Good day, ladies and gentlemen, and welcome to Franklin Electric Company, U.S. Groundwater Distribution Acquisition Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. If anyone should require assistance during the conference, please press star to zero on your touch-tone phone. As a reminder, this conference is being recorded. I would like to introduce your host for today's conference, Mr. John Haines, Chief Financial Officer. Sir, please begin.
Thanks, Ben, and welcome everyone to this special Franklin Electric conference call announcing the company's decision to forward integrate into the groundwater distribution space in the United States. With me today is Gregg Sengstack, our Chairman and Chief Executive Officer. On this call, Gregg will provide an overview of the strategic importance and rationale for the acquisitions we have announced, and I'll give some financial information regarding the acquired entities and the impact they will have on our financial results. When I'm through, we will have some time for questions and answers.
Before we begin, let me remind you that as we conduct this call, we will be making forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are subject to various risks and uncertainties, many of which could cause actual results to differ materially from such forward-looking statements.
Discussion of these factors may be found in the company's annual report on Form 10-K. All forward-looking statements made during this call are based on information currently available, and as required by law, the company assumes no obligation to update any forward-looking statements. With that, I'll now turn the call over to our Chairman and CEO, Gregg Sengstack.
Thank you, John. A principal component of our strategy since forward integrating into pumping systems over a decade ago has been to extend our product lines and expand our distribution reach. Outside the U.S., we have been doing this through a series of acquisitions of pump companies. Inside the U.S., to date, we have focused on partnering with distributors to expand our platform and revenue in this important end market.
The specialized groundwater distribution channel in the U.S., through which we sell our products, is an important element in the ultimate sale, support, and specification to installing water well contractors. As much of the product sales are of an emergency replacement nature, product availability is key, which is why well drillers and installing contractors rely heavily on the distributors that service this industry. While there are many examples of disi ntermediation in other industries, the water systems distributor provides significant value to their customer, the contractor.
Over the past decade, through our strategy of working in partnership with our distributors, Franklin Electric has developed a broad array of products and system solutions that will only grow as regulatory and efficiency demands increase in North America. At the same time, when the strategies of partners diverge, you need to make a change. This was a situation we had four years ago and led to our decision in 2014 to reset our distribution footprint in the U.S.
Change comes at a cost. We invested heavily in increased sales, service, marketing, and promotion to help our new distribution footprint establish relationships with contractors that preferred Franklin product. At the same time, we made financial investments in our new platform.
These investments gave us visibility into the strategies, operations, and financial profiles of several of our distributor partners. It also gave us a greater perspective of the groundwater distribution business. Most groundwater distributors are family-owned businesses. Some have succession plans, but many do not. We saw this situation as an opportunity for Franklin Electric.
First, by acquiring Western Hydro, 2M DSI, and a 2M, DSI joint venture, Franklin Electric is forward integrating into this channel with four strong, customer-focused organizations competing in the market, increasing our commitment to the entire channel and the installing contractor base. With 60 locations, nearly 500 employees, and a national footprint, Headwater will be the largest distributor in this channel.
Second, Headwater provides a platform that moves us one step closer to the contractor. Over the years, we've received valuable feedback from these contractors through our field service organization and technical service hotline.
However, owning a significant distribution platform will provide a greater opportunity to develop even more relevant products and solutions, improve availability, and refine the training programs necessary to support the growing use of electronics, drives, and controls in this market. Third, this investment allows us to own a part of an important end market distribution capability, provide a strong platform for growth, and proactively lowers the overall risk of the customers of this end market being influenced or consolidated in a way that does not support the long-term interest of Franklin Electric shareholders.
Distributors now have another option: Franklin Electric as they evaluate their succession plans. Another point I would like to cover is the fact that our new distribution segment buys pumps from our competitors. This has become increasingly more common. Around the world, Franklin Electric buys products from our competitors, and we sell products to our competitors. We all have access to various customers, so it's just good business. In this case, the focus of Headwater is to supply the customer, the contractor, with what they want.
To provide this focus, we moved Dee Davis, a 25-year industry veteran and an officer of Franklin Electric for the last 11 years, to be president of Headwater. We also moved Dee to Denver so that Headwater's leadership team was physically separate from Franklin's North American water business located at our headquarters in Indiana. Dee has two goals: grow the business and move Headwater's returns on invested capital to be in line with Franklin's manufacturing business. To grow the business, Dee will be looking to service Headwater customers with a full suite of products.
He will also be looking at opportunities to take the pockets of expertise that exist throughout the Headwater's organization in water treatment, water purification, turf irrigation, wastewater, and pressure boosting, to name a few, and cross-sell over a platform of 60 outlets. At the same time, I'm pleased to announce that Don Kenney has been elected president of our North America Water Systems business.
