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Franklin Electric Co. Inc. (NASDAQ:FELE)

Q3 2007 Earnings Call

October 29, 2007 5:00 pm ET

Executives

Mike Butchko - Treasurer

Scott Trumbull - Chairman and CEO

Tom Strupp - CFO

Gregg Sengstack - SVP of Franklin Electric's and Presidentof Asia-Pacific Water Systems and Fueling

Analysts

Matt Summerville - KeyBanc

Michael Schneider - Robert Baird

Ned Borland - Next Generation

Brad Schneider - Schneider Capital

Operator

Greeting ladies and gentlemen and welcome to the FranklinElectric Company Incorporated Third Quarter 2007 Earnings Release. At thistime, all participants are in a listen-only mode. A brief question-and-answersession will follow the formal presentation. (Operator Instructions).

As a reminder, this conference is being recorded. It's nowmy pleasure to introduce your host, Mr. Mike Butchko, the Treasurer for FranklinElectric. Thank you, Mr. Butchko, you may begin.

Mike Butchko

Thank you, Rob and welcome to Franklin Electric's thirdquarter 2007 Earnings Call. With me today, are Scott Trumbull, our chairman andCEO, Tom Strupp, our CFO and Gregg Sengstack, our Senior Vice President ofFranklin Electric's, President of Asia-Pacific Water Systems Fueling. Ontoday's call Scott will review the key issues confronting our company this yearand our prospects as we end and 2007 and move into 2008. Tom will review thethird quarter and year-to-date financials. When Tom is through we'll allow sometimefor questions and answers.

Before we begin let me remind you that any forward-lookingstatements contained herein including those relating to the company's financialresults, business goals and sales growth involve risks and uncertainties,including but not limited to, risk and uncertainties with respect to generaleconomic and currency conditions, various conditions specific to the company's businessand industry, weather conditions, new housing starts, market demand,competitive factors, changes in distribution channels, supply constraints,technology factors, litigation, government and regulatory actions, the company'saccounting policies, future trends, and other risks which are detailed in the company'sSecurities and Exchange Commission filings included in Item 1A of Part I of thecompany's Annual Report on Form 10-K for the fiscal year ending December 30,2006, Exhibit 99.1 attached thereto and in Item 1A of Part II of the company'sQuarterly Reports on Form 10-Q. These risks and uncertainties may cause actualresults to differ materially from those indicated by the forward-lookingstatements. All forward-looking statements are made herein are based oninformation currently available, and the company assumes no obligation toupdate any forward-looking statements.

I will now turn the call over to our Chairman and CEO, ScottTrumbull.

Scott Trumbull

Thank you, Mike. Good afternoon. As we remain attentive tothe decline in our earnings this year, we are also confident that the factorscausing the decline are acute, not chronic, and the actions we are taking thisyear will result in a return to solid earnings growth in 2008. My comments thisafternoon will focus on our basis for this confidence.

We are achieving strong sales and earnings growth in bothour Fueling and International Water Systems end markets. Together these endmarkets represent 53% of our total revenues. This year our Fueling sales are uporganically by 28% and up 48% overall. Our International Water sales are up 11%organically and 22% overall, our sales in developing regions are driving thisorganic growth.

Operating earnings from Fueling and International Water havegrown more rapidly than sales. So in Fueling and International Water, whichtogether represent 53% of our total revenue, our performance has been verygood. The reasons that I will discuss in a moment, we have strong momentum inboth these markets and expect sustained growth through 2008.

However, our growth in these areas in 2007 has been maskedby reduced sales in earnings in the U.S. and Canadian Water Systemsmarket. As those of you who follow the company know, in 2004 we made animportant strategic decision: that is to sell our Water Systems products in theU.S. and Canada primarily through thedistributors, as opposed to large pump OEMs, and to enter the pump businessourselves.

We made this decision because we determined that our salesand earnings, from a complete line of Water Systems products sold todistributors, would grow to exceed the sales in earnings we could achieve fromselling only submersible motors to a highly concentrated group of large pump OEMs.

In the course of implementing of this decision we enteredinto a settle agreement with the two largest pump OEMs, which ensures that wewould supply them with Franklinmotors until January 1st 2007.When that agreement expired on January 1st, we discontinued supplying these twoOEMs. As a result, our sales in the U.S.and Canadato these two accounts declined by $30 million during the third quarter and by$82 million year-to-date.

Our fourth quarter 2007 sales comparison will also be penalizedby about $30 million, representing our sales for the two OEMs during the fourthquarter of 2006. For reasons that we anticipated, we are not fully offsettingthese declines in 2007 with organics sales increases to distributors and othercustomers in the U.S. and Canada.

The primary reason is that during 2006, the two large pump OEMsstockpiled a significant quantity of Franklinmotors that they could liquidate during 2007, after we discontinued supply.Throughout 2006, we advised investors, in each of our quarterly earningsreleases, about our concerns regarding this motor stockpile and its potential impacton 2007 results.

We estimate that the stockpiling increased our sales by approximately250,000 motors or $35 million to $40 million in 2006. In addition, we believeour sales this year have been negatively impacted by a similar amount, as thestockpile has been liquidated and our competitors have continued to supplydistributors and contractors with Franklinmotors.

So as we had anticipated in 2007, we are running againstartificially high prior year comparisons and we are delayed in realizing thesignificant sales growth opportunity as our competitors sell our motors from theirinventory.

An additional issue this year has been unique overall waterssystems industry demand in the United Statesand Canada.Based on trade association data we estimate that industry unit volume is off 12%to 13% due principally to the downturn in new housing starts.

We are encouraged that, in spite of these headwinds, our watersystem sales to distributors, and other customers in the U.S. and Canada, are growing at anannualized rate of $40 million to $45 million in 2007, and sales to ourcustomers accelerated in the third quarter. During the third quarter we startedpicking up increased anecdotal evidence for our field sales organization thatthe remaining stockpile is now being allocated among distributors customers.

