Jeff Frappier - Gregg C. Sengstack - Chief Executive Officer, President and Director John J. Haines - Chief Financial Officer, Principal Accounting Officer, Vice President and Secretary Robert J. Stone - Senior Vice President and President of International Water Systems Group.

Ryan O'Donnell - Robert W. Baird & Co. Incorporated, Research Division Edward Marshall - Sidoti & Company, Inc. James Kim - Wedbush Securities Inc., Research Division.

Good day, ladies and gentlemen, and welcome to the Franklin Electric Quarter Three 2014 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I'd now like to turn the call over to our host for today, Mr. Jeff Frappier, Treasurer for Franklin Electric. Sir, you may begin..

Thank you, Ben. And welcome, everyone, to Franklin Electric's Third Quarter 2014 Earnings Conference Call. With me today are Gregg Sengstack, our CEO; John Haines, our CFO; and Robert Stone, Senior Vice President and President of International Water Systems.

On today's call, Gregg will review our third quarter and year-to-date business results, and then John will review our third quarter and year-to-date financial results. When John is through, we will have some time for questions and answers.

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 in 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.

During this call, we will also discuss certain non-GAAP financial measures, which the company believes, help investors understand underlying trends in the company's business, more easily. A full reconciliation of non-GAAP to GAAP financial measures is included in today's earnings release, which you can find on Franklin Electric's website.

With that, I will now turn the call over to our CEO.

Gregg?.

Thank you, Jeff. During the third quarter, the company achieved record sales. Our adjusted EPS equals last year's third quarter earnings per share, which were the highest reported earnings for any third quarter in the company's history. However, our earnings were below our guidance and expectations, principally due to the mix of sales in our U.S.

Water Systems business. During the third quarter, Water Systems sales in the U.S. and Canada; which were 41% of consolidated sales, increased by 5% compared to the prior year. U.S. and Canada sales of Pioneer branded mobile pumping equipment increased by over 75% in the third quarter of 2014, compared to the prior year.

As I mentioned, last quarter, the contribution margins of Pioneer sales deteriorated year-over-year as we outsourced production and took other actions to assure timely customer deliveries, during this period of rapid sales growth. Sales of other surface water pumping equipment grew by 6% in the third quarter.

These sales increases were partially offset by lower sales of groundwater pumping equipment; which declined about 16% in the quarter. Near perfect, meaning wet and cool weather conditions across much of the country, particularly the Midwest farm belt, reduced demand for agricultural irrigation pumping systems, pushing sales below our expectations.

A second contributing factor was reduced orders, resulting from customer inventory imbalances due to the reset of our U.S. groundwater distribution footprint. We implemented this distribution change during the third quarter.

This shift in mix from our vertically-integrated higher-margin submersible pumping system sales to our less vertically-integrated lower-margin surface pumping systems sales resulted in U.S. earnings below expectations. While our U.S.

earnings were off due to this temporary mix shift, our water systems teams in developing regions continued to deliver solid performance. For example, excluding acquisitions, Asia Pacific sales increased by about 24% compared to the third quarter prior year.

Sales in Southeast Asia grew by 48%, as the company continues to benefit from the introduction of new products, as well as the advantage of having company-owned inventory in the region.

Excluding acquisitions and the impact of foreign currency translation, Water Systems sales in Latin America; which were about 14% of consolidated sales for the third quarter, increased 7%. In spite of the weak Brazilian economy, our Water Systems sales in Brazil were up 10% in the quarter.

Our distribution outlets in Chile and Colombia also contributed to increased sales in these markets, compared to the third quarter 2013. Water Systems sales in the Middle East and Africa; which were about 10% of consolidated sales, were flat compared to the third quarter of 2013.

However, excluding the impact of foreign currency translation, sales increased by about 6% compared to the third quarter of 2013. This, in spite of a double-digit decline in South Africa sales, due to the month-long strike in July by the South African metalworker's union, which impacted many companies, including ours.

While it has taken three months for the supply chain to recover, our South African revenue is now on pace with last year. Our business in Turkey continues to post record results, driven by strong sales of groundwater pumping equipment in Turkey.

In Europe, where economic conditions remain weak, our sales declined by about 5% compared to the third quarter 2013. Sales were flat across the Franklin Electric branded Water Systems products in Europe, but down in the Pioneer branded mobile pumping equipment products in the third quarter of 2014. Turning now to our Fueling business.

The Fueling business team turned in another great quarter, ahead of expectations and guidance, with sales growing 19% and earnings growing by 26%, compared to the third quarter prior year. Fueling Systems grew across all product lines in all regions of the globe. Fueling station owners continue to invest in Franklin Pressure Pumping Systems.

