Zurn Elkay Water Solutions Corp (ZWS) Q2 2026 Earnings Call Transcript

Good morning and welcome to the ZERN LK Water Solutions Corporation's second quarter 2026 Earnings Results Conference Call with Todd Adams, Chairman and Chief Executive Officer, Dan Kuhn, Chief Financial Officer, Dave Foley, Chief Operating Officer, Jeff Kuhn, President and Bobby Balsner. Vice President and Corporate Controller for Zern LK Water Solutions. A replay of this 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 Bobbi Bounsner.

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, which are subject to the safe harbor language outlined in our press release issued yesterday afternoon and 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 Zern LK Water Solutions.

Thanks, Bobby, and good morning. I'm on page three in the slide deck. So this morning, I'll start with some comments on the quarter and trends in our business. Then our CFO, Dan Kloon, will cover the Q2 results, and then just a little bit later, our outlook. You'll then hear from our president, Jeff Schoen, on the IntelliHot acquisition, followed by our chief operating officer, Dave Pauley, who will provide an update on drinking water, as well as some color on the operations and what's driving our record operating results. After that, we'll open it up to your questions. Sales grew 10% organically in the second quarter, while EBITDA grew 15% as margin expanded by 120 basis points to a record 27.7%. In the quarter, we generated $112 million of free cash flow and repurchased $50 million of Zurn LK at roughly $48 a share, bringing our year-to-date investment and repurchases to $100 million. dollars. With respect to the IntelliHot acquisition, this is a category and a company we've been interested in for a really long time. It's a terrific adjacency for us and a category that we feel we can really grow over the coming years as we leverage all the capabilities we bring to bear. The most important being the approach we're going to take to really scale this business by leveraging the Zurn LK business system. The great thing about IntelliHot is that its products are best-in-class from a performance perspective, but there is work to do around the integration. The primary integration work centers around the things that we're really good at, scaling a specified product into our core verticals through the same path we take to market with respect to specification, relationships at the end user, engineer, contractor, and at the wholesale level, all nationally, followed by supply chain excellence. And finally, the power of bringing this additional content to market alongside our leading market share positions within our core verticals in institutional and commercial non-residential construction. In terms of the deal, we paid $109 million in the transaction, $100 million net of a tax asset for a business that will generate about $37 million of sales this year with 50% gross margins and low teens EBITDA margins. We see a very clear path for a double-digit return on invested capital in three years. In our view, we believe that IntelliHot can be a $100 million business with a 30% EBITDA margin in the next five years. To be conservative, maybe it's six. The point is that to get on that kind of trajectory, we're going to invest in it, add products around it, work the efficiency and regulatory angles, and grow the installed base. A great example of where we've done that with great success is what we've been able to do with the LK and filtration. Dave will take you through an update on that as part of his remarks in just a couple of minutes. The final point for me this morning is on our full year outlook. We've had a solid first half and are raising our outlook for the year for sales, EBITDA, and free cash flow. From an underlying market perspective, there's always a few small puts and takes to our underlying assumptions, but generally consistent from what we've assumed for the year. For the year, we've got three to four points of price, a point of market growth, and the rest coming from share gains or simply our exposure to higher secular growth categories, some of which the guys will point out later in the call. The highlight to point out in our outlook is the increase in our anticipated EBITDA, margins, and free cash flow, which at the midpoint equates to 140 basis points of margin expansion year over year. As you've heard us say many times, we develop a three-year strategic plan annually. We then prioritize a small handful of things to focus on, and we call these breakthroughs we then leverage the CERN LK business system to create the capabilities to bring these to life whether it's product channel supply chain and sometimes it's some or all the above what you're seeing in our results and outlook is the compounding benefit of the success of those things happening over the last three to four years with the fastest growing parts of our business also happen to be amongst our most profitable we've also leveraged a disciplined approach to prune certain things in our business that we don't feel provide us the ability to create a sustainable competitive advantage which then gives us the flexibility to flow resources to and reinvest the management time into things that can last but not least I think it's critical to highlight the significant competitive advantage we've created with all of our supply chain work over the last several years which provides us enormous advantages and flexibility in these years being impacted by trade and tariff policy the Cherry, on top of all this is the compounding benefit of the thousands and thousands of continuous improvement activities our people do year in, year out. The net result is a focused business that can immediately outgrow its served markets with terrific profitability and cash flow that allows us to continue to invest in our business to drive even higher levels of growth and performance. With that, I'll turn it over to Dan. Thanks, Todd.

