Zurn Elkay Water Solutions Corp Q3 FY2022 Earnings Call

Good morning, and welcome to the Zurn Elkay Water Solutions Corporation Third Quarter 2022 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 Elkay Water Solutions. This call is being recorded and will be available for one week. The phone numbers for the replay can be found in the earnings release that the company filed in the 8-K with the SEC yesterday, October 25. At the time for opening remarks and introductions, I will turn the call over to Dave Pauli.

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 filings with the SEC. 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 are helpful to investors and contain reconciliations to the corresponding GAAP information. 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 Elkay Water Solutions.

Thanks, Dave, and good morning everyone. I really appreciate everyone taking the time on the call this morning. The earnings release that we issued last night contains some perspective on the approach we're taking with respect to the fourth quarter outlook, and we'll go through that in some detail in just a bit. We'll also spend time taking everyone through the significant progress we've made on the integration of Elkay over the first 90 days and finally provide some color on how we're thinking about 2023. There are obviously a number of moving parts as we bring Elkay into the fold, but in the end, the view and perspective we'll be sharing this morning is essentially aligned with the view that we had from the beginning, which was to bring these two amazing businesses together that streamline and simplify the businesses into two significant product categories that from a performance perspective, we're very concerned about. We've done the work and the path is now clear, and we'll share what that looks like this morning. As it relates to the third quarter, our results were very much in line with our expectations heading into the quarter—solid core growth, the first quarter of Elkay on track, and solid margins and free cash flow. Our leverage ended the quarter at 1.5x, and we expect further reduction in December and in the year between 1.2x and 1.3x. You'll see a chart on the right stacking our core growth for the past three years, inclusive of our fourth quarter guidance, and for 2022 this equates to 12% core growth for the year, which is in line with our expectations for the double-digit core growth we communicated and have reiterated throughout the year. Mark will provide some additional color and unpack the growth for both the third quarter, as well as the outlook in just a few minutes. If you can move on to Page 4. The reality is that it's not even four months since we closed the Elkay transaction. But the amount of progress our team has made is significant. In doing so, it really sets us up to start 2023 as a single integrated business. We'll be wrapping up our first integrated strategic plan over the next several weeks, which will fully embed all of the growth and synergy expectations into our normal business cadence as opposed to developing a plan for Zurn and a plan for Elkay. We start 2023 as one business and we have one plan that we're executing. In the first 90 days, we've completed all of our plans for third-party rep changes, which is a huge undertaking because we're asking independent business organizations to change or change significant portions of their agencies from competitive lines to the new Zurn Elkay while learning new or different products, transacting, and putting in different systems while harmonizing around a set of common commercial practices. Having that behind us 90 days in, with the quality of the third-party representation we now have is a huge thing and will create a lot of leverage as we head into 2023. The other significant change we made is with the organization. We already have a single sales organization across the entire business, a single marketing organization across the entire business, as well as organizations around supply chain and distribution. We've established general manager roles over drinking water, sinks with engineering and product management aligned with these categories, essentially mirroring the Zurn model to organize, align, and focus the business on profitable growth. Without question, the single most impactful thing we've done in the first four months is a rigorous deployment of 80:20. The thing to remember is that as a privately owned business, Elkay had its own rationale for doing things the way they did, whether it was serving certain channels or customers or being in certain product lines or SKUs; it made sense for them at a point in time. As we came together, we went through a very detailed and much-needed fact-based 80:20 review to put ourselves in a position to evaluate where we wanted to focus and deploy resources to drive profitable growth, and where we needed to do something different or simply not do it at all. I'll go on to say that the details I'll share ended up deferring much of the initial assessment, but getting the teams to engage with the data and the details and then framing it all allowed us to understand all the downstream implications of our simplification work. Whether it was customer, employee, or supply chain related, we needed to make sure that we got it right so that we could make decisions and move forward with the conviction and confidence it takes to do 80:20 the right way, which is a relentless prioritization around profitable growth. The punchline on the integration is that it's quickly becoming a single core business as we head into 2023, which bodes well in terms of realizing the expected synergies and even more importantly, being in a spot to leverage our unrivaled product portfolio and solutions to drive better long-term growth and profitability by only focusing on what's core to us. Please turn to Page 5. To ground everyone on this page, when we closed the transaction and announced Q2 earnings, we talked about okay for the full year of 2022—and again, this is for the full year, not the half that we will end up consolidating—having about $600 million of revenues and EBITDA margins in the 14% to 15% range. In our detailed work over the past 90 days, we went through each of the primary categories specifically drinking water, commercial sinks, and residential sinks and accessories, customer-by-customer and SKU-by-SKU. We then had the internal debates about conversations with customers and evaluations of our competitive position and long-term strategy, along with the detailed understanding of any collateral impact from our conclusions. What this page highlights is that basically, inside the $600 million revenue business is a growing and profitable $485 million base business with real sustainable competitive advantages. And then, as we execute our simplification and rationalization initiatives, it's actually more profitable at $485 million than it is at $600 million. There are synergies on top of this run rate. The whole Zurn Elkay will focus on drinking water and commercial sinks. In both cases, we are the clear market leader with above-average growth and terrific margins. We'll be selective in where and how we play in residential, but it will be niche areas where it supports our overall strategy. I want to be clear about the portions of the residential market that we are exiting and what's left. The pieces we're exiting really have no strategic value in a Zurn Elkay context. None of it conveys anything or carries the Elkay brand, or is sold through our current set of wholesalers and reps. It's mainly private label or white label sourced sinks and accessories of all different types of materials, and finally products done for other OEMs sold through home centers. That makes no sense for us to continue to support. The sales of residential sinks will stay in calling roughly $70 million will be Elkay branded, sold through our existing channels, reps, and wholesalers where we believe we do have strategic relationships and products that when paired with our commercial lines make a lot of sense in the market. The other thing to highlight is, this isn't going to all happen overnight. We've got some contractual obligations we have to fulfill. We also want to maximize the value of the assets and inventory associated with the exit, but this is the core of what we're going to build around. And it's our best estimate that we can exit this level of business and start this run rate sometime in the second quarter of 2023. Hopefully, it's also more clear that the drinking water and commercial sink product categories share the same characteristics and look like the core Zurn Business from a growth, profitability, and return's point of view. If you turn to Page 6, I'll share a view of how we think the pro forma mix of the business looks after the rationalization. On the left, you'll see we're still aligned around the four highly profitable categories of specified water solutions that we have real competitive advantages and significant market shares in. On the right, we have a nice balance between new construction and retrofitting with significant U.S. institutional and commercial construction exposure. Institutional and the sub-verticals of education and healthcare make up our largest exposure. We have residential comprising only 15% of the pro forma revenues and leveraged primarily to our packs product offering, where we have a tightly focused strategy and are adapted to the material substitution trend in both residential and commercial. All in all, not wildly different than before but we believe that by focusing 100% of our time on the strategic parts of our business will serve us well. When you look at this over 95% of our revenues come from a number one or number two position. The reality is that being a number five or six in residential sinks, sold through home centers or online, isn't something that we built our business case around. I'll turn it over to Mark to walk through the third quarter and the fourth quarter highlights.