As we look to 2008, we believe our sales to distributors andother customers will continue to grow organically. With this growth fueled byseveral factors;

First, that with the stockpile diminished, we will no longerbe competing against our own motors. This will open an estimated $35 million to$40 million sales opportunity in motors. This amount represents the estimatedvalue of Franklinmotors that were supplied to the market this year from our competitors’stockpile and, in addition, we have the opportunity to sell the pumps that gowith those motors. Our competitors will retain a portion of this business, likeselling pumps with their new motor, but all of our market research, as well as50 years of experience with contractors, gives us confidence that a significantamount of the sales opportunity will come our way.

Second we've achieved an important increase in ourdistribution footprint in several key regions of the country during the backhalf of this year and this will result in increased sales in 2008.

Third, during 2007 we've introduced a series of new pumpproducts that have improved and expanded our product lines. These products arebeing well received by our growing distributor and water well contractorcustomer base and will lead to sales growth in 2008.

And fourth, our QuickPAK and SubDrive product lines areleading a paradigm shift in the water systems industry, as the industry movesto electronic drives as the means for controlling water pressure from a well.We are leading this shift and our drive product lines are growing rapidly asthe change accelerates.

For all these reasons: that is the opportunity in 2008 tosell motors and related pump products that were supplied out of stockpile in2007, our expanded distributor footprint, our broader product line and growthof our constant pressure drive business. For these reasons, we anticipate thatour sales to distributors and other customers in the U.S.and Canadawill continue growing at the $40 million to $50 million or better pace in 2008.

Since we will no longer be running against the stockpile inflated2006 sales comparisons, in 2008 these incremental sales will positively impactthe top and bottom line as organic growth.

In addition, as we look to 2008, we are confident in ourability to continue delivering 20% organic growth in our Fueling business.Fueling represents about 21% of our total sales and grew organically by 29% inthe third quarter and 28% year-to-date.

Looking forward to 2008 and 2009, we believe our growth inthis business will continue as the California Air Resources Board has requiredthat all filling stations in the state install upgraded vapor recovery systemsby mid 2009, in a phased implementation of vapor monitoring systems throughthird quarter 2010.

There are about 11,000 stations in California that remain to be retrofittedover this timeframe. To date, we supply the only approved vapor recovery systemfor the Californiaretrofit market, although we believe that one other competitor may be approved.These systems sell for $18,000 to $20,000 a piece.

Additionally, we continue to work with the California ResourcesBoard on the certification of our vapor monitoring system, except for the systemcomponents that are also required by the regulatory mandate. We expect to beone of only two approved suppliers of these systems in California. These monitoring systems sell for$8,000 to $15,000 a piece.

So over the next 36 months, we anticipate that 11,000 California station ownerswill spend about $28,000 each to purchase vapor control and monitoring systems.This represents $300 million plus market opportunity for Franklin and that's the reason why we wouldconservatively project ongoing 20% organic growth in this business.

Over the past five years, we've built a significant growingand profitable business selling our Water Systems products in developingregions of the world. We've targeted these regions because the primary demandfor Water Systems products is growing more rapidly in developing regions thanin the United States, Canada and Western Europe.

We've also found that in most cases, the indigenouscompetition is relatively weak and the Franklinbrand is well recognized and highly regarded by local water systemsdistributors and contractors. Since 2002, our sales in developing regions havegrown from $38 million to an annualized rate of $145 million today.

2007 year-to-date, our sales in developing regions are up11% organically and 35% in total versus prior year. We are aggressively expandingour distribution networks in these regions and selling a broader line of watersystems products through this network. We expect to achieve high single-digitor low double-digit organic sales growth in developing regions in 2008.

We recognize that as we return to organic sales growth in2008, a key issue will be how much of this growth will contribute to thebottom-line. One consideration will be the extent to which we achieve fixedcost leverage. In the recent past we’ve expanded our sales, marketing andengineering organizations to execute our strategy of selling a more complexproduct line to a more diverse customer base. As a result, we’ve increasedfixed costs at a rate faster than our sales growth.

Our total fixed costs, which includes SG&A depreciation,amortization and manufacturing fixed spending, has grown as a percentage ofsales by 220 basis points over the past 12 months. At this point we have theorganization and cost structure in place to execute our strategy; futureincreases would be only incremental and relate primarily to inflation. In 2008,our fixed spending, as a percentage of sales, is budgeted to decline by about200 basis points versus the 2007 level, exclusive of acquisitions.

While we recognized that, because of the stockpiles and weakindustry conditions, 2007 will be a difficult year. We elected to go forwardwith a number of strategic new product development and facilities initiatives,which would detract from earnings during the year, but lead to improvedearnings in 2008 and beyond.

During 2007, we will introduce new pump designs that will replaceand upgrade about 80% of our U.S.and Canadian Ground Water Pump product line. This activity has not onlyrequired increased development and start up costs, but also resulted inincreased inventories, since we must carry both the new and old SKUs as weconvert each individual and old SKUs as we convert each individual customer tothe new design.

These new designs have the dual advantage of being moredurable and efficient for our customers while also reducing our manufacturingcycle times and costs. We expect to have largely completed the transition fromthe incumbent designs to the new designs by mid first quarter 2008. We are alsobuilding a new 100,000 square foot pump manufacturing facility at Linares, Mexicoadjacent to Linaresmotor plants, which will produce these new designs as well as other pumpproducts. We are incurring the design engineering training and startup coststhis year and we will have the plant operational during the first quarter of2008.

In our Fueling business, we made the decision to shutdownthree satellite manufacturing locations in 2007 and consolidate theseoperations in our recently expanded Madison, Wisconsin facility. Again,incurring engineering training start up and severance cost this year, andresulting in reduced costs following in 2008.

Finally, early in 2007, we made the decision that, in theUnited States and Canada, Water Systems market, this year we would err on theside of carrying too much inventory rather than too little. We were not certainof the size of our competitors’ stockpile or of the impact that housing startswill have on the industry sales, but, under no circumstances, do we want thatcontractors or distributors to be forced to try our competitors motors becauseof our lack of availability.

