Franklin Electric (NASDAQ:FELE) is a manufacturer and distributor of water and fuel pumping systems, composed primarily of submersible motors, pumps, electronic controls and related parts and equipment. The Company's business consists of two reporting segments based on the principal end market served: the Water Systems segment and the Fueling Systems segment. Water Segment accounts for more than 3/4th of the company's revenues and operating profits while fueling segment accounts for the remaining.
The company's stock price has underperformed broader markets declining 18% this year versus over 10% gains posted by S&P500. However, the stock is still trading at a hefty P/E multiple of ~21x FY14 estimated EPS. This is quite high give the company's flattish EPS growth this year. One of the major reasons behind the company's high valuation is reassurance from management that the company will be able to return to normalized product mix (ground water versus surface pumps) during 2015 which will help it regain some of the lost margin potential. However this appears unlikely. Moreover, increased inventory levels and accounts receivables indicate that further pressure on margins is likely in the near term. Here's a detailed look.
Account Receivables and inventory have risen disproportionately as compared to sales
In the last quarter, Franklin electric's account receivables and inventory increased by over 28% yoy and 21% yoy versus 11% yoy increase in revenues.
Table 1: Growth in receivables and inventories versus sales
Source: Company filings
The increase in inventory is even more worrisome as the company's surface pumps business is doing well and most of this disproportionate increase in inventory is likely in high margin groundwater pumps business. Declining sales in the groundwater pumps business coupled with higher than usual inventory levels is a perfect recipe for disaster. If the slowdown in groundwater pump sales and inventory build up continues, the company will be forced to get rid of excess inventories at a discount which will adversely affect earnings.
In addition to rising inventory levels, the company has seen a disproportionate increase in account receivables. While management is saying that it is maintaining pricing discipline, the loosening of credit policy indicates that price discounting may be in the offing going forward.
Despite of over 11.29% yoy increase in revenue last quarter, Franklin electric posted flat EPS versus third quarter last year. Its gross margins declined by 275 bps while operating margins declined by 344 bps yoy last quarter.
Table 2: Year over year change in Franklin Electric's margin
Source: Company filings
Management has attributed this entire margin decline to a mix change towards low margin surface pump equipment from high margin groundwater pumps. In its last quarter earnings call, management said that this mix change is temporary and the company's sales mix will reverse to a more normalized levels in 2015. While many investors are betting on this mix reversal, I don't think it is going to happen anytime soon. Last quarter, the company's groundwater equipment sales in US and Canada declined 16% versus 5% increase in total water segment sales in this geography. Water Systems sales mix returning to historical levels means a significant jump in groundwater pump sales going forward which appears unlikely.
The company blames this mix change on the recent distribution channel change in which they replaced certain outlets with others. However, as per Franklin Electric's first quarter earnings call, the affected annual revenue of distribution outlets which were replaced represented less than 4% of the company's consolidated sales. So, it is unlikely that such a significant slowdown in groundwater pump equipment sales is due to distribution channel change alone. It is more likely that most of the decline in groundwater pump sales and mix change is due to end customer demand, and there is nothing to indicate that it will reverse in the coming quarters.
Weakening emerging market currencies
Franklin Electric derives more than 50% of its sales from foreign countries. Therefore, recent strengthening of US Dollar against other currencies does not bode well for the company as it makes Franklin's product less competitive. Also, Franklin Electric's growth rate in developing markets is higher than that in the US. Thus, any slowdown in Franklin's growth in these markets due to currency fluctuations is likely to affect the company's overall growth profile materially.
Franklin Electric's cash and cash equivalents have fallen by $58 million since the end of last fiscal year. While a part of this reduction is due to more cash being tied up in account receivables and inventories as discussed above, the company has also spent a significant amount on acquisitions. I find the utility of some of the acquisitions questionable. For example, last quarter, Franklin Electric acquired two companies in India for $6.6 million. The company didn't provide much detail on these acquisitions. However, a filing by one of these companies - Pluga Pumps and Motors Pvt. Ltd. - with Indian Registrar of Companies indicates that it was incorporated in August 2013 with a paid up capital of just $1588 (Indian Rupee 100,000). It's unclear what value add this company can provide to Franklin Electric and why Franklin would paid millions of dollars for it just one year after its incorporation.
Franklin Electric is trading at 21x current year estimated EPS , a multiple which usually high growth Industrial companies get. While Franklin's topline growth has been decent on the face of it, most of it has come from low margin products and its bottomline has stagnated. I believe the company is likely to miss earnings over next couple of quarters. This, coupled with investors realizing that the company is unlikely to return to its historical groundwater/surface water pump equipment mix, will cause Franklin's P/E multiple to compress to a level in line with S&P500. I believe there is 15-20% downside likely in the short term.
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