We're delivering fuel dispensers as well as our vapor control and leak detection systems. Returning to the subject of developing regions for a moment. We continue to be convinced that over the next decade, most of the world's growth in demand for our Water and Fueling products will occur in developing regions.

We're pleased that during the third quarter, we completed 2 acquisitions in India, one on the Waterside business and one on the Fueling side. Both of these acquisitions along with the Bombas Leao acquisition in Brazil during the second quarter, are part of our long-term strategy to expand our reach in developing markets.

We believe that after the initial integration costs are behind us, these acquisitions will be accretive to earnings during 2015. Our overall sales in developing regions now stands at 40% of our consolidated revenue and grew by 20% versus the third quarter of last year.

As you look forward to the fourth quarter, our Water Systems outlook assumes the continuation of many of the same factors we experienced in the third quarter.

Although we believe organic revenue growth will be solid, product sales mix will continue to negatively affect our adjusted operating income, as we expect groundwater equipment sales to be lower in the U.S., due, principally, to the decline in the sale of agricultural irrigation pumping equipment.

As a result, we're projecting that our fourth quarter 2014 global Water Systems sales will increase by 8% to 10%, but our adjusted operating income will decline by about 10% to 12%.

However, we expect our Water Systems' adjusted operating income margins will decline about 300 to 325 basis points, as compared to the 430 basis point decline in the third quarter of this year. It is important to point out that this entire margin decline is a function of mix, and not price erosion.

As we move into 2015, and stability returns to our groundwater distribution network, we expect that our Water Systems sales mix will return to more historical levels. Finally, as we enter 2015, we are implementing controls that will materially slow the growth rate of fixed spending.

All these points should restore the operating leverage that the company has consistently achieved. We estimate that our Fueling Systems sales and adjusted operating earnings will grow in the fourth quarter of 2014 by 4% to 6%, as compared to our record 2013 fourth quarter.

And finally, despite the adjusted operating income decline, our consolidated adjusted earnings per share will grow in the 3% to 5% range, due in part to continued tax planning with respect to our foreign operation. I would now like to turn the call over to John Haines, our CFO.

John?.

Thank you, Gregg. Our fully diluted earnings per share, as reported, were $0.46 for the third quarter 2014 versus $0.51 for the third quarter of 2013. As we note in the tables in the earnings release, the company adjusts the as-reported GAAP operating income and earnings per share for items we consider not operational in nature.

We believe presenting these matters in this way gives our investors a more accurate picture of the actual operational performance of the company.

Non-GAAP expenses for the third quarter of 2014 were $3 million and included $2.2 million in restructuring costs, primarily for the European manufacturing realignment announced by the company on July 1, 2014 and $0.8 million for acquisition-related cost. The third quarter of 2014, non-GAAP adjustments had an EPS impact of $0.04.

The non-GAAP EPS adjustments in the third quarter of 2013 rounded to $0.01 reduction in the reported EPS. So after considering these non-GAAP items, third quarter 2014 adjusted EPS is $0.50, which is equal to the $0.50 adjusted EPS the company reported in the third quarter of 2013.

Water Systems sales were $216.6 million in the third quarter of 2014, an increase of $18.7 million or about 9% versus the third quarter of 2013 sales of $197.9 million.

Sales from businesses acquired since the third quarter of 2013 were $9.9 million or about 5%, Water Systems sales were reduced by $2.9 million or about 1% in the quarter, due to foreign currency translation. Water Systems sales growth, excluding acquisitions in foreign currency translation, was about 6%.

Water Systems operating income after non-GAAP adjustments was $31 million in the third quarter of 2014, a decrease of about 16% versus the third quarter of 2013. The third quarter operating income margin after non-GAAP adjustments was 14.3%, down 430 basis points from 18.6% in the third quarter of 2013.

As Gregg has already mentioned, Water Systems adjusted operating income margin declined, primarily due to a sales mix shift during the third quarter. Historical Water Systems sales mix is 65% groundwater and 35% surface pumping equipment. During the third quarter 2014, the actual sales mix was 59% groundwater and 41% surface water pumping equipment.

This shift primarily occurred because of a 6% global decline in the sale of pumps for agricultural irrigation and a 60% increase in global sales of Pioneer-branded mobile pumping equipment. The profit margin on agriculture irrigation pumps is significantly higher than the margin on surface pumps.

Water Systems margins also declined in the quarter, due to higher fixed cost, in part, from the recent acquisitions. Fueling Systems sales represented 22% of consolidated sales and were $61.5 million in the third quarter 2014, an increase of $9.6 million or about 19% versus the third quarter of 2013 sales of $51.9 million.

