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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 President of 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 Franklin Electric Company Incorporated Third Quarter 2007 Earnings Release. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions).

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

Mike Butchko

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

Before we begin let me remind you that any forward-looking statements contained herein including those relating to the company's financial results, business goals and sales growth involve risks and uncertainties, including but not limited to, risk and uncertainties with respect to general economic and currency conditions, various conditions specific to the company's business and 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's accounting policies, future trends, and other risks which are detailed in the company's Securities and Exchange Commission filings included in Item 1A of Part I of the company'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's Quarterly Reports on Form 10-Q. These risks and uncertainties may cause actual results to differ materially from those indicated by the forward-looking statements. All forward-looking statements are made herein are based on information currently available, and the company assumes no obligation to update any forward-looking statements.

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

Scott Trumbull

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

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

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

However, our growth in these areas in 2007 has been masked by reduced sales in earnings in the U.S. and Canadian Water Systems market. As those of you who follow the company know, in 2004 we made an important strategic decision: that is to sell our Water Systems products in the U.S. and Canada primarily through the distributors, as opposed to large pump OEMs, and to enter the pump business ourselves.

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

In the course of implementing of this decision we entered into a settle agreement with the two largest pump OEMs, which ensures that we would supply them with Franklin motors until January 1st 2007. When that agreement expired on January 1st, we discontinued supplying these two OEMs. As a result, our sales in the U.S. and Canada to 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 penalized by about $30 million, representing our sales for the two OEMs during the fourth quarter of 2006. For reasons that we anticipated, we are not fully offsetting these declines in 2007 with organics sales increases to distributors and other customers in the U.S. and Canada.

The primary reason is that during 2006, the two large pump OEMs stockpiled a significant quantity of Franklin motors that they could liquidate during 2007, after we discontinued supply. Throughout 2006, we advised investors, in each of our quarterly earnings releases, about our concerns regarding this motor stockpile and its potential impact on 2007 results.

We estimate that the stockpiling increased our sales by approximately 250,000 motors or $35 million to $40 million in 2006. In addition, we believe our sales this year have been negatively impacted by a similar amount, as the stockpile has been liquidated and our competitors have continued to supply distributors and contractors with Franklin motors.

So as we had anticipated in 2007, we are running against artificially high prior year comparisons and we are delayed in realizing the significant sales growth opportunity as our competitors sell our motors from their inventory.

An additional issue this year has been unique overall waters systems industry demand in the United States and 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 water system sales to distributors, and other customers in the U.S. and Canada, are growing at an annualized rate of $40 million to $45 million in 2007, and sales to our customers accelerated in the third quarter. During the third quarter we started picking up increased anecdotal evidence for our field sales organization that the remaining stockpile is now being allocated among distributors customers.

As we look to 2008, we believe our sales to distributors and other customers will continue to grow organically. With this growth fueled by several factors;

First, that with the stockpile diminished, we will no longer be competing against our own motors. This will open an estimated $35 million to $40 million sales opportunity in motors. This amount represents the estimated value of Franklin motors that were supplied to the market this year from our competitors’ stockpile and, in addition, we have the opportunity to sell the pumps that go with those motors. Our competitors will retain a portion of this business, like selling pumps with their new motor, but all of our market research, as well as 50 years of experience with contractors, gives us confidence that a significant amount of the sales opportunity will come our way.

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

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

And fourth, our QuickPAK and SubDrive product lines are leading a paradigm shift in the water systems industry, as the industry moves to 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 as the change accelerates.

For all these reasons: that is the opportunity in 2008 to sell motors and related pump products that were supplied out of stockpile in 2007, our expanded distributor footprint, our broader product line and growth of our constant pressure drive business. For these reasons, we anticipate that our sales to distributors and other customers in the U.S. and Canada will continue growing at the $40 million to $50 million or better pace in 2008.

Since we will no longer be running against the stockpile inflated 2006 sales comparisons, in 2008 these incremental sales will positively impact the top and bottom line as organic growth.