Don, a 26-year veteran of Franklin, starting at Franklin Fueling Systems where he has been president for the last 12 years. Under Don's leadership, Franklin Fueling Systems' top line grew fourfold and bottom line grew tenfold. I know that Don and our North America Water Systems team will be focused on serving all of our distributor and contractor customers, including Headwater and its customers.
By forward integrating into distribution in the U.S., Franklin Electric is taking a logical next step in our evolution as a groundwater pumping systems company. This action places Franklin Electric shoulder to shoulder with key decision-makers in this end market: distributors and the installing contractors. The Headwater Companies will continue to operate as full-line wholesale distributors with a focus on total water system support, including products from all industry manufacturers. Headwater will maintain a laser focus on supporting professional installing contractors. I will now turn the call back over to John.
Thanks, Gregg. A s we said in our release yesterday afternoon, the company's reached agreement to acquire controlling interest in three distributors in the U.S. professional groundwater market. Franklin Electric will acquire 2M Company, Inc., of Billings, Montana, Western Hydro Holding Corporation of Hayward, California, and Drillers Service, Inc., of Hickory, North Carolina, for about $89 million in the aggregate, which includes assumed debt.
The 2M and Western Hydro transactions closed, and the company expects the DSI acquisition to close before the end of the Q2 of 2017. In total, the acquired entities have approximately 60 sales branches or other facilities, a combined employee count of approximately 500, and annual revenue of almost $275 million. For financial reporting purposes, as of the Q2, all the acquired entities will be wholly owned subsidiaries and included in the company's consolidated results.
The Headwater distribution segment will be reported separately from the existing water system segments, which will continue to report the results of the global water manufacturing business. The new segment is expected to have operating income margins of approximately 4%-6% and pre-tax returns on invested capital consistent with historical Franklin Electric returns after certain integration actions are complete.
The new segment is expected to be neutral to the previous 2017 earnings per share guidance of $1.77-$1.87 that the company has provided. The partial year earnings generated from these entities in 2017 will be about equal to the combined dilutive factors that include interest expense due to higher borrowings, deal costs, and the impact of the deferral of income recognition in our water system segment on sales to the distribution entities. A quick word on that last factor. The company has acquired distribution entities that are water segment customers.
Now that we own the entities, the sales and profits our water system segment would have recognized on the sale product to them is deferred until that product is sold by the distribution segment to their third-party customers. Sales from the water system segment to the distribution segment are intercompany and will be eliminated in our consolidated financial reporting.
I n effect, until the beginning inventory of Franklin Electric product in the Headwater Companies on hand as of the acquisition date is completely sold, noting that they sell on a FIFO basis, and replaced by inventory purchased post-acquisition, and then that inventory is sold on to the distribution customers, the water system segment profit on their sales to the distribution segment will be deferred.
We estimate this to have a dilutive impact on the company in 2017 and is the primary reason why these acquisitions will not be accretive this year. As we look forward, anticipating the operating income range of 4%-6%, we have estimated the earnings from these acquired companies are expected to add $0.12-$0.14 to Franklin Electric's 2018 earnings per share. This concludes our prepared remarks, and we'd now like to turn the call over for questions.
Ladies and gentlemen, if you have a question at this time, please press star, then one on your touch-tone phone. If your question has been answered or you wish to remove yourself from queue, you can do so by pressing the pound key. But again, that is star and then one. Our first question is from Mike Halloran of Baird. Your line is open.
Hey, morning, guys.
Hey, Mike.
C ould you help understand how much Franklin content is rolling through these distributors as a percentage of the $270 million?
W e sold last year, Mike, about $50 million or about a third of what we would articulate as our U.S. commercial business to these four entities, I should say, to these four entities. R oughly a little less than a third, 30%.
T hat's very helpful. W hen you think about the splits of what these guys do, could you give some context to? how the product mix shifts out at these organizations between what your assets are or even your competitor assets, other things they might sell through, what percent service might represent of the overall pie? just getting a better understanding of what the mix of business looks like?
It's slightly different with each of these four entities, p rincipally, these are buy-sell entities, t here's not necessarily a lot of service associated that's built out. There is service and support for the contractor i mean, they'll run a part out to a contractor in the field to keep them up and running t hat's the service level that the contractors expect.
Broadly speaking, you'd say that pumps, motors, controls, it's going to be 30%-40% of these entities' purchase and sale volume. The other items that you're going to see are tanks, water storage tanks. You're going to see drop cable, drop pipe, driller mud, drill bits, a variety of parts that would go into completing the system. In addition, what you're going to see is that there are some specialty in each of these houses that we hope to cross-sell that pointed out.
For example, 2M is bigger in turf irrigation. They supply products in the turf irrigation market W estern Hydro has a commercial business because of their position in California. DSI has got some wastewater business.
