Zurn Elkay Water Solutions Corp Q1 FY2022 Earnings Call

Good morning, everyone, and thanks for joining the call today. Before we begin, I'd like to remind everyone 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 reconciliations to the corresponding GAAP information. Consistent with prior quarters, we will speak to 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, Dave, and good morning, everyone. Hopefully, everyone had a chance to read through our earnings release last night, and we certainly appreciate everyone taking the time to join the call this morning. I guess it's only been about 70 days since we last updated everyone about the Elkay transaction. We've made terrific progress towards the close and bringing the two businesses together. All the regulatory things are behind us, really without a hitch. The S-4 became effective this week, and we'll have the shareholder vote towards the end of May. I think we're going to target a clean closing right at the end of the second quarter. So as we announce our Q2 earnings in July, we'll be in a position to talk about what a combined second half will look like for the new Zurn Elkay Water Solutions business. I'll talk more later about some of the joint preparation we've been doing, but it's been really rewarding to see the teams engage with one another and begin to build action plans to execute the opportunities in front of us as we get to the closing. Moving on to the first quarter results. In a nutshell, it feels like a pretty decent start to 2022. Obviously, there's been a lot of moving parts in the world over the last 10 to 12 weeks, but the benefit of being a focused pure-play water solutions business and the combination of a clear strategic plan around driving share gains in our core business, coupled with the Zurn business system that underpins our strategic and operational execution, provides us great balance to some of the macro uncertainty out there. As we talked about last quarter, we're not immune from the supply chain, transportation, material challenges most everyone is facing. But taken as a whole, this quarter again feels better than the last. There were, are and will, of course, be spot challenges, but our teams continue to navigate with higher risk, while also having to look forward to continue to support what is really good growth for us. There are a few things in the quarter that didn't go our way, but we had a good plan and executed well, and that's simply what it takes to perform at a high level in the type of environment we're in. As far as the quarter, sales were up 17% year-over-year, 15% organically. And again, this is against the first quarter last year, we grew 12% and 4% organically. Our segment margins in the quarter were 24.5%, very much in line and slightly ahead of our expectations, and our pro forma leverage was 2.1x, exactly what it was at the end of December. Mark will cover some additional details on the financials, but a couple of points that I think are incrementally positive for the quarter are we saw really strong order growth across all categories, considerably above our sales growth rate. And secondly, we're seeing great traction from our BrightShield offering and seeing the market embrace it. This integrated solution we've developed is ahead of what will be a busy new construction season in North America over the next 6 or 7 months, as well as what will be the first traditional school MRO cycle in over 2 years. I'll move on to Slide 4. As we've discussed in the past, there are a lot of inherent barriers to entry in our business. It's a complex path to win consistently and at scale. Said another way, building a sustainable competitive advantage is something that's very difficult, and in our case, across the broadest portfolio in the industry, which is only further enhanced with our transaction with Elkay. Many of you already know this, but as a refresher, building codes, regulatory approvals, reliability, quality, service level and innovation really matter. And only with great innovation can you drive high levels of specification share. And then there are the countless relationships at the owner, engineer, architect, general mechanical contractor level that need to be cultivated, both nationally and in local trade areas. The final mile is having the best, strongest local representation, as well as strong, strategically aligned relationships with leading wholesalers. If you've got that, you're in the game. In our case, there's no one that comes close to delivering the content per square foot we can deliver to an opportunity, which makes us the default lowest total cost of ownership. Some of the newer realities in our business are sustainability, labor shortages, value-engineered solutions, pod construction, connected products, and the WELL 2.0 building standard. Providing safe public and private spaces to students, patients and patrons will be an even bigger differentiator moving forward. And these have been the thrust of our strategic plan in the last several years, essentially leveraging our competitive advantage today while skating to where the puck is going. Here's just a simple example of leveraging innovation into a competitive advantage today, one that will absolutely be lasting going forward. PRVs, pressure relief valves. This is a market that we've sized around $120 million. These valves are integral to regulating water pressure inside a building for both potable and fire protection systems. Depending on the size and the location of the building, we have dozens of these. Our new product in the category, across all 6 typical sizes, is a new patented solution that's built with a venturi valve design that handles high-pressure rates while providing industry-best flow performance. It allows for both horizontal and vertical installation options, making it quicker and easier, with the shortest lay length in the industry. This means that for every opening in the market, we can provide a valve. Some competitors' products simply aren't ergonomic. The combination of a stainless-steel interior and composite cartridges extends the life of the valve, and it uses 60% less material than competitive PRVs. And finally, it seamlessly integrates into Zurn's remote pressure monitoring system to easily monitor building water pressure. I share this example not because I'm trying to sell you one, although we'd be happy to, but to highlight how we segment, target and go after opportunities embedded in our strategic plan. This replicates itself dozens, even hundreds of times across categories and compounds over the years. In this case, our new innovation gives us a chance to upgrade specs, change codes while opening up a new category that will turn into meaningful organic growth for us, against a competitor with an inferior design and attributes not suited to how future buildings are going to be built. Next, on Page 5. When we shared the news of the Elkay transaction, we expected the people in the industry to be excited. The feedback from the marketplace and our customers has exceeded all of our expectations, and the unique nature of the transaction and true partnership has created a great dynamic and foundation for all of the integration planning. While we continue to operate and make decisions as independent companies, we've found plenty of opportunity to introduce our teams, hold joint meetings and do some planning sessions. Just this week, we're doing all the diagnostic work for our 8020 implementation with a broad team of both Zurn and Elkay associates while also holding our initial Zurn Business System leadership training session. Ten weeks post the announcement and about ten weeks until we close, the resounding view is that the strategic logic is probably even more sound than we thought when we announced it. The sociology between the two organizations has been really, really good. And finally, our confidence in delivering the financial synergies is exactly where we had hoped it to be. Just one more thing for me on Page 6 before I turn it over to Mark. Having published our sustainability report a few weeks ago, hopefully many of you had a chance to check it out. We've made ESG leadership a priority, and that's only enhanced with Elkay, the clear leader in drinking water for public and private spaces in North America. What's also gratifying is all the progress around ESG is manifesting itself in some recognition. While we're not big on talking about it or advertising it, it's great to see. Actually, we're seeing some strategic advantage from our ESG leadership, attracting and retaining talent, being sought after as a thought leader on sustainable buildings are all things that help reinforce that. By integrating ESG into our strategic priorities, it's helping us grow and build onto the competitive advantage we've already built. So with that, I'll turn it over to Mark to walk you through some additional details on our performance and provide some color on our Q2 outlook.