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

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

There are about 11,000 stations in California that remain to be retrofitted over this timeframe. To date, we supply the only approved vapor recovery system for the California retrofit 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 Resources Board on the certification of our vapor monitoring system, except for the system components that are also required by the regulatory mandate. We expect to be one 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 owners will 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 would conservatively project ongoing 20% organic growth in this business.

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

We've also found that in most cases, the indigenous competition is relatively weak and the Franklin brand is well recognized and highly regarded by local water systems distributors and contractors. Since 2002, our sales in developing regions have grown from $38 million to an annualized rate of $145 million today.

2007 year-to-date, our sales in developing regions are up 11% organically and 35% in total versus prior year. We are aggressively expanding our distribution networks in these regions and selling a broader line of water systems products through this network. We expect to achieve high single-digit or low double-digit organic sales growth in developing regions in 2008.

We recognize that as we return to organic sales growth in 2008, a key issue will be how much of this growth will contribute to the bottom-line. One consideration will be the extent to which we achieve fixed cost leverage. In the recent past we’ve expanded our sales, marketing and engineering organizations to execute our strategy of selling a more complex product line to a more diverse customer base. As a result, we’ve increased fixed 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 of sales by 220 basis points over the past 12 months. At this point we have the organization and cost structure in place to execute our strategy; future increases would be only incremental and relate primarily to inflation. In 2008, our fixed spending, as a percentage of sales, is budgeted to decline by about 200 basis points versus the 2007 level, exclusive of acquisitions.

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

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

These new designs have the dual advantage of being more durable and efficient for our customers while also reducing our manufacturing cycle times and costs. We expect to have largely completed the transition from the incumbent designs to the new designs by mid first quarter 2008. We are also building a new 100,000 square foot pump manufacturing facility at Linares, Mexico adjacent to Linares motor plants, which will produce these new designs as well as other pump products. We are incurring the design engineering training and startup costs this year and we will have the plant operational during the first quarter of 2008.

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

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

As a result, through the back half of this year, we are operating our North American manufacturing plants at a reduced utilization rate to realign 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 and level loading our factories.

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

Material costs are about 50% of the manufacturing costs of pumps and motors. The major material cost elements include copper, steel, stainless steel and freight. In the past year prices for all of these inputs have increased significantly. Against this backdrop, promotional pricing activity 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 this year. The only good news is that our competitors should be feeling the same pain since steel, stainless steel, copper and freight have gone up for everyone.

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

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

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

Tom Strupp

Thank you Scott, further discussed comments third quarter sales for 2007 for the company were a record $165.3 million, an increase of about 6%, with solid growth in international Water Systems sales outside the United States and Canada and significant organic in total growth from the Fueling business.

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

The company's sales volume of 4-inch submersible water load motors in the United States and Canada was reduced due to the continued inventory liquidation by several large integrated pump OEMs that began in the first quarter of 2007.

This factor was further compounded with continuing weakness in the water world industry being off in the high single-digits, as indicated from trade association data for the third quarter compared to 2006. We are encouraged 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 to 11.8% in the third quarter compared to 16.4% during last year's third quarter. Gross profit for the company was down $5.4 million or about 10% from the third quarter 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 $7.5 million or 16% versus the third quarter of 2006. Water Systems gross profit in international 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 Systems market.

In the United States and Canada, 2006 gross profits benefited from unusually high sales of submersible motors to large pump OEMs as they built their stockpile. The loss of gross profit on sales of submersible motors to these OEMs in 2007, was partially offset by increased gross profit on sales of Water Systems products to distributors and other customers throughout North America.

The Global Water Systems gross profit rate declined 540 basis points in the third quarter of 2007 compared to the third quarter of 2006. The gross profit rate decline pertains directly to sales in the United States and Canada market having three principal causal factors.

