Zurn Elkay Water Solutions Corp Q1 FY2023 Earnings Call

Good morning, and welcome to the Zurn Elkay Water Solutions Corporation First Quarter 2023 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 the company filed in an 8-K with the SEC yesterday, April 25. At this time for opening remarks and introduction, I'll turn the call over to Dave Pauli.

Good morning, everyone, and thanks for joining us on the call today. Before we begin, I would 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're 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. Good morning, everyone, and thanks for joining the call. When we announced our Q4 earnings in early February, we talked a lot about 2023 as a year of simply executing against the plans that we had developed throughout 2022. If you look at our Q1 results, it’s simply a down payment on what we said we were going to do. As you'll hear from Mark, for the time being we're leaving our full-year outlook unchanged, but intend to take another look at it after we deliver the Q2 that we've outlined. Pro forma core sales were up 5% and pro forma EBITDA margins were up 280 basis points over the prior year to 19.5%. As we discussed in February and we'll reiterate this morning, we have high confidence that our margins will continue to ramp throughout the year based on the current cost profile we've locked in and the benefit of the $25 million of LK synergies that will continue to roll into the results for the balance of the year. What that means is second half margins will improve at least 250 basis points relative to the first half. Next, we repurchased an additional $37 million or 1.7 million shares against our anticipated minimum $100 million of repurchases this year and have continued to do so to begin in the second quarter. Our Q1 cash flow was even in Q1, which was ahead of our expectations and gives us even further confidence in delivering a strong full year free cash flow. Late in the quarter, we launched a national campaign to bring awareness to the problems with lead in drinking water, particularly in K-12 schools, and what we can do to help them solve this incredibly solvable problem. It's still early innings, but we're seeing demand for our drinking water solutions, both bottle fillers and filtration accelerate. Taken as a whole, Q1 was pretty much down the middle with lead times back to 2019 levels, no supply chain constraints and all the 80-20 simplification work behind us. So we were able to work on the Elkay integration efforts and executing on the strategic growth plan we've developed. We remain highly confident in the 2023 cost synergies from Elkay reading through this year while we continue to do the work to get the incremental $25 million benefit next year. With that, I'll turn it over to Mark on page 4 to take you through some financial details on Q1.

Thanks, Todd. Please turn to slide number 4. On a year-over-year basis our first quarter sales increased 55% to $372 million. The Elkay merger contributed 3% year-over-year growth, while foreign currency translation reduced sales by 100 basis points from the prior year and core sales increased 300 basis points. On a pro forma basis, including Elkay in the prior year's first quarter and adjusting for the product line exits that we outlined during last quarter's earnings call, core sales expanded 5% year-over-year. Breaking on that pro forma core growth, sales for our residential end markets were a bit better than we anticipated, and the mid-teens year-over-year decline was partially offset by a few last-time buys for certain SKUs we exited, resulting in a non-recurring sales of approximately $7 million in the quarter. Sales to our non-residential end markets were also ahead of our outlook for the quarter and increased mid-single digits year-over-year with balanced growth across flow management control, water safety and control hygienic environmental, and drinking water. With respect to our Elkay-related product line exit works, we've completed the exits in the first quarter as planned. As you will see on our outlook slightly later in the call, those exits will have a year-over-year sales impact of $29 million in the second quarter and the $90 million we've been highlighting for calendar year 2023. Turning to profitability, our adjusted EBITDA totaled $72 million in the quarter and our adjusted EBITDA margin was at the high end of our outlook for the quarter at 19.5%. This compares to $52 million and 21.7% in the prior year's first quarter. The benefit of price realization and our productivity initiatives inclusive of the cost synergies that will benefit earnings by a little over $6 million each quarter in calendar year 2023, was more than offset by the sell-through of higher-cost inventory versus last year, investments in our growth, supply chain initiatives, as well as the impact of the Elkay merger. Please turn to slide 5, and I’ll touch on some balance sheet and leverage highlights. With respect to our net debt leverage, we ended the quarter with leverage at 1.6 times, inclusive of approximately $37 million of cash used to repurchase common stock in the quarter. We purchased another $17 million worth of stock through the first part of the second quarter, bringing our total share repurchase to just under $80 million from the fourth quarter of 2022 through yesterday. In February, our Board of Directors approved an increase in our share repurchase program of $500 million. As we highlighted on our earnings call last quarter, we intend to utilize at least $100 million of our free cash flow in 2023 to continue to execute our share repurchase plan while targeting a net debt leverage ratio in the one to two times range over time. I'll turn the call back to Todd.

