Zurn Elkay Water Solutions Corp Q2 FY2025 Earnings Call

Good morning, and welcome to the Zurn Elkay Water Solutions Corporation Second Quarter 2025 Earnings Results Conference Call with Todd Adams, Chairman and Chief Executive Officer; David Pauli, Chief Financial Officer and Bryan Wendlandt, Director of FP&A for Zurn Elkay 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 introductions, I'll turn the call over to Bryan Wendlandt.

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. 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, Bryan, and good morning. Hopefully, everyone's had a chance to read through the release and the charts, so I'll just get right to it on Page 3. The underlying momentum in our business continued in the second quarter as we posted 8% organic growth, EBITDA grew 13% year-over-year and margins expanded 120 basis points. As we discussed last quarter, we continue to have high confidence in the resilience of our end markets, the benefits we're seeing in our targeted growth initiatives and finally, our proven ability to navigate the current global tariff environment with the robust supply chain capabilities and experience we've built. Underpinning all of that is our culture of continuous improvement driven from our deployment of the Zurn Elkay Business System. Last quarter, we reiterated our full-year outlook and provided a framework for what the impact of tariffs and our resulting actions could look like. As things have evolved and changed over the last 90 days, that framework has only improved despite the inclusion of some new items like the 232 copper tariff as well as various trade deals that have been announced as finalized. As a result of our core business trajectory and inclusion of the now more known tariff situation, we're raising our outlook for the year as it relates to top line growth, EBITDA and free cash flow. Like we said last quarter, and we'll probably say several more times this morning, our approach to our outlook this year will be to take things a quarter at a time because there's been several scenarios as to how all of this change could have played out, and yet we find ourselves raising guidance here midway through the year. Things unchanged from the first quarter is our confidence to navigate through all of this in a way that will drive not only great results over the balance of this year, but into 2026 and beyond. Now I'll hand it over to Dave to take you through some more color on the quarter.

Thanks, Todd. Please turn to Slide #4. Our second quarter sales totaled $445 million as we continue to have solid execution on our growth initiatives. The $445 million of sales represents 8% core growth year-over-year. In the second quarter, we generally saw our end markets perform in line with our expectations as the non-residential market remains positive, while the residential markets are experiencing some softness. Within the 8% core growth, there's approximately $8 million to $10 million coming from customers ordering ahead of price increases and 1 point coming from realization on our tariff-related price increase that happened in the quarter. As we mentioned last quarter, we did see some customers ordering at higher volumes late in the first quarter and into the second quarter in advance of our announced price increase. Our team did a good job of working to appropriately manage the incoming orders so as to not create unnecessary inefficiencies within our operations and supply chain. We believe these orders will primarily ship in the third quarter. Turning to profitability, our second quarter adjusted EBITDA was $118 million, and our adjusted EBITDA margin expanded 120 basis points year-over-year to 26.5% in the quarter. At 26.5%, our margins are the highest we've delivered in a quarter since the Zurn Elkay merger occurred a little more than three years ago. The strong margin and year-over-year expansion was driven by volume leverage, productivity initiatives, leveraging our Zurn Elkay Business System and continuous improvement activities across the organization. With respect to the first half, our sales and EBITDA have increased $47 million and $22 million, respectively, which represents a 47% drop-through on a year-over-year volume increase. Our first half EBITDA margin improved 120 basis points year-over-year as core sales grew by 7%. Please turn to Slide 5, and I'll touch on some leverage and free cash flow highlights. With respect to our net debt leverage, we ended the quarter with leverage at 0.7x, the lowest leverage we've had as a public company. Our 0.7x leverage is inclusive of the $33 million we deployed to repurchase shares in the quarter. Free cash flow exceeded $100 million in the quarter for the first time and ended at $102 million. Our balance sheet, leverage and cash flow generation are in a good spot as we continue to cultivate our funnel of M&A opportunities. I'll turn the call back to Todd.