Great. Thanks, Todd. Please turn to Slide #7. So on a year-over-year basis, our first quarter sales increased 17% to $240 million. The November 2021 Wade Drains acquisition accounted for 2% of the year-over-year growth, and the core business drove 15% of growth, with solid core sales across our water safety and control, hygienic and environmental, and flow control product categories. With respect to profitability, our adjusted EBITDA, excluding corporate costs, was $59 million in the quarter, and our adjusted EBITDA margin was at the high end of our expectations at 24.5%, improving 50 basis points sequentially from our fourth quarter of 2021, as the incremental margin on the sequential sales growth was just over 40%. On a year-over-year basis, the benefits of the sales growth, inclusive of price realization and our productivity actions were partially offset by the increase in material and transportation costs as well as our investments in our growth and supply chain initiatives. Regarding corporate costs, we communicated over the past several quarters that with our transition to a stand-alone Zurn business, we're anticipating annual corporate expenses to be approximately $20 million in terms of adjusted EBITDA on an annual run rate and $22 million in calendar year 2022. With the February announcement of the merger with Elkay, which we expect to close in the early part of the third quarter of 2022, as Todd mentioned earlier, we now anticipate our corporate-related expenses to be approximately $27 million in calendar year 2022. Please turn to Slide 8, and I'll touch on some balance sheet and leverage highlights. Regarding our net debt leverage, we ended the quarter in line with our expectations at 2.1x. Pro forma for the adjusted annual corporate expense run rate I just discussed, over the balance of the year, our net debt leverage will decline as our free cash flow generation accelerates and our adjusted trailing 12-month EBITDA continues to increase. Please turn to Slide 9. I'll make a few comments on our outlook for the second quarter of 2022. For the second quarter of 2022, we are projecting total sales to increase year-over-year by a low to mid-teens percentage. We expect our adjusted EBITDA margin, excluding corporate costs, to be between 24.5% and 25% in the quarter, and anticipate corporate costs in terms of adjusted EBITDA to be approximately $7 million in the quarter. Looking at fiscal year 2022, as we mentioned earlier and anticipating the transaction with Elkay closing in the early part of the third quarter, we'll be reporting combined results in the second half of 2022. We'll provide an outlook for the balance of the year in early August. That said, we remain confident in delivering solid double-digit reported in core growth in 2022, with sequential improvement in the adjusted EBITDA margin in the second half of the year versus the first half and strong free cash flow over the balance of this fiscal year. Before we open the call for questions, a few comments on our interest expense, stock compensation expense, depreciation and amortization, tax rate, and diluted shares outstanding for the June quarter. We expect interest expense to be approximately $5 million, our noncash stock compensation expense should be about $4 million in the quarter, depreciation and amortization will come in around $5 million, our tax rate on adjusted pretax earnings will be between 26.5% and 27.5% in the quarter, and diluted shares outstanding will be approximately $129 million in the quarter. With that, we'll open the call up for questions.

