FELE

Business Context and Reporting Period

Company: Franklin Electric Co., Inc.
Filing Type: Form 10-K (Annual Report)
Period Ended: December 30, 2006
Business Overview: Franklin Electric is a global leader in the design, manufacture, and distribution of groundwater and fuel pumping systems, submersible pumps, motors, and electronic controls. The company operates two segments: Water Systems and Fueling Systems. In 2006, the company divested its Engineered Motor Products Division (EMPD), classifying it as a discontinued operation.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 38% to a record $557.9 million. Approximately $86 million (21% of prior year sales) was attributable to acquisitions, primarily Little Giant Pump Company and Healy Systems, Inc. Organic growth and price realization gains also contributed significantly.
• Profitability: Income from continuing operations rose 24% to $56.8 million. Gross margin decreased slightly to 34.3% from 35.4% due to a product mix shift toward higher-cost pump products (Little Giant) and increased commodity costs.
• Acquisitions & Divestitures: The company acquired Little Giant Pump Company ($123.9 million) and Healy Systems ($35.3 million). It divested the Engineered Motor Products Division (EMPD) in Q4 2006.
• Debt & Liquidity: Long-term debt increased significantly to $51.0 million (from $12.3 million) to fund acquisitions. Cash and cash equivalents declined from $52.1 million to $34.0 million. The current ratio decreased from 3.2 to 2.3 as excess cash was deployed for acquisitions.
• Accounting Changes: The company adopted SFAS No. 123(R) for stock-based compensation, resulting in a $3.2 million expense in 2006 (compared to $0.1 million in 2005).

Guidance, Outlook, and Risks

Management Commentary: Management attributes earnings improvement to increased sales, reduced manufacturing costs from international production bases (Mexico, Czech Republic, China), and price realization gains. These were partially offset by higher commodity costs and increased SG&A expenses related to a new direct-to-distributor marketing strategy.

Strategic Outlook: The company plans to continue selling Water Systems products directly to distributors, significantly curtailing sales to integrated pump manufacturers starting in 2007. This strategy aims to broaden the customer base and reduce dependency on large OEMs.

Risks and Contingencies:

• Customer Concentration: While reduced, two major customers (ITT Industries and Pentair Corporation) still accounted for approximately 23% of consolidated sales in 2006.
• Competition: Pump OEMs have acquired the ability to produce submersible motors, potentially leading to excess inventory and price declines in 2007.
• Commodity Prices: The company is exposed to fluctuations in raw material costs (steel, copper) and does not generally hedge these commodities.
• Market Conditions: Demand is sensitive to housing starts and general economic conditions.

Investor Verification Checklist

• Acquisition Integration: Verify the successful integration of Little Giant and Healy Systems and whether they are meeting projected revenue and profitability targets.
• Customer Concentration: Monitor the sales mix to ensure the reduction in dependency on ITT Industries and Pentair Corporation continues as planned.
• Margin Pressure: Assess the impact of rising raw material costs (steel, copper) and the ability to pass these costs to customers without losing market share.
• Debt Servicing: Review the company's ability to service the increased debt load ($50 million revolver + long-term notes) given the decline in operating cash flow.
• Strategic Shift Execution: Confirm the effectiveness of the new direct-to-distributor sales model and its impact on sales volume versus OEM sales.