Thanks, Dave, and I'm back on Page 6. We continue to make solid progress during the quarter on our sustainability initiatives and goals. For our customers, we have delivered 1.2 billion gallons of safer, cleaner filtered drinking water so far this year through our installed base, which is up 21% compared to the prior year. I also want to mention the recent introduction of our total PFAS filter. This is a significant enhancement to our previous PFOA and PFOS filter and is so important as municipalities across the country are dealing with the effects of both lead and PFAS in their drinking water supplies. We've also prevented 9.6 billion single-use plastic water bottles from entering water streams. These benefits will continue to grow as our installed base grows, and filtration attachment rates will improve. Through the end of the quarter, we've done $1.4 million in total philanthropic giving so far this year, which already exceeds our year-end total in 2024. This is part of our Fountains of Youth filtered bottle filler product donations that we're making across the country where lead levels and now PFAS levels are high and resources are low. The donations reach from California to New York and from Jackson, Mississippi to Erie, Pennsylvania. I also want to point out that we've made another improvement to our quarterly reporting. On the right-hand side, you'll now see the methodology behind the sustainability metrics we're sharing. It's unchanged from how we've been reporting it, just more transparency for everyone to see quarter-to-quarter. This information is always available in our annual sustainability report, but we wanted to make it even easier for you to access. The last one for me is on Slide 7. Last quarter, we got the question, so what's happening with drinking water? And we told everyone quite a bit, and there's more to come over the course of the year. So here's that update. In what I'd call the first-ever major refresh since the inception of the bottle filler category, this past week, we shipped our very first units of Elkay Pro Filtration, which meaningfully extends upon the competitive advantage we have and marks another significant milestone in our commitment to immediate and cost-effective solutions to address the country's aging infrastructure by providing cleaner and safer water through point-of-use filtration. Our new Elkay Pro Filtration was developed from enormous amounts of customer feedback and from a variety of constituents in all verticals, where people asked for faster filter changes, longer filter life and enhanced aesthetics. Our new units deliver all that and even more. The best part of all of this is that the new units are a drop-in replacement for the prior generation of bottle fillers, allowing seamless upgrades for units that have become ready for replacement or customers who want all the latest enhancements. To build on my little infomercial here, here are some of the critical features in the new bottle filler. We've moved the filter to eye level to make the filters in our units the easiest and fastest to change. Filters can now be changed in less than 30 seconds, and any teacher, facilities person or even a student can change the filter very, very easily. In addition to having the most efficient filter change, the unit supports multiple filters, including an optional sediment filter for areas where the water quality needs even more filtration. In short order, we'll have the ability to filter up to 20,000 gallons in a single filter change. There's more to come on that later in the year. The filters associated with the new unit were also upgraded. Our highest capacity lead filter certification has increased from 6,000 gallons to 10,000 gallons of filtered water. All the filters also contain a proprietary head that allows only Elkay filters to be installed for the unit to operate properly, which over time will drive an enhanced attachment rate and bring real value to our building owner customers. In addition to increased filter capacity and to follow on my earlier comments, we also improved the PFAS filter, moving from a filter that was certified for only PFOA and PFOS to a total PFAS filter that is certified for substantially more contaminants within the PFAS family. All of the units will be shipped as connected units, and facilities managers can remotely monitor filter life and also the status of the bottle filters. We packaged all of the items I mentioned in a new high-end aesthetic that we believe will resonate with architects and specifiers. So longer filter lives, less maintenance, quicker filter changes, improved aesthetics and connected capabilities all provide customers with just another reason to choose Elkay. Now I'll turn it over to Dave for an update on tariffs and our outlook.

Thanks, Todd. I'm on Slide 8, and we'll provide an update on supply chain. There have been a number of moving pieces with respect to tariffs over the last 90 days. But when we aggregate all of the changes and focus on the tariff environment in place as of today, we expect our tariff cost impact before any price adjustments for 2025 to be between $35 million and $45 million. This is a reduction of $10 million from what we thought 90 days ago. The reduction reflects China's rollback of reciprocal tariffs from their peak of 145%, partially offset by several increases, including country-specific reciprocal tariff trade agreements at rates higher than the initial 10%, the implementation of Section 232 steel tariffs at 50% and the proposed copper tariffs. Our team will continue to monitor and respond to tariff changes to ensure the best possible outcome. As we talked about last quarter, we are committed to significantly reducing our direct material supply chain exposure coming from China. This has been an intentional project over the past several years, and our supply chain team, both here and in Southeast Asia continue managing the process. We're firmly on track and in some areas, ahead of schedule to deliver on our commitment that by the end of 2026, less than 2% to 3% of Zurn Elkay's cost of goods sold will come from China. While the environment around tariffs seems to be a moving target, our team is confident that we can remain price/cost positive in the short and long term. Now to the guidance on Slide #9. For the third quarter of 2025, we are projecting core sales growth and adjusted EBITDA margin to be similar to what we just delivered in the second quarter. Oftentimes, our second and third quarters look very similar given the construction cycle throughout the U.S. As a result of the strong performance in the first half, we are raising our full-year sales, EBITDA and free cash flow guidance. For the full year, we anticipate core sales growth to be at least 5% year-over-year, adjusted EBITDA of $420 million to $430 million, and expect full year free cash flow to be approximately $300 million. We've included our third quarter and full year outlook assumptions for interest expense, non-cash stock compensation expense, depreciation and amortization, adjusted tax rate and diluted shares outstanding. Thanks, everyone. We'll now open the call up for questions.

