Zurn Water Solutions Corporation
Q3 2022 Earnings Call Transcript

Published: 26 Oct 2022

[Operator:]

Good morning, and welcome to the Zurn Elkay Water Solutions Corporation Third Quarter 2022 Earnings Results Conference Call with Todd Adams, Chairman and Chief Executive Officer; Mark Peterson, Senior Vice President and Chief Financial Officer; and Dave Pauli, Vice President of Investor Relations for Zurn Elkay Water Solutions. This call is being recorded and will be available for one week. The phone number for the replay can be found in the earnings release the company filed in an 8-K with the SEC yesterday, October 25th.

[At this time, for opening remarks and introduction, I'll turn the call over to Dave Pauli.:]

[David Pauli:]

Good morning, everyone, and thanks for joining the call today. Before we begin, I would like to remind everyone that this call contains certain forward-looking statements that are subject to the safe harbor language contained in the press release that we issued yesterday afternoon, as well as in our filings with the SEC.

[In addition, some comparisons will refer to non-GAAP measures. Our earnings release and SEC filings contain additional information about these non-GAAP measures, why we use them, and why we believe they're helpful to investors and contain reconciliations to the corresponding GAAP information. Consistent with prior quarters, we will speak to certain non-GAAP metrics as we feel they provide a better understanding of our operating results. These measures are not a substitute for GAAP, and we encourage you to review the GAAP information in our earnings release and in our SEC filings. With that, I'll turn the call over to Todd Adams, Chairman and CEO of Zurn Elkay Water Solutions.:]

[Todd Adams:]

Thanks, Dave, and good morning everyone. I really appreciate everyone taking the time on the call this morning. The earnings release that we issued last night contains some perspective on the approach we're taking with respect to the fourth quarter outlook, and we'll go through that in some detail in just a bit. We'll also spend time taking everyone through the significant progress we've made on the integration of Elkay over the first 90 days. And finally, provide some color on how we're thinking about 2023. There are obviously a number of moving parts as we bring Elkay into the fold. But in the end, the view and perspective we'll be sharing this morning is essentially aligned with the view that we had from the beginning, which was to bring these 2 amazing businesses together and streamline and simplify the businesses into 2 significant product categories that from a performance perspective were very Zurn-like. We've done the work and the path is now clear, and we'll share what that looks like this morning.

[As it relates to the third quarter, our results were very much in line with our expectations heading into the quarter. Solid core growth, the first quarter of Elkay on track, and solid margins and free cash flow. Our leverage ended the quarter at 1.5x, and we expect a further reduction in December, ending the year between 1.2 and 1.3x. You'll see a chart on the right stacking our core growth for the past 3 years, inclusive of our fourth quarter guidance. And for 2022, this equates to 12% core growth for the year which is in line with our expectations for the double-digit core growth we communicated and have reiterated throughout the year. Mark will provide some additional color and unpack the growth for both the third quarter as well as the outlook in just a few minutes.:]

[If you can move on to page 4. The reality is that it's not even 4 months since we closed the Elkay transaction, but the amount of progress our team has made is significant. And in doing so it really sets us up to start 2023 as a single, integrated business. We'll be wrapping up our first integrated strategic plan over the next several weeks, which will fully embed all of the growth and synergy expectations into our normal business cadence, as opposed to developing a plan for Zurn plus a plan for Elkay. We start 2023 as one business, and we have one plan that we're executing. In the first 90 days, we've completed all of our planned third-party rep changes, which is a huge undertaking because we're asking independent business organizations to change, or change significant portions of their agencies, from competitive lines to the new Zurn Elkay. All while learning new or different products, transacting and porting in different systems, while harmonizing around a set of common commercial practices. Having that behind us 90 days in, with the quality of the third-party representation we don't have, is a huge thing and will create a lot of leverage as we head into 2023.:]

[The other significant change we made is with the organization. We already have a single sales organization across the entire business, a single marketing organization across the entire business, as well as organizations around supply chain and distribution. We've established general manager roles over drinking water and sinks with engineering and product management aligned with these categories. Essentially mirroring the Zurn model to organize, align and focus the business on profitable growth. Without question, the single most impactful thing we've done in the first 4 months is a rigorous deployment of 80/20. The thing to remember is that as a privately owned business, Elkay had its own rationale for doing the things the way they did, whether it was serving certain channels or customers or being in certain product lines or SKUs, it made sense for them at a point in time.:]

[As we came together, we went through a very detailed and much-needed fact-based 80/20 review to put ourselves in a position to evaluate where we wanted to focus and deploy resources to drive profitable growth, and where we needed to do something different or simply not to do it at all. I'll go on to say that the details I'll share end up differing all that much from our initial tops-down assessment. But getting the teams to engage with the data and the details and then framing it all to allow us to understand all of the downstream implications of our simplification work took a little bit of time.:]

