Zurn Elkay Water Solutions Corporation
Q4 2022 Earnings Call Transcript

Published: 8 Feb 2023

[Operator:]

Good morning, and welcome to the Zurn Elkay Water Solutions Corporation Fourth 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 numbers for the replay can be found in the earnings release the Company filed in an 8-K with the SEC yesterday February 7. At this time for opening remarks and introduction, I will turn the call over to Dave Pauli.

[Dave Pauli:]

Good morning, everyone, and thanks for joining us on 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 certain 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. This is what we hope is a relatively straightforward call. We'll take everyone through what we saw in the fourth quarter along with some even more recent trends will also lay out what we believe next year could look like which is broadly reflected in the current consensus and then we'll get back to work and execute to maximize what we are actually holding ourselves accountable to. After a couple of years of big transformative transactions to completely change our business to a premier pure-play water business, this upcoming year is simply about executing on what's right in front of us and we really like our hand. It's also not lost on us. The noise of the past few quarters is not what investors expect of us, and realize the only way to do something about it is to execute at a high level, and so, that's what we are going to go do. There were a lot of facets to 2022, including some real challenges and some more perception based. The good news is that over the past six months, we've acted quickly got to the core of what the new Zurn Elkay is and can be. And the overall cadence at which we've operated historically is fully embedded across the new Zurn Elkay to start 2023 just six months after the close of the deal. The third-party rep changes 80-20 simplification decisions, integration planning, supply chain constraints and extended lead times are largely all behind us and now it's about leveraging the Zurn Elkay Business System to drive performance and build upon our competitive advantages. As Mark will discuss the fourth quarter was impacted by some near-end macro issues, including a weaker residential market and some wholesale inventory destocking that is also now essentially behind us. And what's been a pretty eventful last three years, I think it's important to highlight the strength of the legacy Zurn business, which has grown the top line at a compounded annual growth rate of 14% since 2019. If you could turn to Page 4, we've just taken our Board through our three-year strategic plan, and with that as a backdrop, we decided to take the opportunity to formalize a more comprehensive and balanced capital allocation strategy as we start 2023. It's grounded in the resilience of our business, strong balance sheet, and consistently high free cash flow profile we see over the next several years. And our commitment to delivering exceptional shareholder value. Our view of the intrinsic value of the company is materially higher than it sits today. And as a result, we are integrating a significant share repurchase plan into our near to medium-term capital allocation strategy. Our current dividend yield of $0.28 on an annual basis represents a current dividend yield of about 1.3%. We're committed to continuing the dividend and we'll look to review any increases to that annually, given the fact that we just increased the dividend in our third quarter this is something we'll look at over the course of the year and then obviously moving forward. The $500 million buyback represents about 13% of our current market cap in a size and concert with maintaining a leverage profile between 1 time to 2 times while also accommodating macro-driven risks in the economy over the next couple of years. For 2023, the minimum repurchase will be $100 million, and it's something that will be both programmatic and opportunistic about. Finally, M&A has historically been important to us to fill in product categories and enhance our competitive advantages within our portfolio as a bolt-on tuck-in level. The Elkay transaction was transformational and provides us multiple levers to enhance our core growth over time while we continue to cultivate other opportunities. For this year, think of us as singularly focused on delivering the value we see and saw in the combination with Elkay. The punchline is we believe this formalized comprehensive approach provides even more levers to drive shareholder value, and as you see in the release, we've already been executing on it across all fronts with 25 million of shares repurchased in the fourth quarter. I'll move on to Page 5. I touched on our strategic plan just a minute ago, which is our 15th plan since the original Zurn acquisition in 2007. What started as a carve-out diversification play for a private equity-owned multi-industry business and part of the prior Rexnord has now become our core business. And we've taken it a step further with the Elkay transaction last year. As we developed the now Zurn Elkay Business System, one of the significant pieces of learning and change over time has been the benefit of pure focus. And when I say focus, what I really mean is an 80

[Mark Peterson:]

