FELE - Franklin Electric: Medium-Term Headwinds

• Elevated backlog and pricing action should help Franklin Electric’s near-term revenues and margins.
• However, the uncertainty in the housing and agricultural end markets is a potential medium-term headwind.
• Valuation is at a discount to historical levels, but the stock is not cheap if we consider near-term headwinds.

Investment Thesis

Franklin Electric's ( FELE ) elevated open order balance (backlog) and pricing actions should help its revenues and margins in the Q2 and Q3 of this year. I also like the company's M&A-driven long-term growth strategy which should help FELE grow its business geographically and into different product lines. However, the uncertainty in housing and agricultural end markets is creating potential medium-term headwinds. I don't find the company's valuation at 19.99x current year P/E cheap given these headwinds. Hence, I have a neutral rating on the stock.

Revenue Outlook

The company's business is usually short cycle in nature but the recent supply chain challenges, as well as strong end markets, have led to an open order balance of $290 mn at the end of Q1 FY21 compared to $175 mn at the end of last year. In order to complete its order balance and meet the strong seasonal demand in the second and third quarters, the company plans to increase its throughput at its facilities which should help near-term volumes. Further, the company has been implementing pricing actions to offset the inflationary environment. In the first quarter of this year itself, it took five price hikes and ~20% increases based on the region and product line, which is higher than the company's usual low-double-digit range price hikes in the first quarter. Rising inflation across the globe should force the company to implement additional price hikes going forward, leading to a strong double-digit price increase by the end of FY22. I believe the company should be able to deliver good results in the second quarter and the third of FY22 given the strong end markets, pricing actions, healthy backlogs, and seasonality, partially offset by the negative currency translation and supply chain constraints.

However, toward the end of this year, the company should face challenges with declining soft commodity prices and a slowdown in the economy. FELE's water system segment contributes ~60% of the total revenue generated by the company and has residential, agricultural, municipal, and industrial as its end markets. The rising interest rates are a big headwind for the housing market while soft commodities like wheat and corn prices have also started correcting since June casting doubt if the strong demand from the agriculture end market can continue. With the declining commodity prices and increasing input costs, farmers' income should be affected, thus postponing potential investments to upgrade agriculture equipment. I believe the slowdown across industries might affect FELE's revenue growth towards the end of this year and in FY23.

Margins

In terms of margin, the company has been implementing pricing actions across its business portfolio to maintain its margins. However, margins have declined in the last two quarters due to inflationary cost pressures and supply chain challenges. Also, there's a couple of months of lag before the price increases take hold due to the open order balance booked at prior prices. So, as the company works through its open order balance, and the recently implemented price increases start flowing through revenues, we should see some improvement in margins. So, I'm optimistic about the margin for the back half of this year. However, there's not much visibility for margin improvement in the medium term as the risk of end market slowdown and volume growth decreasing is creating some uncertainty.

Inorganic Growth Opportunities

The company's strategy focuses on laying the groundwork to grow as a global provider of water and fuel systems through geographic expansion and extending the product line by leveraging FELE's global platform. This should be achieved by innovating products as per the customer's requirements and identifying inorganic growth opportunities. Since Q3 FY19, the company has acquired five companies to expand its water treatment business, with B&R Industries being the most recent one. FELE acquired B&R Industries in December 2021, which is a water treatment system provider and should help the company expand its presence in the Southwest U.S. region. Franklin Electric's water treatment platform has grown to over $175 mn in annual sales thanks to these acquisitions.

Additionally, the company is expanding its position in the groundwater business by acquiring distribution channels. FELE has acquired four companies since 2017, with Blake Group being the most recent one. The Blake Group is a professional groundwater distributor, which should help improve FELE's presence in New York and New England.

FELE has successfully integrated both B&R into its water system segment and the Blake Group into its distribution segment. I expect continued inorganic growth looking forward. The company has a strong balance sheet with net leverage of just ~0.6x which provides ample flexibility to continue its M&A strategy.

Valuation and Conclusion

The stock is currently trading at 19.99x forward P/E FY22 consensus EPS of $3.64 and 18.42x forward P/E FY23 consensus EPS estimate of $3.95. While it's lower than its five-year average forward P/E of 24.65x, I don't find this valuation cheap, especially given the upcoming medium-term challenges from the potential slowdown in its end markets. I like the company's M&A-driven long-term growth strategy but, in the medium term, it's better to be on the sidelines as the uncertainty in housing and agricultural markets might affect the company's revenue and margin growth over the next couple of years. Hence, I have a neutral rating on the stock.

For further details see: