Franklin Electric Co., Inc. — Q2 2010 Form 10-Q
Reporting period: Quarter ended July 3, 2010; year-to-date figures cover the six months ended July 3, 2010. Comparisons are with the quarter and six months ended July 4, 2009. Amounts below are in millions unless noted.
Business context and performance
Franklin Electric reports Water Systems and Fueling Systems. Q2 growth was driven by higher Water Systems sales across U.S. and international markets; Fueling Systems sales were slightly lower, primarily reflecting reduced California vapor-recovery demand. Management attributed improved profitability to higher volume, operating leverage, and lower material and production costs.
Key financial metrics
| Metric | Q2 2010 | Q2 2009 | Six months 2010 | Six months 2009 |
|---|---|---|---|---|
| Net sales | $190.4 | $165.3 | $350.4 | $315.1 |
| Gross profit / margin | $64.5 / 33.9% | $49.2 / 29.7% | $114.9 / 32.8% | $92.4 / 29.3% |
| Operating income / margin | $18.4 / 9.7% | $10.8 / 6.5% | $30.8 / 8.8% | $18.6 / 5.9% |
| Net income attributable to Franklin Electric | $11.0 | $5.8 | $18.2 | $9.7 |
| Diluted EPS | $0.47 | $0.25 | $0.78 | $0.42 |
| Operating cash flow | Not separately reported for the quarter | $22.1 | $39.0 |
Q2 sales rose 15%; Water Systems sales increased 19% to $160.2, while Fueling Systems sales declined 2% to $30.2. For the first half, Water Systems sales rose 18% to $294.4 and Fueling Systems sales fell 15% to $56.0. The reported Q2 gross margin improved 420 basis points year over year; management attributed about 250 basis points to favorable material costs and manufacturing changes, with the remainder primarily from operating leverage.
At July 3, cash and equivalents were $92.9, current assets $348.1, and current liabilities $108.4. Debt was approximately $151.5, including $150.0 under the Prudential agreement; cash less debt was approximately negative $58.6. Long-term debt was $151.0 on the balance sheet. The company reported $22.1 of operating cash flow, $3.5 of investing cash outflow, and $7.4 of financing cash outflow for the first half. Operating cash flow decreased from 2009, mainly because receivables used $30.9 of cash; inventory also used $4.7, while accounts payable and other accrued liabilities provided $29.0.
Material changes and unusual items
- Operating income increased 71% in Q2 and 65% for the first half, led by Water Systems. Fueling Systems operating income fell to $1.8 in Q2 from $4.9, and to $6.2 for the first half from $11.9.
- SG&A included $3.8 of legal-matter expense in Q2. Management also cited higher legal and professional fees; these matters weighed on Fueling Systems results.
- Restructuring expense was $2.9 in Q2 and $5.1 for the first half, primarily related to closing the Siloam Springs, Arkansas facility. About $2.4 in Q2 was noncash asset impairment; first-half restructuring costs included $3.4 of noncash items. The filing initially estimated $4.0–$4.8 of pre-tax costs for this final closure phase.
- First-half other expense included a $2.9 reversal of a pre-acquisition uncertain tax position and related indemnified receivable; management said the reversal had no effect on net income. Excluding it, the filing said other income would have been about $1.1 and income tax expense about $8.9.
- Foreign currency translation reduced first-half comprehensive income, with a $16.7 translation loss. The company repurchased 126,600 shares for $3.5 in Q2 and paid $5.9 in dividends during the first half.
Liquidity, outlook, and risks
The company reported no borrowings under its revolving credit agreement at July 3 and $117.8 of available capacity, net of standby letters of credit. Prudential capacity was then $25.0; a July 22 amendment increased it to $50.0. Management expected operating cash flows and existing credit facilities to fund operations, capital expenditures, dividends, and debt service. The company said it was in compliance with debt covenants and had no scheduled principal payments under the Prudential agreement until 2015.
Management projected a full-year effective tax rate of about 32.5%, excluding discrete events. It was evaluating additional restructuring opportunities, primarily in North America, but gave no estimate of future charges pending definitive plans. The filing cautions that interim results are not necessarily indicative of full-year results and provides no specific revenue or earnings guidance.
Material uncertainties include California regulatory proceedings concerning Healy vapor-recovery products, including potential penalties or settlements that could materially affect results; litigation with former Healy owner James Healy over retained purchase-price and earn-out amounts, with trial scheduled for October 2010; and other ordinary-course legal and environmental claims. Management said it believed recorded legal expenses were appropriate based on known facts, but outcomes remain uncertain. Other cited business risks include economic and currency conditions, housing starts, weather, demand, competition, distribution changes, supply constraints, raw-material costs, and regulatory actions. Management reported disclosure controls were effective and no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether Water Systems growth and margin gains persisted, and how much depended on favorable input costs and operating leverage.
- Receivables growth and cash conversion, given the decline in first-half operating cash flow and the substantial receivables cash use.
- Final costs and timing of the Siloam Springs closure, including how the $5.1 million first-half charge compares with the stated $4.0–$4.8 million estimate.
- Potential liability, settlement timing, and cash exposure from CARB and air-district matters and the Healy litigation; the filing does not provide a clear estimate of potential exposure.
- Availability of credit facilities, covenant compliance, and the effect of the increased Prudential borrowing capacity on liquidity and leverage.