Please turn to slide number four. Our second quarter sales totaled $491 million, which represents 10% core and reported growth year-over-year, above the high end of the guidance we shared at the outset of the quarter. Our end market continued to perform in line with our expectation as our institutional end markets continue to show positive momentum, partially offset by residential and pockets of commercial softness. While we're experiencing broad-based growth across all product categories, our overperformance in the quarter was led by strong demand within our water safety and control and drinking water product lines. both growing above the fleet average similar to the first quarter we saw price contribute approximately five percent of growth in the quarter turning to our profitability our second quarter adjusted EBITDA was 136 million and our adjusted EBITDA margin expanded 120 basis points year over year to 27.7 percent in the quarter this exceeded the high end of our guidance range of 27 to 27 and a half and this margin performance in the quarter represents our highest quarterly margin since the Zern-LK merger. The strong margin in year-over-year expansion was driven by operating leverage on higher volume, continued productivity from our Zern-LK business system, and ongoing mixed improvement as our highest margin products continue to lead our growth. With respect to the first half, our sales and EBITDA have increased by 91 million and 36 million respectively year-over-year, delivering a year-over-year incremental margin of 40%. Our first half EBITDA margin of 27.3% improved by approximately 140 basis points year-over-year. During the second quarter, we received $48 million in cash related to AIPA and the Reciprocal Tariff Refunds, inclusive of $2 million of accrued interest. This refund is reflected in the cost of goods sold caption on our income statement and had a significant impact on our reported GAAP earnings and EPS for the quarter. I want to be clear that this item is excluded from our adjusted earnings and pre-cash flow. This cash receipt strengthened our already healthy balance sheet, but is not a recurring item and as such has been excluded from our adjusted results. As of June 30th, we have approximately 6 million of IEPA and reciprocal tariffs that remain uncollected and unrecognized in our financial statements. This is slide 5, and I'll touch on some balance sheet and leverage highlights. With respect to net debt leverage, we ended the quarter at 0.3 times, the lowest leverage we've ever had as a public company. Pre-cash flow in the quarter was 112, and our balance sheet liquidity leverage and pre-cash flow generation remain in excellent shape and reflect the financial flexibility. we have to continue to invest in the business, as evidenced by the recently closed acquisition of IntelliHot. I'll turn the call over to Jeff to cover the transaction in more detail on page six.