Thanks, Mark. I'm on page 6. Over the next couple of slides, I want to share a few positive developments on various legislation and other things we're doing to drive outsized growth from our safe drinking water platform. Because there are no safe levels of lead in drinking water, especially when it comes to kids, we were pleased to see the Michigan Senate pass Filter First water safety legislation last week. This legislation is intended to protect children from lead in drinking water by requiring all childcare centers and schools to implement a drinking water management plan, install filtered bottle filling stations or filtered faucets on outlets designated for drinking water, and test the filtered water to ensure that the filters are installed and operating properly. This legislation now adds to the Michigan State House of Representatives for consideration and has widespread support from health and environmental experts because it is more cost effective than requiring repeated testing at every school. While we view Michigan’s legislation as the gold standard, there is growing awareness and more legislation developing in other states across the country, including California, Texas, and Massachusetts as you can see here. And this is all just within the last three months. We've been actively supporting this legislation as well as others and believe the most proactive and protective solution to kids getting exposed to lead through school and childcare drinking water is to place filters at the point of use. And for about $2 per student per year, schools can accomplish that with our filtration solution. Moving to page 7, we're also doing our part to bring greater awareness and understanding about the importance of safer drinking water and healthy hydration through a broad awareness campaign. We started with a video series that launched across social media, connected streaming, and video-on-demand services and supported that with an entire toolkit of information and resources. In addition, we launched a dedicated section of Elkay.com with information designed specifically for parents, teachers, administrators, and facility managers. The content ranges from letters parents can send to school administrators, maps indicating where water quality is most at risk for school boards and administrators, curriculum for students and teachers, plus where to buy and how to change our filters for facility managers. We know awareness drives action, and when parents, teachers, and the community call attention to their drinking water problems, the issue cannot be ignored. Moving to page 8, it's just the fact that some school districts have more resources than others; however, all children deserve clean, safe water in the places where they're learning and growing every day. That's why we created our Fountains for Youth program in 2019, providing filtered bottle filling stations, filters installation grants, or a combination of all of these to schools in need. The program assesses donation needs based on several criteria including water quality issues and the ages of students attending the school, with preference given to schools in early education and elementary schools where lead has the greatest impact on developing minds and bodies. The program has benefited dozens of schools across the country with our most recent efforts focused on Los Angeles, Benton Harbor, Michigan, and Milwaukee. We have plans to roll this out to even more schools across the country this year in places like Jackson, Mississippi, and others. This program is just a piece of our overall ESG efforts and a nice segue to the last one for me on page 9. We continue to make strides in our ESG efforts in Clean Water mission overall. In addition to our 2022 sustainability report issued in February and our UN Global Compact Communication on Progress that we'll issue next month, we wanted to share our first quarter progress against key targets to provide additional transparency and accountability of our ESG journey. Developing clean technology water solutions that help our customers meet their water challenges and goals is core to our sustainability strategy, with 74% of our revenue coming from products with sustainable attributes during the quarter. Our commitment to clean technology innovation and continuous improvements keeps us focused on expanding our line of products to conserve water, contribute to a cleaner environment, protect human health and hydration, and save energy and reduce the use of plastics and other non-renewable resources. Zurn Elkay products save an estimated eight billion gallons of water during the quarter, and our goal is to reach 40 billion gallons of water saved annually by 2024. Additionally, Elkay water bottle fillers have prevented the use of more than four billion single-use plastic water bottles well on our way to the target of preventing 15 billion annually. Within our operations, we identified and are launching eight new projects to reduce our energy usage and greenhouse gas emissions, and we have a clearly defined path to meet targets for both. Collectively for the quarter, our philanthropic donations, in-kind gifts, and associate volunteer time exceeded $1 billion. In March, we announced Emma McTague joined our Board of Directors. With the addition of Emma, our Board now has nine independent directors, three of whom are women. Overall, continued strong progress with our ESG efforts. And now I'll turn it back over to Mark to take you through our outlook.