I would like to ask about the supply chain situation. You mentioned it might be slightly improving. Can you elaborate on what aspects are getting better and what may be worsening? Additionally, could you explain what factors are contributing to the margin changes from the first quarter to the second quarter and how confident you are that margins will increase in the latter half of the year?

Yes, I'll take the supply chain piece and Mark can take you through the margin progression. But I would say, in general, we felt like September and October last year were sort of the peak of the logistics knot and it's gotten a little bit better each quarter, every month from there. On the materials side, we've been, I think, pretty forward-leaning on what our expected demand was. So obviously, by getting our supply chain ramped up to deliver at higher volumes towards the end of last year, that certainly helped us deliver and avoid maybe some of those more recent spot challenges. But look, as I said in my comments, there are a million and one things that are happening. Certainly, one of those — or two of those are going along each and every day. It's really how do you think ahead, how do you plan accordingly and try to stay in front of it. But I wouldn't really point to anything specific other than it's certainly an interesting dynamic that we're all living through. In our case, doing a lot of forward planning, diversifying our supply base, has really been a good move that our teams really looked at towards the end of last year. We made some calls, and it sort of helped us here as we enter the busy part of our year.

Yes. On the margin question, Jeff, I think it's very similar to what we've talked about last quarter. It kind of falls into three main buckets. As the year is progressing, clearly Q2 versus Q1, we have incremental sales volume as we hit the construction season. So just getting the leverage you'd expect on that incremental sales growth. When you look at the second half of the year versus the first half, sequentially, H1, H2, we're going to see a larger step up in sales dollars in the back half versus the first half than what we would have seen last year, for example, just given the demand backdrop that Todd highlighted. The other piece of the puzzle is just price realization. We've been putting price in place. We just had another recent increase that's been announced. So that kind of goes over the course of the year, and we get more realization in the back half versus the first half, that sort of price and inflation cost equation improves and benefits the margin as the year progresses. The last thing then is just overall our cost of productivity initiatives. Todd mentioned earlier, the issue around forward planning and getting more inventory in place sooner rather than later. One thing we were fighting for a while is as the demand is ramping up, for example, an EMEA customer may need a certain valve and we only have it in a warehouse on the East Coast while the customer's on the West Coast, which isn't efficient in shipping. We've improved our SIOP process and gotten a little more aggressive on the demand environment that we're seeing, bringing more inventory in, which is improving our availability regionally and allowing us to be more efficient, reducing our overall costs as we move products around North America. So it really falls into those three big buckets are the things that are benefiting margin this quarter and then more so in the back half.

Okay. Great color there, guys. You mentioned, Todd, the education market hasn't seen an MRO cycle for a couple of years. Can you just talk about, one, that opportunity? And two, if any of those COVID dollars that went to the schools would be flowing around safety and hygienics?

Yes. With the onset of the pandemic, there wasn't a lot happening in '20 and '21. Schools started to ramp up this year, and so there's a lot of routine maintenance and upgrades that go on over the summer when kids aren't there. We're sort of two years behind some of that maintenance. There’s obviously continued retrofit opportunity toward a more hygienic solution in the restroom and other parts of the school. The ESSER funding that's now flowing to the states and ultimately to the school districts has a wide range of what they can do with it. Certainly, hygienic and environmental is part of that. It really is a school district by school district decision and really targeting the top 4,000 school districts, driving awareness, and helping them create a safer environment for their students. It's a positive market backdrop as it relates to schools.

You sound quite confident in the double-digit core growth outlook for the year, incrementally so, and you've posted one solid quarter on that front, so there's clear momentum. Todd, last quarter, you framed kind of low to mid-single-digit underlying market growth, 2 points or so of outgrowth, and then low to mid-single-digit price contribution. How should we think of those buckets at this point?