[Whether it was customer, employee, or supply chain related, we needed to make sure that we got it right so that we could make decisions and move forward with the conviction and confidence it takes to do 80/20 the right way, which is a relentless prioritization around profitable growth. The punchline on the integration is that it's quickly becoming a single core business as we head into 2023, which bodes well in terms of realizing the expected synergies. And even more importantly, being in a spot to leverage our unrivaled product portfolio and solutions to drive better long-term growth and profitability by only focusing on what it is core to us.:]

[Please turn to page 5. To ground everyone on this page:]

when we closed the transaction and announced Q2 earnings, we talked about Elkay for the full year of 2022. And again, this is for the full year, not the half that we'll end up consolidating it having about $600 million of revenues and EBITDA margins in the 14% to 15% range. In our detailed work over the past 90 days, we went through each of the primary categories, specifically drinking water, commercial sinks, and residential syncs and accessories. Customer by customer, and SKU by SKU. We then had the internal debates, conversations with customers, and evaluation of our competitive position and long-term strategy, along with the detailed understanding of any collateral impact from our conclusions.

[What this page highlights is that, basically, inside the $600 million revenue business is a growing and profitable $485 million base business with real sustainable competitive advantages. And that as we execute our simplification and rationalization initiatives, it is actually more profitable at $485 million than it is at $600 million. And then there are synergies on top of this run rate. The core Zurn Elkay will be drinking water and commercial sinks. In both cases, we're the clear market leader with above-market growth and terrific margins. We'll be selective in where and how we play in residential, but it will be niche areas where it supports our overall strategy.:]

[I want to be clear about the portions of the residential market that we are exiting and also what's left. The pieces we're exiting really have no strategic value in a Zurn Elkay context. None of it conveys anything, or carries the Elkay brand, or was sold through our current set of wholesalers and reps. It's made up of private label, white label, source sinks and accessories of all different types of materials. And finally, products done for other OEMs sold through home centers. That makes no sense for us to continue to support. The slice of residential sinks we will stay in, call it, roughly $70 million will be Elkay branded, sold through our existing channels, reps and wholesalers, where we believe we do have strategic relationships and products that when paired with our commercial lines make a ton of sense in the market.:]

[The other thing to highlight is this isn't going to all happen overnight. We've got some contractual obligations we have to fulfill, and we also want to maximize the value of the assets and inventory associated with the exits. But this is the core of what we're going to build around. And it's our best estimate that we can exit this level of business and start at this run rate sometime in the second quarter of 2023. Hopefully, it's also more clear that the drinking water and commercial sink product categories share the same characteristics and look like the core Zurn business from a growth, profitability, and returns point of view.:]

[If you turn to page 6, I'll share a view of how we think the pro forma mix of the business looks after the rationalization. On the left, you'll see we're still aligned around the 4 highly profitable categories of specified water solutions that we have real competitive advantages and significant market shares in. On the right, we have a nice balance between new construction and retrofit replace, with significant U.S. institutional and commercial construction exposure. With institutional and the sub-verticals of education and health care being our largest exposure.:]

[We have residential comprising only 15% of the pro forma revenues, and leveraged primarily to our PEX product offering where we have a tightly focused strategy and our leverage to the material substitution trend in both residential and commercial. All in all, not wildly different than before. But we do think that by focusing 100% of our time on the strategic parts of our business will serve us well. When you look at this, over 95% of our revenues come from a #1 or #2 position. The reality is that being a #5 or 6 in residential sinks sold through home centers or online isn't something that we built our business case around.:]

[I'll turn it over to Mark to walk through the third quarter and the fourth quarter outlook.:]

[Mark Peterson:]

Thanks, Todd. Please turn to slide 7. On a year-over-year basis, our third quarter sales increased 82% to $418 million. The recently completed merger with Elkay, and the prior year Wade Drains acquisition, contributed 67% year-over-year growth. And the core business drove 16% growth with price realization contributing high-digit growth year-over-year and the balance of the core sales growth coming from our nonresidential markets and our strategic share capture initiatives. This growth was partially offset by a softening residential market. Water Safety and Control, hygienic and environmental, and flow control product categories all contributed to the core sales growth. Foreign currency translation reduced sales by about 100 basis points.

[With respect to Elkay, I'll provide some color on the third quarter. Our nonresidential business, which is comprised of drinking water and commercial sinks, grew low double digits on a year-over-year basis, driven by solid market demand in both product categories and improving price realization as we have quickly implemented ZEBS price realization standard work across all product categories within the Elkay product groups. The residential sink product group declined mid-single digits in the quarter as the improved price realization was more than offset by the overall softening in the residential market as well, as the $5 million of product line exits as we started our 80/20 simplification actions in the quarter and began to exit certain residential commodity, private label, and OEM sinks SKUs as Todd just discussed.:]

[Turning to profitability. Our adjusted EBITDA, excluding corporate costs, totaled $91 million in the quarter, and our adjusted EBITDA margin was at the high end of our expectations for the quarter at 21.7%. As Todd discussed earlier in the call, we moved quickly to integrate these 2 businesses into one. That said, we can only provide directional color on margins between the legacy Zurn business and Elkay as the cost structures are quickly becoming one.:]

