Franklin Electric Co., Inc. — Q3 2014 Form 10-Q
Reporting period: Third quarter and nine months ended September 27, 2014; comparisons are with the periods ended September 28, 2013. Franklin Electric operates Water Systems and Fueling Systems businesses.
Key financial results
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Net sales | $278.1 million | $249.8 million | $793.9 million | $735.8 million |
| Gross profit | $89.2 million | $87.0 million | $266.7 million | $255.5 million |
| Gross margin | 32.1% | 34.8% | 33.6% | 34.7% |
| Operating income | $32.4 million | $37.7 million | $97.5 million | $101.6 million |
| Net income attributable to Franklin Electric | $22.7 million | $25.1 million | $66.7 million | $68.7 million |
| Diluted EPS | $0.46 | $0.51 | $1.36 | $1.41 |
Sales increased 11% in Q3 and 8% year to date. Management attributed growth to acquisitions, pricing and volume, partly offset by currency translation. Excluding acquisitions and currency effects, sales grew approximately 8% in both periods. Q3 operating margin was 11.7%, versus 15.1% a year earlier; year-to-date operating margin was 12.3%, versus 13.8%.
- Segments: Q3 Water Systems sales rose 9% to $216.6 million, but operating income fell to $28.3 million from $36.0 million. Fueling Systems sales rose 19% to $61.5 million and operating income increased to $15.4 million from $14.0 million. Year-to-date segment sales were $627.8 million for Water Systems and $166.1 million for Fueling Systems.
- Cash flow: Nine-month operating cash flow was $3.5 million, down from $55.0 million. Receivables and inventory used $50.1 million and $49.9 million, respectively. Investing cash outflow was $68.4 million, including acquisitions; financing provided $11.4 million. Cash declined $57.1 million to $77.4 million.
- Debt and liquidity: Total debt was $227.4 million, including $82.7 million current maturities and short-term borrowings, versus $189.6 million at year-end 2013. Cash was $77.4 million. The company reported $99.2 million available on its $150 million revolver and $50 million capacity under its private shelf agreement. It was in compliance with debt covenants. Current assets were $526.7 million and current liabilities $244.4 million.
- Other: Dividends per share were $0.09 in Q3, up from $0.0775. Nine-month depreciation and amortization was $27.8 million. The effective tax rate was approximately 23% in Q3 and 25% for the first nine months.
Material changes and management commentary
- Despite higher sales, Q3 earnings declined, principally due to Water Systems sales mix, higher material costs, lower fixed-cost leverage and acquisition-related costs. Gross margin declined 270 basis points. Management cited higher shares of surface-water and Pioneer mobile pumping products, which carry lower margins, and temporary outsourcing to meet Pioneer demand.
- For the first nine months, Water Systems adjusted operating income margin declined 220 basis points to 16.4%; Fueling Systems adjusted margin improved 260 basis points to 23.2%. Company-reported adjusted diluted EPS was $0.50 in Q3, unchanged year over year, and $1.45 year to date, up 1%. These are non-GAAP measures.
- Cash generation weakened substantially amid higher inventory for anticipated Pioneer demand, product launches and seasonal stocking, plus higher receivables from sales growth and extended credit terms in some emerging markets.
- Acquisitions included Bombas Leao in Brazil for approximately $30.7 million, plus controlling interests in two Indian businesses for a combined approximately $6.6 million. Their reported-period results were not material. The company also acquired additional Impo ownership earlier in 2014.
- A restructuring announced in July will move manufacturing from Wittlich, Germany, to Brno, Czech Republic, while retaining the Wittlich headquarters and distribution center. The realignment is expected to finish by the end of 2016. Q3 restructuring expense was $1.1 million; nine-month expense was $1.5 million.
Outlook, risks and contingencies
- Management said cash on hand, operations and existing credit facilities are expected to fund operations, capital expenditures, pension obligations, dividends and debt service. No specific revenue or earnings guidance was provided.
- The filing gives differing tax-rate descriptions: Q3 discussion estimates a full-year 2014 rate of about 23% after discrete items, while the nine-month discussion cites a pre-discrete rate of about 27% as a reasonable full-year estimate and describes the projected rate as consistent with 2013. The filing does not clearly reconcile these estimates.
- Risks highlighted include economic and currency conditions, weather and market demand, housing starts, competition, distribution-channel changes, supply constraints, raw-material costs, acquisition integration, litigation and regulatory actions.
- California regulators appealed a 2013 complete defense verdict in the CARB nozzle case. The company planned to file its response by December 12, 2014; a hearing, if held, was expected in late Q2 2015. The company said the case had not affected product certification or sales. Management believed other ordinary-course claims could be resolved without material adverse effect.
- Other unusual items included $2.5 million of executive-transition costs, $1.1 million of Pioneer rental software write-offs and $0.8 million of acquisition-related costs in Q3. The company reported $8.7 million of purchase commitments and an $8.9 million warranty accrual at quarter-end.
Important facts for investors to verify
- Whether inventory and receivables convert to cash and operating cash flow recovers from the sharp year-to-date decline.
- Whether Water Systems margins improve as product mix, outsourced capacity and acquired businesses evolve, and whether Fueling Systems growth persists.
- Acquisition integration, final Bombas Leao purchase accounting valuations and the effect of additional borrowing on debt service and covenant headroom.
- The final full-year tax-rate outlook and the outcome of the CARB appeal, as well as any material developments in other legal or warranty matters.
- The sustainability of management’s non-GAAP adjustments and the gap between reported and adjusted earnings.