I think as Mark highlighted, with the pricing actions we've taken, there's probably incremental price from where we were a quarter ago, so call it 7, plus or minus. I think the market may be incrementally better by 1 point or so. If you take that as a whole, I think we've gotten even more confident in the double-digit growth that we'll see. I highlighted we had terrific orders. When looking at the next 6 to 7 months, that's the peak of the construction season in North America. We saw very strong orders across all categories above our growth rates. We're pretty well positioned heading into Q2 and Q3 to drive really strong growth. Our supply chain is sort of set to deliver against that. If we deliver our guidance, which we fully expect to do, we should have 6 months with meaningful growth above 10%.

That's great to hear. And on the margin front, we have your Q2 guide. Incrementals are implied to step down a bit versus the Q1 level. I guess on a sequential basis, the math is a little cleaner in that regard if we look strictly at Q2 versus Q1 in terms of the step-up. But nonetheless, looking to the back half, should we expect third-quarter core margin to be flat to up year-on-year? Or has the progression, given the headwinds that everyone is facing, been pushed back a bit more in that sense?

The margin year-over-year, I mean our models all along have always had the margins stepping down a bit in the third quarter, but that gap compressing quite a bit. As you can appreciate, through the first, call it, two to three quarters the price inflation cost equation is the toughest for us. It gets better as the year progresses. Then as you get into the latter part of the third quarter, clearly into the fourth quarter, the comps just get easier. The other thing too is we've had investment that we started, call it, midweek of the third quarter, clearly into the fourth quarter, around growth initiatives as well as some things we're doing on the supply chain, working more aggressively on supply chain than we have in the past. We’ll lap against that, so you'll get an easier comp from that standpoint too.

Okay. Completely understood. And then a higher-level one. Zurn has navigated a lot of market turbulence over the last 10 to 15 years, and you've had pretty consistent performance. If we see fears of a 2023 recession come to pass, how should we think about the combined Zurn-Elkay resilience relative to your core operation?

Well, you're correct in your history of our ability to navigate through. Look, I don't want to answer a hypothetical question around 2023, other than with the combination with Elkay, over half of our business or nearly half will be MRO retrofit. If you look at the model we have around design, procure, assemble, test supply chain, we've got a very flexible model there. So we won't absorb fixed costs should things slow. The vast majority of our selling effort is with third-party reps, which are also all variable. Our business model and the resilience of that has only improved really over the last several years with more MRO if you're worried about new construction. The variable model on the supply chain and selling, I think, really positions us well. We're going to be in great shape because, right now, the pro forma balance sheet will have essentially no debt. We're ready to navigate a less favorable environment, but we think '23 can still be very good with the amount of activity around the country.

Just a comment on the margins. So yes, I think we're modeling it the same way, down year-over-year through 3Q. I'm just curious, are you guys still looking to hold margins excluding corporate flattish year-over-year? Or has some of the inflationary pressures impacted margins for the year?

Yes. So look, I think we've said going into this year that our goal was to hold margins generally in line with the prior year. That means exactly what we did last year, which could be 25.8%. Could it be 25.5%? It could be. Generally, we're not looking at a scenario where margins will fall off to 24% or 24.5%. All the things that we have line of sight to and the actions we're taking, I don't think keep us in the ballpark where we're going to be generally close to where we were last year from an overall segment margin standpoint. Obviously, when you bring the Elkay business in, we know that brings a lower margin profile, so that muddies the waters. But talking just about Zurn, that’s what we've been working towards all year.

The bias obviously through, let's just say, through April is the double-digit growth will creep past the 10%. As that migrates up, we have a better chance of getting to where those margins are. By Q3, I think the momentum in Q4, combined with Elkay, and the synergy realization in year one puts us in a great place. Growing at the rates we're growing at the margins we're growing, despite some of the comparable headwinds, I think by the time we get to September, October, with what's in front of us with Elkay, it's going to be a great dynamic and a powerful earnings story.

Yes, that makes sense. And since we're talking about Elkay, I appreciate you guys snapping the line at the end of the quarter, makes things easier for us as well. I'm curious, as you think about the synergies, I think you called out $50 million. Can you start to realize some of those synergies? Or do you expect to realize some in this calendar year if you close by the end of Q2?