Thanks, Dan. I'm excited to walk through the IntelliHot acquisition we announced last week, a relationship we've cultivated for years. This transaction expands our available market by $1.1 billion, within which the tankless segment represents over $200 million today. Tankless is growing meaningfully faster than the overall commercial water heating category it's a strong initial step into a highly complementary adjacent category and one with some of the most favorable regulatory and demand tailwinds we've seen in the space a few drivers give us real conviction here first the doe's efficiency mandate requiring new commercial water heater installations to meet condensing level efficiency second we're seeing owners mandate owner mandates emerge around health and safety as it relates to Legionella liability, moving brand preference to tankless. Third, tankless systems deliver a meaningfully smaller mechanical room footprint, which developers and owners increasingly value. And fourth, tankless delivers real operating savings on a large spend category for building owners, reinforced by local and state level efficiency mandates layered on top of federal standards. Since the announcement, we've received strong support from the industry, and our combined teams are energized by the growth opportunity ahead, which brings me to why Intel Hot itself is such a strong fit and natural complement. Like our core business, it's a specified product sold through the same rep and wholesale channels we dominate today. They have a growing install base with nearly 40% of the revenue already coming from MRO, backed by a growing certified contractor network which we plan to bolster and leverage their tankless condensing water heater water heaters deliver meaningfully meaningful better efficiency cost savings than boilers in traditional tank systems for commercial and institutional customers combined with Zern LK specification contractor and wholesaler relationships we're confident this accelerates our product roadmaps and our growth shifting now over to core growth. A big part of why we consistently outperform the market and take meaningful share comes down to our commitment to the Zurn LK business system. Through our business system, we continuously seek voice of customer feedback and look for ways to drive continuous improvement in how we serve our customers. This discipline has translated into consistent high customer ratings and loyalty, which we do not take for granted. We continue to challenge our teams and partners to find ways to improve. We feel that we've developed the best commercial team and local rep agencies in the industry. Over the past four years, we've made sustained investments in new product development, technology that supports ease of doing business, and our technical and commercial resources. We've used 80-20 to create focus and over-resource our largest growth opportunities such as drinking water, high growth regions, and key institutional verticals. Together, these investments are what allow us to deliver consistent above market growth. Right now, drinking water, water safety control, and flow systems are our fastest growing businesses and all three operate above fleet average margins. With our strategy, our investment in NPD and adjacencies and our focus on operational and commercial excellence through zebs we are confident we can continue to outperform the market with that I want to share two wins in this past quarter that show the strategy playing out delivering over three million dollars of sales first we leveraged the drinking water facilities relationship to address a health and safety concern tied to recent Legionella outbreaks we worked with the end user to upgrade the drinking water and commercial faucet units to Zurn LK with connected technology solutions that monitor usage and automatically flush water lines during low-use periods to help reduce Legionella risk and lower the cost of our of their overall water management plan in second out of our institutional vertical focus we leveraged our specifier and contractor relationships to pull through our full suite of products on a recent hospital expansion in Virginia. As we continue to build out our adjacencies and the breadth of our product offering, the value we deliver to specifiers, contractors, wholesalers, and owners will continue to increase. With that, I'll pass it over to Dave.