A s contractors have extended into other areas, as they've expanded their own businesses, these wholesale distributors have gone on to support them. I think the takeaway would be, again, 30%-40% in the pump, motor, drive, control space, and then the balance is a cadre of other important products to supply to contractors. A s I said, there's some nicheness to each of these distributors.
Then a question on the distributor network for you cumulatively in the North American region. My guess is that these are not the only distributors you will be using, correct? The network broadly hasn't really changed that much y ou're just using these guys exclusively in these territories i s that fair? Or are these the only distributors you're going to be using in the States going forward?
No, let's be clear. As John pointed out, about 30% of Franklin's revenue in this channel goes through these distributors. As of yesterday, the ownership of these distributors changed. I t means 70% of our revenue goes through a number of other distributors, some who are regional, some who are single-store operators, some which are national in the plumbing wholesale space and also carry these products.
And those relationships will continue and will continue to sell through them t hat's why Don Kenney, that's his focus, is Franklin Electric manufacturing is to support all of these distributors, including Headwater. Yesterday, the ownership changed.
Okay. That makes a lot of sense l ast one then. Maybe just talk about how you're viewing the competitive environment after these changes, how some of your peer group might look at this? particularly in relation to some of the distributor changes you made and then the integration you guys did mid-2000s, adding the pump to your motor capabilities. What do you think this does to the dynamic, if much at all?
C ertainly, again, I mean, Headwater's focus is to support the contractor and supplier with the best products that they can get access to. Our competitors in this space all supply Headwater to varying degrees. O ur expectation is those relationships are going to continue because Headwater wants to grow, and our competitors want to grow with them.
Certainly, again, the idea here was to have a vehicle that provided a vehicle for distribution operations to be able to sell their businesses and maintain them intact in a way that their customers and their employees had a place to go and stay within the industry. W e're providing that vehicle. A s I said also in the call, we buy and sell our competitors' products, and our competitors buy and sell our products around the globe w e really don't expect much change there.
Great. Hey, appreciate all the help. Thank you.
Sure, Mike.
Thank you. Again, ladies and gentlemen, if you have a question at this time, please press star and then one. Our next question is for Matt Summerville of D.A. Davidson. Your line is open.
Thanks. Good morning. I want to clarify one thing on the ownership here a re you acquiring 100% ownership in each of these entities? And if not, could you please clarify exactly what you are acquiring?
Yeah, Matt. We are completing the acquisitions to acquire 100% of these entities. T he $89 million that we put out yesterday is to complete 100% ownership. Now, that includes some assumed debt t hat didn't all go to the owners or to the sellers, but some of it went to pay down debt. But yeah, that's 100% ownership of these entities.
And then when you look at the margin profile of the water systems distribution channel, which I assume the three that you're acquiring are roughly representative of the channel overall l et's just call it mid-single-digit operating margins. I guess I'm a little surprised by the level of profitability a little more downstream removed from the manufacturing piece of the business, which let's just use you guys as a proxy for that.
I guess, how do you get the margins? on the distribution side up to roughly double where they're at today from what are you doing from an integration standpoint? How much revenue synergy do you have to get here to do this? Because I mean, a lot of what these guys are selling are ancillary or non-native to Franklin i 'm trying to understand all this.
Matt, let's be clear on the numbers. T he guidance range that we're providing for the segment, so as we said, we're going to report Headwater and distribution in a totally separate financial reporting segment starting in the Q2.
W e provide a guidance of 4%-6%. W e believe that if we can earn an operating income margin, that's a pre-tax operating income margin of, let's just say, 5% on a $300 million top line now, we're not at a $300 million top line, but to keep the math easy, call that $15 million of operating income, right? W e have an invested capital base, and I think that might be the point that we need to clarify.
Remember, the invested capital bases of these businesses are dramatically different than those in a manufacturing business like Franklin is operating on a global basis in our water segment. J ust for ballpark math, let's just call that invested capital base in the $100 million range. Our total investment in these entities is about $109 million. But if we just use 100, assuming some working capital improvement, then you come back to a return on invested capital.
Now, we're talking about a pre-tax return on invested capital. Numerator, operating income. Denominator is invested capital or equity plus net debt. You come to 15%. W e think now, in the early years of our integration activities, these are three separate companies that need to be integrated t hey're operating on different operating platforms, mechanical platforms.
They're not integrated from a sourcing perspective. They're not integrated from a market perspective t here's several integration activities that we believe we can take. I n the end, you can see or we think we can see a $300 million business with a 5% OI margin and somewhere in that $100 million-$105 million invested capital range. That's how we're thinking through the math.
T hat's helpful. T hen I guess the other question that I want to make sure I understand is, and maybe just take a step back and talk about this evolutionary process a little bit i n the mid-2000s, it was all about you're selling to two guys that basically control the distribution channel.