Yes. Look, I think that there may be some, but probably offset with some investment. So consistent with what we said 10 weeks ago, the synergies that are going to sort of sign up for will really begin in 2023. There may be some, but I wouldn't pencil it as anything meaningful. We're going to close, go through a strategic plan, get the org rolling, and aligned around a long-term strategic plan. Will we get after some of the low-hanging fruit early? You bet. But I think, very much consistent with what we said about '23. '23 is the year to start thinking about those synergies impacting the bottom line.

Okay. Got it. That makes sense as well. Just one last one for you guys. The China situation is evolving, shutdowns are continuing. Can you just give us an update on any supply chain issues, particularly from China, that you're seeing with any of your suppliers?

Well, Joe, how much time do you have? The reality is we have a global supply chain with hundreds of critical suppliers. I think we've prioritized the ones that are in zones where you're seeing things like shutdowns and things of the like. We've got plans in place to move supply where necessary. We've got some in transit, some consigned here. It's a pretty complex view that, at any given day, there's something new and different than what we thought. So you've got to plan around various contingencies, and I think our teams have done a terrific job with that. I don't know that it's going to go away anytime soon, so we just have to keep thinking ahead and managing forward. Were there things that didn't go our way in the quarter? You bet. There were small components that, had they arrived, shipments could have been greater. They didn't, but we still delivered a really strong quarter and have a great backlog heading into what is a very busy season for us. But we need to stay in front of them, which is just the reality of the world right now. Nothing below the water line from what we can see.

So it sounds like a very solid demand pulse across most of your markets. I was hoping you could maybe put a finer point on the magnitude of the order increase or book-to-bill or some measure to help frame the momentum here?

Yes. We generally try to stay away from backlog, but if you think about a 15% core number, it was 4, 5, 6 points of that from an order rate perspective year-over-year.

With a book-to-bill above 1.

Okay. Great. And then maybe just a finer point on the individual verticals, be it health care, K-12 universities, where you're seeing that strength? Or is it broad-based? Any color would be great.

It's broad-based. Obviously, health care and education are our two single largest verticals, and we're seeing really good activity there. I think hospitality is improving. Things like municipal buildings and stadiums are all positive. The encouraging part for us was that it was really broad-based across a lot of categories and verticals. So nothing outsized; it wasn't a unique one-time thing. I think the water level is fundamentally higher across many different areas. The integrated solution around BrightShield has gained great traction. We saw significant growth in that this quarter, which is great news for us too. We're winning more in upgrades and retrofit opportunities.

Yes. No, I appreciate you framing that. And then sticking with BrightShield, are the COVID cases a gating factor that drives customer urgency on the hygienic retrofit opportunities? Or do you think customer conversations are pointing to sustainability and the focus on safer, cleaner washrooms is here to stay?

I think it depends on the person. I don't think COVID cases are really driving decision-making. I think sustainability is key. I think handwashing and keeping clean is a great way to avoid spreading the virus. So those themes are universally true, regardless of case counts.

There is more general awareness around hygiene in general.

Yes. No, makes sense. And then just one follow-up because I am the last one. On the Q2 supply chain situation, obviously, very complex. I know you've taken various mitigating actions, some near-shoring and so on. But is there more to do as you try to wean some of the overreliance on particular regions where your supply is coming from? And in terms of Q2 revenue visibility, how many containers have landed that give you comfort that the framework you've put in place is achievable here, even given the supply chain issues?

I would suggest that the overreliance issue is behind us. I think we've got a geographically dispersed supply chain. We'll continue to minimize risk, which is going to be ongoing. We've got good plans, and there'll be a lot of activity in the second half of our year and into the first half of next year to continue to do that in a more scaled way. But I wouldn't say we're over-reliant upon any one region or supplier at this point. In terms of revenue visibility, we import hundreds of containers. Everything we see looks like it will arrive on time based on our SIOP schedule, when we wanted it, when we ordered it, when it’s picked up. We're tracking this at a supplier and container level. So far, we have seen no issues, and I’m not going to project any either. Our guidance takes into account the possibility of issues. If we outperform, that's great, if we miss a container or two, I wouldn't expect us to come back and discuss it. The reality is our team has done an excellent job managing the supply chain and preparing for this. We set ourselves up well last year for the challenges we face now.

No, that’s great. And just last one, any expected change in the adjusted tax rate once Elkay closes?

Elkay is generally, as you can appreciate, a North American company. I don't think it materially changes from where we sit today from an overall North American tax rate on an adjusted basis. You can use what we have guided to for the full year to model out inclusive of Elkay, and I think you'll be fine.

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

And that will conclude today's conference. Thank you for your participation, and you may now disconnect.