Thanks, Jeff. I'm on slide seven and wanted to give a quick update on our margin performance over the past couple years. This is the output of our relentless commitment to the CERN LK business system and getting better each day. On a trailing 12-month basis, our adjusted EBITDA margins have improved 660 basis points from Q1 of 2023 to Q2 of 2026. On a point-to-point basis, our adjusted EBITDA margins are up 820 basis points over the last 14 quarters. That starts with 19.5% margins in Q1 of 2023 compared to this quarter's adjusted EBITDA margins of 27.7%. Talked about it last quarter and will provide some additional color on our margin improvement over the last three years. Part of the Zern LK business system is sharing ideas and wins across the organization so that we can replicate successes. These hashtag CI ideas, as we call them internally, are associate-led ideas that save time, eliminate waste, enhance a process, or reduce costs, to name a few examples. No single hashtag CI on its own is material. They do become material when we have thousands submitted across the organization throughout the year. The graph on the left-hand side of the slide highlights how hashtag CI submissions have grown over the years. Our associates across the organization have bought into the concept and are continuing to find ways to improve their work each and every day. Second, we are seeing unit volume growth in the most profitable areas of our business. Water safety and control, flow systems, and drinking water have all grown over the last several years while we have continued to systematically exit our lowest margin products within the portfolio through the application of 8020 this strategy has allowed us to reposition resources to focus on growth opportunity opportunities while simultaneously reducing complexity and excess cost in our business i'm going to highlight drinking water on our next slide but take filtration as an example the year before a merger with lk the filtration business was less than 25 million dollars of sales. Now, four years later, that high margin business has more than doubled as it will end at over 60 million dollars of sales this year. We did this with focus and intention around filtration, building a dedicated team to focus on filters, investing in innovation, and listening to our customers' filtration needs. Our 80-20 work is not a once-and-done process, but something we are continuing to look at, understanding customer buying patterns, eliminating unnecessary skew complexity in our offering, and making sure that we focus on the core products that matter and make sense from a margin perspective. You will see us continue to challenge our product portfolio and deploy 80-20 on a go forward basis. Third, we continue to make positive structural changes, consolidating our footprint to reduce overhead, introducing and sustaining the Zirn LK business system lean tools into the LK manufacturing facilities and continuing to challenge our strategy around internal manufacturing versus outsourced alternatives. And lastly, our supply chain has been a clear competitive advantage that has allowed us to improve profitability while successfully navigating the tariff environment. Our efforts to move sourcing out of China have proven to provide us with both geopolitical risk mitigation as well as a lower landed cost profile. The culmination of these four factors have led to solid incremental margins, which we are currently seeing at around 40%. From 2024 to 2025, our actual incremental EBITDA margins were 40%. Year-to-date this year, our incremental margins have also been at 40%, ahead of the original 35% incremental margin that we got into at the start of the year. Turn to slide eight. It's been four years since the completion of the merger with LK, and we tend to get a lot of questions on the drinking water business, so wanted to provide an update. Our most notable product launch since the merger was the recent introduction of LK profiltration. We listened to our customers, solicited feedback from installers, maintainers, and users, and built profiltration with them in mind, incorporating their feedback and addressing their concerns. Simply stated, profiltration clearly differentiates LK from our competitive set. The list of upgrades within ProFiltration is significant. Filters are now at eye level and can be changed with a simple drop-down cover and quarter turn on the actual filter. Anyone can now change a filter in a matter of seconds. Historically, our units had one filter. ProFiltration now has the ability to house two filters, allowing customers the flexibility to increase their capacity, increase performance, or protect against sediment through a variety of filter combination options suited to optimize customer needs. We've updated the aesthetics of the unit to appeal to architects and engineers. ProFiltration has an enhanced user interface to more clearly articulate the remaining life of the filter. The units are smart and connected to allow for notifications on filter changes or remote line flushing. Filters now are designed with a proprietary head that does not allow for counterfeit filters to work in the units. And as I will talk about in a minute, we updated our line of filters as well. So far, we've seen very positive reaction in the market to pro-filtration. Our team is working with architects and engineers across the country to change the legacy LK specs to pro-filtration based on the improved features and benefits. We've also put a significant focus on not just selling any unit, but selling filtered units. Our internal team and third-party reps are focused on growing the installed base of filtered units as we retrofit the large installed base. In 2023, 50% of the units we sold were filtered. In 2026, over 60% of the units we will sell will be filtered, and our internal goals are to continue to increase that to 70% filtered in 2027. Teams' efforts, legislation, and water quality concerns are all helping to drive the percent of filtered units higher. And lastly, the technology around filtration has improved considerably over the last four years. at the time of the lk merger lk's main filter was a 3 000 gallon lead filter and we've evolved the filter technology over time to provide both longer lasting and higher performing filters in 2022 we added a high capacity 6 000 gallon lead filter to help reduce the number of filter changes our customers needed to make then in 2023 we released the first point of use pfoa and PFOS certified filter that was rated for 2,250 gallons. In 2024, all of our filters were certified to protect against microplastics, and later in 2024, we added a pre-sediment filter to our lineup. In Q3 of 2025, we started shipping units with a proprietary head to prevent counterfeit filters from being used, and at the same time launched the ability to incorporate UV V filter technology and pro units and added a longer lasting 10,000 gallon filter further upping the bar from our current industry leading 6,000 gallon filter we also added a total PFAS filter rated for 4,000 gallons which is the longest lasting total PFAS filter in the industry pro filtration customers get longer lasting filters with less maintenance events and the maintenance event itself is significantly easier and quicker than non pro units drinking

water has performed ahead of our expectations through the first four years and we see a lot of opportunity for continued growth in the coming years with drinking water i'll turn the call back over to dan to walk through our outlook hey save now under the guidance on slide nine for the third quarter of 2026 we are projecting core sales growth of six to seven percent over the year and adjusted even a margin around 28 percent core growth rate in the third quarter and second half reflects the roll off of last year's tariff related price increases that largely became effective in the back half of calendar 2025. As a result of our strong first half performance, we are also updating and raising our full-year 2026 outlook. We now expect core sales growth for the fourth quarter to be in the mid-single digits, and I would estimate the IntelliHot contribution for the second half to be approximately $15 million in net sales for the last five months of the year. Inclusive of the recently closed acquisition of IntelliHot, we expect full-year adjusted EBITDA to range between $503 million and $513 million, and full-year free cash flow to be at least $350 $150 million, excluding the past or future IEPA reciprocal tariff refunds. Lastly, our outlook fully contemplates the transition away from the expired Section 122 tariffs to the new Section 301 tariffs announced late last week. In the guidance slides, we have included our third quarter and four-year outlook assumptions for interest expense, noncash stock comp, depreciation and amortization, adjusted tax rate, and diluted shares outstanding. Please note that the DNA figures do not include the incremental impact of the IntelliHot acquisition as we have not yet contemplated a preliminary purchase price allocation. We will update our outlook for these items on our next quarterly call. We will now open the call up for questions.

