Zurn Elkay Water Solutions Corp Q3 FY2021 Earnings Call

Good morning. Welcome to the Zurn Water Solutions Corporation Third Quarter 2021 Earnings Results Conference Call with Todd Adams, Chairman and Chief Executive Officer; Mark Peterson, Senior Vice President and Chief Financial Officer; and Dave Pauli, Vice President of Investor Relations for Zurn Water Solutions. This call is being recorded and will be available on replay for a period of 2 weeks. The phone numbers for the replay can be found in the earnings release the company filed in an 8-K with the SEC yesterday, October 26. At this time, for opening remarks and introduction, I'll turn the call over to Mark Peterson.

Thank you. Good morning, everyone. Before we get started today, we're pleased to announce that Dave Pauli will be assuming the day-to-day Investor Relations responsibilities as of this earnings call. Many of you have already had a chance to work with Dave over the past 6 months as he's been instrumental in assisting us with the Investor Relations during that time. Dave has been with the company for the past 9 years working in several financial roles and has been our Corporate Controller for the past 4.5 years. So before I turn the call over to Dave for some opening comments, I just want to touch on the RMT transaction that closed on October 4. Given the timing of the close, our third quarter results include the PMC segment. Starting with the fourth quarter of 2021, the PMC segment will be reported as discontinued operations. We will provide high-level comments on PMC's financial results this quarter, but we ask that you hold any questions you may have on the PMC segment for Regal Rexnord's earnings call next week on Tuesday, November 2. I'll now turn the call over to Dave Pauli.

Thanks, Mark. Good morning, everyone. I'd like to remind you that this call contains certain forward-looking statements that are subject to the safe harbor language contained in the press release that we issued yesterday afternoon as well as in our SEC filings. In addition, some comparisons will refer to non-GAAP measures. Our earnings release and SEC filings contain additional information about these non-GAAP measures, why we use them, and why we believe they're helpful to investors, and contain certain reconciliations to the corresponding GAAP data. Consistent with prior quarters, we will speak to certain non-GAAP metrics as we feel they provide a better understanding of our operating results. These measures are not a substitute for GAAP, and we encourage you to review the GAAP information in our earnings release and in our SEC filings. With that, I'll turn the call over to Todd Adams, Chairman and CEO of Zurn Water Solutions.

