Zurn Water Solutions Corporation
Q1 2019 Earnings Call Transcript

Published: 31 Jul 2018

[Operator:]

Good morning, and welcome to the Rexnord First Quarter Fiscal 2019 Earnings Results Conference Call with Todd Adams, President and Chief Executive Officer; Mark Peterson, Senior Vice President and Chief Financial Officer; and Rob McCarthy, Vice President of Investor Relations for Rexnord. This call is being recorded and will be available on replay for a period of two weeks. The phone numbers for the replay can be found in the earnings release the company filed in an 8-K with the SEC yesterday, July 30. At this time, for opening remarks and introduction, I'll turn the call over to Rob McCarthy.

[Robert McCarthy:]

Thank you, Paulette. Good morning, and welcome, everyone. Before we get started, I need to remind you 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 data. Consistent with prior quarters, we will speak to core growth, adjusted EBITDA, adjusted earnings per share and free cash flow, as we feel these non-GAAP metrics provide a better understanding of our operating results. However, these measures are not a substitute for GAAP data, and we urge you to review the GAAP information in our earnings release and in our filings with the SEC. Please note that the presentation of our operating results is now focused on our continuing operation, as our VAG operations are now being reported as discontinued. Today's call will provide an update on our strategic execution, our overall core performance for the first quarter of our fiscal 2019, and our outlook for fiscal year 2019. We'll cover some specifics on our two platforms, followed by selected highlights from our financial statements, and afterwards, we'll open up the call for your questions. So, with that, I'm pleased to turn the call over to Todd Adams, President and CEO of Rexnord.

[Todd Alan Adams:]

Thanks, Rob, and good morning, everyone. As you hopefully saw in our release last night (00

[Mark W. Peterson:]

Thanks, Todd. Please turn to slide number 6. On a consolidated basis, our first quarter of fiscal 2019 financial results were slightly ahead of our expectations. On a year-over-year basis, our total sales grew 14%, our core sales increased 4%, and our adjusted EBITDA increased by 23% to $105 million, and our adjusted earnings per share increased by 41% to $0.41. Moving to slide number 7, our outlook for our fiscal 2019 continues to incorporate mid-single digit core sales growth, but as Todd discussed, we've slightly increased our outlook for adjusted EBITDA to a range from $425 million to $440 million or 10% to 14% year-over-year growth for our continuing operations. And we expect to deliver another year of free cash flow ahead of net income. Turning to slide 8, we summarize our consolidated results for the quarter. Let's move on to slide 9 and discuss the first of our two platforms

[Operator:]

Thank you. We will now begin the question-and-answer session. And our first question comes from Jeff Hammond from KeyBanc Capital Markets. Please go ahead.

[Jeffrey D. Hammond:]

Hey good morning, guys.

[Todd Alan Adams:]

Hey, Jeff.

[Mark W. Peterson:]

Good morning, Jeff.

[Jeffrey D. Hammond:]

Hey. So looks like relative to normal seasonality, strong start to the year and 2Q seems to be shaping up well. Can you just talk about how you're thinking about the second half in terms of tough comps or any slowing just within the guidance? Thanks.

[Todd Alan Adams:]

Yeah. Jeff, it's Todd. Embedded in the guidance really is mid-single-digit core growth over the course of the year. We expect to be there for the first half and the second half as well. And so I'm not particularly worried about tough comps as we go through the year. We think the momentum in both platforms is strong. The reality is most of the pricing actions that Mark talked about in his comments really sort of benefit the second half. And so with steady end market demand, the price impact, we expect to see solid core growth over the course of the year.

[Jeffrey D. Hammond:]

Okay. Can you give a little more color on what you're doing on price kind of order of magnitude and where you're putting price through most aggressively?

[Todd Alan Adams:]

Yeah. Obviously, we're not going to comment on discrete price increases other than to say, with being the market leader, we have the ability to gain price, as Mark talked about in his comments. And I think we're taking advantage of being the leader, but doing it smartly and trying to stay in front of what we see as potential cost inflation throughout the year. So we will see that play out over the second half, but suffice to say that we have the ability to pass on price. We've been doing it and we'll continue to do it selectively and smartly, but it should be at worst, margin-neutral as we go through the year.