As a result, through the back half of this year, we are operatingour North American manufacturing plants at a reduced utilization rate torealign inventories. As we go into 2008 with the stockpile no longer a factor,we have clear visibility of demand and we'll be more successful scheduling andlevel loading our factories.

Another key issue will be the pricing environment,particularly in the United States and Canada Water Systems market, becauseof the weak market conditions this year, and our rapid share gains withdistributors, our competitors have responded with unusually heavy pricepromotional activity in 2007. This activity has occurred at the same time thatthe pump and motor industries worldwide have experienced heavy cost inflation.

Material costs are about 50% of the manufacturing costs ofpumps and motors. The major material cost elements include copper, steel,stainless steel and freight. In the past year prices for all of these inputshave increased significantly. Against this backdrop, promotional pricingactivity takes a particularly heavy toll on margins.

We estimate that cost increases, in excess of the price increases,have reduced our overall gross profit margins by about 200 basis points thisyear. The only good news is that our competitors should be feeling the samepain since steel, stainless steel, copper and freight have gone up foreveryone.

We believe that distributors and contractors understand thecost pressures that their pump and motor suppliers are facing and they will beprepared to accept, “inflation justified”, price increases during the firstquarter of 2008. We also believe that it would be rational for our competitorsto lead or follow these increases.

We recognize that competitive market price behavior isdifficult to predict, but, while we are naturally concerned by the earningsdecline we are experiencing this year and we remain uncertain regarding thepricing environment in the United States and Canada Water Systems market, forthe reasons I've enumerated, we are confident that we are taking the right stepsto restore earnings growth in 2008 and beyond.

Now, Tom Strupp, our CFO, will provide some color on ourfinancial performance during this quarter and year-to-date.

Tom Strupp

Thank you Scott, further discussed comments third quartersales for 2007 for the company were a record $165.3 million, an increase ofabout 6%, with solid growth in international Water Systems sales outside theUnited States and Canada and significant organic in total growth from the Fuelingbusiness.

The Healy Systems, and pump brands acquisition, increased overallsales by about 12% during the quarter and foreign exchange changes increasedsales an additional 2%. Third quarter sales, exclusive of acquisitions andforeign exchange, declined by 8% from the same period a year ago.

The company's sales volume of 4-inch submersible water loadmotors in the United Statesand Canadawas reduced due to the continued inventory liquidation by several largeintegrated pump OEMs that began in the first quarter of 2007.

This factor was further compounded with continuing weaknessin the water world industry being off in the high single-digits, as indicated fromtrade association data for the third quarter compared to 2006. We areencouraged by the underlying expansion of our water systems pump product lines,being sold to distributors and other customers in the United States and Canada.

Operating margins for the consolidated business declined to11.8% in the third quarter compared to 16.4% during last year's third quarter. Grossprofit for the company was down $5.4 million or about 10% from the thirdquarter 2006. The company’s overall third quarter gross profit rate was 29.0%of sales versus 34.2% in the prior year.

Global Water Systems gross profit declined by about $7.5million or 16% versus the third quarter of 2006. Water Systems gross profit ininternational markets continued to grow at a faster rate than sales; however,this growth was offset by gross profit declines in the U.S. and Canada Water Systemsmarket.

In the United Statesand Canada,2006 gross profits benefited from unusually high sales of submersible motors tolarge pump OEMs as they built their stockpile. The loss of gross profit onsales of submersible motors to these OEMs in 2007, was partially offset byincreased gross profit on sales of Water Systems products to distributors andother customers throughout North America.

The Global Water Systems gross profit rate declined 540basis points in the third quarter of 2007 compared to the third quarter of2006. The gross profit rate decline pertains directly to sales in the United States and Canada market having threeprincipal causal factors.

First, approximately one third of the gross profit ratedecline was attributable to product mix changes. Pumps have become a higherpercent of sales and they generally carry a somewhat lower gross profit marginthan submersible motors. Approximately one third was attributed to fixed costcoverage as the company's North American submersible motor plants operated atlower capacity utilization rates during the third quarter of 2007 compared tolast year.

The remaining third was due to increased costs of material andfreight net of realized market price increases. There continues to be anunusual amount of promotional pricing in the United States and Canada WaterSystems market, as competitors react to the company's growing pump marketposition and the weak overall industry conditions this year.

Fueling Systems gross profit increased by $3 million for thequarter or 43% versus the third quarter of 2006. Fueling Systems gross profitrate declined modestly during the quarter due to an unusually high mix ofinternational tender sales during the third quarter of 2007.

Selling and administrative expenses in the third quarter of2007 decreased as a percent of sales to 17.1% from 17.8% for the same periodlast year. The company's overall selling and administrative expense for thethird quarter of 2007 increased by $0.4 million over the same period in theprior year. Acquisitions increased selling and administrative expenses in thethird quarter of 2007 compared to last year by about $2.6 million. Theincremental acquisition expenses were largely offset by reduce spending and thebase business operations.

Interest expense increased by $1.2 million during thequarter, versus the same period in the prior year, as the company's debt hasincreased for the funding of our 2007 acquisitions. Pump Brands Inc. in South Africaand the Canadian Pump Division of Monarch Industries and increases in workingcapital during the year.

During the third quarter of 2007, the company continued toexecute its global manufacturing realignment program. As part of Phase-II, the companyjust announced the phased reallocation of the Little Rock,Arkansas Water Systems pump manufacturing tothe new pump plant in Linares, Mexico over thenext several months. The new TRI-SEAL and Series V 4-inch submersible andVERSA-JET pump product lines will be in full production in Linares during the first quarter of 2008. Themission of the Little Rockfacility will now be centered on becoming a world class distribution hub forWater Systems product shipments to the company's growing North Americancustomer base.

Restructuring expenses year-to-date 2007 were approximately$1.9 million on a pretax basis and reduced EPS by approximately $0.05 pershare. Full year 2007 restructuring expenses are estimated to be $4.0 millionagain pretax and will include severance and other employee expenses as well asmanufacturing equipment relocation costs.