Thank you. We will now begin the question and answer session. If you have dialed in and would like to ask a question, please press star 1 in your telephone keypad to raise your hand and enter the queue. If you would like to withdraw your question, simply press star 1 again. If you are called upon to ask your question and are listening by a loud speaker on your device, please pick up your handset and ensure that your phone is not on mute when asking your question. On today's event, we request everyone to please limit yourself to one question and one follow-up only. Thank you. And your first question comes from the line of Brian Blair with Openheimer. Your line is now open.

Thank you. Good morning, everyone. Another really solid quarter. Good morning, Brian. Good morning. You mentioned the continued outgrowth of your higher margin platforms, water safety and control, drinking water flow systems. Curious if you could rank order those. I assume that drinking water is leading the pack. And then hygienic and environmental, how much below the growth rates of the other platforms is that currently?

Yeah. I don't know that it's discernible between water safety and control and drinking water are sort of above a little bit above flow control flow systems and then I jack in environmental is still positive and much much more so on a unit volume basis because you know that's a that's a more competitive category it's our smallest category in general but you know it's still it's still it's still positive but you know that's the that's the ranking is as you've asked the question.

Okay, understood. IntelliHot is a very intriguing deal for your team. Maybe offer a little more color on the uniqueness of the asset, you know, why IntelliHot specifically was, you know, the right deal for you to enter this adjacency. And then you gave us a snapshot of, you know, current operations and profitability and the, you know, medium long-term outlook and what your your team can do with the business, can you offer any additional detail on what we should anticipate for year one or 2027 as we, you know, contemplate, you know, shorter term Yeah, as you probably can assume, you know, it's a complicated category to get into.

And so when you look at the competitive set, it's a combination of foreign suppliers and some domestic suppliers, but the roadmap to develop technology is pretty extensive. And it's one of those, you know, sort of like the last remaining business around in that category with the best technology. And so it was a founder-inventor sort of led company for a long time, and we stayed close to it. And eventually it became, you know, an opportunity for us to acquire. And so it's one of those things where, you know, if you would have asked us seven or eight years ago, you know, what would have been the best target we would have told you this and so we stuck with it and we're able to sort of you know find a transaction that worked and so I think we're really excited about getting into the category because it's really a very positive extension to us in the mechanical room particularly in non res and so as it relates to next year you know we honestly didn't buy it for next year we bought it because we do think this can be a hundred million dollar business in the next five or six years with 30 percent margins. It's already got 50 percent gross margin, as Jeff pointed out, a nice both MRO and retrofit opportunity. And so the power for this is something that we've coveted for a long time. We've cultivated this particular business based on the technology that it has relative to anybody in the industry. And, you know, we think we're going to treat it and act like, you know, this is something we're going to own forever and grow a meaningful share in and so I think the sketch that we gave you for 26 assume that it's gonna it's gonna grow nicely and we're gonna work the margins but as Jeff said you know part of this is the longer game of driving specification preference adding innovation bringing it to and alongside the content we already provide a lot of the customers we serve today so I think we're we're thrilled to have gotten in this category and we think that there's more to do.

Well, understood. Makes sense. Appreciate the call.

Your next question comes from the line of Andrew Crill with Deutsche Bank. Your line is now open.

Hi, thanks. Good morning, everyone. I wanted to ask on price. I think it's great to see realizations stay elevated at 5% in the second quarter. So for the full year, I think, is it fair that you're trending towards the high end of the 3% to 4% you cited?