[Starting with the legacy Zurn business, margins did decline approximately 100 to 150 basis points year-over-year as we anticipated, as the benefits of the sales growth, inclusive of price realization, our productivity actions were partially offset by the increase in material and transportation costs as well as our investments in our growth and supply chain initiatives. With respect to Elkay, margins saw a substantial improvement from low double digits in the prior year third quarter to mid-teens in the 2022 third quarter, driven by the accelerating price realization I discussed earlier as well as some early benefits from our integration actions, partially offset by some of the investments needed in the business as well as the adverse impact of material and transportation-related inflation. With respect to corporate costs, they totaled $7 million in the quarter as we had expected.:]

[Please turn to slide 8, and I'll touch on some balance sheet and leverage highlights. Our net debt leverage ended the quarter in line with our expectations of 1.5x. Pro forma for the adjusted annual expense run rate of approximately $27 million and the inclusion of cash utilization to pay off a legacy Elkay term loan to close as well as transaction costs related to the combination. As a result of the leverage reduction, we did trigger a 25 basis point reduction in our base term loan rate that goes into effect during the fourth quarter. As we look to the end of the year, we continue to anticipate ending the year at 1.2x to 1.3x net debt leverage.:]

[Please turn to slide 9, and I'll cover some of the highlights of our outlook for the fourth quarter. For the fourth quarter of 2022, we are projecting consolidated Zurn Elkay sales in the range of $350 million to $365 million, and our consolidated adjusted EBITDA margin to be between 20% and 21% in the quarter, inclusive of our corporate costs, which we expect to be approximately $7 million in the quarter. I'll come back to some of the details on page 9.:]

[Let's move to page ten and cover some of the items that on the back of our third quarter sales to our fourth quarter outlook. As you know, our fourth quarter traditionally has fewer shipping days as well as a seasonal slowdown in nonres construction activity as we enter the fall and early winter season in certain regions of the country. This seasonality primarily impacts the legacy Zurn side of the business given the product categories, and to a lesser degree, the Elkay product groups. Note that last year was an unusual year in Zurn as approximately $10 million in scheduled third quarter shipments shifted to the fourth quarter due to certain container delays. But if you adjust the prior year third quarter and fourth quarter for that timing issue, the usual Q3 to Q4 decline did take place.:]

[As both Todd and I discussed earlier in the call, we have accelerated our 80/20 simplification actions. Over the past 90 days, we've been able to thoroughly review the Elkay sales volume at a SKU level and customer level and have finalized the plan and simplify the business to focus on better growth, better margins, and better returns on invested capital. In late July, we had line of sight to at least $10 million to $20 million of exits in the second half of 2022. And with the completion of our analysis, we'll be exiting $25 million in the second half of 2022, with $5 million already taking place in the third quarter and $20 million occurring in the fourth quarter for an incremental $15 million of exits on a sequential basis from Q3 to Q4.:]

[Lastly, the residential market has softened from where we were 90 days ago. In the third quarter, we experienced a low double-digit decline in our served residential market. As we look ahead to the fourth quarter, we anticipate further declines in the residential market and have built that into our outlook as a year-over-year contraction of approximately 20% in the fourth quarter. It's important to note that our products that serve the residential market tend to be more of a stocked product. So the decline we experienced in the third quarter, and our assumptions for the fourth quarter, include market decline as well as destocking. The items I just covered walk our third quarter sales to the high end of our fourth quarter outlook. And given the fact that we are entering into the end of the calendar year and that the macro environment appears to be deteriorating, we believe customer sentiment and market behavior could be more volatile. And as a result, we are adding some additional conservatism into our outlook, as highlighted on the right side of the slide.:]

[Turning to profitability in the third quarter. At the midpoint of our guidance range for adjusted EBITDA margin and the midpoint of our sales range, the sequential decremental margin from the third quarter to the fourth quarter is less than 20%. Exits of lower-margin SKUs, improving price realization in the Elkay product groups, cost controls, and our continued actions to integrate into one business are all contributing to improved margins despite the lower sales.:]

[Before I turn the call over to Todd for some closing comments, I'll touch on a few additional outlook items that were on page 9. We anticipate our interest expense to be approximately $9 million. Our noncash stock comp expense should be about $8 million. Depreciation and amortization will come in around $22 million. Our tax rate on adjusted pretax earnings will be about 27% to 28%. And diluted shares outstanding will be approximately 179.5 million to 180.5 million in the quarter.:]

[With that, I'll turn the call back to Todd on page 11.:]

[Todd Adams:]

Thanks, Mark. Before we turn it over to your questions, I just wanted to cover a little bit about 2023 and some perspective. Hopefully, everyone appreciates the level of transparency we went through this morning. In an ideal scenario, we would have been able to lay off this entire simplification story last quarter or perhaps even before. But the reality is the amount of work, decisions, and conversations that needed to be had just took a little bit of time. We pride ourselves on simplification. And I think as we reflect on, and I reflect on, how the last quarter went, we're not happy with it. And so hopefully we're providing the amount of clarity with purpose this morning that you can appreciate. Obviously, the changes will have a huge impact not only the dollars of profit but a dramatic impact on the margins on a pro forma basis as we exit '22 and look to '23.