The company's effective income tax rate in the third quarterof 2007 was 33.8% compared to 35.0% in the prior year. The tax rate decreasedin the third quarter as attributable to onetime adjustments to the taxprovision primarily for announced income tax rate reductions in Germany.

Cash flows generated by operating activities in the thirdquarter of 2007 were $26.6 million, with approximately $10 million resultingfrom a reduction and accounts receivable working capital. Cash flows used forinvesting activities in the third quarter were $23.3 million and were used primarilyfor the acquisition of the pump division of Monarch Industries. While cash flowsfrom financing activities were essentially flat.

In the third quarter the company did issue $40 million oflong-term fixed rate debt with a coupon of 5.79%. Proceeds were used to pay offfloating rate, debt outstanding at the time. As a result the company enteredthe third quarter with $60 million of cash on the balance sheet, $150 millionof ten year fixed rate debt with a coupon of 5.79% and no outstandingborrowings on its $120 million revolving credit agreement.

The company repurchased 186,000 shares of its common stockfor $8.1 million in the second quarter of 2007 and had no repurchase activityin the third quarter of 2007. This now concludes our prepared remarks on thethird quarter 2007 results. We would now like to open up for questions.

Question-and-AnswerSession

Operator

Thank you. (Operator Instructions). Our first question comesfrom Matt Summerville with KeyBanc. Please proceed with your question.

Matt Summerville -KeyBanc

Couple of questions. First I guess all things consideredthat you went through Scott, how much should your spending go down next year in'08 compared to '07 around new product development, product launch costengineering, or there is a more concrete way to quantify them and I guess howwe think about SG&A going forward now?

Scott Trumbull

Well, we indicated that while our fixed spending overallwhich includes SG&A, manufacturing fixed and depreciation was up in thelast 12 months as a percentage of sales, I think it went from 29.1% to 31.3%,220 basis points. Our plan is to reduce that percentage by about 200 basispoints in 2008; while that’s above this much guidance as I give you on that.

Matt Summerville -KeyBanc

Okay, your discussion around fuel, I mean, looking for a 20%growth or more. It sounded like ’08 versus ’07, I guess. If you think aboutyour capacity in that business, doesn’t your capacity contemplate significantlyhigher growth in that -- I guess and try and understand, if that’s a prettyconservative viewpoint?

Scott Trumbull

I think it is a conservative viewpoint. The issue for uswill be that the timing of the demand surge as it pertains to this California mandate,which by the way isn’t the only thing driving the demand for our fuelingbusinesses. But that is obviously a major factor over the next 24 to 36 months.In the past, we have seen mandated capital investments for filling stationoperators, for instance, the tank change that occurred at the end of the 90’swhere they had to go to double walk-off tanks.

And what typically happens is the station operators will putoff the capital expenditures as long as they can and do it near the end of theconversion figures. So, that’s certainly will -- if not everybody is going todo it in the last month that’s not going to happen, but we don’t know for surewhat the timing will be of the demand surge, are they little, you know,occurred kind of evenly over 2008 really picked up in the back half of 2008,what have you.

Our -- we are gearing up to supply this demand surge and weare structuring our facilities and capacity to respond to it, even if it occursfairly intensively late in the gain. We’re going to be prepared to supply asignificant share of this total gains. I don't think it’s going to come all ofthe -- in the last six months or some or anything like that. But we don't knowfor sure how that demand surge is going to come to us over the course of 2008and in the early part of 2009, and if even to the back half of 2009.

Matt Summerville -KeyBanc

Outside of California, canyou kind of walk through what other states, if they are considering legislationor have passed legislation, kind of, what is the outlook for fueling in the US, outside of California. And then, when you look acrossinto the international piece of businesses, I mean, maybe you can give a littlemore color on the kinds of growth rates you are seeing place of like China and India. And how do you expect thatto play out over the next year too?

Scott Trumbull

In response to the question on fueling I'm going to ask GreggSengstack, who is with us today and who is President of our Fuel and Businessto comment on that.

Gregg Sengstack

Hi, Matt.

Matt Summerville -KeyBanc

Hi.

Gregg Sengstack

Hey Matt, I would respond that in the United States outside of California,there has already been a mandated change in the State of Texas, which is pretty much behind us. So,now it will be a replacing market. The what I call the NESCAUM states, thestates in the Northeast. The agreement states that are all subject to vapor recovery. I think these people arelooking at whether they should do something similar to Texas and that is toslap out their incompatible systems that exist today with large enoughcompatible systems. And that will be mandated, I think state-by-state whetherthey are making their state implementation plant with [EPM] or not and that's whenthis growth will come and unfold in the next couple of years.

Outside the United States,obviously there are huge opportunities basically in Chinaand India.For example, in China theyhave mandated the vapor recovery into the Beijingarea in advance of the Olympics. I would say that, they are expecting a lot toget done. They are going to do that before the Olympics, but that maybe thekickoff for a general move within China. There has also been amandate in the Shanghai area by 2010 and also inGuangzhou areaby 2010, with the balance of the stations by 2015.

In India,I do not know the formal mandate, but because of the high temperaturesconditions in India and alarge amount of evaporative loss issues in India. The Indian oil companies arevoluntarily putting in vapor recovery to yield the evaporate loss as well todeal with the safety on the station because they are fulltime dependence in theinhalation of VOCs in Benzene. So we are seeing opportunities in both thosemarkets.

Europe is a market where wecurrently are not involved. Europe already has the second highest number of gasstation after the United States in vapor recovery, somewhere there inthe 50,000 station range. And I don't see an initiative in Europe, I do see acontinued vapor recovery need in Europe and Ido see that expanding.

Matt Summerville -KeyBanc

Okay. Great. Thanks, very helpful. I'll get back in queue.Thanks.

Operator

Our next question comes from the line of Michael Schneiderwith Robert Baird.