[Jeffrey D. Hammond:]

Okay. And then just one quick one on water. The margins looked particularly strong there and I guess it's hard to kind of see with the VAG pull out, what – maybe just talk about how you saw those versus your expectations. Any positive surprises there? Thanks, guys.

[Todd Alan Adams:]

You bet. In our release, we do a little bit of reconciliation so you can actually see the margins over time. And so the Zurn business has solidly been in the mid-20%s as we've worked it up over the years. And so from a quarter perspective, the margins weren't a surprise to us and we continue to see opportunities to improve the margin profile of the business going forward with the things we've done with SCOFR, continued focus on RBS, and likely a SCOFR 2 and potentially a SCOFR 3 down the road, so strong margins that should continue to go higher.

[Operator:]

Our next question comes from Mig Dobre from R.W. Baird. Please go ahead.

[Mircea Dobre:]

Yes. Good morning, gentlemen. And maybe to go back to this question on margin in Water Management. Asked differently, when I'm looking at this 35% incremental EBITDA margin, I mean this is quite good, and again I am wondering whether or not there were some – anything that was special about this quarter or if we should sort of range our expectations going forward in this area, this 35% area, especially since you're talking about incremental price increases and things like that down the line?

[Todd Alan Adams:]

Well Mig we'd obviously not likely to change your expectations too much, but the profit in the business in the quarter and really last year benefited from no one-time or unusual items. As we go through and we've been talking about it for a while, the mix towards institutional offers us – it's a higher margin mix for us just based on the content that would go in the buildings and the products that the margins we make on those products. So fundamentally, the margins and the incrementals are tracking to what we'd expect given the projects and the mix, but that's just sort of the way the business has performed for a while. So we're optimistic that with the price increases, and again with further cost reductions and leveraging RBS, we have the ability to continue to generate strong incrementals over the course of the year and in the future.

[Mircea Dobre:]

Okay. So basically steady as she goes from here with this kind of performance. That's kind of what you're saying. You also talked about new product introductions and that's something that we've heard in the past within this segment. Maybe a little more color here and help us understand if these new product introductions, well, first, the magnitude and then, are these accretive to margin? Is that also part of the story?

[Mark W. Peterson:]

They are. We want launched a number of products really over the course of the last year and into this year that all have a favorable margin profile relative to some of the legacy products. At the same time, the legacy products are also highly profitable. And I don't know that we're going to get into the magnitude of the product launches, but they've clearly grown well above the market, sort of in line with our expectations primarily based upon the value that they delivered in customers. If you think about reducing build cost, accelerating the build cycle, these are products that play right in to what end users and contractors want which is to reduce labor costs and overall build cost as they build buildings.

[Mircea Dobre:]

Okay. I want to switch to maybe asking you a question about the overall guidance. You raised the low end of EBITDA. Obviously, there's still a range out there. You sound confident overall, but I'm wondering what are the puts and takes to low end versus the high end? I don't know if this is a range of growth that you have in mind really for the full year or if it's mixed or if there're other cost elements here that might not necessarily be obvious from the outside? Any help would be useful.

[Todd Alan Adams:]

Yeah. I think what you see, Mig, is we've got a mid-single-digit expectation for growth and that translates to what we think is a range of EBITDA, $425 million to $440 million. And so, to the degree we migrate towards the higher end of mid-single-digit, I'd suspect you'd see the EBITDA range towards the higher end of that. Obviously, we're also working cost levers, productivity and price increases. And so, I don't want to say it's linear, but we see good growth over the course of the year and I think we're comfortable that the earnings range that we've got, we hope, turns out to be something that we land in or potentially towards the high end. And that's really – that's the way to interpret it. I don't think there's a lot of science behind it, but it's more art. We're trying to manage the business smartly over time. And with nine months left in our fiscal year, we're just trying to give you our best look of what we think the range of outcomes is. But clearly after the good start, we felt like it was prudent to pick the bottom end of the prior range up a little bit.

[Mircea Dobre:]

Sure. But if I understand this, you're saying that it's a function of top-line variation, maybe a little stronger, maybe a little bit weaker around that mid-single-digit range. It's not something within the margin specifically that generate the low-end versus high-end of EBITDA.

[Todd Alan Adams:]

And obviously I think – correct. But that being said, if mid-single-digit as we interpreted, is 4% to 6%, we wouldn't be comfortable telling you that 5% is the midpoint of the range because we do other things to try to drive the earnings higher with cost reductions and other productivity. So, it's not linear per se, but it is sort of our best shot at what we think the range of outcomes looks like from here, assuming margins are relatively consistent with where they've been and where they're tracking.