[We believe we're taking an appropriately cautious view on the fourth quarter, but I wanted to spend some time on 2023. From an end market perspective, we see record levels of nonresidential construction backlog and strong confidence indicators in the contractor community. The momentum around institutional construction continues to be very strong. Commercial construction will always be more mixed and super hyper local. In aggregate, we think the market will still be up next year, probably more so in the first half or at least more confidently in the first half than the second.:]

[So we'll continue to watch on how that develops. Our quotation volume, however, continues to be strong, and we're not seeing any material slowdown in demand whatsoever. Residential, as Mark highlighted, will without question be impacted. Near-term, we're seeing a kneejerk reaction across the board. The lagging impact from where mortgage rates have gotten to and are going is having an adverse impact on the residential side of things, but as you saw earlier, it's now only 15% of our business. And inside of that, multifamily should continue to see growth. And we have a highly variable model inside our residential served product lines. So the impact on profitability is relatively muted, relative to the other markets and product lines we have.:]

[After 3 years of challenge, I think we start 2023 with supply chain dynamics that are a lot more stable. Lead times are back to normal. Container costs are down dramatically. Understanding on how all that changes order behavior is something to watch, that we don't have all that much inventory at all sitting on shelves in wholesale or retail distribution. We're generally seeing live demand in our order rates, and we'll end the year with a smaller backlog than we started. But I think the net impact of all of that heading into next year is a positive, particularly when we monetize some of the higher cost inventory we have throughout Q4 and Q1, which means cash flow should be very strong. In our design for cure assembled test model will benefit from lower input costs and a strong U.S. dollar as we procure through our supply chain. And we're quite confident the combination of lower input prices, lower freight, and the inventory reductions will end up being a positive for the year.:]

[In a scenario where markets slow, we really don't have we don't have much in the way of fixed cost to absorb and the vast majority of our selling expenses are tied to variable rep commissions. And finally, we've got the benefit of $50 million of synergies flowing through the next 2 years with a great balance sheet. And our ESG profile continues to improve as we focus our business on the 4 key pillars of water. We're going to continue to monitor all of this over the coming months, but our takeaway is that as we look at next year, we think that the overall setup for our business is a lot more half full than half empty than a lot of other years at this point in time. Couple that with our resilient business model, the Zurn Elkay business system, and a great team, we sit here and believe we can deliver a ton of value both in the marketplace and to the shareholders over the coming years.:]

[With that, we appreciate everyone's time on the call this morning, and we'll open it up to your questions.:]

[Operator:]

[Operator Instructions] Your first question comes from the line of Bryan Blair with Oppenheimer.

[Bryan Blair:]

I appreciate the perspectives on 2023 setup. And I guess, if we can maybe offer a little more detail on how your team is thinking about the setup for growth on the nonresidential side. Of course, we're interested in your core verticals of education and health care, and how those projects are progressing as we approach the new year. And then on the resi side, I guess, the key question is just how much pain is ahead after the channel reset of Q3 and Q4.

[Todd Adams:]

Yes. I think as we look at nonresidential taken as a whole, institutional is approaching 50% of our overall business. And when you look at backlogs across the country, they're at near record levels. And when you think about the amount of time that it's going to take for that to roll through the build cycle, it's really all of '23 and probably part of '24. Our quotation levels are continuing to be really good. And so we believe that the market is going to be up next year in aggregate. I think commercial construction will continue to be more mixed. Obviously, the office segment of that is muted. But we're seeing growth in retail for the first time in 25 years.

[So I think that's really a very hyper-local game. So you might see a lot of activity in Florida and Texas and Southern California, and maybe not as much in the upper Midwest to the Northeast. So taken as a whole, we think the market is up next year, 1 to 3 points. I think we're going to monitor it over the course of the next 4 months and into next year. But I do think that the market growth in nonresidential is going to be there as well as in waterworks.:]

[And so far as it relates to residential, look, we took some of the pain in the third quarter. We're going to take some more in the fourth quarter, as Mark highlighted. But when you take a giant step back, housing is still underbuilt. There is going to be some level of new construction. Perhaps it's not at the same level as everyone thought 6 months ago. But the trend around multifamily, which frankly is sort of critical in the product lines that we have, should be contribute to be strong as people need places to live. And so I would say that for the next quarter or 2, I think residential is going to be a little dodgy. But hopefully, by the time we get to the second half of next year, we're on plan and it's not as big of a headwind as it was in the third quarter and the fourth quarter and likely will be as we start 2023.:]

[Bryan Blair:]

I appreciate that color. And with regard to Elkay, maybe offer a little more detail on how we should think about the cadence of continued 80/20 rationalization? It seems extremely first half weighted in terms of 2023 impact. And then on a net basis, how should we think about base earnings growth outlook, cross-selling synergies, and netting against the planned rationalization going on?

