Zurn Elkay Water Solutions Corp (ZWS) Q4 2024 Earnings Call Transcript

Good morning and welcome to the Zern LK Water Solutions Corporation 4th Quarter 2024 Earnings Results Conference Call with Todd Adams, Chairman and Chief Executive Officer, David Tolley, Chief Financial Officer, and Brian Wedland, Director of FP&A for Zern LK Water Solutions. A replay of the conference call will be available as a webcast on the company's Investor Relations website. At this time, for opening remarks and introduction, I'll turn the call over to Brian Wedland.

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 can contain certain reconciliations that corresponding gap information similar the prior quarters we will speak to certain non-gap metrics as we feel they provide a better understanding of our operating results these measures are not a substitute for gap we encourage you to review the gap information in our range of earnings release and in our SEC filings turn the call to Todd Adams chairman and CEO of zero and LK water solutions thanks Brian and good morning everyone and appreciate everyone who's joining us this morning I'll start right on page three fourth quarter again and

a little bit better than what we had guided to basically across the board we leveraged fourth quarter core growth of four percent into eight percent adjusted EBITDA growth which drove margins to 24.6 percent up about 100 basis points year over year for the year we delivered four percent organic growth amidst a market that in aggregate was sort of flattish and EBITDA grew about 15 percent to 390 million dollars for the total year margins for the year ended at 24.9 percent up 270 basis points in absolute dollar terms we leveraged our 36 million dollars of sales growth into 50 million dollars of ebitda growth year over year our free cash flow in the quarter was 55 million bringing the full year to 272 million dollars the court in the quarter we deployed 20 million dollars to repurchase 533,000 shares bringing the full-year repurchases to 150 million dollars in an average price of just under 32 dollars we also use 20 million dollars in the fourth quarter to top off our pension plan and we'll be exiting that over the course of 2025. Dave will spin through our outlook later in the call but take it as a whole I think we feel good about the trajectory of our end markets we feel great about how we're executing while still having plenty of opportunities and things to improve upon in the coming year and finally confident that we have the ability to navigate through some of the potential uncertainties that will invariably arise throughout 2025 by leveraging the Zurn LK business system. I'll turn it over to Dave to take you through some more color on the quarter.

Thanks, Todd. Please turn to slide number four. Our fourth quarter sales totaled $371 million, which represents 4% core and reported growth year over year. Continuing what we've seen throughout 2024, mid-single-digit core sales growth in our non-residential end markets were partially offset by softness in residential and pockets of the commercial segment within non-residential. Solid execution on our growth initiatives drove our sales performance to the higher end of the outlook we provided 90 days ago, as the end markets largely performed as anticipated. Turning to profitability, our fourth quarter adjusted EBITDA was $91 million, and our adjusted EBITDA margin expanded 100 basis points year-over-year to 24.6% in the quarter. Strong margin and year-over-year expansion was driven by the benefits of our productivity initiatives, leveraging our CERN-LK business system and continuous improvement activities across the organization, as well as executing on the final quarter of LK-related synergies. Fourth quarter year-over-year margin expansion continued on a trend we saw all year of strong year-over-year margin expansion. For calendar year 2024, we saw year-over-year adjusted EBITDA margins improve by 270 basis points as our margins ended at 24.9 percent. Please turn to slide five and I'll touch on some balance sheet and leverage highlights. With respect to our net debt leverage, we ended the year with leverage below one at 0.8 times. 0.8 times leverage is inclusive of the $20 million we deployed to repurchase shares in On a year-to-date basis, we deployed $150 million to share repurchases and $57 million to dividends. Given the balance sheet position and our strong free cash flow generation, we have a lot of capital allocation optionality going forward. I'll turn the call back over to Todd.

