Foreign currency translation decreased sales outside the U.S. and Canada 12%. Excluding the impact of foreign exchange, sales were led with double-digit increases in both Latin America and EMEA and a single-digit increase in the Asia Pacific market. Water Systems operating income was $44.1 million in the fourth quarter of 2023, down $0.5 million or 1% versus the fourth quarter of 2022. Operating income margin was 15.8%, down 10 basis points compared to last year.

The decrease in operating income was primarily due to lower sales and higher operating expenses. Distribution’s fourth quarter sales were $148.0 million versus fourth quarter 2022 sales of $148.9 million, a 1% decrease. The Distribution segment’s operating income was $1 million for the fourth quarter, a year-over-year decrease of $1.9 million. Operating income margin was 0.7% of sales in the fourth quarter 2023 versus 1.9% in the fourth – in the prior year. The Distribution segment income was negatively impacted by adverse weather, consistent with our prior comments. Income was also negatively impacted by margin compression from lower pricing on commodity-based products sold through the business. Fueling Systems sales were $65.7 million in 2023 versus fourth quarter 2022 sales of $85.5 million, a 23% decrease.

As a reminder, the current year represents a tough comparison for the Company as fourth quarter 2022 Fueling Systems sales represented an all-time fourth quarter record. Fueling Systems sales in the U.S. and Canada decreased 18% compared to the fourth quarter of 2022, as described by Gregg in his comments. Outside the U.S. and Canada, Fueling Systems sales decreased 35% due primarily to lower sales in the Asia Pacific region. Fueling Systems operating income was $19.4 million in the fourth quarter 2023 compared to $24.3 million in the fourth quarter 2022. The fourth quarter 2023 operating income margin was 29.5% compared to 28.4% of net sales in the prior year. Operating income decreased primarily due to lower volume, while the margin percentage increased due to a favorable product mix, gross margin expansion, and outstanding cost management.

Franklin Electric’s consolidated gross profit was $160.0 million for the fourth quarter of 2023, down from last year’s fourth quarter gross profit of $166.2 million. The gross profit as a percentage of net sales was 33.8% in the fourth quarter 2023 versus 34.0% in the prior year. Selling, general and administrative or SG&A expense was $108.8 million in the fourth quarter of 2023 compared to $109.7 million in the fourth quarter of 2022. The decrease in SG&A expense was largely due to lower incentive-based compensation expenses in the quarter. SG&A cost as a percent of net sales increased to 23% in the fourth quarter of 2023 from 22.4% in the fourth quarter of 2022. Consolidated operating income was $50.8 million in the fourth quarter 2023, down $5.4 million or 10% from $56.2 million in the fourth quarter 2022, due to year-over-year declines in Fueling Systems and Distribution as previously discussed.

The fourth quarter 2023 operating income margin was 10.7%, down from 11.5% in the fourth quarter of 2022. The effective tax rate was 18% for both fourth quarters of 2023 and 2022. We generated approximately $316 million of operating cash flow in 2023 compared to $102 million in operating cash flow in 2022, an improvement of $214 million. In 2022, we invested in higher levels of working capital, predominantly inventory to compensate for longer lead times and decrease supply availability. In 2023, supply chain conditions have improved working capital has returned to more normal levels, leading to higher levels of cash flow. We used the cash flow generated primarily to repay debt and return capital to shareholders via dividends and share repurchases.

At the end of the year, our net debt was approximately $15 million compared to approximately $170 million at the end of 2022. The Company purchased approximately 144,000 shares of its common stock in the open market for about $13 million during the fourth quarter of 2023. At the end of the fourth quarter of 2023, the remaining share repurchase authorization is approximately 900,000 shares. On January 22, the Company announced a cash dividend increase of 11%, which marks the 32nd consecutive year that Franklin has increased our cash dividend paid to shareholders. This concludes our prepared remarks. We’ll now turn the call over to Andrew for questions.

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Q&A Session

Operator: [Operator Instructions] And our first question comes from the line of Matt Summerville with D.A. Davidson.

Matt Summerville: Thanks. Good morning. A couple of questions. Maybe can you talk across the three business segments about where you think your own inventories or comment on how you’re feeling about your own inventory levels, and how much inventory still needs to kind of come out of the channel to be fully normalized? And then I have a follow-up.