First, approximately one third of the gross profit rate decline was attributable to product mix changes. Pumps have become a higher percent of sales and they generally carry a somewhat lower gross profit margin than submersible motors. Approximately one third was attributed to fixed cost coverage as the company's North American submersible motor plants operated at lower capacity utilization rates during the third quarter of 2007 compared to last year.

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

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

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

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

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

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

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

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

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

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

Question-and-Answer Session

Operator

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

Matt Summerville - KeyBanc

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

Scott Trumbull

Well, we indicated that while our fixed spending overall which includes SG&A, manufacturing fixed and depreciation was up in the last 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 basis points 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 about your capacity in that business, doesn’t your capacity contemplate significantly higher growth in that -- I guess and try and understand, if that’s a pretty conservative viewpoint?

Scott Trumbull

I think it is a conservative viewpoint. The issue for us will 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 fueling businesses. 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 station operators, for instance, the tank change that occurred at the end of the 90’s where they had to go to double walk-off tanks.

And what typically happens is the station operators will put off the capital expenditures as long as they can and do it near the end of the conversion figures. So, that’s certainly will -- if not everybody is going to do it in the last month that’s not going to happen, but we don’t know for sure what 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 we are structuring our facilities and capacity to respond to it, even if it occurs fairly intensively late in the gain. We’re going to be prepared to supply a significant share of this total gains. I don't think it’s going to come all of the -- in the last six months or some or anything like that. But we don't know for sure how that demand surge is going to come to us over the course of 2008 and in the early part of 2009, and if even to the back half of 2009.

Matt Summerville - KeyBanc

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

Scott Trumbull

In response to the question on fueling I'm going to ask Gregg Sengstack, who is with us today and who is President of our Fuel and Business to 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, the states in the Northeast. The agreement states that are all subject to vapor recovery. I think these people are looking at whether they should do something similar to Texas and that is to slap out their incompatible systems that exist today with large enough compatible systems. And that will be mandated, I think state-by-state whether they are making their state implementation plant with [EPM] or not and that's when this growth will come and unfold in the next couple of years.

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

In India, I do not know the formal mandate, but because of the high temperatures conditions in India and a large amount of evaporative loss issues in India. The Indian oil companies are voluntarily putting in vapor recovery to yield the evaporate loss as well to deal with the safety on the station because they are fulltime dependence in the inhalation of VOCs in Benzene. So we are seeing opportunities in both those markets.

Europe is a market where we currently are not involved. Europe already has the second highest number of gas station after the United States in vapor recovery, somewhere there in the 50,000 station range. And I don't see an initiative in Europe, I do see a continued vapor recovery need in Europe and I do 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 Schneider with Robert Baird.

Scott Trumbull

Just to finish up though on Matt's question. He asked about the international side and the developing region side. As I mentioned in my comment our sales in developing regions over the past five years have grown from about 40 million to an annualized weight currently of a 145 million. We talk about developing regions. We are talking about Latin America, Eastern Europe, Middle-East and North Africa, Southern Africa and Asia-Pacific. So from over those five years 38 million to 145 million -- of that 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, I believe you said $35 to $40 million you are expecting to recover in 2008, as result of Beijing act 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 two different topics here, but the pump roughly did about 60 million last year. And I believe the goal going into the year was to double that business, which was roughly 120 million but it sounds like that goal is now abandoned when we scale back and there is $35 million to $40 million rather than…?

Scott Trumbull

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

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

That certainly our competitors will retain some of that as with their pumps and their new motor but our expectation is that we’ll get a significant share of that next year just based on our what we see going on in the market. In addition, I pointed to the fact that we’ll have a broader distribution footprint which will enhance our sales next year we’ll have a variety of products on line over the course of the full year, which will enhance our sales next year. We’ll have a broader product line over the course of full year, which will enhance our sales. And we’re also experiencing good sales growth with our driving control product line. 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 show up as organic growth next year, because we won't have the headwinds of the stockpile liquidation in the prior year numbers. Is that clear?