Thanks, everyone, and good morning. I hope you had a chance to review the release from last night, which includes the consolidated Rexnord numbers for the last time. As Mark mentioned earlier, this call will focus on the results of Zurn Water Solutions, and the Regal Rexnord team will cover PMC results when they report next week. This is a significant quarter for us, as we completed the RMT transaction with Regal Rexnord in just about 7.5 months, showcasing the cooperation between both companies and the tremendous effort from everyone involved. I'm especially grateful to our team for their hard work in facilitating this separation. Undertaking such a transition involves many factors that need to be resolved promptly, such as antitrust issues, SEC regulations, IRS matters, contracts, licenses, IT challenges, and tax benefits. It’s fulfilling to navigate all of this without any setbacks. Achieving everything needed for Day 1 as a standalone entity, while maintaining high execution levels, speaks volumes about our talented team. As of October 1, we are focused on a bright future. The transaction is a positive result for both companies and their shareholders, and we look forward to the standalone journey of Zurn Water Solutions as well as supporting the new Regal Rexnord team, which we believe has a promising outlook ahead. Now, let’s discuss ZWS. From a revenue perspective, we experienced a 15% growth in the quarter, with a 5% core growth, building on the 5% core growth from the previous year. It could have been even higher, but our teams have done an amazing job managing through challenges like tariffs, supply and labor limitations, and current logistical issues. Our expertise in managing a complex supply chain has helped us maintain favorable pricing while achieving industry-leading lead times. This, in turn, has enabled us to invest more in growth rather than focusing solely on capacity and maintenance capital expenditures. Regarding logistics, we initially planned to import nearly 900 containers this quarter, though about 50 were delayed. Some of the delays were due to COVID-related shutdowns at ports in China and other Southeast Asian locations, while others were caused by logistics issues with our suppliers related to trailer or driver shortages. The remaining delays stemmed from using break bulk transport, which faced delays at various U.S. ports. If even half of these containers had arrived on time, we could have seen core growth of 9% to 10%. Importantly, these issues are not due to labor shortages or product supply problems within Zurn, but rather various transportation delays. We believe the third quarter represents a turning point for transportation and logistics challenges. As we begin the fourth quarter, it seems we are in a great position; everything that needed to leave ports has done so, and what's here is moving out of ports and warehouses. With a month of the fourth quarter behind us, we’re off to a solid start. Overall, we expect the second half of the year will align with our expectations from 90 days ago. In terms of profitability, ZWS achieved margins of 26.5%, meeting our high expectations despite lower shipments. Our strong execution on the price-cost equation is evident, and I want to emphasize that our margin strength is due to much more than simply implementing price increases. One major competitive advantage we hold is the significant market share we have across the widest range of products in the industry, which is challenging to replicate. This advantage means that in the current environment, products that integrate well and simplify installation are more likely to succeed, which benefits us further as we expand our product offerings. Additionally, while we generally lead the market in pricing, we also focus on improving product design and innovation. For example, we've developed a patented product that is a quarter of the weight of our competitors’ offerings. This not only gives us cost advantages but also means we can price competitively while keeping material costs significantly lower. Looking ahead, ZWS's future as a standalone entity is promising. This is a key reason for our decision to separate PMC now. We foresee substantial growth opportunities both organically and through mergers and acquisitions—particularly in water and sustainability trends, where we are still early in our journey. With an infrastructure bill potentially benefiting our business too, we have more organic opportunities now than ever before. One of the main opportunities we've discussed over the past year is our touchless hygienic solution, BrightShield, which has significant medium- to long-term potential, especially in the retrofit market. Furthermore, we have effectively transformed our drain business with patented solutions that outperform competitors, reduce costs for installers, and allow us to reshape specifications. Our expansion into adjacent markets like fire protection, site work, and pretreatment presents further opportunities for market share growth. E-commerce has opened new customer segments for us, and we are excited about the prospects in the Jan-San channel, which we believe presents considerable growth potential. Additionally, we are not just focused on extracting cost synergies from past acquisitions but also on leveraging growth opportunities, particularly under Zurn’s leadership. In short, we see a clear path to double-digit growth next year, with optimism surrounding potential M&A opportunities that could drive robust growth into 2023 and beyond. We will take a measured approach but are confident that ZWS can expand into a much larger company with a steady financial profile while concentrating on our core competencies. Transitioning to our ESG initiatives, now that we are a pure-play water business, our impact is more pronounced. We believe our role extends beyond providing products that conserve water and ensure safety; it’s about doing so in an inclusive manner, and we are prepared to take on this leadership role. We have been on this path for some time, and we look forward to engaging with investors on this topic, especially as we prepare to release our upcoming corporate social responsibility report. Lastly, as some may recall, we previously established a comprehensive capital allocation strategy for Rexnord, which focused on our multi-industry business model and strong deleveraging characteristics. After a private equity-led IPO left us highly leveraged, we have finally reached a financial position that allows us to return capital to shareholders through a reasonable dividend and a share repurchase program, prioritizing water-related acquisitions. For ZWS, our capital allocation strategy remains focused on communicating our value clearly as we start our standalone journey. ZWS is a growth company, characterized by a mid-single-digit core growth rate, excellent margins, and strong deleveraging abilities. We begin with a leverage level of only 2 times, aiming to maintain a target range of 2x to 3x. Recently, our Board announced an initial dividend of $0.03 per quarter or $0.12 annually—though modest, we believe it can increase selectively and comfortably as we grow. Finally, we have a solid pipeline of acquisition opportunities that align with our return criteria and will enhance our long-term growth rates and returns while keeping open the possibility for larger transformative acquisitions if they arise. Now, I’ll turn it over to Mark for further details on our performance and insights into our Q4 outlook.