[Mircea Dobre:]

Got it. That's helpful. Lastly for me. Within the quarter, you had a segment leadership change in Water Management. Maybe tell us a little bit about that if you can and whether or not that involves any other changes within the business?

[Todd Alan Adams:]

I don't think we're going to spent a lot of time commenting on it, Mig, other than to say we made some strategic decisions with respect to the portfolio as well as some decisions around the org structure to drive what we think is the most effective growth in profit we can. And so as a result of that, we made a change. We're very comfortable with the change we make. And as you can see, the business is performing quite well and we expect it to continue to perform quite well. And so like anything else, the structure of the organization needs to match the strategy and the execution, and we're optimistic that you'll see that continue over the course of the year.

[Mircea Dobre:]

Thank you.

[Operator:]

Our next question comes from Julian Mitchell from Barclays. Please go ahead.

[Julian Mitchell:]

Thank you. Good morning. Maybe just a first question on the free cash flow, it was down quite a bunch year-on-year because of, I guess, inventories and accruals. Wondered if that was simply a function of the top-line outlook? For example, one of your or another industrial company today talked about how they were pre-buying inventory because of tariffs. So I wondered if there was any of that in your free cash or it was simply because the orders and top-line looks so good.

[Todd Alan Adams:]

I'll give you sort of the view that we have, which is, for the year, we expect free cash flow to exceed net income, which is going for $200-million-ish. Obviously, last year, there was a bit of an anomaly in the way the first quarter cash flow rolled out. It was seasonally stronger due to the timing of a few things. This year, those things sort of normalized, and we did do some buy-aheads for inventory in advance of the tariffs, but also to reflect the strength of the top line that we're seeing in Zurn. So, if you think about the Zurn business, the seasonal quarters, the seasonal high quarters are the June and September quarters based on the non-residential construction cycle in North America. And so, with that strength, with tariffs, and the unusual nature of last year, you sort of get to the root of your question. All that being said, over the course of the year, we still expect the $200 million of free cash flow to be there by the end.

[Julian Mitchell:]

Thank you. And then my second question, amidst to what is clearly a very good top line environment, you still have a couple of sort of yellow or amber lights in the traffic light scheme you have on end market outlook, maybe just touch on those two, because everything else is so good, so just what are you seeing in sort of European industrial distribution, and then has your view changed on the non-res North America construction market?

[Todd Alan Adams:]

Yeah. I think, overall, our views are unchanged over the course of the quarter. And so I think we're just taking a cautious outlook on Europe with industrial distribution. It's not a big piece of our business, to be honest, but it's something we're watching, and we still see plenty of support for solid growth. Backlogs are in good shape. Our spec rates and our win rates are very high. And we feel good about where non-res sits. Obviously, we've had a view that commercial and industrial non-res building was going to slow. I think that continues, it's not negative, but it's a slower growth end market as institutional, education, healthcare, all those things really are quite strong. So, unchanged for the quarter and the year, and just something that we're going to keep an eye on those two areas.

[Julian Mitchell:]

Great. Thank you.

[Operator:]

Our next question comes from Charley Brady from SunTrust Robinson Humphrey. Please go ahead.

[Charles Brady:]

Hey, thanks. Good morning. I was just going to kind of tail-in on the end market question, in the Water business, on those end markets. Can you give us a little bit more sense of kind of what kind of growth you're seeing in those particular end markets, particularly the ones that are growing a little bit better, the institutional or the rotation that you've seen there?

[Todd Alan Adams:]

Sure. Obviously, institutional is growing at a higher rate than commercial. Commercial is still positive in the lower-single digit range, but institutional above that. And then, we're seeing pricing above that. So it'll be tough to really give you a sense of what we think the overall market is, but think about commercial as low-single digits, think about institutional as mid-single digits, plus some price, and that's where you get to the 7% for the quarter and last. And we think that as you go over the course of the year, it'll fluctuate a little bit. But we're optimistic that the second quarter for Zurn will also be very strong. So, we're watching everything. We think that the markets are frankly quite strong if you look at where backlogs sit, and that's probably as good as we're going to get Charley.