Thanks, Dave, and I'm back on page six. Throughout the year, we continue to advance our sustainability strategy and, more importantly, our impact. We've set a clear path to advancing sustainability within our own operations and achieving measurable progress towards our goals, as you can see here. In 2024, our relentless focus on continuous improvement and solving complex water issues drove tangible results. At the same time, we've strengthened communities through volunteerism and philanthropy including product donations in communities facing high levels of lead in their drinking water most recently places like Syracuse New York we advocated for filter first legislation in Pennsylvania Minnesota Wisconsin Massachusetts and New Jersey and we reinforced our mission to create a safer healthier more sustainable planet whether it's optimizing our products to further reduce water usage enhancing our filters to remove new types of contaminants or helping eliminate single-use plastic bottles. Our products enable our customers to efficiently and effectively improve their own sustainability profile. I'm now on page seven. I think a lot of our past success and confidence moving forward stems from a very clear understanding of the game we want to play, from our board on down through all of our 2,400 associates, our third-party reps, and our supplier partners, as well as a relentless focus on measuring our outcomes against world-class measures of performance versus our direct industry. For us, it's all about building a sustainable competitive advantage in the game we're choosing to play. So in many ways, this is our strategy on a single page. Starting on the left, starting with being a pure play water business with carefully chosen targeted attributes around which end markets, geographies, and verticals that we believe will drive superior performance over time we're discriminating we're discriminating on how and where we want to spend our time we know our competitors as well as our customers and that drives us to build meaningful and sustainable competitive advantages across multiple facets of our business whether that's on the commercial side of the business or the operational side of it in the middle of everything is our business system it's our common language that allows us to all be on the same page move with confidence and speed and most importantly we believe drive superior performance in all parts of our business it's rooted in our mindset of continuous improvement and it drives our behaviors our habits and finally is our culture we use the cadence and tools we've learned and developed over time as well as continually refined to drive above-market core growth and strong incremental margins while generating consistently high levels of free cash flow that we used to invest back into our business M&A that meets our criteria and finally to return money to shareholders done consistently and well we believe our customers will trust us with more their business our shareholders will generate superior returns our associates will be highly engaged and choose to grow their careers with us and finally we'll help our customers meet their sustainability needs while we do the right thing in our business with respect to sustainability it's intentionally simple but requires discipline and at this point it's simply the way we work moving quickly to page eight given we just wrapped up 2024 and our beginning 2025 I'll share a little bit of how we go about our annual cadence inside the Zurn okay business system a lot of people are perhaps even many have adopted similar methodologies are shown similar charts but what we believe is unique about us is that it's become deeply rooted in our culture and it's just a way of life for us all of our tools and processes are built around the categories of people plan process performance and purpose we also believe that each year is a new baseline or level of performance we expect to sustain to which we can apply continuous improvement to as well then invest in three to five significant breakthroughs or initiatives that done well materially improve our performance relative to the market and our direct competitors creating a higher baseline for the following year. Some good examples of how this has worked for us is our core growth track record over the past 14 years as well as the 880 basis points of gross margin improvement from 22 to 24. And Dave will cover some of these a little bit later in the call. If you know our end markets and our competitors, we're highly confident that we've done considerably better than that and we're convinced that it's due to our strategy deployment process. Again, easy to say, harder to commit to do with the same rigor year in and year out page nine the engine that enables all of this is the spirit we have around continuous improvement making things just a little bit better every day across all aspects of our business we've institutionalized this into what we call hashtag ci which is a scrolling library uh internal library of what people have done the impact it's had and also a way to radiate a culture of sharing ideas teaching and training problem solving while engaging each and every one of our associates. This past year, we documented 3,749 unique hashtag CI submissions. That's up 33% over the prior year and double from 2022 as our new LK associates embraced this way of thinking. We reward the initiative, not the absolute dollar impact, but taken as a whole, these 3,749 actions that were initiated, led, and executed by our associates have reduced lead times improved quality and customer satisfaction minimized waste and of course reduced our costs it's not an exact science but we believe we saved about 5.9 million dollars last year because of these actions or 1586 dollars per submission some considerably more some hard to pinpoint in exact savings but in aggregate 1586 dollars per submission this is above and beyond the expected annual productivity, targeted cost reductions, and supply chain actions. And the beauty of it is that it compounds each and every year, giving us more flexibility to invest into growth and back into our business, improve our margins, and improve our customer satisfactions. For 2025, we're challenging ourselves internally to get to 5,000 of these. It's a big lift, but in reality, it's a little bit more than two per person who work here, myself and Dave included so so just a glimpse into a big part of what gives us confidence that despite some uncertainties in the market and in the world the thing we can control is how we wake up every day and make things just a little bit better than the day before last one for me is on page 10 and we do a tops down bottoms up three-year plan every year that becomes the basis of our long-term incentive targets and gives us the roadmap to allocate resources and make decisions as part of our strategy deployment process this year without going into too much detail we've got four breakthroughs we're deploying some in year two or three of maturity and some new but here's where we'll be where we will be spending our time strategically throughout 2025 and where our senior team is spending 80% of their time so that's pretty much it for me before I turn it over to Dave all in a pretty decent 2024 lots of internal momentum in business as we start 2025 you know we'll manage through this emerging tariff dynamic in many ways we've been working at it for the past six or seven years and finally a huge thanks to all of our associates for doing what you do each and every day to help us win dave todd i'm on slide 11 with our 2025 outlook with respect to the full year and based on the assumptions i'll touch on shortly