Scott Trumbull

Just to finish up though on Matt's question. He asked aboutthe international side and the developing region side. As I mentioned in mycomment our sales in developing regions over the past five years have grownfrom about 40 million to an annualized weight currently of a 145 million. Wetalk about developing regions. We are talking about Latin America, EasternEurope, Middle-East and North Africa, Southern Africaand Asia-Pacific. So from over those five years 38 million to 145 million -- ofthat about 45% of that growth has been by acquisition and 55% has been organic.Mike, we're on to you.

Michael Schneider -Robert Baird.

Good afternoon, guys.

Scott Trumbull

Good afternoon.

Michael Schneider -Robert Baird.

Maybe first, we can just start with the concept of 35, Ibelieve you said $35 to $40 million you are expecting to recover in 2008, asresult of Beijingact competing against your own motors. Did I that hear that correctly Scott?

Scott Trumbull

Yeah.

Michael Schneider -Robert Baird.

Okay. So I'm trying to reconcile, and I may be mixing twodifferent topics here, but the pump roughly did about 60 million last year. AndI believe the goal going into the year was to double that business, which wasroughly 120 million but it sounds like that goal is now abandoned when we scaleback and there is $35 million to $40 million rather than…?

Scott Trumbull

Now, what's that $35 million to $40 million is the -- inthis year, we estimate that the motor sales value -- that of the value of themotors that were sold out of the stockpile, and again, this is all estimate. Weestimated that at 250,000 units or that would have a sales value of $35 millionto $40 million of motors. Okay, that's nowhere to the value of those motorsthat went out of the stockpile. Most of them with the pumps attached butleaving the pumps out of it, the value of those motors we estimate to be $35million to $40 million.

So as we look to next year, what we are seeing is thatcustomers who bought $35 million to $40 million worth of Franklin motors are going to need -- willwant to buy pumps and motors, again, next year and we’ll have the opportunityto supply those motors. And by the way also with the pump attached and my pointwas so we are looking at next year being able to address this opportunity whilethis year it was fore closed from us. Because somebody else supplied thosemotors out of their inventory and acknowledging the $35 million to $40 millionactually as a larger opportunity because there are opportunities to also sellthe pumps that go with those we recognized that we will get all thoseopportunities.

That certainly our competitors will retain some of that aswith their pumps and their new motor but our expectation is that we’ll get asignificant share of that next year just based on our what we see going on inthe market. In addition, I pointed to the fact that we’ll have a broaderdistribution footprint which will enhance our sales next year we’ll have a varietyof products on line over the course of the full year, which will enhance oursales next year. We’ll have a broaderproduct line over the course of full year, which will enhance our sales. Andwe’re also experiencing good sales growth with our driving control productline. And all of that I indicated would add up to we anticipate $40 million to$50 million of sales growth in the U.S. and Canada next year and that will showup as organic growth next year, because we won't have the headwinds of the stockpileliquidation in the prior year numbers. Is that clear?

Mike Schneider -Robert W. Baird

Yes and okay. Thank you for that and than that second datapoint is what I wanted and also try and reconcile. So in the release and thenin your prepared comments you said that the growth of sales to distributors hasnow reached a rate of $40 million to $45 million this year. That's anannualized rate. That is pumps, motors and controls all products?

Scott Trumbull

Yes.

Mike Schneider -Robert W. Baird

Okay. So with that in mind again if you were looking to growthe pump business $60 million this year and the growth to distributors is $40million to $45 million for all three products. Does that mean that you temperedyour pump forecast for the year just given the market conditions or again bymixing apples and oranges here?

Scott Trumbull

No, we have tempered our forecast, our dollars forecast,yes. Compared to where we were as we went into the beginning of this year.

Mike Schneider -Robert W. Baird

Okay. Can you then maybe attribute the rational is it marketrelated is it the dynamics or just a competitive environment now?

Scott Trumbull

Its market related and as we entered this year we didn'thave as clear a picture of the size of the stockpile.

Mike Schneider -Robert W. Baird

Okay. And then so looking into '08. Can you give us a senseof what your expectations were for pump market share and what you think you canachieve now in '07 or '08 or however you've analyzed this?

Scott Trumbull

Our pump market share has continued to grow rapidly and as Ihave mentioned I thought that we were either number one or number two in theindustry and I believe that is true as far as pumps alone are concerned. As atotal supplier to the water systems distribution channel, we clearly are thelargest supplier to the water systems distribution channel. But we haven’t Mikedisclosed precise market share numbers and I am not going to for competitivereasons, get into that on the call here.

Mike Schneider -Robert W. Baird

Okay. and then just given some of the gross margins ormargin topics you talked about, you are adding 200 basis points back or I guessrecovering 200 basis points of the fixed cost. Is that assuming in effect thatyou get back the to one-third, that was lost to materials and freight deflationand then the other one-third of manufacturing under absorption?

Scott Trumbull

No. The fixed costs that we are talking about are SG&A,depreciation and amortization and manufacturing fixed cost, which really isplant supervision and the maintenance departmental and there was people thatare not involved in directly manufacturing the products. All costs that aredirect costs are not in that calculation. So we are going to spread those fixedcosts and get pick up 200 basis points on those alone. That would not includeany assumptions that we have made about freight going up or down or copper orsteel or what have you in our ability to recover those with price. Okay.

Mike Schneider -Robert W. Baird

Okay, and then just drilling down the SG&A, that wasclearly the swing back during this up [strike] to my model this quarter.Amazingly, it looks like you took $3 million out of SG&A, justsequentially. Can you talk about where that money came out of and just break itdown in rough buckets for us and if that level is sustainable?

Scott Trumbull

I don't believe that we're going to sustain at the samelevel, our SG&A spending going forward that we had in the third quarter.Just a variety of a accruals and accounting entry that enables that to be downsomewhat, not really accounting entries but some of the accruals that we haveworked a little bit lower than they were in the prior year. This quarter isalways the lowest quarter for us as far as the spending as a percentage of salesare concerned. We came in for the quarter at around $28 million and we're goingto be a little bit higher than that in the fourth quarter.

Mike Schneider -Robert W. Baird

In dollars?

Scott Trumbull

In dollars.

Mike Schneider -Robert W. Baird

Okay, that makes sense. And the accruals, did you forexample, reverse out any of the warranty accruals or the incentive compensationaccruals for the year?