Thanks, Todd. Please turn to Slide number 7. On a year-over-year basis, our third quarter sales grew 82% to $418 million. The recent merger with Elkay and last year's acquisition of Wade Drains accounted for 67% of this growth, while our core business contributed 16%. Price realization provided a solid single-digit growth year-over-year, and additional growth in core sales came from non-residential markets and our strategic share capture efforts. This growth was somewhat balanced out by a softer residential market, with all key product categories contributing to the core sales growth. Foreign currency translation impacted sales by about 100 basis points. Regarding Elkay, I'll give some details on the third quarter. Our non-residential sector, which includes drinking water and commercial sinks, experienced less than double-digit year-over-year growth, thanks to strong market demand in both categories and improving price realization as we swiftly implemented our price standards across the Elkay product lines. The residential sink product segment saw a mid-single-digit decline this quarter, as improvements in price realization were outweighed by a general downturn in the residential market and $5 million of product line exits as we initiated our simplification strategy in the quarter, exiting certain residential commodity, private label, and OEM sink SKUs. Moving to profitability, our adjusted EBITDA, excluding corporate costs, reached $91 million this quarter, with our adjusted EBITDA margin at the high end of our expectations, sitting at 21.7%. As Todd noted earlier, we acted quickly to integrate these two businesses into one. However, we can only provide preliminary insights on margins between the legacy business and Elkay as the cost structures are rapidly merging. Concerning the legacy business, margins declined roughly 100 to 150 basis points year-over-year as expected, due to the sales growth benefits being partially offset by increased material and transportation costs, along with our investments in growth and supply chain initiatives. For Elkay, margins saw a considerable improvement from low double digits in the same quarter last year to mid-teens this quarter, driven by accelerated price realization and initial integration benefits, although these were partially countered by necessary investments and inflation in materials and transportation. Our total corporate costs for the quarter were $7 million, as anticipated. Please turn to Slide 8 for balance sheet and leverage highlights. Our net debt leverage at the end of the quarter aligns with expectations at 1.5x, factoring in the adjusted annual expense run rate of about $27 million and utilizing cash to pay off a legacy Elkay term loan and cover transaction costs linked to the merger. This reduction in leverage triggered a 25 basis point decrease in our base terminal rate, effective in the fourth quarter. Looking toward the year's end, we expect to finish with a net debt leverage of 1.2x to 1.3x. Please move to Slide 9 for highlights of our outlook for the fourth quarter. For Q4 2022, we project consolidated Zurn Elkay sales between $350 million and $365 million, with an anticipated consolidated adjusted EBITDA margin of 20% to 21% for the quarter, which includes corporate costs estimated at $7 million. I'll elaborate on the specifics later on Page 9. Turning to Page 10, I’ll review the factors affecting our third quarter sales as we project our fourth quarter outlook. Traditionally, our fourth quarter has fewer shipping days and experiences a seasonal decrease in non-residential construction activity in certain regions as fall and early winter set in. This seasonal impact mainly affects the legacy side of the business due to product categories, while Elkay product groups are affected to a lesser extent. Last year, Zurn saw about $10 million in scheduled third-quarter shipments postponed to the fourth quarter because of container delays. However, factoring in this timing issue, the usual decline from Q3 to Q4 did occur. As Todd might have mentioned earlier, we have expedited our simplification strategy. In the past 90 days, we thoroughly examined Elkay’s sales volumes at both SKU and customer levels and finalized plans aimed at achieving better growth, margins, and returns on invested capital. In late July, we committed to at least $10 million to $20 million in product exits for the second half of 2022. Following our analysis, we decided to exit $25 million worth of products in the second half, with $5 million already occurring in Q3, and an additional $20 million planned for Q4, reflecting a sequential increase of $15 million in exits from Q3 to Q4. The residential market has deteriorated compared to 90 days ago, with a low double-digit decline reported in our served residential market for Q3. As we look ahead to Q4, we anticipate further declines in this market, projecting an approximate year-over-year contraction of 20% for the fourth quarter. It's essential to recognize that our residential products are often stock items for clients, as seen in Q3. Our assumptions for Q4 incorporate both market declines and destocking. I will now detail our transition from third quarter sales to the upper end of our fourth quarter outlook. As we approach the end of the calendar year, the macro environment is looking less favorable; hence, we believe customer sentiment and market behavior might be more unpredictable. Consequently, we're incorporating some additional caution into our outlook, as noted on the right side of the slide. Regarding profitability in Q3, at the midpoint of our adjusted EBITDA margin guidance and our sales forecast, the decrease from Q3 to Q4 is under 20%. Exiting lower-margin SKUs, enhanced price realization for Elkay products, cost controls, and our ongoing integration efforts are contributing to improved margins, even amid lower sales. Before I hand it back to Todd for his closing remarks, I’ll address a few additional outlook items from Page 9. We estimate our interest expense to be around $9 million, with non-cash stock compensation expenses expected to be approximately $8 million and depreciation and amortization projected at about $22 million. Our tax rate on adjusted pre-tax earnings is anticipated to be in the 27% to 28% range. We expect diluted shares outstanding to be around 179.5 million to 180.5 million this quarter. With that, I’ll turn the call back to Todd on Page 11.