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

Hoping you could offer a bit of color on Q2 growth by product category. I noticed in the Q that all categories grew. Just curious if you can offer some detail there and then what you're contemplating by category in the Q3 guide as well.

Yes. I don't know that we're going to get into that from an outlook perspective, but you saw the growth rates by category. I would say that a lot of the innovation that we've been talking about over the last couple of years in obviously drinking water, but also flow systems and water safety and control is absolutely reading through. We're looking at significant unit volume growth and share gains that we think are clearly sustainable. And so I think what you're seeing is the momentum around some of the new product development that's been going on in the last several years really starting to hit the market. And I think that feels very sustainable to us as we go into Q3 and beyond.

And perhaps speak to your M&A pipeline. You're obviously not in any way capacity constrained, and it sounds like your team has been quite active, just haven't had a meeting of the minds to get a deal through. Any detail you can offer on the composition of the pipeline, perhaps actionability would be helpful.

Yes. I mean, obviously, Bryan, it's part of what we do. We've just spent the last two days going through our product life cycle management process where we not only think through what the next generation of our products look like, we do deep dives on the competitors in each of our segments and look for opportunities. And then those opportunities are things that we generally end up cultivating for a number of years. We also augment that with getting into new categories organically. I'm not sure I'm going to ring the bell on giving you every detail about our funnel and where we're at otherwise to say that I think we've got a very good process around identifying targets where we want to go and cultivation. As something moves to a closer stage, we obviously will be in a position to get it done. But at the present, I think we're just going to continue to do the work, do the cultivation, build the relationships and work on potentially plan B if we can't get there fast enough, which is to do it on our own. And so nothing changed from that regard. We'd certainly like to get something done because we clearly have both the management capacity to do it, the optionality with our balance sheet and increasing levels of free cash flow. And then obviously, bringing the business system to bear on a potential acquisition. So we're just going to keep doing the work, and we know that it will come through at the right time.

Your next question comes from the line of Andrew Krill with Deutsche Bank.

I was hoping to get an update on the end market outlook, even if you don't want to comment on the product line specifically. Last quarter, the market growth rate was about 1% when we considered institutional, commercial, residential, and waterworks. What are your thoughts on these different sectors now? It seems that the residential sector is a bit weaker; can you share what might be offsetting that?

Andrew, it's Dave. I think when you look at the guidance that we gave initially back in February, if you look at that stoplight chart, what we said for each of the end markets, I think, is largely playing through. I think the only thing that I would point out that has changed from our initial guidance is that the residential market does seem to be a touch softer. But otherwise, I'd say our outlook for institutional, commercial and waterworks is unchanged from that initial guidance. We think that will continue to play through the rest of 2025.

Okay. Great. That's helpful. And then I'd like to see the new filtration offering at Elkay. In the past, I think there had been a target out there of getting to around $100 million or so in annual sales. So can you level set us where you are on that now? Is that $100 million still the target? Or could that be revised higher? And any sense of growth rates in this product line would be helpful.

Yes, as time progresses, our installed base expands, and the target of reaching $100 million in sales will likely be increased. In the upcoming years, we anticipate that this target will exceed that amount. It's crucial to emphasize that with the Pro Filtration, if we can enhance attachment rates through the features and benefits I've mentioned, we believe we've made significant progress, and there's more innovation on the horizon. The question isn't whether we'll reach $100 million, but rather when it will happen. The growth rate has consistently been in double digits and continues to be strong, and I believe we are really finding our rhythm with the filtration aspect of the bottle filler market. Our teams have done excellent work, and it's now much easier to change filters. The higher-capacity filters are appealing to building owners since they require less frequent changes throughout the year. I believe everything we've accomplished will lead to substantial growth in the filtration sector for the foreseeable future.

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

I guess I'll do a follow-up on the new filtration product there. Is there a materially higher average selling price for this kind of product? Is this more of a market share play? Or just what's the value to Elkay and to the customer from this?

Yes. I think Todd went through some of the features and benefits to the customer, which I think are a nice improvement over the historical unit. In terms of just selling price, Nathan, I think we'll probably see a 10% increase in average selling price or list price to what the historical units or equivalent unit had been in the past.

That's helpful. My other question is, I guess, on some of the dynamics that you saw in the quarter. I think you talked about $10 million of demand pulled forward into Q2, but said that would ship in Q3. Is that right?