Thanks, Todd. Please turn to Slide number 10. On a year-over-year basis, our fourth-quarter sales increased 46% to $340 million. The recently completed merger with Elkay contributed 50% year-over-year growth while foreign currency translation reduced sales by 100 basis points from the prior year and core sales declined 300 basis points sales to our residential end markets down 30% and sales to our non-residential end markets expanding low single-digits versus the prior year fourth quarter. Our Fourth quarter sales were impacted by two things. During the quarter our lead times continue to improve and are back to historical normal levels. At improvement -- at a near-term impact on order patterns from our channel partners in the quarter as reacted to our improved lead times. In addition, our residential end markets were approximately 10 points tougher than we had anticipated heading into the quarter. With respect to Elkay in the quarter, I'll provide some color on the fourth quarter, update on demand trends in 80

[Operator:]

[Operator Instructions] We will take our first question from Bryan Blair from Oppenheimer. Please go ahead.

[Bryan Blair:]

Thank you. Good morning, guys.

[Mark Peterson:]

Good morning, Bryan.

[Todd Adams:]

Good morning, Bryan.

[Bryan Blair:]

I was hoping you could offer a little more color on the impact of destocking in Q4 and perhaps offer your views on channel position in Q1 where we know that the resi remains on a downward trajectory for the time being that's unsurprising. More so curious the trends and then any insight you can offer on the non-res side and how we should think about Q1 impact and then going into the seasonally stronger quarters?

[Todd Adams:]

Yes. Bryan, it's Todd. I'll start and then Mark will sort of fill in some of the blanks. Fundamentally, the order patterns really sort of in the back half of November into December. We're sort of unprecedented in terms of how weak they were and a lot of it materially driven by wholesale inventory destocking as our lead times came down. And so, when we crossed over the year and have gotten through January and sort of most of the first couple of weeks of February or at least first week of February, it's sort of much better than it has been and I would say obviously there is not a lot of inventory where non-res products in the channel. So, what we saw was maybe a lot less inventory destocking and also a combination of our lead times coming in and being sort of back to normal. And so, our order patterns really through the first five or six weeks here have been, I would say very much in line with what we would expect to see at this time a year, and then obviously ramps heading into the busier parts of the middle of the year for us.

[Todd Adams:]

Yes, I think just to put some numbers in the first part of your question. Bryan if you think about the outlook that we had and let's use the midpoint as a simple starting point. We fair to say if you look at the delta from there to $340 million mid to high single-digit millions will be coming from the residential decline and the balance that are really coming from that Todd talked about from the order pattern. So, that's just kind of put some numbers to what Todd was discussing.

[Bryan Blair:]

Okay. Appreciate the color. And if we think of your core non-res outlook growth in the mid-single-digit range. How are -- as your team contemplating the growth trajectory for your key verticals you discussed education, specifically any context of the Elkay opportunity, but that is your largest end market and there are even broader opportunities beyond what was presented their funding backdrop seems quite good. Any incremental color you can offer in education and then of course healthcare matters quite a bit as well?

[Todd Adams:]

Yes. Again, I think half of our non-res is -- are those two verticals, which as you pointed out, continue to be quite good. I think the initial framework that we've laid out certainly the hedges, all of that growth to get to the range that we're sort of talking about in that mid-single-digit range. I think we're going to take an intentionally cautious view to start 2023. But I think qualitatively from an end market standpoint, those two are actually still quite good and obviously, with the drinking water opportunity we see in schools and the way we're investing, we certainly hope to do better than that. So, I would characterize it as sort of a cautious way to start the year and with a variety of outcomes that are going to play themselves out over the next 11 months. But I think we feel really good about those two verticals in particular.

[Bryan Blair:]

That makes sense. One last one if I may. Thinking about 2023 EBITDA guidance. Maybe walk us through the bridge starting with $265 million in '22. How to think about a year-on-year contribution from core Zurn the full year of Elkay contribution and then layering on deal synergies and within to that perhaps how you think of the potential risk to the framework and well also upside to that range?

[Todd Adams:]

Sure. I think if you were to pro forma '22 to include sort of a more full year of Elkay, you really start the year closer to $300 million. Obviously, we've got $25 million of synergies. And then if we get some of the growth we expect you find your way to the higher end of the range. Obviously, as Mark pointed out, we're chewing through some of that high-cost inventory to start the year. And so, I think the framework around guidance really puts a premium on just executing at a high level to start the year worked through that high-cost inventory and then obviously get the synergies from the Elkay transaction that we're highly confident in, and we're starting the year with the range of $325 million to $345 million. I think we're optimistic that if we execute well and the world sort of hangs together. We've got a chance to clearly end up inside that range at the end of the year. Throughout a variety of different scenarios rather than try to walk it for you Bryan, I think that's more the context of how we're thinking about it.