Thanks, Mark. Before we turn it over to your questions, I just wanted to cover a little bit about 2023 and some perspective. Hopefully everyone appreciates the level of transparency we went through this morning. In an ideal scenario, we would have been able to lay off this entire simplification story last quarter or perhaps even before, but the reality is that the amount of work, decisions and conversations that needed to be had just took a little bit of time. We pride ourselves on simplification. And as we reflect on how the last quarter went, we’re not happy with it. And so hopefully, we're providing the amount of clarity with purpose this morning that you can appreciate. Obviously, the changes will have a huge impact not only on the dollars of profit, but a dramatic impact on the margins on a pro forma basis as we exit '22 and look to '23. We believe we're taking an appropriately cautious view on the fourth quarter, but I wanted to spend some time on 2023. From an end market perspective, we see record levels of non-residential construction backlog and strong confidence indicators in the contractor community. The momentum around institutional construction continues to be very strong. Commercial construction, as always, will be more mixed and super hyper-local. In aggregate, we think the market will still be up next year, probably more so in the first half, or at least more confidently in the first half than the second. So, we'll continue to watch on how that develops. Our quotation volume, however, continues to be strong, and we're not seeing any material slowdown in demand whatsoever. Residential, as Mark highlighted, without question, will be impacted. Near term, we're seeing a near-jerk reaction across the board. A lagging impact from where mortgage rates have gotten to and are going is having an adverse impact on the residential side of things. But as you saw earlier, it's now only 15% of our business. Inside that, multifamily should continue to see growth, and we have a highly variable model inside our residential serve product lines. So, the impact on profitability is relatively muted compared to the other markets and product lines we have. After three years of challenges, I think we start 2023 with supply chain dynamics that are a lot more stable. Lead times are back to normal. Container costs are down dramatically. Understanding how all that changes ordering behavior is something to watch as we don't have much inventory at all sitting on shelves in wholesale or retail distribution. We're generally seeing live demand in our order rates. We'll end the year with a smaller backlog than we started. But I think the net impact of all of that heading into next year is positive. Particularly if we monetize some of the higher cost inventory we have throughout Q4 and Q1, which means cash flow should be very strong. In our design, procure, assemble, and test model will benefit from lower input costs and a strong U.S. dollar as we procure through our supply chain. We're quite confident that the combination of lower input prices, lower freight, and the inventory reductions will end up being a positive for the year. In a scenario where markets slow, we really don't have much in the way of fixed costs to absorb, and the vast majority of our selling expenses are tied to variable rep commissions. Finally, we've got the benefit of $50 million of synergies flowing through the next two years. With a great balance sheet, our ESG profile continues to improve as we focus our business on the four key pillars of water. We're going to continue to monitor all this over the coming months. But our takeaway is that as we look at next year, we think the overall setup for our business is a lot more half full than half empty compared to a lot of other years at this point in time. Coupled with our resilient business model, the Zurn Elkay Business System, and a great team, we believe we can deliver a lot of value both from the marketplace and to shareholders over the coming years. With that, we appreciate everyone's time on the call this morning, and we'll open it up to your questions.