No. I think what Dave was saying is in the second quarter, there was probably $8 million to $10 million of true pull ahead from a sales perspective. The order pull ahead was probably a little bit bigger than that. And that piece will be extinguished over the course of Q3. So, I think that when you think about how the year has evolved sort of beginning mid- to late March, there was the noise around tariffs and then there was Liberation Day and then there was announced price increases and then there was the secondary reaction to even higher-than-expected tariffs, and now that's pulled back. So from like sort of March through maybe early June, mid-June, we saw extended sort of order rates. Some of that wound its way into the quarter, but based on managing customer demand, we were able to push it into the Q3 period and avoid spending a ton of money on expedites and overtime and buying even more inventory for what was not real live demand. I think there was a little bit of a surge to beat some of the price increases, but I think that sort of leveled out. We certainly saw that over the course of July. And again, sort of steady as she goes Q3, and we'll see what happens throughout Q4.

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

Just following up on that last one there. I mean the dollar numbers you're talking about from a prebuy perspective aren't particularly large. So I'm guessing you would say that the inventory levels from a channel perspective are relatively balanced, adjusting for some modest prebuy here and there?

I absolutely think that's the case, Mike. It sort of always is with us. I mean I don't think we've ever really talked about any sort of channel situation because these are all products that are going to sort of live opportunities as construction happens or an MRO event, right? So, it's not like you're going to put a lot of these at a job site just because you could buy it for a little bit less, but you could buy it six months early. I don't think we have much of any channel dynamic on the come.

Yes. Makes sense. And then just a guidance question. If I take the third quarter comments on relatively similar margin levels to Q2, it implies a step down in the fourth quarter on the margin level, which I think is at odds with the commentary and the confidence you have. So is that just related to Todd, your early comments of you're taking this quarter-to-quarter and probably haven't fine-tuned the Q4 margin all that much? Relatively normal seasonality expected going into the fourth quarter? Maybe just help me triangulate to that a little bit.

Yes. I think maybe what it implies is not quite what we're thinking. I think you're 100% correct. We're just sort of taking it quarter by quarter. We don't have any event-driven things that we're signaling with that fourth quarter margin. I think when we get to October and we're back together, we'll sort of let you know exactly what it's going to look like. But at the present, I don't think there's anything to read into what the, I guess, implied margin number looks like in Q4.

Your next question comes from the line of Andrew Buscaglia with BNP Paribas.

This is Ed on for Andrew. Some industrial companies have cited some concerns on budgetary spending for healthcare and education, which might already be starting to show up in their results, but it doesn't look like you guys are seeing this based on this quarter and last. Can you draw a line as to why you may not see any weakness in these areas yet? And if this may be something you see delayed? Just an update on those end markets.

Yes. We really haven't seen the impact of some of the cuts that you're talking about. If we look, healthcare and education are a big piece, our two largest end markets. And so we still continue to see that end market being strong. I think if you look specifically within education, a lot of the cuts were to specific programs versus the spend that would be in and around building upgrades and things like that. We just haven't seen it impact. We haven't seen it come through in terms of orders or how those end markets are performing.

I would like to highlight that as we approach the third quarter, similar to previous years, we will provide our best insight into the market based on the Dodge data and additional observations. To emphasize what Dave mentioned, we are not witnessing any slowdown. It's important to note that very little of our revenue in the first half came from projects initiated this year. Therefore, over time and throughout our construction cycle, the effects tend to balance out in ways that may differ from what others have noted.

Can you provide insights on the current state of water funding and regulations at both the federal and state levels? Are there any significant pieces of legislation or rulings expected soon that we should be aware of?

Yes. At a state level, we still continue to see states be active in proposing what's known as filter first legislation, which requires all K-12 schools to have filtered bottle fillers available to their students. So, the state of Michigan passed that into law last Q4. They actually awarded the money to schools. We've seen schools in Michigan actively upgrade to filtered bottle fillers this summer. The schools have until next year to comply with the law. There's active legislation in Wisconsin, Pennsylvania, New Jersey, Massachusetts, New York. New Jersey actually just released some funding within the last month to help schools within the state upgrade their infrastructure specific to water. So, there's a number of states that are looking at their own water quality issues, primarily lead and some PFAS and taking the steps and proposing legislation in that space, and we see that as continuing.

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

Yes. So I wanted to ask a question. I want to make sure I understand the core sales growth assumption, the 5-plus percent for the year. When I go back and I take a look at your end market assumptions from that February release, it doesn't look like there's a lot of volume baked in and then you're talking about residential maybe getting a little bit lower. So is the core sales, the 5-plus, is that mostly price? Or is there a volume assumption baked in there as well?