And can you give us any update on, like, have you had to put through more price or are close to needing more price you know mid-year or have there been more surgical changes with kind of inflation tariffs a little bit more under control this year thanks yeah i think it is sort of in that three to four percent range and it obviously varies by uh category and competitive set i mean you can sort of back check that by thinking about 50 million in refunds against the prior year of about 1.7 billion and you get to right around three points of price for the year. So we haven't really had to put in any additional price throughout 26. You know, I think as we look forward, it looks like sort of a normal pricing year for us as opposed to being any elevated. And so it's three to four points for the year, point of market growth in the remainder, some of the things that we've talked about this morning. So nothing out of the ordinary. I think that the new tariff regime that was announced, you know, we had sort of assumed something would replace what was in place. And so no hiccups there. And I think, as Dave highlighted, you know, we continue to make problems.

Great. Very helpful. And then to go back to IntelliHot on the margin expansion, I think, Chris, you see the gross margins are, you know, very similar to a modestly above ZERN. So no problem there. Can you unpack a little bit like the progression of the EBITDA margins, getting those higher? Is this some combination of private company, elevated cost structure you can wring out and then also leverage your scale purchasing powers? Any more help there? And is it a somewhat linear progression over this timeframe up to 30%? Thanks.

I think the answer is simply yes to all of the evolve.

Okay, fair enough. Thank you.

Your next question comes from the line of Nathan Jones with Payful. Your line is now open.

Morning, everyone. I've got a bit of a longer term or maybe more philosophical question for you, Todd. You talked about every year having a three-year strat plan that has just a handful of things that are the primary focus in each year. Can you talk Talk about what you think those few areas of primary focus will be for 2027.

I think it'll be, you know, a continued progress on adjacencies, you know, categories that are in and around what we do today in the $100 to $200 million range where we think, you know, over a three-year period we can generate $20 to $30 million of revenue by launching the product leveraging the channels and relationships we have and pulling it through and and then obviously leveraging our sourcing platform so those are the types of things that you know we've been working on you'll see some of those you know be announced over the course of the the back half of this year and into 27 and so you know as we as we go through the fall here you know it'll probably be a handful of things like that so expanding our available serve market by 100 to 200 million dollars a year across three or four different things is the way to think about it, Nathan.

Thanks for that. And then maybe one for Dave or Dan, looking backwards a little bit. It's 660 basis points of margin improvement over the last few years. I wonder if you could give us a little more details on the different buckets that have driven that. I know there's been things like probably positive price cost mix, obviously, with higher margin stuff growing faster, productivity. Could you just give us the main contributors, maybe? I'm sure you don't want to break it out per basis point kind of thing, but maybe rank order their buckets in order of their contribution to that margin expansion over the last few years, and thanks for taking the questions.

Sure. I think if you go back to where that graph started, Nathan, I mean, that was at the time of the LK merger. And so call it the first $50 million of profit improvement was really around some of the synergies with LK. And so, you know, at a very high level, the first 25 were a lot of SG&A cost-out type activities. The next 25 were more structural things, so footprint, reducing our overhead, putting through some of the process improvements in the LK manufacturing sites. And then even beyond that, I think, and while all that was going on, you've got the mixed factor, you've got the just hashtag CI continuous improvement activities that we're doing on a day in and day out basis. So I think all those things are combining for what you see in the margins. And then the other thing I'll point out is just, we did a nice job with 80-20 along the So, you know, reducing some of those low margin in the beginning, and then we've continued to prune and do 80-20 in the product portfolios along the way, and that's also helped. So reducing some of those low margin products and focusing on the higher-growing, faster-margin products.

Your next question comes from the line of James Cole. With Jeffries, your line is now open.

Good morning. Thanks for taking questions here. I wanted to touch on the IntelliHut. again here you kind of frame the hot water heating addressable market as 1.1 billion and tankless at like 200 million today and yeah so are you targeting that full 1.1 billion water heating market over time or is the ambition specifically the tankless segment yeah thanks that's a good question i think as you think about the 1.1 billion that is commercial water heating that's going to be over the 200,000 BTU threshold.

So this is more your large institutional commercial jobs. And then if you think about the tankless portion of it, tankless is a little bit over 200 million today. That organically is going to grow just with the industry trends that are taking place. And then if you look at our commercial engine, we feel that we have an ability to accelerate that and also take our unfair share of the $200 million. So over time, the $1.1 billion is absolutely what we're targeting. It'll take time to move that from traditional boiler and tank units to tankless.