[Todd Adams:]

Yes. I think what we recognize, Bryan, is that it's going to be something that we have to over-communicate. I think what we tried to do with this morning was basically give you a pro forma look at 2022, if we were to have accomplished this all from there. What we'll do prospectively is take that $45 million, and that $92 million to $95 million of EBITDA, and articulate our results around that. As we go through the quarter, we'll obviously have some revenue related to the stuff we're exiting, but we'll try to isolate that and articulate how much is left to go. What did we exit in the quarter?

[And what you'll see, I think, is the margin profile for that core Elkay business continuing to grow. And so you'll see the growth in the core Elkay happening real time, quarter-by-quarter. So we'll try to be transparent around of the $485 million, what's growing from a market standpoint, what's growing from a pricing input, what's growing from a strategic initiative and cross-selling opportunity that may show up either on the Zurn side or the Elkay side. I mean, I think the big takeaway starting '23 is that it really is just one business with 2 additional really, really dynamite product lines that are now structured and being run like we're running the Zurn business. So we're going to do our very best to communicate and articulate around that kind of framework as we get into 2023.:]

[Bryan Blair:]

That detail will be very helpful. And I guess just to level set a bit more

[Todd Adams:]

Sure. When we made the announcement, we said approximately $700 million. Elkay had a budget of roughly $690 million. Obviously, the backlog reduction and all the noise that we talked about to get to the $600 million, that happened before we owned the business and obviously, what's happening in real time. When we went to our board and we evaluated this, we felt very confident that $60 million of revenue was stuff we were going to walk away from. And there was another, call it, $60 million under review. And I think that the details over the last 3 months have given us the conviction that that $60 that was under review was really something that we should walk away from.

[So when you look at the analysis, and the business case, and the approvals that we went through - when you look at year 3 and year 4, our return on invested capital is within 50 basis points of what we had using the base Elkay numbers. And the difference really being nothing to do with the walkaway decisions because we felt like we would be able to, through a combination of synergies and reducing fixed costs, make that a net positive. It really has to do with that lower starting point than maybe the $690 million. So I think our business case is very, very much on track.:]

[The push is probably less than 6 months when you look at the timing of when we get on the return on invested capital run rates that we had anticipated initially, relative to where we are today. And that's something we've looked very carefully at because the returns on invested cash for the deal and the industrial logic, the strategic logic, the financial logic is off the charts. And it probably just gets even incrementally better when you strip away some of the things we're walking away from. But I appreciate you asking the question because we continue to see the return targets very much, very much in line with what we said when we did the deal.:]

[Operator:]

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

[Michael Halloran:]

Just to follow up on one of the last couple of questions there. You're talking about $80 million or so of cold revenue having been executed on by the end of the year, and the incremental $35 million or so is what's going to be left to be executed on the front half of the next year as far as the run rate goes. Is that a fair thought process?

[Todd Adams:]

No. It's a little bit different than that, Mike. So we think we will have gotten at $25 million by the end of 2022, with the remaining $90 million to go in 2023.

[Michael Halloran:]

Was the $25 million an annualized number or a quarterly number?

[Mark Peterson:]

No. It's in the quarter.

[Todd Adams:]

In the quarter.

[Michael Halloran:]

Okay. So I guess I'm confused then. Why wouldn't you be able to annualize that number to get to the $115 million?

[Mark Peterson:]

I'm not sure I understand the question.

[Michael Halloran:]

So you're saying in the fourth quarter, you've called $25 million of revenue, or $20 million to $25 million of revenue, right? So is that an annualized number that represents the annual number? Or is that the revenue that is attached to that fourth quarter?

[Todd Adams:]

That is the revenue attached to the fourth quarter.

[Mark Peterson:]

Yes. $25 million out of this year, Michael. $115 million in total. If you walked 229 to '23, there'd be 90 more that would come out in '23 if you walk the year-over-year.

[Michael Halloran:]

Right. But I guess what I'm saying is, if you've got a 20-year or so run rate from the fourth quarter, you've executed on the 80 or so because that's the run rate from a full year perspective. And then what you're executing on from a remainder perspective is like 35%, or?

[Todd Adams:]

I think the issue, Mike, is you've got to start at $600, right? When you look at the reported revenues for the year that we thought 90 days ago, it was roughly $600 million. From there, we'll walk away from out of that revenue run rate basis. We'll walk away from $125 million. Or $115 million. I think what Mark said is exactly right. The $25 million is specific to the quarter; the $90 million will come next year, off of that $600 million run rate. So the numbers that we're going to be reporting will have the absolute impact of the walkway that happens in the quarter. We could have done it in a different way, saying if you would have started '21, it would have looked maybe more in line with the run rate that you're talking about. But since we're doing it from a static starting point, that's the level of walk away.