Your first question comes from the line of Bryan Blair with Oppenheimer.

I appreciate the perspectives on the 2023 setup. And I guess, if we can, maybe offer a little more detail on how your team is thinking about the setup for growth on the non-residential sides; of course, I'm interested in your core verticals of education and healthcare and how those projects are progressing as we approach the New Year. And then, the residential side, I guess the key question is just, you know, how much pain is ahead after the channel reset of Q3 and Q4?

Yes. Look, I think as we look at non-residential, taken as a whole, you know, institutional is approaching 50% of our overall business. When you look at backlogs across the country, they're at near record levels. The amount of time that it's going to take for that to roll through the build cycle is really all of '23 and probably part of '24. Our quotation levels are continuing to be really good, and so we believe that the market is going to be up next year, in aggregate. I think commercial construction will continue to be more mixed; obviously, the office segment is muted. But we're seeing growth in retail for the first time in 25 years. I think that's a really a very hyperlocal game. You might see a lot of activity in Florida and Texas, Southern California, and maybe not as much in the Upper Midwest to the Northeast. Overall, we think the market is up next year, one to three points. I think we're going to monitor it over the course of the next four months and into next year. I do think that the market growth in non-residential is going to be there, as well as in waterworks. As it relates to residential, look, we took some of the pain in the third quarter; we're going to take some more in the fourth quarter as Mark highlighted. But when you take a giant step back, housing is still under built. There will be some level of new construction, perhaps not at the same level as everyone thought six months ago. The trend around multifamily, which frankly is sort of critical in the product lines that we have, should continue to be strong as people need places to live. I would say that for the next quarter or two, I think residential is going to be a little dodgy. But hopefully, by the time we get to the second half of next year, we're sort of on a play and it's not as big of a headwind as it was in the third quarter and fourth quarter and likely will be as we start 2023.

I appreciate that color. And with regard to Elkay, maybe offer a little more detail on how we should think about the cadence of continued 80:20 rationalization. It seems extremely first half weighted in terms of 2023 impact. Then, on a net basis, how should we think about base earnings growth outlook, cross-selling synergies, and netting against the planned rationalization?