We expect to generate core sales growth similar to what we delivered in 2024, deliver adjusted EBITDA of $405 million to $420 million, and generate approximately $290 million of free cash flow in 2025. On the upper left-hand side of the slide are a few assumptions embedded in our outlook. From an end-market perspective, our outlook assumes our markets in total look a lot like what we just saw in 2024. As a low single-digit decline in our commercial end markets will be partially offset by low single-digit growth in our institutional and waterworks end markets and flattish conditions in our residential end markets. We anticipate capturing approximately a point of price realization during the year and for our strategic growth initiatives to generate positive core growth over the prior year. One of the uncertainties that Todd mentioned that will impact 2025 that we are actively monitoring is the tariff environment. As a business, we navigated the initial tariffs that were put in place several years ago very While we successfully managed the day-to-day impact of those first tariffs, we also implemented a multi-year strategy to significantly reduce our exposure to China that we are now seeing the benefits of. As a result of those efforts, we will have less than 10 percent exposure to materials from China by the end of 2026. For the first quarter of 2025, we are projecting core sales growth to increase in the low single digits over the prior year, and we anticipate our adjusted EBITDA margin to be in the range of 24.5% to 25% for the quarter, which is 40 to 90 basis point margin expansion over the prior year. One housekeeping item that impacts the first quarter is shipping days. First quarter has one less shipping day than the prior year. In total, the full-year shipping days are the same as Q3 has one incremental day over the prior year. Within slide 11, we've included our first quarter and full-year outlook assumptions for interest expense, non-cash stock compensation expense, depreciation and amortization, adjusted tax rate, and diluted shares outstanding. Before we open the call for questions, I wanted to walk through slide 12 that illustrates some key factors that have helped drive consistent growth, margin expansion, and exceptional free cash flow over the years. Over the last 56 quarters, we have had positive core growth 52 times, and our longer-term core sales kegger back 10 years is 6%. We are focused on a single geography in North America, and within that geography are focused on the stable and growing education and health care end markets within institutional. Our retrofit exposure has increased to 45% of the business. This is a hyper-local, hyper-regional business, and we deploy resources at the local, regional levels where we win every day. There's not a single contiguous non-res market here in the U.S., and our strategic actions reflect unique dynamics within local markets across the U.S. We benefit from a CapEx light business model with a highly variable cost structure that can consistently deliver strong incremental margins. In 2024, we delivered consolidated EBITDA margins just under 25%, and our expectation is 30% to 35% incremental margins as we move forward. Our margin strength has come from our relentless focus on continuous improvement through the deployment of the Zern LK business system. And finally, on capital allocation. Our balance sheet gives us tremendous flexibility. We currently have the lowest leverage we've had as a public company, allowing us to increase our return of capital to shareholders via dividend and share repurchases while in the background continuing to cultivate M&A. When you add it all up, our end markets, our business model, and our balance sheet, we have a business that has demonstrated a consistent track record of profitable growth with strong cash flow. We'll now open the call up for questions.