Got it. That's very helpful. And kind of touching on incremental margins here, you kind of talked about that being around 40%, like way above 30% to 35% long-term framework that you guided to. and I think you guys talked about like revisiting this framework when you guys are ready. So given that you guys have been outperforming that guidance for a while, like are you now ready to formally raise that like incremental margin guidance? Or if not, what is the kind of threshold that would like get you to raise that?

Yeah, James. I mean, again, I think we've when you say formally, I guess we've always provided that as sort of a guidepost for people to think about um and obviously with some of the the progress we've made over the last several years and many of the things that dave just touched on with respect to um faster growing higher margin supply chain benefits and all that it's it's at least in the near term it's at 40 um so i think i would view it as a snapshot um today and really sort of moving forward as sort of the same kind a general guideline. I don't totally understand the formal part of what you're asking us, but yeah, there may be periods where we invest more in new products. But for the present, with the pace that we can see, I think that the 40% is a reasonable way to think about our incremental margins.

Your next question comes from the line of Edward Maggi with BNP Paribas.

Your line is now open morning guys thanks for taking my questions um yeah starting here um with the telhot again i know um you know we talked about some sizable competitors in the space so i have to think that you know given to me a prepared remarks on the quality of the asset um that this would be something that they might have wanted to have so any color on the process and if it was competitive bidding process that would be helpful to start well it really wasn't a process so again i think as we've Highlighted in the past and with essentially all the transactions we've done over the years and even with legacy companies, you know, we prefer to develop relationships and find the right time.

And in this case, you know, this is a, I think the first contact was somewhere around 2016. And so there was not a process and it was really a relationship. And frankly, you know, I think they felt like this was the right place and the right home for it. You know, it's a technology leader in a space that is maybe not as progressive as the industry is trending. And so with us, by entering the category with the technology leader as our sort of anchor into this, I think they viewed that as a great home as well. And so that's how we got to the finish line.

Yeah, I can appreciate that. You know, it sounds like an exciting asset coming in. And maybe the follow-up would be on some of the stuff that's come out of the portfolio over the last couple years. Can we just, you know, click into 80-20 a little bit more? How you guys have gone about identifying some of those businesses to walk away from? And then, you know, moving forward, is there any more areas that you guys have identified specifically where you would expect to move away from in the coming year or two?

You know, so as a precursor to our strategic planning process, we go through a detailed product lifecycle management review where we look at all of our products, our categories, our channels, and really sort of dive into the competitive dynamics, the outlook, and also investments required in things that we know we want to invest in. And so, you know, falling out of there, there's usually been a handful of things. Early on, as Dave highlighted, residential sinks sold through big box retail. You know, there's hundreds of competitors. The channel's really disrupted with online activity, and it's a big fixed cost investment. And so we made, at the moment, the difficult decision to do it, but you can see the benefits long term, not only in the profitability and the growth, but the management time and the resources to reinvest in faster growing things. And so as we sit here today, obviously, we're going to go through that review. And of course, there might be things that fall out. I don't think that's going to be anything significant in any particular way. But there's always going to be something that we're looking at saying, should we continue to invest in this at the expense of things that can grow faster. And that's, to me, the full life cycle of 80-20. It's one thing just to exit it, but the real power of 80-20 is focusing your resources on things that actually grow and can outrun the deficit that you're creating by exiting something. And so as we go through the summer here, we'll go through that review.

And do I expect that it'll be anything significant no but do i think that there likely could be some all gray color thanks guys yep your next question comes from the line of jeff reeve with rbc capital markets your line is now open thank you good morning everyone so you talked about growing filtration attachment rates and drinking water but also shifting the mix towards retrofit and replacement which is now about 50 percent. How important is expanding either recurring revenue and MRO exposure as part of the adjacent growth strategy? Is there a long-term mix you're targeting?

Yeah, I mean, within drinking water, we've always focused on growing the install base of filtered units. And so, you see in some of the numbers that I talked about how that filtered install base has grown.