Yes. I think what we recognized, Bryan, is that it's going to be something that we have to over-communicate. What we tried to do this morning was basically give you a full-form look at 2022 if we were to have accomplished this all from there. What we'll do prospectively is take that $45 million and that $92 million to $95 million of EBITDA and articulate our results around that. As we go through the quarter, we'll obviously have some revenue related to the stuff we're exiting, but we'll try to isolate that and articulate how much is left to go, what did we exit in the quarter. What you'll see, I think, is the margin profile for that core Elkay business continuing to grow. You'll see the growth in the core Elkay happening in real time, quarter-by-quarter. So, it won't be—we'll try to be transparent around that 485 million, what's growing from a market standpoint, what's growing from a pricing input, and what's growing from strategic initiatives and cross-selling opportunities that may show up either on the Zurn side or the Elkay side. The big takeaway at the start of '23 is that it really is just one business with two additional, really dynamite product lines that are now structured and being run like we're running the Zurn business. We're going to do our very best to communicate and articulate around that kind of framework as we get into 2023.

Okay. That detail is very helpful. I guess, just to level set a bit more, how much does your planned rationalization now exceed the initial deal plan? Where, on the commercial side, is there some 80:20 taking place that seems mathematically implied?

Sure. When we made the announcement, we said approximately $700 million; Elkay had a budget of roughly $690 million. Obviously, the backlog reduction and all the noise that we talked about to get to $600 million, that sort of happened before we owned the business and obviously what's happening in real-time. When we went to our Board and evaluated this, we felt very confident that $60 million of revenue was something we were going to walk away from, and there was another $60 million under review. The details over the last three months have given us that conviction that the $60 million under review was really something that we should walk away from. When you look at the analysis and the business case and the approvals we went through, when you look at year three and year four, our return on invested capital is within 50 basis points of what we had using the base Elkay numbers. The difference really has nothing to do with the walkaway decisions because we felt like we would be able to combine synergies and reduce fixed costs to make that a net positive. It really has to do with maybe a lower starting point than the $690 million. Our business case is very much on track. The push is probably less than six months when you look at the timing of when we get on the returns on invested capital run rates that we had anticipated initially, relative to where we are today. That's something we've looked at very carefully because the returns on invested cash capital deal, the industrial logic, the strategic logic, the financial logic is off the charts. It probably just gets even incrementally better when you strip away some of the things we're walking away from. I appreciate you asking the question because we continue to see the return targets very much in line with what we said when we closed the deal.

Your next question comes from the line of Mike Halloran with Baird.

Just to follow up on one of the last couple of questions there. So, you're talking about $80 million or so of called revenue having been executed on by the end of the year. The incremental $35 million or so is what's going to be left to be executed in the front half of the next year as far as a run rate goes. Is that a fair thought process?

No, it's a little bit different than that, Mike. We think we will get net $25 million by the end of 2022 with the remaining $92 million to go in 2023.

Was that $25 million an annualized number or a quarterly number?

No, it is in the quarter.

Yes, this year, Mike, $115 million in total, so you've got $22.9 to $23 million, and there'd be $90 million more that would come out in 2023 as you walk year-over-year.

Right. But what I guess is, if you've got a $20- or so million run rate from the fourth quarter, you've executed on the $80 million or so because that's the run rate from a full year perspective. And then what you're executing on from a remainder perspective is like $35 million?

I think the issue, Mike, is you've got to start at $600. When you look at the reported revenues for the year that we saw 90 days ago, it was roughly $600 million. From there, we'll walk away from, out of that revenue run rate basis, we'll walk away from $125 to $150 million.

Yes.

So, I think what Mark said is exactly right. The $25 million is specific to the quarter. The $90 million will come next year off of that $600 million run rate. So, the numbers that we're going to be reporting will have the absolute impact of the walk away that happens in the quarter. Had we done it a different way, we could have done it a different way, saying if you would have started from $21, it would have looked more in line with the run rate that you're talking about. But since we're doing it from a static starting point, that's the level of the walk away.

Yes. I actually think we're saying the same thing, just different phrasing. I'll take it offline. It's not a big deal.

Yes.

So, you talked about the balance sheet being in really good shape. The allocated piece, do you feel comfortable that you've made the right kind of strategic decisions to execute on it? So, what's the willingness to bring stuff in today? How does that pipeline look? Has the environment changed? What does that pipeline look like multiples, anything like that?