Scott Trumbull

We may have reversed out some accruals, right. But they werenot the major factors driving the percentage decline in operating expense.

Mike Schneider -Robert W. Baird

Okay, then just in terms of seasonality, now with all thedynamics of this market. We have somewhat lost touch of the seasonality, wouldyou expect us to return in the fourth quarter to the typical seasonality whereyou're down sequentially in earnings, just generally speaking?

Scott Trumbull

Yeah, the fourth quarter normally is down versus the thirdquarter and the second quarter. Frequently in the fourth quarter there is asurge in sales at the of the quarter as customers try to reach year end rebatelevels. The levels are progressive and so the more you buy the better yourebate and if customers are close to a incremental rebate level they maystretch at the end of the fourth quarter to hit back. This year because theindustry’s been all off, we’re not certain how much of that will occur and sowe’re anticipating that just sequentially the fourth quarter will be down andthe fourth quarter may also be off a little bit. And again this is notsomething that I am certain of but it’s something that should be considered.Fourth quarter could be off this year, because there will be less buy upactivity in December than there has been in prior year fourth quarter’s.

Mike Schneider -Robert W. Baird

And there was a big pre-buy last year in the fourth quarterby the integrated OEMs, correct?

Scott Trumbull

Well, as I mentioned $30 million of purchases of motors inthe fourth quarter last year by the OEMs

Mike Schneider - RobertW. Baird

Okay and then along those lines gross margins againstsequentially you're talking recovering a lot of these fixed costs heading into2008. Does any of that start in Q4 or again or at this 29% gross margin leveldoes that seem at least in the range at least for the fourth quarter till weget some relief in '08?

Scott Trumbull

Mike, I indicated that one of the key issues for us is thepricing environment and the degree to which we’ll be looking at promotionalpricing during the quarter. The good news is that we have not seen list pricereductions. What we've seen are one off promotions, which have same effect tothe bottom line, but at least they are not permanent. And so going into thefourth quarter the question for us that will determine to some extent to alarge extent, our gross profit level will be the degree to which there ispromotional pricing activity over and above what normally occurs. And for thatreason I'm reluctant to get too specific as far as guidance is concerned,because I can't control that.

Mike Schneider -Robert W. Baird

Although a year ago again just for comparison sake again youwouldn’t have been discounting Q4 of last year. Tell me what you know aboutwhat your largest customers were doing with stockpiling correct?

Scott Trumbull

Right.

Mike Schneider -Robert W. Baird

Okay. So year-over-year that makes a difference. And thenjust finally before I monopolize all the time here. The European market itselfand the growth you are enjoying over there in the submersibles business. Haveyou seen any impact as a lot of articles including cover stories in the WallStreet Journal about European housing market rolling over? Have you seen anyimpact of that and I guess what are you anticipating in '08 given the trendsthere?

Scott Trumbull

So far we have not seen a significant impact there. I thinkone thing that's important to point out is in Europe were here up in NorthAmerica or in the U.S. and Canada quite a significant percentage of ourproducts go into residential applications. There are 4-inch and they are outthere in individual farms and vacation homes and places where people areoutside the municipal water system and have their own well.

In Europe, a much higher percentage of our sales are largerpumps that go into agricultural, industrial, municipal and commercialapplications and so the mix is different in our susceptibility to a housingdecline in Europe is different than it ishere. But having said that, we haven't seen a material impact in our businessas a result of housing.

In Europe, the weather seems to be a bigger factor overthere, in a really dry season particularly in Southern Europe will move the needle quite a bit. But we are having adecent year in our European business and our volumes overall have been aboutwhere we have anticipated them to be.

Mike Schneider -Robert W. Baird

Okay. I'll get back in line. Thank you.

Operator

Our next question is from the line of Ned Borland with NextGeneration. Please proceed with your question.

Ned Borland - NextGeneration

Good afternoon guys. Just a quick question here onutilization, the inventory build here. What is that costing you in terms ofutilization at your plants and how quickly you think you can get through that?

Scott Trumbull

Well, again I think, perhaps the best way to respond to thatis to go back to this issue of fix cost coverage and leverage. And as Imentioned, the combination of us increasing our fixed spending this year and atthe same time suffering a material reduction in volume because of the inventoryliquidation. The impact that had played through year-on-year numbers. Thedouble whammy of selling it last year and not selling it this year. That hasdriven up our fixed cost as a percentage of sales over the last 12 months by220 basis points and as we look out, because those fixed costs are going tolevel off and our sales are going to start showing up as organic sales, becausewe are not going be running against the big negative numbers any more as wemove into the first quarter of next year.

We are targeting to bring that back down by 200 basis pointsas we go through the year. I mean, capacity [utilize] we have tremendousflexibility around the amount of capacity that we can bring through ourfacilities, on the upside and so there won't be any issue of responding tosurges in demand. The issue is, how do we cover fixed costs in those facilitiesand I think that's probably the best look at it. It's the clearest guidance wecan give you on that.

Ned Borland - NextGeneration

Okay, well just sort of a follow up on that and one of theprevious questions on SG&A. I mean, should we be thinking in '08 17% ofsales rate is sustainable?

Tom Strupp

Ned, I think you need to look at the year-to-date run ratethis year at 20% and factor in a component of the improvement in fixed costSG&A that Scott mentioned the 200 basis points, a significant component ofthat would apply to SG&A, yes.

Ned Borland - NextGeneration

Okay thanks

Tom Strupp

Work of the year-to-date rates.

Ned Borland - NextGeneration

Okay.

Operator

Then we have a follow up question from the line of MattSummerville of KeyBanc

Matt Summerville -KeyBanc

So Scott, I guess when we think about this over hang andwhat you are hearing in the market in terms of duration how much do we haveleft and now that we are pretty through October do you think it’s fullyresolved?