By and large, you need to go buy pump companies y ou need to become more vertically integrated, if you will y ou did that a nd in doing that, you really relied, at least, I always felt, that you relied very heavily on the Franklin brand to sort of get that done. And are you saying today that the brand doesn't matter as much? It's more about the value that this water systems distributor is adding to the contractor? I guess, Greg, maybe walk through that and help clarify the evolutionary process here.
Sure, Matt. I appreciate you asking the question because, yeah, the brand absolutely matters. That's why we've gotten the return on invested capital we have with the Franklin manufacturing business. What we saw is that this is a relatively small industry. It's $2 billion out the door at distribution level. It was an industry that we see is potentially changing over time. We also see that the products are getting more sophisticated.
T here's a greater need for training and understanding the needs of the contractor as we go more and more to system selling. W e just saw this as being a natural extension to enhance the value of the Franklin Electric products that we were developing as opposed to the question you were raising about saying, "Okay, well, is this just something that's going to be on somebody's shelf somewhere?" Is that the contractor here adds value.
W e want to add value to them by supplying complete systems t he systems are getting more complex. We certainly want to have the training and support w e see by being one step closer to the contractor, by having what's nominally 15% of the distribution business as a way to do that, and it's also providing a vehicle for other distribution companies to, if they want to sell their businesses, to sell them into Franklin, into Headwater, and so that they have continuity for their employees and for their customers.
If you think about it from that point of view, what we're doing is we're providing that vehicle for other distributors to consider as an option for their business. When we looked at this, we looked at it over several years. You've got to come down and say, "We're in the distribution business because we like the business." The financial returns on distribution, as John pointed out, can approach the financial returns that we see in our manufacturing business, and we just see it as being a good business and a natural extension for us and a place for us to double down is right here in North America.
What do you think happens there? I guess, what's your assessment maybe, if you will, of what a move like this could do to the pricing environment and how you view inventory risk on a go-forward basis having both a manufacturing and distribution business?
A gain, we're going to run this as a separate entity. We've physically separated the leadership team, and we've moved from the ownership structure from four independent ownerships into one company called Headwater, which is this standalone investment vehicle.
W e are the deals they had before, the deals they have tomorrow. We don't expect to see a whole lot of change there. Now, I mean, Headwater is going to want to grow. Everyone wants to grow. W e see Headwater and Dee and his team growing through offering a higher level of service and continuing to raise the bar on service and support for the contractor.
Great. Thanks, guys.
Thank you. Our next question is from Ryan Connors of Seaport Global. Your line is open.
Good morning.
Morning, Ryan.
I want to make sure I understand this. It seems like to some degree, you're becoming a competitor with some of your current distribution partners. H ave you guys assessed that? and do you think there's any risk of sort of sales decay now that you're competing against these guys?
C ertainly, with the ownership change, yes, you could say that we are not competing with our other distributor customers. W e've always kept close relationships with these people, and the value equation hasn't changed from one day to the next. Our manufacturing team led by Don Kenney is fully focused on that. T hen the Headwater team is focused on growing their position in the distribution marketplace w e've always had also, Ryan, we've had selective distribution. We don't sell to quote everybody w e've had selective distribution in markets. T hat will also continue.
I s there a way you could give us a sense? I don't know if you can quantify it, but just of the sort of geographic overlap that Headwater has with sort of your that other 70% base of distribution partners?
A gain, it's the same geographic overlap that existed before we acquired these entities. Headwater is strong kind of Rockies West and Southeast t here's also a Midwest component to the DSI and 2M DSI JV. We have other large regional distributors that would butt up against these regions that we developed over the years. T hen overlaying all that are a series of smaller distribution houses that have been carrying Franklin Electric for decades, well, for over a decade now.
I guess, are we going to see more of this going forward, do you think? I mean, do you have a funnel of additional smaller distribution companies, like you said, that don't have a succession plan? And I guess, how soon could we see you guys become active like this again?
Again, it's really a function of the owners of these companies. We've built a reputation over the years that I think would be of pretty good acquirers, very good acquirers of family businesses across the globe. W hen individuals are thinking about their future plans, they know they can give us a call. Timing on those calls can vary.
I've made the point in Brazil that it took us nine years to get that deal to the finish line. It took nine years for that family to be ready to sell their business. W e're here. They have our phone numbers. They know us. W hen they're ready to sit down and talk, we're certainly in a position to listen.
Appreciate it. Thanks, guys.
Thank you. At this time, I see no other questions in queue. I'll turn it back to Mr. Sengstack for any closing remarks.
We thank you for joining us this morning on this important strategic development for Franklin Electric. We look forward to speaking to you about our Q1 results later this month. Thank you.
Ladies and gentlemen, thank you for your participation in today's conference. This concludes. You may now disconnect. Everyone, have a great day.