You know, I think it's probably very early to say, but if we look at our pipeline of opportunities, it's pretty extensive and expensive. We're going through an understanding of how these businesses and their outlooks get impacted by maybe what's in front of us. There are certain things that are going to convert over the next six to 12 months because they look exactly like what it is we do. We have confidence understanding what the market outlook is like. So I think the pipeline is relatively unchanged. The pace of the integration and the capacity and the team that we've built and added to over the last six months gives us a lot of confidence that we can continue to do M&A. We think we can do it at the right levels to create great returns. We're looking for things that fit really, really well inside of our core. There'll be a period of time where expectations need to get reset; we have to understand the value. However, I think we're going to continue to do what we've been doing for a long time, which is cultivate opportunities that fit inside of our core, transact at reasonable levels, integrate well, and grow from there.

Appreciate that. Last one just under destocking side, based on the positive commentary in the non-residential businesses, sounds like there's no destocking needs there; if anything, maybe the opposite. Confirm that one way or another and then also, how long do you think the destocking is going to take to get to the right normalized level of inventory in the channel perspective on the residential side?

You're correct. I mean, from a non-residential side, there's really not that much inventory at all throughout all the various channels. What we're seeing now is probably a little bit of lead times coming in, people being more cautious with order patterns, and a little bit of backlog reduction. We think the vast majority of that is behind us in the fourth quarter. On the non-res side, when you look at residential, I think we're taking a big hit in the third and fourth quarters; there may be a little impact in the first quarter, but I don't think it's material in the grand scheme of things. I think we get clean shelves through the demand numbers late Q1 and into Q2. Our business is not a push model, where we have a lot of stuff on the shelf; it's really a spec-pull through. Nobody's really procuring this before they need it. There's really not much in the way of shelf inventory, so I think we'll see this channel dynamic change dramatically. The impact of lead times coming in, people being more cautious—that will vary on a case-by-case basis. But all that being said, as long as we're driving specification and preference and we see this backlog continue to be strong in the non-residential side, the growth rates we deliver are broadly speaking real-time demand.

Your next question comes from the line of Jeff Hammond with Keybanc Capital Markets.

Just as we go back to kind of the '23 look, can you give us a sense of how you're thinking about carryover price, as well as kind of outgrowth momentum in the core?

Yes. In terms of a carryover standpoint, if you think about next year, there's only—obviously go ahead of the pricing gain faster. We didn't allocate, we've made a lot of progress in Elkay back half. On the Zurn type product categories, you'll probably think about a low single-digit type number next year given the comps. On the Elkay side, given the fact that our debt capital was a little bit stronger in the first step, if you think about that as more of a mid-single digit on Elkay as we're going to blend it together, it would translate to that low to mid-single-digit range from a price realization going into next year, Jeff.

At this point, Jeff, we're not really looking to push a lot more price heading into '23. We'll obviously continue to evaluate it. But as the world sits today, with input costs coming down and everything else, we've got a sizeable tailwind of lower input costs. We want to leave ourselves room if we need to be a bit sharper on pricing areas, and we certainly have the carryover and the tailwind. So, if you think broadly about March numbers, we see a low to mid-single-digit carryover. Non-residential is clearly up while residential is down a touch, and then, with some outgrowth, you can find your way to pretty reasonable growth over the course of '23. How it shakes out by quarter will be impacted by some of the dynamics that we've talked about, but it's more half-full than half-empty when you look at the concentrated, simplified business post-rationalizations.

Yes. And Jeff, I missed your comment. Of course, at mark, ultimately, if you think of what we're doing strategically, we feel every given year, we're trying to get two to three points on the share capture side. We won't feel any different about that vision that we have in the prior years and our ability to execute on strategic growth initiatives.

Okay, great. And then, it looks like the water fountain in the commercial sink business grew pretty well. I think you said low double digits, just talk about the order in quoting activity and does that align with kind of the legacy Zurn commercial or just how's that trending?

Commercial sinks, yes. I think it looks very similar to that element within our Zurn business based on our product categories. We've seen already the power of having both brands in our portfolio, and so from a growth standpoint, that category both brands showed low double-digit growth in the third quarter. We expect that to be very similar in the fourth quarter.

Okay. And then, just last one. I mean, certainly with some of the Elkay resets, the stock has been under considerable pressure here. Just how are you thinking or have you revisited share buybacks as a use of cash for free cash flow generation?

We have. We have 168, 170 million left on our repurchase plan. We also have a year of very strong free cash flow ahead of us. The combination of all that can work your way to a leverage number of a half a turn by the end of next year without doing anything.

Yes.