Thanks, Todd. Please turn to slide 10, and I'll cover the highlights of our outlook. As you saw in the press release we issued yesterday, for 2023 we are going to continue to take a view on our external outlook that encompasses a broader range of volatility than we have in the past couple of years. Our outlook for calendar year 2023 remains unchanged with sales in the range of $1.5 billion to $1.55 billion and our consolidated adjusted EBITDA in the range of $325 million to $345 million, resulting in year-over-year margin expansion of at least 110 basis points up to 170 basis points. Similar to last quarter, to help better understand the growth trends in the business in 2023, on the right side of the chart we presented Zurn Elkay pro forma 2022 sales for the second quarter, which takes reported sales for 2022, plus Elkay sales for the second quarter of 2022 less the year-over-year impact of the 80/20 product line exits we have executed. For the second quarter of 2023, we are projecting sales to be in the range of $385 million to $395 million and our adjusted EBITDA margin to be in the range of 21% to 21.5%, which is a 150 to 200 basis points step-up from the first quarter. With respect to the sales outlook, you can see on the page our assumptions for year-over-year growth in our non-residential and residential product groups, which are impacted by the timing of shipments last year, as we began working down an elevated backlog in the second quarter of 2022. We anticipate pro forma orders in the second quarter will expand the low-to-mid-single digits year-over-year with mid-to-high single-digit growth in our non-residential end markets, partially offset by a mid-teens decline in the residential end market. Turning to profitability, our second quarter margin is expanding 150 to 200 basis points sequentially from the first quarter of 2023. As the sell-through of the higher-cost inventory we purchased in 2022 will be complete in the first part of the quarter, and our margin will begin to benefit from the lower commodity and transportation costs in the back half of the second quarter and into the second half of 2023 where we anticipate another margin step-up in the second quarter. Our synergy savings related to the Elkay merger will continue to deliver just over $6 million a quarter and $25 million for the full year in 2023. Before we open the call for questions, just a reminder that we have included on page 10, our second quarter outlook assumptions for interest expense, non-cash stock comp expense, depreciation and amortization, our adjusted tax rate, and diluted shares outstanding. We'll now open the call up for questions.

Our first question will come from Bryan Blair with Oppenheimer. Please go ahead.

Thank you. Good morning, guys.

Good morning, Bryan.

Good morning, Bryan.

I believe you said that residential was down mid-teens with roughly $7 million of unanticipated sales that, while being indiscernible, stayed in the quarter. Just to clarify, what was the margin on the $7 million?

The margin of $7 million was about the fleet average we had for the quarter. So we did a little better on that given the fact that the last time buy is below what you'd net normally in that state, but it didn't materially impact the overall EBITDA margin in the quarter.

Okay. Understood. Maybe offer a little more color on the year-on-year backlog dynamics impacting Q2? Any additional insight you can offer there in terms of how much of a headwind that is and how we should think about the phasing and, in extension, the progression of growth rates into the back half for non-residential in particular but also your residential sales obviously easier comps as the year progresses?

Yes. Specifically, as it relates to Q2, there's a sizable headwind in Q2 from a backlog reduction. So, we built backlog in Q1, reduced it significantly in Q2 and Q3. So, if you look at our order rates relative to the prior year in Q2, they're actually going to be up nicely. So, the sales growth is clearly impacted as a result of the backlog reduction in Q2 reasonably acutely, and also Q3. So, we are seeing the trajectory of year-on-year order rates continue to stabilize and be positive as we go throughout the year. But the phenomenon that you talked about, Bryan, is impacting what we're talking about in terms of sales growth for the quarter. It's not what we would characterize as the underlying demand or market growth.

Yes, if you go back and look at the backlogs, just go back to last year's Qs, it was about a $60 million backlog burn last year on the Zurn side of the core business. That's what Todd's referring to. When you look at the order sales rates, you've got to take that into consideration. As Todd pointed out, the order rates are accelerating in Q2, and we think right now we see a good second half year-over-year demand pattern.

Got it. And one last one. Higher level question. Just be great to hear your thoughts on non-res in general. There's been a fair amount of concern regarding the cycle that's obviously levered in recent past consternation related to the banking sector. Just wondering how your team feels about the backdrop overall and in which end markets or product lines you're most confident in growing through an uncertain market and where there may be a bit more risk to Zurn Elkay going forward?

Sure. Yes, we've heard the concerns. I think qualitatively if you look at our forecast for the remainder of the year, it's essentially unchanged from what we had developed to start the year. I think that's an important piece to take into consideration. Secondly, if you look at our overall non-residential mix, 47% of that is institutional, primarily healthcare and education and some water works. So, you get to over half of the overall revenue. If you look at the slice of commercial, obviously, we're watching it. When we entered the year, we had obviously identified a lot of that risk in the outlook that we had provided. We're not seeing anything that points us to being more outsized than that at this point. But again, Bryan, I think our forecast for the remainder of the year is essentially unchanged. That wouldn't be reflected in sort of the consensus view of the world, but from our standpoint, very little change in the last 90 days relative to maybe the range of outcomes that we thought could happen for the year.