JeffTaylor: Yes, Matt. I’ll give some high-level comments in terms of inventory. And we don’t disclose inventory by segment. But overall inventory reduction, we finished this year at about $509 million. We finished last year at $545 million. So we had a nice reduction year-over-year. That translates into about 2.5 turns for the business – for the Company for the full year. Our goal is to drive that closer to three turns. And so in terms of continued inventory reduction, that’s, that’s the direction we’re driving and where we want to go. When we look across the three segments, I think all three segments made nice progress in terms of normalizing their inventory levels as – , as supply conditions have improved. And so, across all three businesses, and water has pulled their inventory levels down.

Distribution has done a really nice job of pulling their inventories down on a year-over-year basis. They’re a good indicator for us as to what would be happening in the channel. And we believe that what our team has done is reflective of others than we think that most of the channel inventory destocking has taken place to this point, and, and we look forward to seeing an uptick in demand and then that pull through in 2024. And then fueling has managed their inventory levels at as good as anybody in the business, certainly given how their business has slowed down in 2024. And so across the board, all three, all three businesses made meaningful improvement in terms of how they manage it without disclosing the hard numbers.

Matt Summerville: Got it. And then I think, Gregg, towards the end of your prepared remarks, you went through a number of factors impacting the business in the case as we move through the year. You referenced price pressure. I was wondering if you could put a little finer point on that? And then maybe, Jeff, if in the normal year, I kind of went back and looked. And on average, you guys do about 45% of your EPS in the first half, 55% in the back half. That’s not every year, but I’m just kind of pointing to a general rule of thumb, given all the factors Gregg kind of talked about, how should we be thinking about that first half, second half cadence this year? Thank you, guys.

Gregg Sengstack: Yes. So Matt, I would say that the pricing is more behaving more like it was before the pandemic. And that is where you’re, you’re getting promotional activity in the market. Now I’m talking principally groundwater principally in North America or the U.S. and Canada. And so it’s more kind of normal conditions with inflation on input costs slowing. Again, as Jeff pointed out, there’s still some excess inventory in the channel at manufacturers and maybe the less degree of Distribution. So we’re seeing more – I’ll use hand-to-hand combat as a terminology for that in this case. And then on the, on the spread of earnings, yes, you’re correct, and Jeff can get into more detail about that. With the Distribution business, we were getting more, I think, a 50-50 break because distribution – manufacturing does well in Q2.

Distribution does better in Q3. But that’s – but we’re going to have a kind of a slower start to the year. So Jeff, do you want to give Matt your thoughts?

JeffTaylor: Sure. And I think that’s a great lead-in, Gregg, is we expect the start of 2024 to really kind of move sideways where we ended. Obviously, Q1 seasonally is typically the lowest quarter for us in the Company. And now I went back and looked at the past three years for Q1, earnings as a percent of full year is averaging about 18% in Q1. The range is from about 16% to 19%. And so, I would say, certainly this year, we would expect to see a similar profile, and given that we expect to build as we go through the year, that first half, second half may be more heavily weighted towards the back half of the year.

Matt Summerville: Okay. Got it. Thank you.

Gregg Sengstack: Thanks, Matt.

Operator: Thank you. One moment, please, for our next question. And our next question comes from the line of Bryan Blair with Oppenheimer.

Bryan Blair: Thank you. Good morning, everyone.

Gregg Sengstack: Good morning, Bryan.

Bryan Blair: Action Manufacturing strikes us as strategically very important, expands into the Southeast for your water treatment platform. What is the revenue base there? You mentioned, approaching $200 million in total for the platform. And then off of that base, how is your team thinking about 2024 growth?

JeffTaylor: When you say what’s the revenue, are you asking specifically for Action Manufacturing?

Bryan Blair: Yes. Just what does that contribute to the approaching $200 million?

JeffTaylor: Yes, that – it will be in the $15 million to $20 million range overall for Action Manufacturing. In terms of operating margins, we expect to get that business in line with the rest of the water treatment business in 2024.

Bryan Blair: Okay. And the, the water treatment revenue base, all in? How is your team thinking about ’24 growth prospects?