As we talked a little bit earlier, we've got some M&A that we want to do, we want to keep the balance sheet pretty conservative as we go through this period of uncertainty. But share buybacks, should we feel appropriate, are definitely on the table. We're confident in our ability to execute in '23 and '24, and if we see a situation where there is dislocation, at least in the near term, I think there's a chance that we may do something. I think the other part of it is, as we scale the business, we'll probably revert to a more balanced return of capital to shareholders through M&A, dividends, and stock buybacks, just like we did prior to the RMT. I think we're probably a quarter away from that moment, but I think that's definitely on the table. We do have the capacity to do that with the kind of cash flow and balance sheet profile we have.

Your next question comes from the line of Nathan Jones with Stifel.

I want to ask a question around the stickiness of pricing. You obviously had a lot of inflation flowing through this year. You talked about monetizing some higher-priced inventory late this year, early next year, which I guess implies that you have some lower-priced inventory coming along. How sticky do you think pricing is likely to be from the price increases that you've already put through now in a deflationary environment? And how accretive could that be to margins in 2023?

Yes, it's very sticky. When you look at specified cleaning products, the pricing is sticky. I don't recall a scenario in the 15 years I've been around the business where it has not been. That being said, on a project-by-project, opportunity-by-opportunity basis, you have to be aware of what’s happening amongst the competitive set. We've seen a very early market-to-date, and we would expect that to continue. If it plays out where the prices continue to be sticky, we are selective about where we choose not to be. There is a sizeable tailwind coming through with lower input costs. We've left ourselves the room in the way we've thought about 2023 to see a position to do that, but it's our position that pricing is sticky. When you think about inflation that we've passed through relative to other products that go into non-residential construction, if anything, we've fallen down to afraid of because we haven't seen the doubling of prices in some categories, and our price increases have been really to offset some of the input costs that we've managed really well. Our business model does not have the fixed costs. We're not mining spot commodities. We’re well positioned to capture that tailwind. When you think about what that could mean to margins, it's significant—even without all of that, and I think we may see pretty strong margin accretion into next year on maybe not even a double-digit growth sort of level. Our business model is built for this kind of environment.

Thanks. I had a couple of questions around Elkay. I would assume that the revenue that you're exiting would have been lower growth than the revenue that you're maintaining. I think you'd already targeted Elkay over the long term to be a double-digit growth kind of business. Does this increase the expectation of long-term growth profile of Elkay?

I don't know that we would sign up to increasing that. But when you look at the categories that really now make up and constitute the core Elkay, we absolutely think drinking water has a longer-term secular growth trend above what we have. As Mark pointed out, with the relative market share we have in commercial sinks, we have a terrific opportunity to outgrow the overall market just because of the size, scale, presence, and spec nature of that category. The way to think about it is a much higher degree of confidence around the kind of outgrowth as opposed to increasing the absolute outgrowth.

Then just last one. The exit of the residential sinks business, I would assume, comes with a fair amount of inventory liquidation. Can you talk about the cash generation that you should see from the exit of that business?

Yes. It will be sizable. Obviously, the inventory investment to support that portion of the business was not generating much of any profit and was outsized relative to the inventory positions in what is core. I think it's at least $45 million as we liquidate those inventories and likely more.

Your next question comes from the line of Joe Ritchie with Goldman Sachs.

This is Vivek Srivastava on for Joe Ritchie. Thanks for the question. Not to beat a dead horse here, but the $90 million that you exit next year on Elkay, most of it is first half. Is that the right way to think about it? That $20 million goes away in Q4 '22, and then $45 million each goes in Q1 and Q2 of '23. So sequentially, basically, like $25 million higher exit inventory in '23 versus the fourth quarter of '22?

I think the way Mike was talking about is more accurate. You've got $20 in this quarter as a $20 million impact with $5 million last quarters turning in the back half. Those actions do annualize. So, as you think about the walk, yes, as I said in the walk, you got a $90 million impact year-over-year, but a big chunk of the actions have taken place as you start analyzing those numbers. What I think Mike was describing is accurate. So the annual walk is laid out as intact, but a lot of the actions are taking place now that will drive the incremental impact next year, really more so in the first half of next year.

Yes. To make it very simple, before any market price or strategic growth initiatives, running rate Q1 at $120 million and Q2 at $120 million and Q3 at that's the base before we do anything.

Correct.

As we walk away from this, that's what I talked about. We're going to try to isolate that and communicate around what that $120 million is growing year-over-year, what are the margins related to that? Then we'll give you what we walked away from and the impact of that. But that's really the way to think about it.