Thank you. Ladies and gentlemen, we will now begin our question and answer session. If you have dialed in and would like to ask a question, please press star followed by the number 1 on your telephone keypad. If you would like to withdraw your question, simply press star 1 again. We kindly ask everyone to limit themselves to one question and one follow-up. Again, that is star 1 to ask a question. We will pause for a moment to compile the Q&A roster. Thank you. Your first question comes from the line of Brian Blair with Oppenheimer.

Please go ahead. thank you morning guys nice finish to the year morning morning brian uh so we know your your full year outlook by buy-in market 25 kind of shakes up similarly to 24 um all of which seems reasonable given that the tea leaves as uh we now see them maybe offer a little more color on on her thinking about first first second half dynamics across uh institutional waterworks resi and commercial exposures.

Yeah, I'd say, Brian, if you go back to some of the Dodge starts data that we shared in Q3, you saw that, you know, Dodge is predicting a decent increase in starts from 24 to 25. So I think if those starts happen, and the starts obviously have to happen, I think we could see, you know, the institutional where we're heaviest in healthcare care and education. I think you could see that start to accelerate in the second half. And I think you see, you could potentially see something similar, but maybe not the same magnitude in commercial. But I think the first half looks a lot like, you know, the quarters that we just turned in in 2024.

Understood. That makes sense. And Dave, you've emphasized capital deployment optionality a couple of times in prepared remarks. I think that's undeniable at this point, given your balance sheet position. Maybe offer a little color on your M&A funnel and your team's confidence in getting a deal or two across the finish line this year. Understanding that's not entirely in your control, but speak to any momentum, just the general backdrop, actionability, et cetera.

Sure. I mean, we're working really hard on a handful of things that we think are really smart and make a ton of sense for us. And as you point out, You know, timing is not always perfectly in our control, but, you know, we're not missing anything. You know, there's some things that are advancing, and as you also point out, we've got, you know, I think plenty of balance sheet optionality to go alongside with that. So I think we're going to continue to be very disciplined around, you know, where we choose to spend our time and who we choose to spend our time with. And, you know, I won't speak to the confidence in terms of the timing this year or not, but I can tell you, we think we're working well with a handful of things that we think are really smart and make a lot of sense for us.

Appreciate it. Go ahead. Thanks, John.

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

Good morning.

This is Adam Farley on for Nathan.

I wanted to start on expectations for tariffs. Were any incremental tariff impacts contemplated in the guidance range?

Yeah, so Adam, we haven't contemplated the tariffs. I think the environment is just changing so rapidly. What I will tell you is, you know, when the first round of tariffs were put in several years ago, I think our team navigated it very well. I think we have the ability to navigate whatever tariffs ultimately come in place. We'll navigate through very well. We have the ability to implement price increases, and we'll react to it accordingly. I think the other thing to keep in mind is, you know, our exposure to China, as I mentioned in some of the prepared remarks, has come down considerably. That exposure to China and potential tariffs to China will continue to come down throughout 2025 and 2026. So we feel good about where we are in terms of tariffs, and we'll continue to watch the news like everybody else and react to the latest changes.

Maybe just to follow on a little bit to what Dave said, you know, don't read the fact that we haven't included any impact into guidance. That doesn't correlate to being prepared to act. So whether that is moving suppliers, whether that is enacting laser-focused price increases where we actually need to, I think we've done an amazing job of being prepared to do that at our choosing based on the competitive dynamics, the market dynamics, the timing dynamics. But, you know, as Dave, I think, clearly pointed out, you know, this – the top line that we're talking about wouldn't have price increases above and beyond, you know, what we've already put in place, nor the tariff impact or – nor, frankly, inventory decisions. So, taken as a whole, I think we are poised and ready to do things that, you know, make sense for our business. But in every scenario, I think we're really well prepared to navigate that.

