Franklin Electric: Remaining On The Sidelines (NASDAQ:FELE)

Investment Thesis

Franklin Electric’s (NASDAQ:FELE) stock price has declined slightly since our last article where we rated it neutral. The company is well positioned to benefit from good demand for its groundwater business given the healthy trends in the market, such as increased crop prices and water scarcity in certain regions of the U.S. However, the company’s presence in the residential end market and fueling systems business is a headwind. The residential end market is getting negatively impacted by rising interest rates and the company is expecting a potential slowdown in investments by the oil marketers in FY23, which should impact its fueling systems business. The margins should remain flattish with inflationary headwinds offset by benefits from the pricing actions, supply chain improvements, and SG&A expense control. I prefer remaining on the sidelines till the headwind in the residential and fueling end market subsides, and have a neutral rating on the stock.

Revenue Outlook for FELE

FELE experienced healthy demand in its end markets in Q3 FY22, leading to double-digit topline growth across its three segments. The Water Systems segment grew 12% Y/Y due to strong organic growth driven by demand in groundwater pumping, surface pumping, and water treatment. The Distribution segment grew 38% Y/Y driven by solid demand in groundwater pumping, price realization, and the acquisition of Blake Equipment in January 2021. The Fueling segment’s sales grew 11.4% Y/Y due to the strong demand for fuel management services in the U.S. and Canada, along with sales growth in India and EMEA, offsetting lower sales in China. The company’s total backlog remained elevated at $250 mn but was down $40 mn sequentially due to the completion and shipments of past orders and improvements in the supply chain compared to the second quarter of 2022.

Looking forward, the company’s revenue should benefit from the healthy backlog levels and the improvement in supply chain constraints. Also, the company plans to take additional price hikes as it is still experiencing inflationary pressure in certain commodities. The trends in the groundwater business, particularly in the U.S., due to the strong crop prices and water scarcity in some regions, should benefit revenue. The decline in the water table due to water scarcity should lead to increased demand for large pumping systems that go deeper. FELE is well-positioned to address this demand.

However, the company should face some headwinds in FY23 given its presence in the residential market and the fueling systems business. Due to higher mortgage rates and inflation, the residential end market is experiencing weakness. Further, the company benefited from the migration of people to rural areas during the pandemic. However, with the reopening of offices, people are moving back to urban settings, which should negatively impact the demand for the company’s products. FELE experienced strong demand for its fueling systems business in Q3 FY22, driven by major oil marketers investing in new locations. However, the company is seeing some indications of a potential slowdown in these investments in FY23, which should impact the demand for its product.

I believe the healthy backlog levels, pricing actions, and tailwinds in the groundwater business should help the company post good sales in Q4 2022 but growth will slow meaningfully in FY23 as some of the headwinds become more apparent. The current sell-side consensus estimates expect Y/Y revenue growth to slow from 25.97% in FY22 to 1.95% in FY23.

Margin Outlook

In Q3 FY22, the gross margin declined 100 bps Y/Y to 34.5% due to headwinds from supply chain constraints, inflationary costs, and higher inbound freight costs, partially offset by pricing actions. The adjusted operating margin improved by 230 bps Y/Y due to leverage on higher sales volume and SG&A spending controls. SG&A as a percentage of revenue was 340 bps Y/Y lower due to disciplined SG&A spending.

Looking forward, the company is experiencing a cooldown in inflationary pressures in some of its commodities. However, the price of oil & gas products, plastics, and resins remains high along with the transportation costs. FELE plans to recover these costs by increasing prices incrementally. I believe the pricing actions, along with the improvement in supply chain constraints, and disciplined SG&A spending should offset the inflationary cost pressures resulting in flat margins in FY23.

Valuation & Conclusion

The stock is trading at 19.25x FY23 consensus EPS estimate of 4.19x, which is lower than its five-year average forward P/E of 24.48. The company’s revenue should benefit from the improvement in supply chain constraints, pricing actions, and healthy trends in the groundwater business. However, the slowdown in the residential end market and fuel systems business is a big headwind and should decrease the revenue growth meaningfully. The margins should remain flattish with inflationary cost pressures offset by benefits from the pricing actions, supply chain improvements, and control in SG&A expense spending. Despite the lower valuation, I have a neutral rating on the stock due to the uncertainty in the residential end market and the decreasing capital deployment by oil marketers, which are negatively impacting growth.