Thanks. That's helpful. I have a question on free cash flow. I think the color you provided on inventory liquidation. That is helpful. Anything else from the SKU rationalization, which will impact your FCF conversion? And how should we think about your free cash flow conversion longer term?

Well, I think specifically as it relates to the fourth quarter, we're going to see free cash flow in the $90 million to $100 million range. If we think about 2023, we think that the inventory reduction across the enterprise is going to be sizable. Free cash flow next year should be, I would say, outsized relative to this year. You've obviously got that liquidation factor that is going to be permanent. I don't think there's anything unusual; we've obviously got to pay for some of the restructuring to achieve these $50 million of synergies that we've signed up for but nothing else is, other than I think free cash flow next year should be very, very strong.

Thanks. And then last one on revenue synergies quickly. Are you already starting to get some traction here, and maybe, just if you can provide some color on what are the opportunities on this front and any color on timing on this?

Yes. We're in the throes of it right now. Think of some of the S-4 and how we're funded as it relates to secondary education. We're immediately adding the conversations not only around drinking water but also around our bright shield offering. We've targeted 25 school districts around the country where we're doing all the work to get at some of those funding, and we're seeing that convert in real time. We are leading with drinking water and then I think we're in a position to pull through some of the other more hygienic products or vice versa, where we've had good conversations with school districts around creating more hygienic spaces and we're not pulling through the drinking water. The opportunity around filtration that we highlighted initially is significant. The filtration opportunity amongst the combined business over the next several years is $50 million to $75 million of growth at very high margins. The commercial teams are already engaged in the field on some of these things. We're going through our strategic plan on how we deploy those. The case of bringing these two businesses together and being able to provide even more specified content to customers is working.

Your next question comes from the line of Brett Linzey with Mizuho.

I just want to come back to this $70 million of retained Elkay residential revenue that you're selling through the existing channels. Are these pieces closer to the corporate average, or are these revenue pools that are maybe still under-earning or make negative that you think you can enhance the profitability over time and maybe review in a future date?

I think that these come in a little bit below the fleet average, but, you know, these are with our core wholesale customers. They are Elkay branded. They do have an element of conveyance with other products. So, these are sort of professional-grade plumbing, showroom-type products. There's without question, as we bring the two companies together, the opportunity to eliminate SKUs, work on continuous improvement to drive that up. I don't know that there's a meaningful price opportunity, but there certainly is a cost opportunity. As we bring the two companies together, I think consolidating manufacturing, simplifying the SKUs, combining the spend, and really focusing on manufacturing all these in a more efficient way should drive the margins closer, if not to the fleet average over time. That was the calculus in terms of why we decided to stay in. I mean, it was branded products that have conveyance that we can improve the margins on and fit with our overall go-to-market through specification, third-party reps, wholesalers that we're strategic partners with.

Yes. That makes a ton of sense. And then just my follow-up: Sounds like you're progressing well on the integration efforts. Just in terms of the phasing of some of those savings and how that might have now changed relative to earlier expectations. Do you think those ramp a little bit quicker here in Q4 and early '23? And I'm curious if there would be a change in any of the normal seasonal margin realization than you would typically see on a quarterly basis as you pull in these synergies, and these rationalization efforts start to ramp up.

Yes. No, I think we're going to hit the ground running in 2023 with the synergy realization as a result of I think the significant work we've done around creating these product lines and moving on some of the costs that we had line of sight to. I'll leave it to Mark and Dave to communicate. Obviously, our seasonal patterns—our first quarter is generally lower than our second and third, and our fourth is as well, based on the weather patterns in non-residential construction. So, I think they'll all be amplified by margin perspective relative to where they've been, solely because of the synergies that we're going to generate. I don't know that it's outsized at any one quarter relative to the next.

Yes, that's fair. We'll obviously provide more colors at the close, but right now, we wouldn't say that it's overweight back out or the way front. I think that a lot of the actions are occurring now what we feel pretty good about being at that run rates going into next year. So there isn't really an outsize related.

It will be incremental to each quarter. I think that's probably the way to think about it.

At this time, there are no further questions. Are there any closing remarks?

Yes. Thanks everyone for joining us on the call today. We appreciate your interest in Zurn Elkay Water Solutions. We look forward to providing our next update when we announce our December quarter results in early February. Have a good day.

This concludes today's conference. You may now disconnect.