Franklin Electric Offers Solutions To Long-Term Water Issues, But The Near Term Is More Challenging

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.

 

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Franklin Electric Offers Solutions To Long-Term Water Issues, But The Near Term Is More Challenging

Franklin Electric Offers Leverage To Real Pain Points In Water

One of my criticisms about the typically richly-valued industrial water sub-sector is that many of these companies aren't especially well-leveraged to real pain points in global water - namely, ensuring adequate supplies of clean drinking water. Leak detection, condition monitoring, advanced metering, and basic infrastructure (pumps, valves, et al) certainly have their place, but I think Franklin Electric's (NASDAQ:FELE) focus on groundwater pumps and growing focus on water treatment/quality sets it apart.

These shares have outperformed other water stocks like Mueller (MWA), Watts (WTS), and Xylem (XYL) by pretty meaningful amounts since my last update (around 20%, 15%, and 35%, respectively), though the shares are only up slightly in absolute terms (and Evoqua (AQUA) has done even better). Given the company's performance since that last update, including strong pricing power, I'm more bullish on the shares and the valuation today.

 

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Franklin Electric Offers Leverage To Real Pain Points In Water

Franklin Electric Offers Attractive Leverage To Water Scarcity And Water Quality

 

Water is still abundant on this planet, but accessing clean water is getting more and more challenging in many areas as population growth and demands from agriculture and industry are leading to more intense groundwater depletion. That’s not a good thing, but it creates opportunities for Franklin Electric (NASDAQ:FELE) through its diverse line of groundwater pumps and related equipment, as well as its recently-assembled water treatment business.

There’s more to Franklin than groundwater pumping, as the company also has a large business in surface pumping equipment, as well as pumps and other system components for fueling systems. There’s really no such thing as a cheap water stock these days, but I do find a little more relative appeal in the idea of owning a stock that has such a clear tie to water accessibility and water quality.

 

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Franklin Electric Offers Attractive Leverage To Water Scarcity And Water Quality

Fortive Could Be A New Industrial Star

When you carry the legacy of Danaher (NYSE:DHR) with you, expectations are going to be high. That is already the case for Fortive (NYSE:FTV), as this high-quality industrial conglomerate has debuted with a premium valuation and high expectations for growth. That said, those expectations aren't necessarily unreasonable, as the company's existing businesses already enjoy good market share, solid margins, and attractive free cash flow.

Valuing a stock like Fortive is tricky. If you exclude the impact of future M&A, you're largely missing the point of the business (which is to add value by skillful M&A selection, integration, and execution). On the other hand, modeling the impact of future M&A is a level of guesswork above and beyond the assumptions that underlie all modeling. Consequently, while Fortive doesn't look particularly cheap today (particularly after the post-election run), I wouldn't ignore it simply on the basis of valuation and would, at the very least, keep this on a watch list.

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Fortive Could Be A New Industrial Star

Seeking Alpha: Is Gorman-Rupp Overpriced, Or Is Cash Flow Not The Right Metric To Use?

The water industry is a nearly perennially hot topic - almost every investment writer looks at the trends in freshwater infrastructure and eventually writes their "water is the commodity of the future" piece. For better or worse, the long-term potential of many players in the water space is pretty well accepted by investors, and many of these companies sport valuations not only higher than non-water industrials, but higher than what their cash flow would seem to be able to support. So it is worth asking, then, whether the well-run and well-respected Gorman-Rupp (GRC) is indeed overpriced today, or whether discounted cash flow just isn't an effective way to value this stock.

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Is Gorman-Rupp Overpriced, Or Is Cash Flow Not The Right Metric To Use?

Investopedia: Can Lindsay Pump Out More Growth?

If only investing were as easy as saying "crop prices are strong, so buy stocks like Potash (NYSE:POT), Deere (NYSE:DE) and Lindsay (NYSE:LNN)." Although global crop prices were indeed strong in 2011, they were actually fairly weak in the latter half of the year and quite a few ag-related stocks have been weak as well. Making matters worse, Lindsay's irrigation business is almost as volatile as the commodities themselves, making this a consummate feast-or-famine type of equity.

A Good Start to the Year  
Lindsay doesn't often do as expected; surprises good and bad are more the norm. In this quarter, it was a good surprise - revenue rose 34% and easily topped the high end of the analyst guesses. Growth was driven by the irrigation business where revenue climbed 68% on fairly equal growth in domestic and international sales. The almost equally volatile infrastructure business saw revenue drop 37%, due in large part to shortfalls in the Quick Moveable Barrier (QMB) business.

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A.O. Smith Gets Out While The Getting Is Good

It looks like ABB (NYSE: ABB) has managed to shake up the electrical motors business. In the press release announcing a deal whereby A.O. Smith (NYSE: AOS) will sell its motors business to Regal-Beloit (NYSE: RBC), AOS tacitly acknowledged that industry consolidation, and this recent deal between ABB and Baldor Electric (NYSE: BEZ), has made it too difficult to continue on with their own efforts. Facing up to reality and making the best of the situation, AOS is getting a pretty decent going-away prize for this business.

The two companies announced that Regal-Beloit would buy AOS's motors business for $875 million in a combination of cash ($700 million) and stock ($175 million). That is a healthy multiple (1.4x trailing sales) for a business that was the #4 player behind Emerson (NYSE: EMR), Regal-Beloit, and Beldor and relied heavily upon replacement sales (75%) for its business. By comparison, Beldor sold out for about 1.9x sales - Beldor was far larger, more diversified, more leveraged to growth opportunities, and filled a key gap in ABB's motors business.

A.O. Smith management was a little cagey about their plans for the proceeds - talking about using the capital to expand the water products business into new markets and perhaps acquire other products/technologies in that sector. That's almost certainly not enough money to acquire Franklin Electric's (Nasdaq: FELE) water pumps business, but maybe the company would think of taking a run at a large target like Badger Meter (NYSE: BMI) if management felt especially ambitious. What is much more likely, though, is that AOS would target one or more of the numerous small private companies that are involved in heaters, boilers, or tanks - particularly those that have a good business in emerging markets like China or Brazil.

I give AOS management a lot of credit for having the humility and rationality to realize that ABB was putting them in a box that would make their business increasingly nonviable and unlikely to earn attractive returns on capital. That does not mean that it's an awful deal for Regal-Beloit. Quite the opposite actually. Regal-Beloit has the scale that AOS lacked (especially with this deal) and does not seem to be overpaying for what should be a leveragable business. I would expect RBC to able to integrate this deal fairly easily and make it accretive in relatively short order.

Win-win deals are not that common, and certainly seldom come from a major rival getting more active in the space. Nevertheless, ABB's efforts to grow its North American motor business may just end up helping these two companies out if A.O. Smith can put the capital to good use and Regal-Beloit can avoid the footfalls of the new giant.