Appreciate all the color. Solid start to the year.

Your next question comes from the line of Jeff Hammond with KeyBanc. Please go ahead.

Hey, good morning, guys.

Good morning, Jeff.

Good morning, Jeff.

Can you remind us of the factors influencing the margin transition from the first half to the second half? I know there are higher inventory costs, investments in safe drinking water, and synergies, but could you walk us through the anticipated 250 basis point change from the first half to the second half?

Yes, Jeff, the synergies are consistent throughout the quarter, so there isn't a noticeable difference between the second half and the first half regarding those synergies. There has been a slight decrease in some front-end weighted investments, but the crucial aspect is the inventory cost structure. As mentioned, we were purchasing inventory in 2022 at higher costs, which impacted Q1 and will affect us slightly in the early part of Q2. The significant change will occur in the latter half of Q2 and into Q3 and Q4, where we will benefit from lower commodity and transportation costs that we've been experiencing for some time, impacting the profit and loss statement. The most noticeable improvement will be in Q3, as the conditions will remain the same for Q4. Therefore, we can expect a significant enhancement in the Q3 margin, although it will decline slightly in Q4 due to seasonal sales reductions, which typically leads to a normal decremental margin in that period. Q3 will showcase the full impact of those reduced commodity and transportation costs on the profit and loss statement.

Okay, perfect. And then just on this clean water opportunity, can you just maybe size it and what you think the funnel of opportunities is and just how important it is for additional states to drive regulation versus just more organic penetration?

Hey, Jeff, as it relates to our regular way core new construction work, we think that that is going to continue to accelerate and grow as it has been for a long period of time. The opportunity is measured in the hundreds of millions when we look at a combination of aftermarket retrofit replace and filtration. And obviously, we've got some pretty targeted initiatives in key states, as well as this broader awareness campaign that we're going state-by-state, school district by school district to begin to identify where is the problem most acute? What's installed? What can we do to replace? And then, obviously, how can we provide that filtration on a recurring basis? And so I think the opportunity continues to be there. I think the awareness campaign and this legislation is just bringing it closer and closer to impact. And so we're building the funnel as we speak. We're, obviously, addressing these states particularly the ones we identified first. But I think this has got a very long tail. And we would qualify it as something measured in the hundreds of millions of dollars over the next three to four years, incremental to that core business that we continue to see nice growth from.

And then you mentioned filtration. Can you just, kind of, as you've dug in on the integration, maybe reassess where you see the filtration opportunity relative today to what you thought initially?

Well, it's not much different than we identified. If you think about the attachment rate and you think about the ability to continually provide this through subscription services or other things and really drive the replacement with our filters was not a strategic focus that Elkay really had spent a lot of time on. We identified it through the size of the installed base, the conversion from non-filter to filtered units, and then obviously ensuring that we would capture that replacement event. And so we think this is clearly identifiable and broadly the same size we thought, but it's not crazy to think about this as a $100 million opportunity in the next two to three years.

Okay. Thanks, guys.

Your next question will come from the line of Mike Halloran with Baird. Please go ahead.

Good morning, everyone. In response to Bryan's last question, regarding the guidance for the second half of the year, I understand it remains unchanged for the full year, all else being equal. Are you assuming any specific demand trends in relation to normal seasonality? Is it just stable conditions on both the residential and non-residential sides once you account for inventory adjustments and other factors? Are you expecting a generally consistent demand pattern, or is there something unique happening?

We are not assuming a significant change. Looking back 90 days, we believed that the residential market might improve slightly in the latter half of the year while non-residential remains fairly stable. When I say slightly, I mean not enough to counterbalance a potential slowdown in the fourth quarter. Additionally, based on our interactions with contractors across various regions, there is still a reasonable level of confidence regarding 2023. Although visibility has its limits, the data we are receiving from our key contractors and representatives does not indicate any major downturn on the horizon for the second half of the year.

That makes sense. And then on the inventory side, maybe just talk to how you feel about channel inventories as well as how you feel about your own inventory levels, and how you see that working out through the year?

Yes. I think from a wholesale channel inventory perspective, there's the right levels of inventory for the future demand that we see. We don't see it elevated in really any specific categories. So taken as a whole, I think we're sort of through that rightsizing more based on where our lead times are today, relative to maybe where they had been over the course of 2021 and 2022. So that feels very normal. In terms of our inventories, obviously, we've got an outlook on the second half. We've essentially dialed in the purchase requirements that we see that met that. And so you'll see inventory continue to come down over the course of the year, as lead times from our suppliers have sort of normalized. So taken as a whole, I think the jockeying of lead times in inventory for us and our suppliers is largely behind us. So sort of steady state at much lower cost, as Mark identified, and that's where we see the margin is sort of spot rate current purchases that we've locked in. We feel we've got a nice cost tailwind heading into the second half.