Mike Schneider - Robert W. Baird

Yes and okay. Thank you for that and than that second data point is what I wanted and also try and reconcile. So in the release and then in your prepared comments you said that the growth of sales to distributors has now reached a rate of $40 million to $45 million this year. That's an annualized 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 grow the pump business $60 million this year and the growth to distributors is $40 million to $45 million for all three products. Does that mean that you tempered your pump forecast for the year just given the market conditions or again by mixing 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 market related is it the dynamics or just a competitive environment now?

Scott Trumbull

Its market related and as we entered this year we didn't have 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 sense of what your expectations were for pump market share and what you think you can achieve now in '07 or '08 or however you've analyzed this?

Scott Trumbull

Our pump market share has continued to grow rapidly and as I have mentioned I thought that we were either number one or number two in the industry and I believe that is true as far as pumps alone are concerned. As a total supplier to the water systems distribution channel, we clearly are the largest supplier to the water systems distribution channel. But we haven’t Mike disclosed precise market share numbers and I am not going to for competitive reasons, get into that on the call here.

Mike Schneider - Robert W. Baird

Okay. and then just given some of the gross margins or margin topics you talked about, you are adding 200 basis points back or I guess recovering 200 basis points of the fixed cost. Is that assuming in effect that you get back the to one-third, that was lost to materials and freight deflation and 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 is plant supervision and the maintenance departmental and there was people that are not involved in directly manufacturing the products. All costs that are direct costs are not in that calculation. So we are going to spread those fixed costs and get pick up 200 basis points on those alone. That would not include any assumptions that we have made about freight going up or down or copper or steel 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 was clearly the swing back during this up [strike] to my model this quarter. Amazingly, it looks like you took $3 million out of SG&A, just sequentially. Can you talk about where that money came out of and just break it down 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 same level, 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 down somewhat, not really accounting entries but some of the accruals that we have worked a little bit lower than they were in the prior year. This quarter is always the lowest quarter for us as far as the spending as a percentage of sales are concerned. We came in for the quarter at around $28 million and we're going to 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 for example, reverse out any of the warranty accruals or the incentive compensation accruals for the year?

Scott Trumbull

We may have reversed out some accruals, right. But they were not 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 the dynamics of this market. We have somewhat lost touch of the seasonality, would you expect us to return in the fourth quarter to the typical seasonality where you're down sequentially in earnings, just generally speaking?

Scott Trumbull

Yeah, the fourth quarter normally is down versus the third quarter and the second quarter. Frequently in the fourth quarter there is a surge in sales at the of the quarter as customers try to reach year end rebate levels. The levels are progressive and so the more you buy the better you rebate and if customers are close to a incremental rebate level they may stretch at the end of the fourth quarter to hit back. This year because the industry’s been all off, we’re not certain how much of that will occur and so we’re anticipating that just sequentially the fourth quarter will be down and the fourth quarter may also be off a little bit. And again this is not something 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 up activity 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 quarter by the integrated OEMs, correct?

Scott Trumbull

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

Mike Schneider - Robert W. Baird

Okay and then along those lines gross margins against sequentially you're talking recovering a lot of these fixed costs heading into 2008. Does any of that start in Q4 or again or at this 29% gross margin level does that seem at least in the range at least for the fourth quarter till we get some relief in '08?

Scott Trumbull

Mike, I indicated that one of the key issues for us is the pricing environment and the degree to which we’ll be looking at promotional pricing during the quarter. The good news is that we have not seen list price reductions. What we've seen are one off promotions, which have same effect to the bottom line, but at least they are not permanent. And so going into the fourth quarter the question for us that will determine to some extent to a large extent, our gross profit level will be the degree to which there is promotional pricing activity over and above what normally occurs. And for that reason 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 you wouldn’t have been discounting Q4 of last year. Tell me what you know about what 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 then just finally before I monopolize all the time here. The European market itself and the growth you are enjoying over there in the submersibles business. Have you seen any impact as a lot of articles including cover stories in the Wall Street Journal about European housing market rolling over? Have you seen any impact of that and I guess what are you anticipating in '08 given the trends there?