JeffTaylor: Yes. I think we see that, we’ve always said that the Water Systems has kind of, GDP plus, 3% to 5% plus top-line growth. We see water treatment can be a little stronger than kind of the segment average there as we continue to grow that business and, and leverage it. And so I think top-line, that’s, that’s typically what we expect for growth in, in Water Systems.

Bryan Blair: Okay. Understood. And specific to water treatment staying there, how does your deal funnel look coming into ’24 and given the assets that you have in place? How is your team thinking about or prioritizing new technologies, further geographic expansion or penetration, and perhaps more of a move into commercial applications?

Gregg Sengstack: You covered all three points well. Yes, there is certainly moving into Florida in a meaningful way. It’s a key market. There are other key markets around – in the Southwest, which we’ve acquired into. We have privately held companies that people are reaching out to us, which is always good to see. And I think the opportunity to move up the complexity and size of the system into like commercial industrial, it would be a next logical extension for us as well.

Bryan Blair: Understood. If I can sneak in one, one last one, I think you mentioned, record revenue from critical asset monitoring. I understand that’s off of a relatively small base. But if you could speak with the momentum there, what you’re seeing going into ’24, and how large that business maybe come, medium term, that would be helpful?

Gregg Sengstack: Right now, the business is approaching – it’s about 10% of the fueling segment. When you look at the critical assets monitoring that relates to the grid, okay, what we call the grid business, it grew north of 20%. It’s been growing at that rate now for several years, admittedly, again, off a small base. We’re getting specked by more and more utilities. We’re getting bigger orders from utilities. These are for monitoring devices that go on to high-voltage circuit breaker, medium-voltage circuit breakers, full-top transformers, also major transformers that are used to bring in power to, to communities. And then we’re also into telco, into server farms, into railroad crossing, backup battery systems, and so on.

So, we think that just as our name gets out there, as we get more brand recognition, more specification, and as the world moves more to electrification over time, that’s going to take time – is that we’re in a good place with that business. And we think it’s kind of like where we started with fueling many, many years ago, is that we started with, one product and we added that product. We listened to our customers. We listened to their pain points, and we helped sell pain points for customers. And we’re beginning to see where customers across not only the U.S., but across the globe, are talking with us about their pain points, and we hope to solve more problems and challenges for them on a go-forward basis. We like the space.

Bryan Blair: That’s encouraging. Appreciate the color.

JeffTaylor: Thank you, Bryan.

Operator: Thank you. One moment, please, for our next question. And our next question comes from the line of Ryan Connors with Northcoast Research Partners.

Ryan Connors: Good morning, gentlemen.

Gregg Sengstack: Morning, Ryan.

Ryan Connors: So I have a few questions. Most of them are actually follow-ups on things you’ve discussed here in the Q&A already. But the first was, you were talking with Mr. Blair there about the water treatment business. But in the press release, you do mention some softness, actually, in the quarter in that business. So, can you talk specifically about what was behind that? Any particular markets or products? Is that more volume or price? Curious, what was the weakness there in the quarter itself?

Gregg Sengstack: Yes. Ryan, a couple of factors. One is, just like in other product lines in the U.S., is that we do sell in wholesale. And again, seeing a lack of enthusiasm for taking additional inventory or people taking inventories down, that’s a softer. The other thing is that, water treatment business is more housing start-related impact, as well as existing home sales. Because people often will make a decision to install or upgrade a water treatment system when they move. And so with existing home starts being at the lowest level in 30 years, where they move, rather than dramatic move in interest rates, as it’s been well talked about, that certainly has put downward pressure on that business. We now think that we’re kind of lapping that.

You’re seeing interest rates coming down a bit. You’re seeing home starts beginning to come up a little bit. So, that’s why we’re a little more optimistic about ’24. But I think it’s going to, again, the comparables will be easier in the back half of ’24, like many companies in this area than, than in the front half.

Ryan Connors: Okay. Good. And then, and then over to the fueling side and on this discussion of channel inventory destocking, we’re trying to get comfortable with reconciling that with the comments you made regarding – Gregg, regarding the underlying demand growth still being intact. So you can just discuss for us, why would we be seeing destocking, persist this long there if the demand effect is still robust underneath it. Obviously, lead times have come down. But at some point, we expect that to run as course. Can you talk about the timing where in fueling specifically what your base case is for when that dynamic kind of levels out and that growth will start to shine through?