Scott Trumbull

Well, one word I've got to say that we just had our nationalsales meeting, which I sat through the whole thing and in the meeting we askedour sales people each individual territory manager talking account-by-accountdistributor-by-distributor to identify the degree to which our competitorspumps are still being sold with Franklin motors. The bottom line of that surveyand again these guys are out there in the market and have no reason to beanything other than completely accurate in their projections as best as theycan. We’re still seeing 50% to 70% depending on the markets of what’s going ofthe competitors products that are going off the distributor shelves stillhaving a Franklinmotor on it.

Now having said that we are also picking up increased datapoints where distributors are telling us that they will no longer be able toget one of our competitors brands with a Franklin motor or a state, there areseveral states where our competitors have now indicated that they will only beable to supply Teradyne product no longer will they be able to supply Franklinproducts.

So we are seeing more and more instances and getting moreand more calls from distributors and contractors who are saying, hey, I can'tget my product anymore with a Franklinmotor. Let's talk about me getting started or accelerating my use of Franklin pumps in order to ensure that I continue to getthe Franklinmotor. So we are seeing more and more incidences of that showing up in themarket.

So I think there is still product and inventory that I thinkthat they are starting to run out and they are starting to allocate it amongcustomers and that it will become less and less a factor, certainly as we gothrough the fourth quarter and as we go into next year.

I think they'll continue to hold some in inventory to supplycustomers who they think they have a chance to convert, but who are remainabsolutely committed to a Franklinmotor and so they will increasingly try to allocate the product around, aroundthose kind of customers.

Matt Summerville -KeyBanc

Okay and then in terms of I think you mentioned that theNorth America Water Systems industry was down 12% year-to-date. I was wonderingfirst you have a figure on the third quarter and then can you talk about yourNorth American volume in context of that and then whether or not the magnitudeof pricing degradation you saw in Q3 was equivalent to what you saw in thefirst six months?

Scott Trumbull

Okay. The industry was down probably high single-digits inthe third quarter. On the back of a strong September and when we talk about theindustry, we are talking about shipments from the pub companies thedistributors, because our only data point on industry shipments is tradeassociation data, which measures the shipments of selected products from thepub companies to the distributors.

And sales in the month of September were up significantly,primarily driven because of price promotions, which were occurring in Septemberwhich they – the distributors knew would go away on October 1. So, whether ornot that represents a permanent increase in demand or just a bulge in inventoryremains to be seen. But having said that, demand was down in the third quarterby less than it was in the prior quarters this year.

There was, from our perspective, somewhat less pricepromotional activity in the third quarter then there was in the first andsecond quarter of this year. Not altogether surprising, because the pricepromotional activity, kind of trends down under any circumstance in the thirdquarter, because distributors are not that interested in stocking up, becausewe are going in to the slow season at this point. Or as in the first quarterand the second quarter, promotional activity can result in getting moreproducts on the shelf.

But there was, more in the third quarter this year thenthere was in the third quarter last year, significantly although, whensequentially it was down somewhat. And how that will play through in the fourthquarter remains to be seen. Did that respond to your questions?

Matt Summerville -KeyBanc

Yeah. I guess the other one that I'll logged in there it wasjust, all right, if the market was down high-single, how much do you think yourNorth American motor volume is down?

Scott Trumbull

Well…

Matt Summerville -KeyBanc

I'm trying to put this in context for your utilization ratesand kind of build that picture.

Scott Trumbull

Okay. Our North American pump and motor combination, pumpmotor product, when I talk about the market being down, what I'm doing reallyis talking about the Bellwether product is the pump motor, 4-inch pump motorassembly.

Matt Summerville -KeyBanc

Yeah.

Scott Trumbull

Which is the Bellwether product in the industry, that wasdown a high single-digits in the quarter and our pump motor business was updramatically. And I'm not going to give you a precise number, but it wasn'tquite double, but it was up at a very high rate in the quarter.

Matt Summerville -KeyBanc

Okay. And then just, Tom, maybe can you talk about what yourthoughts are on share repurchase going forward and maybe, given that the stocksitting here below 40 why not get more aggressive?

Tom Strupp

Well, we are certainly going to deploy our cash, looking ata number of strategic options including acquisitions as we go forward. Andthose decisions will play out as we have our options that we consider goingforward. And yes, that would be a possibility, but we are not going to providespecific guidance in that area in terms of what you will expect.

Matt Summerville -KeyBanc

And then maybe just one more comment on SG&A, as we moveinto '08 product development cost, engineering spend coming down is that partof the 200 bit, Scott? And then just to clarify in the third quarter thesequential decline, was that related to maybe some of the spend here or I guessI am trying to understand as well why it was down so much, because I don'tthink just accrual reversal would have done that?

Tom Strupp

Certainly the front part of 2007 had a heavier spend for thenew product development projects that we have spoken about and that would be afactor, as well as the third quarter of 2006 having a somewhat higher spendversus the third quarter of 2007.

So it’s really a combination of both and some of the accrualactivity that was mentioned.

Scott Trumbull

But really, part of it I think, because what we arereferencing here is sequential. The part of the what makes it look like such anextraordinary decline is that in the first quarter our SG&A was around $29million, the second quarter it bounced up to $32 million, the third quarter itwent back to $28 million, the unusual number was the $32 million in the secondquarter.

Matt Summerville -KeyBanc

Okay

Scott Trumbull

And we will not go back to $32 million, but it wasn’t thethird quarter was so much dramatically low, it was that the second quarter waspretty high and now as we are kind of providing some guidance in the fourthquarter, it will certainly be higher than it was in the third quarter, but alsocertainly lower than it was in the second quarter.

Matt Summerville -KeyBanc

Okay great, that clarifies that, thanks a lot.

Operator

And final question of today comes from line of [Brad Schneider]with Schneider Capital

Brad Schneider -Schneider Capital

Good afternoon guys.

Scott Trumbull

Yes, Brad.

Brad Schneider -Schneider Capital

I just wanted to clarify, a couple of things. When you talkabout the -- I am sorry to ask another question on the expense side, but withthe consolidation that you announced the first part of the fourth quarter forsome of your fueling systems satellite office, , is that incremental to theexpense reductions, the 200 basis points that you are planning for 2008?