Scott Trumbull

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

In Europe, a much higher percentage of our sales are larger pumps that go into agricultural, industrial, municipal and commercial applications and so the mix is different in our susceptibility to a housing decline in Europe is different than it is here. But having said that, we haven't seen a material impact in our business as a result of housing.

In Europe, the weather seems to be a bigger factor over there, in a really dry season particularly in Southern Europe will move the needle quite a bit. But we are having a decent year in our European business and our volumes overall have been about where 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 Next Generation. Please proceed with your question.

Ned Borland - Next Generation

Good afternoon guys. Just a quick question here on utilization, the inventory build here. What is that costing you in terms of utilization 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 that is to go back to this issue of fix cost coverage and leverage. And as I mentioned, the combination of us increasing our fixed spending this year and at the same time suffering a material reduction in volume because of the inventory liquidation. The impact that had played through year-on-year numbers. The double whammy of selling it last year and not selling it this year. That has driven up our fixed cost as a percentage of sales over the last 12 months by 220 basis points and as we look out, because those fixed costs are going to level off and our sales are going to start showing up as organic sales, because we are not going be running against the big negative numbers any more as we move into the first quarter of next year.

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

Ned Borland - Next Generation

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

Tom Strupp

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

Ned Borland - Next Generation

Okay thanks

Tom Strupp

Work of the year-to-date rates.

Ned Borland - Next Generation

Okay.

Operator

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

Matt Summerville - KeyBanc

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

Scott Trumbull

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

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

So we are seeing more and more instances and getting more and more calls from distributors and contractors who are saying, hey, I can't get my product anymore with a Franklin motor. Let's talk about me getting started or accelerating my use of Franklin pumps in order to ensure that I continue to get the Franklin motor. So we are seeing more and more incidences of that showing up in the market.

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

I think they'll continue to hold some in inventory to supply customers who they think they have a chance to convert, but who are remain absolutely committed to a Franklin motor and so they will increasingly try to allocate the product around, around those kind of customers.

Matt Summerville - KeyBanc

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

Scott Trumbull

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

And sales in the month of September were up significantly, primarily driven because of price promotions, which were occurring in September which they – the distributors knew would go away on October 1. So, whether or not that represents a permanent increase in demand or just a bulge in inventory remains to be seen. But having said that, demand was down in the third quarter by less than it was in the prior quarters this year.

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

But there was, more in the third quarter this year then there was in the third quarter last year, significantly although, when sequentially it was down somewhat. And how that will play through in the fourth quarter 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 was just, all right, if the market was down high-single, how much do you think your North American motor volume is down?

Scott Trumbull

Well…

Matt Summerville - KeyBanc

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

Scott Trumbull

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

Matt Summerville - KeyBanc

Yeah.

Scott Trumbull

Which is the Bellwether product in the industry, that was down a high single-digits in the quarter and our pump motor business was up dramatically. And I'm not going to give you a precise number, but it wasn't quite 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 your thoughts are on share repurchase going forward and maybe, given that the stock sitting here below 40 why not get more aggressive?

Tom Strupp

Well, we are certainly going to deploy our cash, looking at a number of strategic options including acquisitions as we go forward. And those decisions will play out as we have our options that we consider going forward. And yes, that would be a possibility, but we are not going to provide specific 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 move into '08 product development cost, engineering spend coming down is that part of the 200 bit, Scott? And then just to clarify in the third quarter the sequential decline, was that related to maybe some of the spend here or I guess I am trying to understand as well why it was down so much, because I don't think just accrual reversal would have done that?