Thanks, Todd. Please turn to Slide #7. On a year-over-year basis, our third quarter consolidated sales increased 13% to $557 million. The growth was driven by a 100 basis point benefit from foreign currency translation, a 400 basis point positive contribution from our Hadrian acquisition in our Water Management platform, partially offset by a small divestiture in the PMC platform that reduced our total sales by approximately 100 basis points, and finally, core sales growth of 9%. Turning to profitability. Our adjusted EBITDA increased 18% from the prior year third quarter to $128 million, and our adjusted EBITDA margin expanded 100 basis points year-over-year to 23%. The incremental sales volume and the realization of our SCOFR 3 and other productivity actions drove the year-over-year improvement in our margin this quarter despite the headwinds we faced from the temporary cost reduction actions we took last year due to the COVID-19 pandemic. Please turn to Slide 8, and we'll review our platform results. At the platform level, Water Management sales were up 15% from the prior year September quarter as the Hadrian acquisition contributed 9 points of growth, positive foreign currency translation contributed 1 point, and the core business increased 5%. While sales were adversely impacted by approximately 400 to 500 basis points due to some temporary transportation delays that Todd touched on earlier, the demand in Zurn remained strong in the quarter as orders increased high single digits over the prior year quarter. With respect to profitability, our Water Management platform delivered a 9% increase in adjusted EBITDA over the prior year as margins were in line with our expectations of 26.5% in the quarter, inclusive of our continued investment in growth. Year-over-year margin contribution was impacted by the COVID-19 related temporary cost reduction actions we took in the prior year third quarter as well as the temporary mix impact on the Hadrian acquisition. Excluding those two items, margins in the core business expanded year-over-year. Turning to PMC, sales increased 11% and includes a 100 basis point benefit from foreign currency translation, a 200 basis point reduction from the small 2024 core divestiture in China, and a core sales increase of 12%. The core sales increase was driven by a 14% increase in non-aerospace end markets, coupled with aerospace sales that were flat year-over-year. Demand trends remain solid as core orders in non-aerospace end markets increased nearly 30% from the prior year and year-over-year orders grew over 100% in aerospace end markets, and the book-to-bill ratio was above 1 for the quarter. PMC's adjusted EBITDA margin increased 260 basis points year-over-year to 23.5% as the benefits from the sales growth, SCOFR actions, and other structural cost reduction initiatives more than offset the year-over-year margin headwinds and the temporary cost reduction actions we took last year due to the COVID-19 pandemic. So please turn to Slide 9, and I'll touch on some of the cash flow and balance sheet highlights. With strong free cash flow generation in the quarter and growth in adjusted EBITDA, our net debt leverage was reduced to 1.5x at the end of the September quarter from 2.1x at the start of the calendar year. In conjunction with the close of the RMT transaction, we paid off the $500 million notes, including the make-whole fee and the $625 million term loan, both of which are on our balance sheet as of September 30. Our new capital structure that went into place with the close of the transaction includes a $550 million term loan B with a $200 million revolver that is currently undrawn. Our new 7-year term loan has an interest rate of 2.25% with a 50 basis point LIBOR floor and pushes any debt maturities out to 2028. With respect to our cash balances, we anticipate ending our fiscal year 2021 with approximately $125 million to $130 million of cash on the balance sheet. Please turn to Slide 10, and I'll make a few comments on our outlook for the fourth quarter as well as some items that will help with fiscal year '22 modeling. For the fourth quarter of 2021, we are projecting total sales to increase year-over-year by a high teens percentage. With respect to margins, we expect our adjusted EBITDA margin to be between 24% and 24.5%, which excludes what we've historically referred to as corporate segment costs. We anticipate corporate costs in terms of adjusted EBITDA to be approximately $10 million in the quarter. We remain on track to reduce our corporate expenses to approximately $20 million on an annualized basis, again in terms of adjusted EBITDA during the first quarter of 2022.