[Michael Halloran:]

Yes. I actually think we're saying the same thing, just different phrasing. I'll take it offline. It's not a big deal. So you talked about a balance sheet being in really good shape. The Elkay piece, you feel comfortable that you've made the right kind of strategic decisions to be able to execute on it. So what's the willingness to bring stuff in today? How does that pipeline look? And has the environment changed what that pipeline looks like, multiples, anything like that?

[Todd Adams:]

I think it's probably very early to say. But I think if we look at our pipeline of opportunities, it's pretty extensive and expansive. I think that we're going through an understanding of, "Okay, so how do these businesses and their outlooks get impacted by maybe what's in front of us?" There are certain things that are going to convert over the next 6 to 12 months because they look exactly like what it is we do. We have confidence in understanding what the market outlook is like. So I think it's relatively unchanged. I think the pace of the integration, and the capacity, and the team that we've built and have added to over the last 6 months gives us a lot of confidence that we can continue to do M&A.

[We think we can do it at the right levels to create great returns. And I think, things that fit really, really well inside of our core. And so I think there'll be a period of time where expectations need to get reset. We really have to understand in terms of value. But I think we're going to continue to do what we've been doing for a long time, which is cultivate things that sit inside of our core transact at reasonable levels, and integrate it well, and grow from there.:]

[Michael Halloran:]

I appreciate that. And last one, just on the destocking side. Based on the positive commentary in the nonresidential businesses, it sounds like there's no destocking needs there; if anything, maybe the opposite. Confirm that one way or another. And then also how long do you think the destocking is going to take to get to the right normalized level of inventory in the channel perspective on the residential side?

[Todd Adams:]

So you're correct. I mean from a nonresidential side, there's really not that much inventory at all throughout all the various channels. And so what we're seeing now are probably a little bit of lead times coming in, people being more cautious with order patterns and a little bit of backlog reduction. We think the vast majority of that is behind us in the fourth quarter. On the nonres side... I think that when you look at residential, we're taking a big whack out of it in the third and fourth quarter. There may be a little bit in the first quarter, but I don't think it's material in the grand scheme of things. So I think we get a clean sell-through the demand numbers late Q1 and into Q2.

[Our business is not a push model where we have a lot of stuff on the shelf. It's really a spec pull-through. So nobody is really procuring this before they need it, and there's really not much in the way of shelf inventory. I think we'll see this channel dynamic changed dramatically. The impact of lead times coming in, people being more cautious. I think that's going to be a case-by-case basis. But all that being said, as long as we're driving specification and preference, and we see this backlog continuing to be strong on the nonresidential side, I think the growth rates that we'll deliver are, broadly speaking, real-time demand.:]

[Operator:]

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

[Jeffrey Hammond:]

Just as we go back to the '23 look, can you give us a sense of how you're thinking about carryover price as well as outgrowth momentum in the core?

[Mark Peterson:]

Yes. I think, Jeff, from a carryover standpoint, if you think about next year, on the Zurn side, we have obviously had the pricing gain faster. We've done Elkay. We've made a lot of progress on Elkay in the back half. So when you think about pricing, I'd say on the Zurn-type product categories, you probably think about it as a low single-digit type number in the next year given the comps. On the Elkay side, given the fact that our back half is a little bit stronger in the first half, if you think about that as more of a mid-single digit on the Elkay side. If we're going to blend it together, it's that low to mid-single-digit range from a price realization going into next year, Jeff.

[Todd Adams:]

At this point, Jeff, we really don't have a view on pushing a lot more price heading into '23. We'll obviously continue to evaluate it. But as the world sits today with input costs coming down and everything else, we've got, I would say, a sizable tailwind of lower input costs. And so we want to leave ourselves in the room if we need to get a little bit sharper on pricing areas. We certainly have the carryover, and we certainly have the tailwind. So if you think about Mark's number in aggregate of, call it, low to mid-single-digit carryover, we think that the market on the nonres side is clearly up.

[We think res called it down a touch, and then some outgrowth. And so you can find your way to, I think, a pretty reasonable growth over the course of '23. How it shakes out by quarter will be impacted by some of the dynamics that we've talked about. But as I said in my comments, it's a little more half full than it is half empty when you look at the really concentrated, simplified business post some of these rationalizations.:]

[Mark Peterson:]

Yes. And Jeff, I missed your question on market output. If you think of what we're doing strategically, we feel any given year, we're trying to get 2 to 3 points right on the share capture side. We wouldn't feel any different about that this year than we have in the prior years, and our ability to execute on strategic growth initiatives.

[Jeffrey Hammond:]

Okay. Great. And then it looks like the water fountain in the commercial sink business grew pretty well. I think you said low double digits. Just talk about the order and quoting activity. Does that align with the legacy Zurn commercial? Or just how is that trending?

[Mark Peterson:]

Commercial sinks? Yes. I think it looks very similar to that element with our Zurn business, very similar product categories. I think what we've seen already is the power of having both brands in our portfolio. So I think from a growth standpoint, that category, both brands saw low double-digit growth in the quarter, for sure. In the third quarter. We expect that to be very similar in the fourth quarter.