Understood. doing that's really helpful. Just thinking at a higher level, interest rates have stayed relatively elevated. If interest rates stay higher for longer, do you believe that might impact your overall growth rate over the medium to long term?

Yeah, Adam, I don't know. It's a very difficult to answer hypothetical. Right. And, you know, I go back to the vast majority of our business, whether that be the institutional part of it, you know, through education and health care or the retrofit replaces, you know, it's largely not interest rate sensitive. So I don't think it helps, but I don't know that I could quantify how much it hurts. And, you know, I think we're sort of focused on the realities of, you know, where interest rates are and then what can we do to drive above market growth beyond that, as you saw in those four pillars of things that we're working on. So nice question to ask, but I'm not sure how to answer it. And I think we're focused on what we can do.

Okay. Thank you for taking my questions.

Your next question comes from the line of Jeffrey Hammond with KeyBank. Please go ahead.

Hey, good morning, guys. Just on the vertical growth assumptions, one, I'm just wondering if anything has meaningfully changed and how you're thinking about those versus 90 days ago, just given election certainty, you know kind of the prior rate question you know any noise and then you know last quarter you did a great job of breaking out kind of where you play versus kind of the dodge data and so i just want to clarify you know when you talk about institutional being up low single digits are you talking about that within the context of your markets or within the broader context of dodge I mean, I'll let Dave build on what I'm saying, but, you know, we just refreshed all of that

internally in the last couple of weeks, and, you know, fundamentally, the numbers are all on the same trajectory. They wiggle some up, some down relative to the update that we provided at the end of the quarter, but I would say very much intact. When we're talking about what Dave guided to from an end market perspective for institutional, That's very much the aggregate impact of starts that had occurred, the lead lag, and everything else included. So I would say it's not a number that is discreetly identifiable based on that lead lag model that we turned in last year. So I think what we think and what Dodge thinks is that it starts – begin to improve in the back half of 2025, which, based on the way our products get used over the course of a build cycle, would portend better growth into 2026. So if that makes sense, we're living with sort of the starts throughout largely 23 and the very first part of 24 to drive that growth that we're talking about today in institutions.

Okay. And then just on tariffs, you mentioned kind of getting to less than 10% exposure to China by the end of 26. Can you just kind of level set us on where were you at peak? Where are you today?

And then, you know, as we get clarity in the near term, you know, on tariffs, whether it be China or elsewhere, what are maybe some of the things that you would do on a near term basis um you know to react other than you know price well again i think that at its peak you know it was probably 70 to 75 percent uh and dave gave you the end point of you know sort of less than 10 and 26 i think the one thing that um i would say is that the supply chain moves that we've made over the course of the last you know five or six years have allowed us to be flexible so that you know we can move from china to southeast asia or china to north america or in the event that there is or is not a tariff in mexico we can move volume from distant places so it's it's it i would say we're in the continuum of being able to migrate our supply base to where it offers us you know the the overall best cost and um so you know we're certainly less than 50 we're certainly less than 40 at this point but you know I think to think that it's a digital action that we're thinking about is the wrong way to think about it we've created flexibility in a bunch of regions to allow us to flex you know where we're where we're acquiring products from and that includes the US and so I think Dave's signaling something what are we in china now less than 25 yeah we're around 25 so you know who knows what happens i mean we saw tariffs start on sunday and by lunchtime on monday that it had changed for mexico and by five it had changed to canada so i think you know if we were responding to to those kinds of signals it would be a challenge but you know i think we're taking a very measured approach as we have for the last six or seven years to sort of create an enormous amount of flexibility in our overall supply chain to position us to serve the market at the best cost.

Appreciate it.

As there are no further questions at this time, that concludes the Q&A session. I would now like to turn the call over to Brian Wendland for closing remarks.

Thanks everyone for joining the call today. We appreciate your interest in Zern LK water solutions and we look forward to providing our next update when we announce our first quarter results in April. Have a good day.

That concludes today's call. Thank you for your participation. You may now disconnect.