To quickly level set on Q4 core growth expectations. Is low to mid-teens the right range if we account for two months or so incremental Hadrian contribution than kind of high single-digit range accounting for the delayed shipments from Q3?

Well, yes, we talked about we said high teens all-in. So think about the core and that number is going to be yet, as you said in the low teens from a core growth standpoint in the fourth quarter, Bryan. And there is a bit of a spillover as we mentioned earlier from some of the growth that we did have picking up in the early innings of the fourth quarter.

Okay. Makes sense. And more importantly, I was hoping you could offer a little more color on your team's confidence in double-digit core growth in 2022. Any insight on volume versus price contribution? We suspect there will be quite a bit of carryover with the latter. Relative growth rates of your major product categories or any callouts by key end markets would be very helpful.

It's a very balanced outlook moving forward. The mix of reasonable market pricing actions we currently have, along with contributions from some breakthroughs I've mentioned, gives us both confidence and some leeway to achieve a double-digit core growth rate for 2022. It's been some time since we felt this level of confidence looking ahead. While we still have a few months to refine our projections, I believe we have a solid balance between market organic growth initiatives and existing price factors that will continue to support us. The combination of these elements should enable us to exceed 10%.

It's great to hear. Could you provide more details on the Hadrian integration? We understand there were some challenges earlier this year that were beyond your control. Have efforts to move forward picked up? What are our current run rate margins? We notice there's still a significant degree of dilution compared to the core, which you mentioned has increased year-on-year. Is there any change in perspective and confidence regarding reaching 20% over time?

It's incrementally better, Bryan. I think the reality is the COVID shutdown impact to that business probably far more than many others. So the volume ramp is probably nine months behind what we would have anticipated. That is the beginning. We're starting to see that happen in the quarter. And I think we're making good headway on the actions required to get the margins toward that fleet average or at least something with a two in front of it. I think '22 is going to be the big year for margin expansion for Hadrian. I think from a competitive standpoint, we feel really good about the progress we've made. We're starting to get traction with specifications and conversions. And so I would anticipate, along with a better environment plus the opportunity to really dig in and get at it, '22 will be the big year from a margin expansion at Hadrian.

Could you provide an update on how the safety flow and hygienics business units are trending in terms of order rates or revenues for this quarter?

I would tell you that I think Water Safety and Control grew the most, Flow Systems grew the next, and hygienic environmental finished third in the quarter. I think as my comments alluded, we still believe in the medium- to long-term growth. I can tell you as a category, it's been slower this year than we would have anticipated. I think we're hearing that both from the wholesale community as well as some of the competitive intelligence we've picked up, but we are starting to see it pick back up here in September and October. And so I think you had a rush, if you will, to get ready for some sort of reopening. And now that people are back in, we're getting back to more of that steady conversion as opposed to this wave. And so I guess the good news is the opportunity is there. And I think we've outlined it is massive. I think the things we've put in place around the Jan-San channel, e-commerce, and BrightShield give us a lot of confidence that it's on the come, we're seeing traction with a number of opportunities. But in the meantime, Water Safety Control continues to take market share. And I think my comments on the drain line being reinvented are giving us great growth and a nice trajectory. So that's how it would sort of shake out in the one, two, three for the quarter.

Okay. And then just on the hygienics, I know there's this kind of COVID-related opportunity with the education channel, where they're getting allocated dollars. What are you seeing on that end in terms of capturing some of that federal money?

Well, we think we're going to get it. I think if you follow the bouncing ball, the funds get allocated to schools and then the school boards prioritize. And so I think from an opportunity set, we know regionally, who's got what. And then it's really about calling on them and helping with the conversion and then the priority towards providing a hygienic space inside of a school. But I think the way we've contemplated that growth is it probably comes a lot more in '22, and I think we're well positioned to capture a bunch of it.

Okay. Great. And then just last one. You guys certainly have had a lot of balls up in the air and maybe been internally focused. Maybe just speak to M&A pipeline valuations, your thoughts on getting something done into '22?

