FOOL ON THE HILL

The Case for Franklin Electric

You may never have heard of Franklin Electric or its products, but chances are you've taken advantage of their many uses. This small company has forthright management and great returns on equity. It may be worth putting on your watch list for when the market offers a price well within a margin of safety.

Format for Printing

Format for printing

Request Reprints

Reuse/Reprint

By Richard Rockwood
November 7, 2002

Franklin Electric (Nasdaq: FELE), based in Bluffton, Ind., is one of those companies that almost always drifts under the radar screens of investors. It says in its annual report that it is "the world's largest manufacturer of submersible water and fueling system motors." No, the company doesn't manufacture submarine motors, in case you're wondering.

But Franklin Electric is worth examining for three reasons: its rational, high-quality management, historically high returns on its equity, and products (they don't become obsolete every two to three years, but rather eventually wear out and need to be replaced).

Management
The vast majority of individual investors will never be able to speak to management on a one-to-one basis. Fortunately, company annual reports provide us with a good feel for whether the management team is rational and shareholder-focused. The team is one of the main sources of communication between individual shareholders and management.

Here are my observations from reading Franklin Electric's annual reports from 1996-2001. Every year, management provides a summary of the last year's major events. Readers also receive a briefing on the current direction of the company, management's five strategic goals, and how they are progressing toward achieving them. This information allows shareholders to measure management's performance quite easily over an extended period of time.

One way to understand management's temperament is to examine how it discusses bad news with shareholders. Franklin Electric experienced a decline in earnings in 2000, and the chairman used four paragraphs of his letter to shareholders discussing the reasons behind the earnings decline, admitting the company did "an unsatisfactory job" in several areas that year. That type of honesty isn't forthcoming enough on Wall Street these days.

When judging a management team, I also check to see if they have taken any restructuring charges. Here are Warren Buffett's comments on this topic from his 2000 letter to shareholders: "The financial consequences of these boners [bad capital allocation decisions] are regularly dumped into massive restructuring charges or write-offs that are casually waved off as 'non-recurring'." Franklin had one restructuring charge from 1987 to 2001, which occurred in 1997. The charge was a gain on the sale of a subsidiary so it passed this test.

While it may not be quite as exciting as one of Stephen King's early novels, Franklin Electric's letter is an informative read. The company also provides a very useful 10-year financial summary in its annual reports. This is a feature I wish more companies would include in their reports, since examining a company without looking over its long-term financial results is like watching the last 15 minutes of a two-hour movie.

Another benefit of having long-term financials to examine is that it is easy to see what the average earnings picture of the company has looked like over a significant period of time. This can be useful as an indicator of how it performs in recessional periods and when its particular industry is in a "funk." Franklin Electric's performance during the last official recession (July 1990 to March 1991) was fine; net income increased from $11.5 million in 1990 to $13.1 million in 1991.

Business
Can a company selling pump motors and electronic drives be a good business? At first blush, I had my doubts. But upon closer examination, I discovered that many items we use daily incorporate some type of Franklin product. For instance, gasoline dispensers, paint-handling equipment, explosion-proof vapor exhaust fans (cool!), livestock systems, and soft-serve ice cream machines. These products are used worldwide, and they will hardly become obsolete like the Betamax video format.

Capital allocation
Management's primary mission is to allocate capital in a rational manner, and Franklin Electric has certainly done this. The company has been producing very nice returns on its capital. Return on equity (ROE) has averaged 25.6% since 1993. This is an impressive performance considering the minimal amounts of leverage  the company employs; increasing its debt level would tend to boost its ROE numbers. The company's debt-to-equity ratio has remained below 25% since 1995, and it currently stands at 11.7%.

Try thinking of ROE this way: Since Franklin Electric has produced an average ROE of 25.6% since 1993, 25.6 cents of new assets are created for each dollar that it originally reinvested back into its business.

Buffett considers this measurement of performance important enough to list as a requirement before he'll buy any business. He seeks "businesses earning good returns on equity while employing little or no debt."

Valuation
I use a two-stage discounted cash flow (DCF) model to value companies. With a DCF model, you essentially estimate how much cash the company will generate over a certain time period (10 years, in our example), and extrapolate what the cash would be worth today (i.e., its intrinsic value). This amount is then divided by the shares the company has outstanding to arrive at a per-share valuation.

When using this method to calculate a company's value, investors must remember to pay close attention to their inputs. If their inputs aren't reasonable, then the intrinsic value calculation will not be realistic. No sane person would be willing to buy a 1988 Chewy Citation for $9,000, no matter how much you talk up its great fuel efficiency and attractive body style!

Here were my valuation inputs for Franklin Electric:

Free cash flow*: $33.6 million
Average 10-year growth rate: 6%
Period 1-5 growth rate: 7%
Period 5-10 growth rate: 5%
Terminal growth rate: 0%
Discount rate: 10%
Shares outstanding: 10.8 million

*FCF = EBIT + 20% of Depreciation & Amortization � Change in Working Capital

Using these assumptions (one of several possible valuation scenarios), the intrinsic value of Franklin Electric would be approximately $48. I believe investors should always purchase shares in a company when they are trading at a 30% discount to their intrinsic value (always build a margin of safety into your purchase price to account for the unexpected), so they could purchase shares in Franklin Electric if its stock price dropped below $34.

The stock's 52-week range has been between $34 and $61. While it's not currently trading at a bargain-basement price, you never know when Mr. Market will enter into another one of his famous depressive funks and price the stock attractively again.

Conclusion
Why invest in Franklin Electric, or take the time to study it yourself? The company has a rational management team; it has historically produced solid returns on the money it has reinvested in its business; and its products will not become technologically obsolete. The combination of these factors could certainly produce satisfactory long-term results for potential shareholders, if the purchase price is right.

Guest writer Richard Rockwood is the founder of FocusInvestor.com. He believes in the power of portfolio concentration and value investing. You can email him at focusinvestor@yahoo.com, or find him on various Fool discussion boards. The Motley Fool is investors writing for investors.