When a company’s operating environment is good, even a mediocre management team can look like geniuses. You learn far more about the quality of a team when things get rough. We spoke with Franklin Electric CFO John Haines recently about the significant headwinds their team is facing and came away more confident in the company than we were before.
Franklin manufactures pumping systems for the water (~82% of FY15 revenue) and energy (~18%) industries – both of which have been impacted negatively by market shifts. The fundamental reasons for the oil & gas price weakness are: increased North American land production, the potential for Iranian supplies coming on line, and some softening in demand from China. There is also a pricing factor: since oil trades in US dollars, as the dollar has strengthened, the price of oil has gotten measurably more expensive in foreign markets. The record rainfalls in particularly the eastern half of the U.S. this Summer have also impacted sharply the demand for irrigation systems. Add Franklin’s recently increased presence in a weakening Brazilian market to the mix, and you have a situation that CEO Gregg Sengstack referred to as “a perfect storm” of external negative factors.
With that as background, we wanted to better understand how the environment is impacting operations and whether it would mean any changes to Franklin’s strategic plan. Liquidity is clearly a focus for Franklin, and presents no measurable challenges, in large measure because of tighter working capital management and adequate credit access. Market share is a short-run challenge in North America following Franklin’s 2014 distributor re-alignment, but management believes they’ve addressed vulnerabilities and views the share loss as minor and temporary.
A far bigger concern for us is what we refer to as the “big, dumb acquisition.” Feeling the heat from shareholders to ‘do something,’ managers often become too aggressive in their growth plans. Mr. Haines communicated a much more disciplined posture, noting that they were not interested in “buying an expensive car that we don’t want.” And we feel more assured that as Franklin pursues joint ventures and acquisition opportunities in key foreign markets, their due-diligence process will help them avoid deals with questionable business practices.
Franklin operates in fragmented markets, and this team has demonstrated the ability to buy and integrate companies that either extend their distribution footprint, or offer products which fit well with the existing lines. In fact, one of our key investment themes is that they have the opportunity to continue executing this strategy well. While we’re pleased with their capital allocation opportunities in the near term, we are a bit concerned to learn that the pace of acquisitions may be slowing. To borrow from baseball, as shareholders we don’t want management to swing at bad pitches, but their historical slugging percentage is pretty good, and we prefer to see them with more at-bats, not fewer.
Mr. Haines expects that Franklin’s operating environment will improve, piece by piece: first with easier year-over-year currency comparisons, followed by firming of North American demand, and finally through energy market rationalization. Peloton estimates that it may take 18-36 months for all of those factors to work themselves out. In the meantime, we’re confident that the team making the decisions is disciplined and committed to growing the right way.
Peloton Wealth Strategists owns the common stock of Franklin Electric Co, Inc. The opinions expressed above should be construed as neither investment advice nor a solicitation to buy or sell securities. Peloton Wealth Strategists assumes no liability for losses pursuant to investment actions entered into as a result of opinions expressed herein. Changes in economic and capital market conditions and the unique objectives of each investor should be considered before investing in securities.