I believe that everything we've been doing has been on a proprietary basis, and we'll continue with that approach for now since it's been effective. I’m optimistic about some upcoming conversions between now and the first half of 2022. The valuations seem to provide the returns we expect. Without going into too much detail, I feel confident we'll see some conversions that align with our current efforts. When considering entities like StainlessDrains, World Dryer, Hadrian, and Just, these have all been competitive moves to engage with the market. As we integrate these into our operations and leverage our strengths, we start gaining attention for our initiatives. Consequently, I believe we will pursue some impactful mergers and acquisitions, though I won't comment on the timing. However, from a valuation perspective, it looks favorable, and I’m confident we'll complete some transactions.

Congrats. For what it's worth, I mean, I think if the supply chain issues continue into next quarter, opening up the earnings call with the harmonica would be kind of awesome. So, just my two cents.

It was contemplated, Joe. We decided against it.

So getting back to the main topic, you mentioned that as a Water Management business, margins would have increased this quarter, and the core business would have performed better if not for certain issues and the dilution from Hadrian. I'm curious, from a pricing perspective, are you currently ahead of costs? Furthermore, as you look ahead to 2022, do you anticipate maintaining a pricing advantage that will positively impact margins?

Yes. I think I would tell you at this point with what we've put in place today. We are running ahead. And I think the way we've thought about '22 is we continue to run modestly ahead, which is entirely consistent with the last 14 years of my experience with Zurn. So I don't see a reason why we would fall behind.

Okay. That's great to hear. And then, Todd, can you maybe elaborate a little bit more on the Jan-San opportunity? Is this gaining greater share of wallet in some of the larger kind of like industrial distributors? Or how should we think about the opportunity and exactly what you're doing from a channel perspective to gain traction?

Yes, there is a segment of people who go into commercial buildings to clean and perform maintenance activities that we had not previously engaged with. Over the past six months, we have established partnerships to create representatives who reach out to these businesses and work with local wholesalers to facilitate this process. It's still in the initial stages, but there are numerous $100 million Jan-San companies servicing various local areas. Our goal is to connect these companies with the BrightShield opportunity, encouraging them to reach out and sell with our support, while also utilizing local inventory in their trade area. Additionally, we can assist them in scheduling installations if they need external help. We have partnered with mechanical contractors who handle that aspect for us. Although this initiative is still new, we first discussed it about six months ago, and I believe it will bolster new construction efforts. This market is largely untapped for us, and the BrightShield solution, which creates a completely hygienic environment in commercial buildings, presents a strong value proposition with significant long-term potential.

Yes. That makes sense. One last one for you guys. And Dave, congrats on the removing the interim title. But there's been a lot of discussion from the investor base on when you guys would have potentially an Investor Day. And so I'm curious to hear any thoughts around timing with the new business.

Joe, we're going to use the fourth quarter to start doing some targeted marketing during this quarter. I think we're looking to the first half of next year from Investor Day where we would like to do something like that in person. I know kind of the situation we're all in right now, it doesn't look like that was going to happen this calendar year. So we're looking at the first half of next year, when we have guidance out for '22 to have a full-blown Investor Day. But this quarter, we will be doing a lot of target marketing with the new business.

Congrats on completing the RMT transaction, guys.

Thank you, Mig.

Thanks, Mig.

So maybe we can talk a little bit about serving supply chain. I know you have a design and assembly business, but most of your revenues are in North America, as the vast majority of it. I'm sort of curious how your supply chain sets up relative to that. How much would you say of your components are imported? And where are they normally imported from what sort of region?

Well, for various competitive reasons, I don't think it's appropriate to discuss that in detail. However, a significant portion of our cost of goods sold comes from imports outside the United States. I can tell you that this percentage is lower than it was five years ago as we have brought some production back domestically to reduce lead times and address tariff issues. Our current supply chain is much more balanced compared to three or four years ago because we consciously decided to minimize supply chain risks associated with relying too much on countries like China. Overall, while our supply chain has changed significantly over the last few years, it’s important to note that we operate on a model where we design, procure, assemble, and test our products, utilizing third parties for manufacturing some goods and making necessary adjustments before final assembly. It’s not as reliant on China as one might assume.