Scott Trumbull

No, that would be part of it. Although we will also havewhat we'll work out to be direct cost reductions as a result of that. We willhave, because we have consolidated the fueling operation, the fill tight operation,and the extrusion operations for our pipe business, all of those going out ofstandalone facilities into or satellite facilities into medicines. That willgive us an opportunity to reduced fixed costs, which is part of the 200 basispoint reduction. But, in addition, the pipe product line that we were buying,we have had all equipment in an outside vendor who was supplying that pipeproduct line to us as a variable cost, they were charging us for that. When wemoved that in to medicine and produced it ourselves we are going to find amaterial cost reduction, as well which will help us out as a result of thatmove. So, it's in the 200 basis points reduction, but will also have someadditional benefit that will flow through, as a results of the change outsideof the 200 basis point reduction.

Brad Schneider -Schneider Capital

Okay. So these expense reduction, the consolidation of theFueling System satellite offices, as well as, I believe you've talkedpreviously when you entered the year, you were looking for some expensereductions, because of the Siloam Springs facility is in some of the layouts atthose facility. Is there a way to think of and I assume that is our pro formafor the acquisitions and the incremental SG&A from Monarch and from pumpbrands, which would be included in this 200 basis points reduction?

Scott Trumbull

I am sorry. Please repeat your question?

Brad Schneider -Schneider Capital

I guess, with the moving pieces, with the acquisitions ofpump brands and with the acquisitions of Monarch, there is some incrementalSG&A that's going to be consolidated into the business. And I believe inthe past, that you've spoken about some expense reduction, headcount reductionsas your motor facility and also with your pump facility in moving themanufacturing down to Monarch?

Scott Trumbull

Yes.

Brad Schneider -Schneider Capital

Correct. I am just -- is the 200 basis points that you arediscussing, is that fully incompact sort of all of these changes to thedifferent pieces of the business? Is that sort of pro forma for everything allthe moving parts?

Scott Trumbull

It is pro forma for the SG&A, the manufacturing fixedand the depreciation and amortization on all of the businesses that arecurrently part of the business, including pump brands and Monarch.

Brad Schneider -Schneider Capital

Okay. And just one last --

Scott Trumbull

But it does not include the savings that we get, forinstance if we have moved as we have over the course of this year, if we hadmoved manufacturing to Siloam and replaced direct labor in Siloam, with directlabor in Linares, or as we move forward next year having curtailed pumpproduction in Little Rock replacing Little Rock a direct labor with directlabor in Linares. That savings because of the difference between $18 to $20 anhour labor, and $2 an hour labor to $50, that savings is not included in thatcalculation.

Brad Schneider -Schneider Capital

Okay. So thas saving is still incremental.

Scott Trumbull

Yes.

Brad Schneider -Schneider Capital

Okay. And just one last question, then, I'll follow-up withyou guys a little bit later. You've outlined over the past three quarters verywell the impacts from, let's call it this year's change in the product mix withthe motors versus the pumps and some of the aspects that are taking place inthe water systems.

Is there a way to think about the revenue dollar leverage,is it fair to say that the revenue dollar leverage that you would have receivedin motors as you work through the inventory adjustment going into 2008, ifyou're able to achieve the same kinds of rates that within motors, withinfueling systems that the incremental margins, is it right to think of the samehistoric incremental margins on that business as you received previously?

Scott Trumbull

Well, you know, when we talked about this in the pressrelease, but as our mix of business has changed, and we are selling more pumpsand the pump portion of the business becomes a higher percentage of our overallbusiness that mix effect because pumps generally carry a lower gross profitmargin than motors. They are somewhat less capital intensive but they carry alower gross profit margin than motors.

Then, as pumps grow the gross profit margin will be down andwe’re saying of the 520 basis points or so, reduction that we have incurredthis year in gross profit margin about a third of it you’d call structural dueto the affect of just the mix shift. And about a third of it pertains to fixedcost coverage and the subject that we’ve discussed and about a third of itpertains to prices relative to direct costs. And the price direct costcontribution margin squeeze that we have incurred this year. Okay

Brad Schneider -Schneider Capital

I’m sorry, I guess what I’m asking is I understand that theproduct mix shift in the pumps, maybe, I can check with you later. But I justwant to understand when you talk about the incremental business, the inventoryoverhead; you’ll be competing for that business, because you were previouslycompeting against yourself. Within the motor segment of the PMA market that youare going to be addressing, is there any reason to think that the historicalmargins, the operating margins that you received in motors would be anydifferent in 2008 if you are able to achieve that business than it was in 2005or 2004, just in the motor segment?

Scott Trumbull

Most of that $35 million to $40 million opportunity is --that reflects the motors that we sold to OEM’s in 2006. The 250,000 motors thatwe think went into the stockpile and the value of those was $35 million to $40million.

Brad Schneider -Schneider Capital

Right.

Scott Trumbull

As we have an opportunity to address those in themarketplace in 2008, for the most part we will be selling motors attached topumps or pumps attached to motors.

Brad Schneider -Schneider Capital

Right.

Scott Trumbull

And the key to answering your question will be what will themarket price be of the PMA -- and of -- the pump motor assembly, because theprice of the motor will be varied in that. And the issue there will be whatkind of a pricing environment where we face is, we sell those products in themarket as pumps next year.

Brad Schneider -Schneider Capital

Okay.

Scott Trumbull

And so as motors they should be the same price. The issue willbe as PMAs, how will they come through in the marketplace, sustain in next yearas far as margin are concerned. Do you understand?

Brad Schneider -Schneider Capital

I do. Thank you.

Scott Trumbull

Okay.

Operator

Gentlemen. We are out of time for today's conference, Iwould like to turn the floor back over to you for any closing comments.

Scott Trumbull

Thank you for participating in our call. And we'll lookforward to having a discussion with you at the end of the next quarter.

Operator

This concludes today's teleconference you may disconnectyour lines at this time. Thank you for your participation.

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Source: Franklin Electric Q3 2007 Earnings Call Transcript
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