[Jeffrey Hammond:]

Okay. And then just a last one. I mean certainly, with some of the Elkay resets, the stock has been under some considerable pressure here. Just how are you thinking, or have you revisited share buybacks as a use of cash or free cash flow generation?

[Todd Adams:]

We have. We have... what's the number left on there? Roughly $200 million.

[Mark Peterson:]

Call it 168 million.

[Todd Adams:]

$168, $170 million left on our repurchase plan. We also have a year of very, very strong free cash flow ahead of us. And so the combination of all that, you can work your way to a leverage number of half a turn by the end of next year without doing anything. And so as we talked a little bit earlier, we've got some M&A that we want to do. We want to keep the balance sheet pretty conservative as we go through this period of uncertainty. But share buybacks, should we feel it appropriate, are definitely on the table. We're confident in our ability to execute in '23 and '24. And if we see a situation that is a dislocation, at least in the near term, I think there's a chance that we may do something.

[I think the other part of it is, as we scale the business, we'll probably revert to a more balanced return of capital to shareholders through M&A, dividend, and stock buyback just like we did prior to the RMT. And so I think we're probably a quarter away from that in the moment. But I think that that's definitely on the table, and we do have the capacity to do that with the kind of cash flow and balance sheet profile we have.:]

[Operator:]

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

[Nathan Jones:]

I wanted to ask a question around the stickiness of pricing. You obviously had a lot of inflation flowing through this year. You talked about monetizing some higher-priced inventory late this year, early next year, which I guess implies that you'll have some lower-priced inventory coming along. How sticky do you think pricing is likely to be from the price increases that you've already put through now in a deflationary environment? And how accretive could that be to margins in 2023?

[Todd Adams:]

Yes. It's very sticky. When you look at specified plumbing products, the pricing is sticky, and I don't recall a scenario in the 15 years I've been around the business where it has not been. That being said, project by project, opportunity by opportunity, you have to be aware of what's happening amongst the competitive set. And we've seen a very orderly market to date. We would expect that to continue. And so if it plays out where the prices continue to be sticky, and we're selective where we choose not to be, there is a sizable tailwind coming through with lower input costs. And so we've left ourselves the room in the way we've thought about 2023 to be in a position to do that, but it's our position that the pricing is sticky.

[And if you look at the inflation that we've passed through relative to other products that go into nonresidential construction. If anything, we've fallen down the Pareto because we haven't seen the doubling of prices in some categories. And our price increases have been really to offset some of the input costs that we've managed really well. But based on our model, we don't have the fixed costs. We're not buying spot commodities. We're well-positioned to capture that tailwind. And when you think about what that could mean in the margins, it's significant. Even without all of that and some of it, we see pretty strong margin accretion into next year -maybe not even a double-digit growth sort of level. So I think our business model is built for this kind of environment.:]

[Nathan Jones:]

A couple of questions around Elkay. So I would assume that the revenue that you're exiting would have been lower growth than the revenue that you're maintaining. I think you'd already targeted Elkay over the long term to be a double-digit growth kind of business. Does this increase the expectation over the long term outside of any 2023 market disruption for the growth profile of Elkay?

[Todd Adams:]

I don't know that we would sign up to increasing that. But I think when you look at the categories, that really now make up and constitute the core Elkay, we absolutely think drinking water has a longer-term secular growth trend above what we have. And as Mark pointed out, with the relative market share we have in commercial sinks, we have a terrific opportunity to outgrow the overall market just because of the size, scale, presence, and spec nature of that category. And so I think maybe the way to think about it is a much, much higher degree of confidence around that kind of outgrowth as opposed to increasing the absolute outgrowth.

[Nathan Jones:]

And then just a last one. The exit of the residential sinks business, I would assume, comes with a fair amount of inventory liquidation. Can you talk about the cash generation that you should see from the exit of that business?

[Todd Adams:]

Yes, it will be sizable. Obviously, the inventory investment to support that portion of the business was not generating much of any trough that was outsized relative to the inventory positions in what is core. And so I think it's at least $25 million as we liquidate those inventories, and likely more.

[Operator:]

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

[Vivek Srivastava:]

This is Vivek Srivastava on for Joe Ritchie. Not to beat a dead heart here, but the $90 million that you exit next year on Elkay, assuming most of it is first half

[Todd Adams:]

I think the way the way Mike was talking about is more accurate, right? In this quarter, it's a $20 million impact. We had 5 last quarter, so putting them in the back half. Those actions, they do annualize, right? So as you think about the walk, yes. As I said on the walk, you got a $90 million impact year-over-year. But a big chunk of the actions have taken place you start annualizing those numbers. I think the way Michael is describing is accurate. So the annual walk as we laid out is intact, but a lot of the actions are taking place right now that will drive the incremental impact next year, and really more so in the first half of next year, not laid out.

[Mark Peterson:]

I think maybe to make it very simple, before any market price or strategic growth initiatives, run rating Q1 at $120 million, and Q2 at $120 million, and Q3. That's the base before we do anything, as we walk away from this.