Yes. I mean I wasn't necessarily thinking China. I was just sort of curious as to how that was set up because I would presume that you would have the opportunity to acquire suppliers in other places as well, not just China. As we're thinking longer term here though, given the learnings over the last couple of years, is it fair to say that you're going to continue to work towards localizing the supply chain presuming that, again, your geographic revenue mix remains as it is today?

I wouldn't say that. I think what we've done is really set up a global network of finding the highest quality suppliers at the best cost with the best lead times and done that with redundant suppliers usually in different geographies to avoid some sort of event, whether that be environmental or geopolitical or whatever the case would be. And so I think we've got a relatively dispersed supply chain with redundant capabilities. And obviously, some of that has included domestic suppliers, suppliers in Wisconsin, suppliers in Texas, you pick it. I don't think you're going to see a sea change in that approach. I think we've steadily tried to create a redundant capacity for our supply base. And I think we'll continue to do that. So I don't think there's anything materially different. I don't think we're going to start buying suppliers or things like that. I think we're going to continue to do what we do. And if we see an area where we're not pleased with the quality or the performance where we see an opportunity to improve our competitive position and lead times, we can do that. So I think we're really happy with how our supply chain has performed for a very, very long time. I think this logistics sort of, I think I'd call it, a shake-up, is somewhat unfortunate. But I don't think it changes our view on how we're going to invest and grow our business.

I appreciate that. Regarding the logistics issue you mentioned, your track record shows you've effectively managed to pass on raw material cost increases through pricing. I'm interested in how transportation or logistics costs operate. Do you have any pricing flexibility to counter those costs? Should we regard your margin performance in the fourth quarter as reflecting this challenge, with the expectation that improvements in 2022 will positively impact incremental margins?

Look, I think when we issue a price increase or take a price increase, we contemplate all sorts of inflation. While I would tell you that it's hard to say that because containers went from $5,000 to $20,000, we've perfectly dialed in a price increase to cover that, I think we've got some of it, Mig, probably not all of it. So a nice way of saying I think you got to look at the margins and just say sort of is what it is. Maybe we're a little bit short, maybe we're a little bit ahead. But in general, I think our price increases are offsetting our cost inflation. And I think the other point is the things that I tried to talk about when we're actually designing, developing, and selling a product that weighs 75% less than our competitors, that's a big deal. And that's something that we can keep for a long period of time. And so we're pretty happy with our overall performance here, disappointed that a few didn't show up on time. But nonetheless, it's not just about covering all the cost inflations, it's about finding ways to work around that and control your destiny a little bit as opposed to just pass price on to the market.

I appreciate that. Lastly, could you remind me what the typical incremental margins for the water business look like? Also, you mentioned that the margin expansion at Hadrian will significantly take off in 2022. While I don't want to hold you to guidance, how might this potentially contribute to boosting these incrementals as we approach next year?

Yes, historically, we've targeted our incremental margins to be around 30%. While there may be some variation in certain quarters, we typically average this range and expect it to remain stable moving forward. Next year is when we will definitely see margin expansion at Hadrian, as we've observed it progressively throughout the year. Small acquisitions will contribute, although they won't significantly impact our margins. Additionally, we have growth investments planned to enhance our market share. Overall, looking at this platform, maintaining that 30% range over time is reasonable, especially with the necessary growth investments to capture share in our markets.

We have no further questions at this time. I'll turn the call back over to the presenters.

Thanks for joining us on the call today, everyone. We appreciate your interest in Zurn and look forward to providing our next update when we announce our December quarter results in February of 2022. Have a good day.

Thank you, ladies and gentlemen. This concludes today's conference call, and you may now disconnect.