Fueling Systems sales increased by $0.3 million or less than 1% in the quarter, due to foreign currency translation. Fueling Systems acquisition-related sales in the third quarter were less than 1%. Excluding acquisitions and the impact of foreign currency, Fueling Systems sales increased about 18% compared to the third quarter 2013.

During the third quarter 2014, Fueling Systems shipped about $3.5 million of equipment to India, to partially fill a large customer order. Excluding the impact of these India sales, Fueling Systems sales grew by about 11%. Sales growth was across all product lines and all regions of the world.

Fueling Systems operating income after non-GAAP adjustments was $15.7 million in the third quarter of 2014, compared to $12.5 million after non-GAAP adjustments in the third quarter of 2013, an increase of about 26%.

The third quarter operating income margin after non-GAAP adjustments was 25.5%, an increase of 140 basis points from the 24.1% of net sales in the third quarter of 2013. The increase was primarily driven by a fixed cost leverage on higher sales.

The company's consolidated gross profit was $89.2 million for the third quarter of 2014, an increase of $2.2 million or about 3% from the third quarter of 2013 gross profit of $87 million. The gross profit as a percent of net sales was 32.1% in the third quarter of 2014, down about 270 basis points versus 34.8% during the third quarter 2013.

The previously discussed mix shift in the Water Systems segment, contributed significantly to lower gross margins in the quarter. Selling, general and administrative or SG&A expenses were $55.6 million in the third quarter of 2014 compared to $48.4 million in the third quarter of the prior year, an increase of $7.2 million or about 15%.

Increase in SG&A expenses from acquired businesses were $3.2 million. Excluding the acquisitions, the company's overall SG&A expenses in the third quarter of 2014 increased by $4 million or about 8% to the prior year third quarter.

These remaining -- the remaining increases in SG&A were primarily driven by higher sales, commissions, marketing and selling related costs in support of higher sales and increases in research, development and engineering spending.

The tax rate as a percent of pretax earnings for the third quarter of 2014 was about 23%, a decrease of about 5% from the third quarter of 2013 tax rate of about 28%, primarily due to the income mix by jurisdictions and the expiration of the statutes of limitations for certain -- for some uncertain tax positions.

The full year 2014 rate is estimated to be about 23%.

As Gregg mentioned in our guidance, we expect the fourth quarter 2014 tax rate to be about 10% due to the continued benefit of restructuring of FE's international entities; which will result in the reversal of certain deferred tax liabilities, a discrete event in the quarter, as well as reduced tax expense in future periods.

The company ended the third quarter of 2014 with a cash balance of $77.4 million, which was $57.1 million lower than at the end of 2013. The cash balance decrease is primarily attributable to increased working capital needs and acquisitions.

The company had borrowed $45.7 million on its revolving debt facilities at the end of the third quarter of 2014, versus no borrowings at the end of the third quarter of 2013. The company purchased about 59,000 shares of its common stock for approximately $2.2 million in the open market during the third quarter 2014.

This brings our total share repurchases year-to-date 2014 to about 203,000. The total remaining authorized shares that may be repurchased is about 910,000.

Finally, on October 24, the Board of Directors of the company declared a quarterly cash dividend in the amount of $0.09 per share for outstanding shares of common stock on November 20, 2014, with a record date of November 6, 2014. This concludes our prepared remarks. We'd like to now turn the call over for questions..

[Operator Instructions] Our first question comes from the line of Ryan O'Donnell of Robert W. Baird..

This is Ryan on for Mike.

Could you guys just bucket out, maybe, the groundwater decline, ag relative to kind of the near-term channel shifts you guys are seeing?.

Ryan, the way we look at it is probably more than half the of decline was weather-related and less than half of the decline was inventory adjustments or lack of underlying demand, given the channel and the channel inventory levels..

And then it sounds like ag should continue to be weak in 4Q.

Is this still -- it sounds like primarily weather but, how much of it is maybe due to the underlying spending constraints that we're seeing in the market, overall?.

This ag mix of product..

The mix improving back toward normalized levels in Water Systems. Could you just talk about kind of the shifts you're going to see next year with, I guess, maybe, Pioneer has continued to grow pretty fast? And then, maybe, a bounce back in ag, and some of the channel shifts going away. Just talk about the moving pieces there..

Yes. Ryan, the way we're looking at is that Pioneer is now operating at a higher level. You're not going to see that kind of growth next year, year-over-year. And what we're looking for in Pioneer, is that now that we're operating at these levels, is to improve the underlying profitability of Pioneer over a period of time.