[Todd Adams:]

That's the part I talked about. We're going to try to isolate that and communicate around what is that $120 million growing year-over-year? What are the margins related to that? And then we'll give you what we walked away from and the impact of that. But that's really the way to think about it.

[Vivek Srivastava:]

That's helpful. And I have a question on free cash flow. I think the color you provided on inventory liquidation - that is helpful. Anything else from the SKU rationalization which will impact your FCF conversion? And how should we think about your free cash flow conversion longer term?

[Todd Adams:]

Well, I think specifically as it relates to the fourth quarter, we're going to see free cash flow in the $90 million to, call it, $100 million range. If we think about 2023, we think that the inventory reduction across the enterprise is going to be sizable. And so free cash flow next year should be, I would say, outsized relative to this year. And then you've obviously got that liquidation factor that is going to be permanent. And so I don't think there's anything unusual. We've obviously got to pay for some of the restructuring and things like that to get the $50 million of synergies that we've signed up for and seen. But nothing outsize other than, I think, free cash flow next year should be very, very, very strong.

[Vivek Srivastava:]

And then I have a last one on revenue synergies quickly. Are you already starting to get some traction here? And maybe just if you can provide some color on what are the opportunities on this front? And any color on timing on this?

[Todd Adams:]

Yes. I mean we're in the throes of it right now. When you think about some of the ESR and HERR funding as it relates to secondary, post-secondary education, we're immediately adding to the conversations, not only around drinking water, but also around our BrightShield offering. And so we've targeted 25 school districts around the country where we're doing all the work to get at some of that funding. And we're seeing that convert real-time. And so we're leading with drinking water. And then I think we're in a position to pull through some of the other more hygienic products or vice versa, where we've had a good conversation started with some school districts around creating more hygienic spaces that we're now pulling through the drinking water. The opportunity around filtration that we highlighted initially is significant. The filtration opportunity amongst the combined business over the next several years is $50 million to $75 million of growth at very, very high margins. And so the commercial teams are already engaged in the field on some of these things. We're going through our strategic plan and how we deploy those. But I would say that the case of bringing these 2 businesses together, and being able to provide even more specified content to customers, is working.

[Operator:]

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

[Brett Linzey:]

Just want to come back to the $70 million of retained Elkay resi revenue that you're selling through the existing channels. Are these pieces closer to the corporate average? Or are these revenue pools that are maybe still under earning or mix negative that you think you can enhance the profitability over time and maybe review at a future date?

[Todd Adams:]

I think that they come in a little bit below the fleet average. But these are with our core wholesale customers. They are Elkay branded. They do have an element of conveyance with other products. So these are in sort of professional grade plumbing showroom type of products. And so there is without question, as we bring the 2 companies together, the opportunity to eliminate SKUs, work on continuous improvement to drive that up. I don't know that there is a meaningful price opportunity. But there certainly is cost opportunity as we bring the 2 companies together. And I think as you look at that

[David Pauli:]

That was the calculus in terms of why we decided to stay. I mean, it was branded products that have conveyance that we can improve the margins on and fit with our overall go-to-market through specification, third-party reps, wholesalers that we're strategic partners with, and things and the like. The other stuff really was totally detached and had a lot of resource and a lot of inventory tied up in it, and it was never going to be the kind of returns business that we wanted to create when we put these 2 together.

[Brett Linzey:]

No, that makes a ton of sense. And then just my follow-up, it sounds like you're progressing well on the integration efforts. Just in terms of the phasing of some of those savings and how that might have now changed relative to earlier expectations. I mean, do you think those ramp a little bit quicker here in Q4 and early '23? And just curious if there would be a change in any of the normal seasonal margin realizations than you would typically see on a quarterly basis, as you pull in these synergies maybe a little bit earlier next year and these rationalization efforts start to ramp up?

[Todd Adams:]

No, I think we're going to hit the ground running in 2023 with the synergy realization, as a result of the significant work we've done around creating these as product lines and moving on some of the costs that we had line of sight to. I'll leave it to Mark and Dave to communicate. I mean, obviously, you know our seasonal patterns. Our first quarter is generally lower than our second and third, and our fourth is as well based on the weather patterns in nonresidential construction. So I think they'll all be amplified from a margin perspective relative to where they've been solely because of the synergies that we're going to generate. But I don't know that it's outsized in any one quarter relative to the next.

[Mark Peterson:]

Yes, that's fair. We'll obviously provide more color as we get closer. But right now, we wouldn't say that it's overweight back half or overweight front. As Todd said, a lot of the actions are occurring now where we feel pretty good about being at that run rate going into next year. So there isn't really an outsize overweight quarter.

[David Pauli:]

It will be incremental to each quarter, I think. It is probably the way to think about it, right?

[Mark Peterson:]

Yes.

[Operator:]

Are there any closing remarks?

[David Pauli:]

Yes. 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 December quarter results in early February. Have a good day.

[Operator:]

This concludes today's conference. You may now disconnect.