Tom Strupp

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

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

Scott Trumbull

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

Matt Summerville - KeyBanc

Okay

Scott Trumbull

And we will not go back to $32 million, but it wasn’t the third quarter was so much dramatically low, it was that the second quarter was pretty high and now as we are kind of providing some guidance in the fourth quarter, it will certainly be higher than it was in the third quarter, but also certainly 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 talk about the -- I am sorry to ask another question on the expense side, but with the consolidation that you announced the first part of the fourth quarter for some of your fueling systems satellite office, , is that incremental to the expense reductions, the 200 basis points that you are planning for 2008?

Scott Trumbull

No, that would be part of it. Although we will also have what we'll work out to be direct cost reductions as a result of that. We will have, because we have consolidated the fueling operation, the fill tight operation, and the extrusion operations for our pipe business, all of those going out of standalone facilities into or satellite facilities into medicines. That will give us an opportunity to reduced fixed costs, which is part of the 200 basis point 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 pipe product line to us as a variable cost, they were charging us for that. When we moved that in to medicine and produced it ourselves we are going to find a material cost reduction, as well which will help us out as a result of that move. So, it's in the 200 basis points reduction, but will also have some additional benefit that will flow through, as a results of the change outside of the 200 basis point reduction.

Brad Schneider - Schneider Capital

Okay. So these expense reduction, the consolidation of the Fueling System satellite offices, as well as, I believe you've talked previously when you entered the year, you were looking for some expense reductions, because of the Siloam Springs facility is in some of the layouts at those facility. Is there a way to think of and I assume that is our pro forma for the acquisitions and the incremental SG&A from Monarch and from pump brands, 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 of pump brands and with the acquisitions of Monarch, there is some incremental SG&A that's going to be consolidated into the business. And I believe in the past, that you've spoken about some expense reduction, headcount reductions as your motor facility and also with your pump facility in moving the manufacturing down to Monarch?

Scott Trumbull

Yes.

Brad Schneider - Schneider Capital

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

Scott Trumbull

It is pro forma for the SG&A, the manufacturing fixed and the depreciation and amortization on all of the businesses that are currently 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, for instance if we have moved as we have over the course of this year, if we had moved manufacturing to Siloam and replaced direct labor in Siloam, with direct labor in Linares, or as we move forward next year having curtailed pump production in Little Rock replacing Little Rock a direct labor with direct labor in Linares. That savings because of the difference between $18 to $20 an hour labor, and $2 an hour labor to $50, that savings is not included in that calculation.

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 with you guys a little bit later. You've outlined over the past three quarters very well the impacts from, let's call it this year's change in the product mix with the motors versus the pumps and some of the aspects that are taking place in the 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 received in motors as you work through the inventory adjustment going into 2008, if you're able to achieve the same kinds of rates that within motors, within fueling systems that the incremental margins, is it right to think of the same historic incremental margins on that business as you received previously?

Scott Trumbull

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

Then, as pumps grow the gross profit margin will be down and we’re saying of the 520 basis points or so, reduction that we have incurred this year in gross profit margin about a third of it you’d call structural due to the affect of just the mix shift. And about a third of it pertains to fixed cost coverage and the subject that we’ve discussed and about a third of it pertains to prices relative to direct costs. And the price direct cost contribution 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 the product mix shift in the pumps, maybe, I can check with you later. But I just want to understand when you talk about the incremental business, the inventory overhead; you’ll be competing for that business, because you were previously competing against yourself. Within the motor segment of the PMA market that you are going to be addressing, is there any reason to think that the historical margins, the operating margins that you received in motors would be any different in 2008 if you are able to achieve that business than it was in 2005 or 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 that we think went into the stockpile and the value of those was $35 million to $40 million.

Brad Schneider - Schneider Capital

Right.

Scott Trumbull

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

Brad Schneider - Schneider Capital

Right.

Scott Trumbull

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

Brad Schneider - Schneider Capital

Okay.

Scott Trumbull

And so as motors they should be the same price. The issue will be as PMAs, how will they come through in the marketplace, sustain in next year as 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, I would 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 look forward to having a discussion with you at the end of the next quarter.

Operator

This concludes today's teleconference you may disconnect your 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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