This isn’t a particularly good time to be leveraged to residential construction, and while Franklin Electric (NASDAQ:FELE) offers better near-term leverage to ongoing demand for irrigation and dewatering, the prospect of weaker residential and below-ground fueling systems, not to mention ongoing supply/margin challenges, is weighing on the shares. Down about 5% since my last update, Franklin has more or less kept pace with the broader industrial sector, and staked out a middle ground between better-performing water stories like Xylem (XYL) and Lindsay (LNN) and weaker names like Mueller (MWA) and Zurn Elkay (ZWS).
The challenge in approaching Franklin Electric today is balancing out the near-term end-market weakness with above-average long-term potential, as well as a valuation that’s not so exceptional compared to industrials in general, but looks rather good compared to how the market has traditionally valued water plays.
Residential Will Cool, But The Long-Term Need Is There
The U.S. housing market has already started to cool, and at this point I’m expecting a roughly 10% decline in 2023 in response to higher interest rates and weakening overall consumer confidence (as well as ongoing affordability challenges). With Franklin Electric getting somewhere around a quarter to a third of its revenue from the residential market, that’s a definite near-term challenge.
Longer term, though, I think the company’s groundwater pumps and surface pumps for water utilities will see healthy demand (above underlying GDP growth). A key focus of the U.S. infrastructure bill was improving the quality and capacity of drinking water supplies, and groundwater pumps are likely to be a meaningful part of the picture going forward. This is likewise true overseas, where contamination or pollution is often forcing municipalities to turn to deeper sources of drinking water.
Management indicated that supply challenges did limit its aboveground business in the third quarter (up 4%) and that the residential market was starting to weaken. Mueller likewise commented on signs of weakness in the residential market, and so while the long-term outlook is positive, there will be weakness in the short term.
Agriculture And Industrial Could Show Similar Trends To Residential
Agriculture is a significant end-market for Franklin Electric, likely larger than residential (the company doesn’t regularly produce end-market exposure data), and another with mixed trends.
As I discussed recently with Lindsay, the need for groundwater-based irrigation continues to grow, as more and more regions of the U.S. (and areas outside of the U.S.) experience more frequent and more severe droughts. There is also strong evidence that mechanical irrigation leads to meaningful increases in crop yield (and lower year-to-year variability) that drive attractive payback periods of groundwater-based irrigation systems. I’d also note that crop prices and farmer incomes remain rather healthy by historical (10-year and beyond) standards.
The “but” is that farmer sentiment is not strong right now, and farmers have multiple demands on their budget, including refreshing heavy machinery (the agricultural equipment fleet is overaged) and investing in newer opportunities like precision agriculture. So as in the case of residential demand, I believe the longer-term outlook for agriculture demand is healthy, but it could be rockier in the short term as farmers deal with higher costs (equipment and interest rates) and lower confidence regarding making large capital investments at this point in the cycle.
Turning to industrial/commercial applications, Franklin Electric generates a reasonably significant amount of revenue from its dewatering operations. I expect healthy demand in 2023 from oil/gas and mining markets, but I expect construction demand to be weaker, as I’m relatively bearish on the near-term outlook for non-residential construction activity.
The Fueling Systems business saw 13% growth in the third quarter, but management’s commentary did include mention of some reduction in customer buildout plans for 2023. The company has been gaining share as competitor systems reach the end of their useful lives, and also seeing better share of wallet as emerging market customers install more advanced systems (including vapor recovery and whatnot), but weaker overall capex in the retail fueling space looks like a risk for the next year. It’s pretty normal for miles driven to decline with weaker economic activity, and with trucking companies already seeing a downturn, it’s not unreasonable to think that service stations will be more cautious on capex commitments.
Franklin Electric has actually performed rather well on balance this year. Management’s updated guidance was a little light relative to the prior quarter, but the company will likely end up a little higher than expected for revenue, and while gross margin pressure remains an issue, the company has exceeded expectations in offsetting that pressure with lower SG&A spending. There will be a sharper seasonal step down in the fourth quarter, but all in all this has not been a bad year.
In light of a weaker residential environment and greater uncertainty in agricultural, I’ve trimmed back my FY’23 revenue estimate (by about 3%), but I’m still looking for long-term revenue growth in the mid-single-digits (closer to 6% than 5%). While cost pressures should ease next year, mix shifts and inefficiencies tied to end-market slowdowns could mitigate some of the margin benefits. Still, I expect an EBITDA margin in the mid-teens and gradual longer-term improvement.
Modeling free cash flow is complicated by uncertainties in forecasting when Franklin Electric will be able to release inventory and work that down to more normal levels – like many companies, they’ve built up inventory to ensure availability and maintain production schedules. I expect that will start happening next year, but the exact timing is still uncertain. Either way, I expect low-double-digit FCF margins over time and normalized FCF growth in the high single-digits to low double-digits.
Discounted cash flow suggests a total long-term annualized potential return in the high single-digits. That’s not bad, particularly for a water play, but it’s also not necessarily compelling at a time when many stocks are offering double-digit prospect returns. Likewise, while the next 12-18 months is perhaps not the most representative sample set for Franklin Electric’s margins and ROICs (powerful drivers of forward EBITDA multiples in the industrial space), the shares don’t look dramatically undervalued by that metric either.
The Bottom Line
I like Franklin Electric; I think this is a well-run company and I like the long-term opportunities in groundwater for both residential and agricultural applications (in the U.S. and abroad). I also like the growth potential in the water treatment business, an area I’d like to see management build through M&A, and I think there is room to scale the distribution business further from here.
The valuation is mixed, though, and I don’t like that in combination with a weaker outlook for 2023. It’s certainly possible that water stocks could heat up again and regain their former valuation premiums, but outside that sort of shift in sentiment, I’m more neutral on this name than I was before, or at least for the next six months or so.