Well, I think as we've tried to highlight and point out, I wouldn't view the 5% as anything other than a placeholder for the time being. It sort of gives us a bunch of room if the fourth quarter turns out to be weaker than what we expect or see or the trajectory we're on. We started the year with sort of flattish, maybe up a little bit market, a couple of points of share gain and market outgrowth and then maybe a point of price. As we find ourselves here today, there's probably just a touch more price than we thought going into the year. So you go from 4% to 5%. Obviously, the unit volumes and the organic growth that we're seeing and traction we're seeing is showing up in the second quarter. We're obviously guiding to that. Maybe we're protecting a little bit for some unknowns in the fourth quarter, but there are no knowns in the fourth quarter at this point. So I'm guessing it doesn't quite work in your spreadsheet, but I think more to come as we get done with Q3 and give you our best cut at what Q4 looks like.

Got it. Okay. That's helpful. The margin is showing unexpected improvement. You mentioned staying positive on pricing and costs both in the near term and longer term. As of now, the gross tariff impact has decreased. How should we consider the list pricing you anticipated implementing during our last discussion compared to what actually occurred? I'm trying to understand how much flexibility you have given the current tariff situation.

Yes. I mean we obviously had an April 15 price increase. That's been the only one that we've announced and implemented. As we've gone through the last 90 days with all the various puts and takes and pauses and things of that nature, we're finding that as a whole, we don't need to do anything else in the moment. But as Dave said, we're getting much more traction as we migrate our supply chain and those come online faster. So, obviously, the price piece is, I'd say, in great shape for what we need, but it's the other things, right? It's going faster, getting better benefits on some of the supply chain moves and something that we get to keep forever, which is all of our continuous improvement activities. So last year in the second quarter, we did 835 of these across the company. The second quarter of this year, we did 2,575. That's up 210%. In many ways, we are clearly in a dynamic environment where you've got to get price, you've got to do big things on the supply chain side. Those are important in digital. But the 2,575 things that happened over the course of the quarter also have a big impact on the margin and are sustainable. I think it speaks to a combination of, yes, we're getting price. Yes, we're moving the supply chain, but the culture around continuous improvement and what we can do to make our own weather despite everything else going on, I think is an important fact to understand the margin progression over the course of the year and really over the course of many years.

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

Just back on price. Can you give us price in the quarter?

Well, the total price year-over-year is probably 2 points. So we had a point coming into the year. And as Dave mentioned in his comments, probably 1 point of price yield from the announced price increases sort of midstream here.

Okay. Great. And then, Todd, you laid out, I think, third quarter last year, some Dodge information and kind of how you think about your end markets. And the idea that with Dodge starts moving in '25, that would give you visibility for better growth in '26. Just wondering, as you see the Dodge start data come in, how that's progressing versus maybe how you would have thought six months ago?

I would say that it hasn't changed significantly as a whole. It varies from month to month and is typically revised upwards historically at the same time. From our perspective, let's consider which side of the equator it’s on. It remains clearly positive. As we progress through the third quarter, we'll conduct a similar analysis for everyone using the publicly available data and run it through the lead-lag scenarios we've discussed. However, I don't believe it's drastically different. It's still positive; whether it was 6% and is now 5% doesn’t seem to make much difference to us because, as we've mentioned throughout the call, we are experiencing substantial real share gain and real unit volume growth that has been ongoing and is starting to become evident. If the market remains positive and we can achieve some price increases along with the unit volume growth and share gain we’ve been seeing, I think growth in 2026 should be solid.

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

I want to come back to Section 232, so the steel tariffs and then the incremental copper considerations. Are there any hedging mechanics that we should be aware of or that you might be taking and then thinking about any lagged impact as you roll those through on the higher prices later in '25 or maybe in early '26?

Yes. We do not do any hedging. We do a rolling sort of demand view and then locking in purchases and levels of purchases at different intervals. Yes, we've done the analysis and don't see any sort of lagging effect either this year or really into next year.

Okay. And then just back on the Q3 core sales guide, they are similar to Q2. Just want to be clear here. So 8% organic in Q2, are you adjusting out the few points of prebuy as the starting point for Q3? Or are you saying the year-over-year in Q3 is going to be 8% or so?

The latter. Yes. We're saying we're not adjusting Q2 in any way. We tried to be clear as to what the benefit was, but the 8% in Q3 is 8% year-over-year against the same comparable quarter a year ago.

I will now turn the call back to Bryan Wendlandt for closing remarks.

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

Ladies and gentlemen, that concludes today's call. You may now disconnect. Thank you.