Thanks. Appreciate it, gentlemen, everyone.

Thanks.

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

Hey, good morning, guys.

Good morning.

So I'm just trying to square your non-res commentary. Back of the envelope it looks like non-res is probably up, I don't know, high single digits this quarter, and now we're expecting it to be negative modestly in the second quarter. And I'm just wondering, is this mostly channel inventory dynamics? Were there any cancellations in your backlog? I'm just trying to understand that a little bit better.

Joe, I think we touched on it a little bit earlier. The sales growth in Q2 and Q3 would be impacted by backlog reduction last year. So, not necessarily the order rates or the market. It's a function of last year's Q2, Q3 comparable would have a pretty significant backlog reduction from both the Zurn and Elkay. As a result of that, obviously, we're working through that headwind, but if we look at sort of daily order rates and what we're projecting for Q2 and see in Q3, the order growth in non-res would be positive for those two quarters. Remember, last year in the first quarter lead times were extended, supply chains were long. And so we built backlog and then spent Q2 and Q3 reducing that. So, I wouldn't say that our outlook on the market is really any different from Q1 to Q2. It's more a function of the comparable last year as we reduced backlog.

Okay. That's helpful. As we move through the year, I appreciate the insights on the margins improving, especially in the third quarter. I know you typically don't provide pricing details, but I'm interested in the positive trends in pricing and costs within the sector. Could you share some quantification about how lower cost inventories impacting your P&L might translate into dollar figures? I'm trying to grasp the expected impact for the second half.

Yes. We're not going to disclose the actual revenue for the third quarter. We will provide our outlook at the end of this quarter when we report again in July. Regarding pricing and costs, we've been discussing the expectation of achieving a low single-digit price realization year-over-year this year, which has remained consistent. There has been no decline in pricing as we anticipated, and we believe this trend will continue for the rest of the year. From a cost perspective, we mentioned a headwind of about 250 basis points year-over-year in the first quarter, which will decrease to around 100 basis points in the second quarter, and eventually, that headwind will dissipate. The positive aspect is that we will achieve the lower cost structure we’ve been discussing while maintaining pricing stability in the second half, which will significantly reflect in the third quarter margin when we provide our outlook.

Okay. Thank you.

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

Good morning, everyone.

Good morning, Nathan.

I want to maybe take a look a little further into the future. You guys have talked about some of these new non-res projects that you're aware of. You track for up to two years before they turn into revenue which gives you some visibility not only into 2024, but maybe even out into 2025, which I think is probably where people are more concerned on at least the commercial side of non-res construction. Can you talk about that sales funnel that you track further out into the future and whether you're seeing much change in that more distant kind of opportunity?

Yeah. I think it's way too early, Nathan. The short answer would be, it would be unidentifiable for us to look at 2024 and 2025 and notice a meaningful change as a result of what's happened in the last 90 days. So there's been no significant adds beyond what we would normally expect or cancellations. Taking as a whole, the market and the level of project activity that we're seeing, particularly on the institutional side, is not changing dramatically one year, two years out as a function of where interest rates are, or the banking crisis. I would say when you look at our commercial exposure, it's a mix of retail, office, warehouse, hospitality, and other things. And so I think, it'd be disingenuous to say that we've seen any change in our project outlook beyond qualitatively saying it's probably not going to be as good in 2024 as 2025 as a function of where rates are today. But I don't think that we could identify anything specific that would maybe answer what you're trying to get at.

Okay. Fair enough. Maybe just on the share repurchase higher than the average for the first quarter. You talked about having done more in the second quarter here. Is how much you execute on the share repurchase in 2023 dependent on share price opportunities you find for other capital deployment bolt-ons, anything like that? Just any more color on where that number might end up for the year?

Well, I think obviously we communicated a minimum of $100 million. We're off to a very strong start on free cash flow. We're executing against the projections that we had. The stock price has been, obviously, a little bit lower than maybe we would all like. And so I think that there's upside to that $100 million, and we'll just continue to work at identifying how much we do and how we execute throughout the year.

Okay. Thanks for taking my questions. I'll pass it on.

I will now turn the call back over to Dave for any further remarks.

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

Ladies and gentlemen, that will conclude today's meeting. Thank you all for joining. You may now disconnect.