[Charles Brady:]

No, I appreciate that. And just on PMC, the commentary on the aerospace orders, the timing there, can you give us a little more color on exactly what's that, what that entails, what's going on with that?

[Todd Alan Adams:]

Yeah. I mean, it was a combination of some slight push-arounds, not outs, but push-arounds within the customer base that resulted in the supply chain sort of not being able to deliver in the quarter. And so, the order of magnitude is between $4 million and $5 million. And we think that most of that, if not all of that, sort of falls into the second quarter which puts a sort of hole for the first half. Order rates have been very good. And so, we'd expect, after this sort of shift between Q1 and Q2, the balance of the year to be pretty steady.

[Charles Brady:]

Great. And then kind of a comment on the supply chain leads me to the next question, are you seeing a pent in the supply chain? Is your supply chain able to – given some of the strong growth you're seeing in these end markets – kind of keep pace with what you're seeing on your end?

[Todd Alan Adams:]

I think the answer is generally yes. Obviously, as we've gone through the Supply Chain Optimization over the last couple of years, we've done more with outside suppliers. The aerospace has nothing to do with that change. But so far, we've been pleased with the way the supply chain has been performing. It's really incumbent upon us to keep them up to date with the latest sales, inventory and operations planning because they need to take their cues and plan capacity around the cues that we give them. So, giving them an accurate projection of what we're seeing on a go-forward basis makes them equally as effective in delivering to that. So, it's not just a supply chain problem, it's really stuff that we can control by sending our suppliers the right cues and right capacity going forward.

[Charles Brady:]

Great. Thank you.

[Todd Alan Adams:]

Sure.

[Operator:]

And our next question comes from Joe O'Dea from Vertical Research. Please go ahead.

[Joseph John O'Dea:]

Hi. Good morning.

[Todd Alan Adams:]

Good morning.

[Joseph John O'Dea:]

Maybe just to confirm, it sounds like within the guide, the EBITDA expectations are for kind of neutral price-cost experience for the remainder of the year with respect to margin. And then related to that, when you take stock of the various inflationary pressures out there, have you announced the pricing for what you see and anticipate, or do you expect that there will be incremental price actions in the remainder of the year in order to hit the guidance that you have?

[Mark W. Peterson:]

Joe, this is Mark. Yeah, your first comment was correct. As we look at over the course of the year, for us the price, material cost equation doesn't adversely impact our margins. So, that's one of the assumptions that we have that I talked about in the call and we had kind of baked into the course of the year and then saw that obviously in our first quarter. When you think about the pricing actions, the majority of our pricing actions are in place. We do not – or at this point in time have a lot of things that need to be done from here. Now, clearly, the situation is a little fluid as we all know. And one of the things about our business model that's powerful is our ability to react quickly. So, if things do change from here, we don't have any concerns of our ability to take additional pricing actions, but right now the majority of what we need to accomplish from here we've put in place at this point in time.

[Joseph John O'Dea:]

Got it. And then, commentary around an acceleration in some of the sell-through in distribution, I think we went through kind of early stages of recovery and what looked like would have been kind of lighter inventory levels in distribution. As you see things accelerate, what does that mean in terms of a scenario where distributors are just under-stocked at this point and that in this year, you could see – as we see accelerating demand, a better degree of confidence and a period of some restock in distribution?

[Todd Alan Adams:]

Hey, Joe, it's Todd. To-date, we haven't seen any level of restocking, so all of the end demand is being serviced by our ability to accelerate lead times. And while I think we'd be pleased with the level of restocking, we haven't seen it. And part of it is perhaps our own fault that we can continue to meet the end market demand with improved lead times and delivery performance. So, I think what that leads to is a very healthy level of inventory when you think about an overstock situation. There is no risk of an overstock situation given where inventory levels reside. So, we're, like everybody else, complaining a little bit that the channel is a little thin. But at the same time, as long as we're able to meet the end demand and serve customers well, I think it bodes well for the way people think about us and really the future. So, no restocking is embedded in the way we're thinking about the rest of the year per se. And it certainly hasn't happened in the first quarter.

[Joseph John O'Dea:]

Okay. Thanks very much.

[Operator:]

We're showing no further questions. I will now turn the call back to Rob McCarthy for closing remarks.

[Robert McCarthy:]

(00

[Operator:]

Thank you. Ladies and gentlemen, this concludes today's conference. Thank you for participating and you may now disconnect.