That growth in the filtered install base has then directly led to a nicer mix in terms of how big the filter businesses itself and so combination of making the units easier to change filters doing some things to enhance the attachment rate has all led to that filter portion of drinking water growing even faster jeff maybe one thing to add to what dave said um you know i think if you look at our new construction versus mro retrofit replace as you highlight uh it is about 50 and so i don't know that we have a target other than to say it certainly creates a hedge against new construction activity so I don't know that we have a specific target but with the massive installed base of not only drinking water but water safety and control hygienic and environmental products all those do undergo a combination of due to usage and then as buildings and facilities get repurposed there is a retrofit opportunity. And so a 50-50 mix is a great place to start. You're seeing that sort of play out even with IntelliHot and obviously drinking water. So it's a great point to make that 50% of our business that is MRO retrofit replace is sort of immune from whatever activity happens in new construction.

Very helpful. And then as a follow-up, Just on the organic opportunity to expand in adjacencies, is there a framework for how much annual organic growth you'd like adjacencies to contribute? Should we think of this as 50 bits a year, 100 bits, or something more meaningful over time?

I don't know that I would give it to you per year. I think it's going to be one of those things where, you know, as we look at these $100 to $200 million markets and bring things where we can develop a meaningful share, and we're trying to think about it as, you know, a $20 to $30 million opportunity over three years. it may not all show up in year one. It may be more aggressive in year two. So I think it's really a function of identifying categories where we can win and build a competitive advantage, develop the products, source them the right way, work through the specifications, and then begin to pull it through. And so the compounding benefit of that is what sort of you're seeing in some of that outgrowth today. And our objective is to continue to do that, you know, pretty much in the same way over the coming years.

Great. Thank you.

Yeah.

Your next question comes from the line of Jeff Hammond with Key Bank Capital Markets. Your line is now open.

Hey, morning, everyone. This is David Tarantino on for Jeff. Maybe following up on IntelliHot, how should we think about the levers you can pull to grab more of the TAM aside from just to shift to tankless from the broader end market? I guess, what are the opportunities to grow spec share? And are there gaps you'd like to fill from a product perspective, either organically or through bolt-ons?

Well, maybe a way to think about it, David, is, you know, when you think about some of the regulatory tailwinds, some of the efficiency tailwinds, you know, we think that that tankless addressable market today is growing in the mid to high single digits relative to the remainder of the category, which is growing 1% to 2% a year. And again, this is all sort of X price. And so we think we're in a great segment of a very big market that will convert over a long period of time. So we're not anticipating big changes in the size of the surf market, but we do expect that tankless category to grow. And so if you marry that with our ability to leverage the portfolio we have and transportation capabilities we have with the full suite of influencers, right, owners, engineers, architects, wholesalers, you know, we think that not only can the spec share go up, but the category itself will grow. And on top of that, our ability to leverage everything else we do with these customers will aid in all of that pull through.

Jeff I don't know if you had anything else yeah I think as you asked the question this is a heavy spec product and as Todd mentioned these are projects that were already working on as you think about the beginning of the construction cycle starting with our waterworks and and flow systems portfolio and so we feel that these are engineers that were already having deep relationships and design discussions with and contractors that are using the breadth of our portfolio. And so we think that with those leverages, we can take our unfair share of that TAM versus IntelliHot being a single line manufacturer and trying to get leverage with not only the rep network, but also the specifiers, contractors, and wholesalers.

Great. That's helpful color. And maybe looking at the guide for 3Q and 4Q, how should we think about the underlying assumptions here from an end market standpoint? I assume the core growth step down is more moderating price as you lap kind of the tariff increases last year. But is there also some conservatism here, especially in 4Q on that market?

I think the way to you were absolutely right in that, you know, the compounding benefit of the price that was put in place is less in the second half versus the first. You know, we're still seeing good unit volume growth. if I wouldn't call out any discernible changes in sort of our end market view. And, you know, we've given you a Q3 and we've got a place marker in for Q4 and we'll sort of update what that looks like when we announce Q3 earnings right around Halloween.

That concludes the question and answer session. I will now turn the call back over to Bobbi Belsner for closing remarks.

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

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