With respect to the ag and overall mix shift, when you see -- we have a challenge because it's been a soft market. We are going through a change in our distribution footprint. We terminated a relationship that's affected 30 outlets. We've added more than 50 to 60 additional outlets in replacement of those.

And so that's going to work its way through time, and we would expect that as the 2015 year unfolds, that we'll kind of go back towards history -- historic levels during the year..

Our next question comes from the line of Edward Marshall of Sidoti & Company..

So I'm curious, if you could potentially quantify, maybe, some of the loss margin potential that you've had on, say, Pioneer by outsourcing that to some of these components to a supplier?.

Yes. I'm not going to give you the exact margin differential, but when we look at our variable contribution margins, net sales less variable cost of sales, they're significantly lower than where they were this time last year.

And as we said in our comments, the URI relationship is a fantastic win for Franklin Electric, and we're in a position where they have placed very large orders and had very large demand on us for, certainly, in the second and third quarters of this year and that will continue in the fourth quarter. And we wanted to meet that demand.

So customer service and meeting their requirements for fulfillment and delivery, in our mind came first. The price for that, however, was that we had to go outside, in many cases, to expand our capacity footprint, in some cases to get the right mix of product that we -- that customer wanted.

And that cost us from a margin perspective, but it was very significant. Now good news there is, when you look sequentially at this same variable contribution margin over the month, let's say, from -- call it, from June to September, it is getting better. And we would expect -- we reviewed this with the Pioneer team.

We understand their 2015 plan, I think, fairly well, and we would expect that these variable contribution margins for Pioneer would kind of come back to 2013 levels next year. So that's -- it's definitely an issue impacting us, but it's not one we see continuing into the future..

And as that business continues to grow and I understand you're going to step off the growth rates you've seen, but I'm curious if there's any kind of plans for potential capital on your end, kind of expand your capacity there to maybe meet future demands?.

Within the concept of our overall capital investment, the company will fit within that plan. We typically spend, as a company, between 3.5% and 4% of revenue on CapEx. And we look around the globe, and it will fit within that -- those parameters..

Okay.

And I understood your comments about maybe being tough at your end to kind of see the inventory in the channel, but I'm kind of curious, if there is any way you can kind of -- how do you gauge the pulse there, or maybe how much inventory do you see? And how long does that persist? I guess there are equal people on both sides of the aisle that say, ag could be up or down next year, but, kind of, how do you see it? You are guiding to growth next year.

I'm just kind of curious how you see that coming through with the inventories and how that flushes out.

Is it more back-end loaded, or how do you see it?.

We have customers that are on annual purchase targets and so that also adds a level of variability. But when people are coming into the back half of the year, and it's been a wet year, they are a little reticent to carry inventory into the next year. To your point, next year's ag situation could be very dry and would be ideal for groundwater pumping.

It could be another wet year where it'll be an easier comp in that respect. But it's not like the distributors are carrying 6 or 7 months inventory, they're carrying a couple 3 months inventory, but we just know coming at the end of the year that it's heavy and it's particularly in the Midwest region..

Okay.

And when you look at your change in ag, is there a way for you to parse out, maybe, what has been distribution changes and what's been just sluggish demand and the impact of both or the percentage change in both? I mean, is there any way to quantify that for us?.

Again, I mentioned earlier that I think, maybe, half of the decline, a little more of that decline is weather-related and the other is just, kind of again, restocking and destocking that we talked about, would be occurring over the next couple of quarters or the last quarter, and probably fourth quarter.

To give you a point of reference, in Brazil, where the economy apparently is not growing on a macro basis, our sales are up 10% and they're up 10% partly because it's been relatively dry and people are looking to Franklin Electric to solve their groundwater needs.

And when you get into wet and dry years, you can have that level of variance, so it just gives you another market where we're seeing relatively dry conditions being a nice boost to our business when the economy in Brazil has been kind of weak..

And ladies and gentlemen, that does conclude our Q&A session. I'd like to hand the conference back over to Mr. Gregg Sengstack, CEO, for any closing remarks..

Hang on a second here, Ben. I think we have another analyst who would like to ask a question.

If you can bring him online?.

We see, Ben, that David Ross just came into the queue.

Is David on?.

Mr. Rose from Wedbush Securities..

Yes. This is actually James in for David today. So, question here on expenses.

So looking at Q4 other than the negative sales mix you expect, are you guys expecting any incremental expenses in the quarter? I mean if I were to look at maybe Q4 of last year, you guys had a lot of nonrecurring, kind of, onetime charges related to IT expenses at the new headquarters, and you had some expenses related to pump rental initiatives and commercializing artificial lift, and et cetera, et cetera.

So want to see if any of those expenses actually roll off and you may see some, either tailwinds or headwinds from those?.

Well, I think, James, in the corporate segment of that corporate group that we captured just costs in, I would expect that to be up 3% to 4% in the fourth quarter of 2014. So there is some inflation in that. There's some incremental increase in that, but that's what our current expectation is for that bucket of expenses..

Okay. So for -- for your expectation, you're just mainly, the negative impact is from the sales mix, in Q4? The water ....

Yes. The Q4, as Gregg pointed out in our guidance, James, we're expecting our water operating income to decline in the fourth quarter and that decline is almost entirely the result of the continuation of these factors we've been discussing, the mix shift from groundwater to surface, the lower-than-expected margins on the Pioneer product sales.

So those factors will continue into the fourth quarter and when you look at that operating income decline in water, those are the primary factors contributing to that..

Okay. And going back to the groundwater pumping equipment, you talked about, obviously, weaker demand, driven in part by the distributor reset. I think last quarter, you didn't see much of that, but that seemed to have changed and you talked about just overall ag being down and inventory levels sort of having to reset.

Is that the main impact or was there any change in the distribution network that you could point out?.

No. James, what -- going into the third quarter, things were, as you pointed out, kind of going -- unfolding as planned. We actually didn't make the change. We announced the change earlier. We didn't actually didn't make the change until the third quarter. And so, really that's when it unfolded.

And then, that along with the poor climatic conditions just doesn't encourage people to take a lot of additional inventory. They've got to work off that which they have. So it was just a compounding factor in Q3, the weather being really pretty ideal for farming, but not so ideal for pumping..

Okay. And last question, actually. Regarding the sales mix, I know, obviously, Pioneer had a very strong quarter driven by URI.

Was that the increase mainly driven by URI? Or was there kind of a broader uptick in the business? And then, another question is, when you talk about sales mix going back to the historical levels, is that because you're expecting -- I know you mentioned it before, but expecting the surface water, kind of, the Pioneer brand demand decline next year or going back to the historical levels like you said, despite the ag, kind of, environment being weak at this point?.

Okay. Two-part question. I'd say that, as you look into 2015, I mentioned earlier, is that we expect the Pioneer sales to now be operating at a new level; much higher obviously to 2013. And then, we'll be expecting to see a recovery in our submersible groundwater pumping business in 2015, so that the mix will rebalance.

With respect to your first question about Pioneer sales mix, I'm going to ask Robert Stone to address that question to you..

The URI has been a significant driver and we're actually expecting that their demand, in terms of fleet build will start to taper, going into 2015. But we've also seen a lot of growth in other market areas, such as Australia, where we've had very nice growth this year and we're expecting more growth in Australia next year.

So we'll have a little bit of an offsetting condition with URI volume, but improving margins for the Pioneer piece in 2015..

And again, James, as John Haines pointed out earlier in the call, we're expecting the operating margin, while it's going to be a decline, we expect it to be a decline in fourth quarter Water business, it will be a smaller decline in the third quarter, and that shows some recovery. And to Robert's point, some improvement in profitability at Pioneer..

Thank you. We also have a follow-up from the line of Edward Marshall of Sidoti & Company..

Just a quick follow-up. You mentioned the tax rate. I guess I'd be remiss about not asking. Did you say, it was -- I think you said it was a 10% tax rate in the quarter. I think you were taking some -- reversing some deferred tax liabilities.

What would be your effective tax rate for the fourth quarter? Is it still along those 28%? And I guess, same question for 2015?.

Yes.

The effective tax rate for the full year '14, Ed, is that what you're asking?.

Well, I mean, if you ex out these deferred tax liabilities that you're going to be taking in the quarter, what would your tax rate look like? Would it be closer to the 28% range? You did say it was coming down a bit..

Yes. It's in the 27% range..

And actually -- and as we look out to 2015, same kind of outlook, 27% on a go forward?.

Yes. 25% to 27%, somewhere in that range..

Okay. So that lowers it quite considerably.

What region of the world is this adjustment?.

It's mainly Latin American entities that are going into this international tax structure that we have. And so, it's the addition of -- the largest ones are the additions of the Brazilian entities..

Thank you. I'm showing no further questions in queue. I'd like to turn the conference back over to Mr. Gregg Sengstack, CEO..

Thank you, Ben. And we appreciate everyone following Franklin Electric, and we'll talk to you after the first of the year..

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program, and you may all disconnect..