[Bryan Blair:]

Understand. Thanks, again guys.

[Operator:]

And our next question will come from Jeff Hammond with KeyBanc Capital Markets. Please go ahead.

[Jeff Hammond:]

Hi, good morning, everyone.

[Mark Peterson:]

Good morning, Jeff.

[Jeff Hammond:]

So, just wanted to go back to the margin ramp. One, can you just talk about how much of this accelerated investment falls into Q1? And then just maybe talk through a little bit more of the higher cost materials because it seems like you guys have been pushing price and staying ahead and now it seems like you're kind of maybe having a price cost issue in 1Q. And then just the cadence of the synergies? Thanks.

[Mark Peterson:]

Yes. Jeff to start with the high-cost inventory I think it's been headroom we fought over the course of the year, and this is really expected the same phenomenon with the fact that price, yes, it's discovering the higher inventory cost but its adversely impacting margins as we're not been generating a normal incremental margin on those price dollars. So, I think it kind of came to ahead in the fourth quarter into the first quarter and I think we're at the point where we're still covering the cost, but the margin pressure is just peak at this point in time. So, I think, as Todd mentioned, look we feel good about working through that. During the second quarter is also part of the margin progression. Over the balance of the year is that finding is a way to more of a -- let's say a normalized incremental margin on the price and then getting some benefit in the back half of the year as the price we put in place last year fixed is and you start getting all the full benefit of improved transportation costs and in the commodity environment. As far as investment goes, again H1 weighted given some things we're trying to get in front of around safe drinking water, marketing campaigns getting pretty aggressive with that early in the year. So, think about that is something that we're going to be again weighted heavier in the first half and in Q1 probably being the heaviest overweight quarter of all of them. And that will slowly reduce as the year progresses. And Elkay synergies, think about relatively flat over the course or I should say consistent -- with the course about $25 million, let's start with that $6 plus million in Q1, a couple of things got to get done in this quarter, but then kind of getting back to that little over $6 million cadence over the balance of the year to equal of the $25 million. So, I think a long-winded answer to your question, but hopefully I covered, and then you're trying to touch on.

[Jeff Hammond:]

No. That's very helpful. And then just on some of the non-operating items, just can you walk through what's driving the higher tax rate and the interest rate looks hardly high for $540 million of debt? So, just maybe hit those two items?

[Mark Peterson:]

Yes, interesting, we've just kind of use the forward curve assume interest rates stay high for the balance of the year. So, we were hopefully, a little sooner than that. But we're assuming that they stay elevated over the balance of the year using the forward curve for 2023. Tax rate, tax is really a functional some timing of compensation that ties in this [161] adjustment as effectively a fixed tax item that this year just increases for us for numerous reasons. So, it's not a variable element to deal with. I'll also say too, Jeff and our tax rate, we don't assume any equity exercises of the year to the extent that our equity exercises that would drive the rate down, people exercise any form of equity. So, we assume that doesn't happen in our base rate. So hopefully, there's a chance to do a little bit better than that over the course of the year.

[Jeff Hammond:]

Okay. Thanks, guys.

[Operator:]

Our next question will come from Mike Halloran with Baird. Please go ahead.

[Mike Halloran:]

Thanks. Good morning, everyone.

[Todd Adams:]

Good morning.

[Mark Peterson:]

Good morning, Mike.

[Mike Halloran:]

I just want to make sure I understand the dynamic and how you're thinking about the cadence or the growth cadencing through the year on the non-res, it seems like the first quarter is simply sellout still strong but selling a little softer as the order patterns normalize. But beyond the first quarter, the expectation is to have sell-out sell-in be more aligned. And therefore the commentary on the end market strength coming through more fully in your numbers, right? I mean it's just as simple as that.

[Mark Peterson:]

That's it, Mike.

[Mike Halloran:]

Good. So, Mark touched on some of the growth initiatives, talking about some of the promotional activities. Maybe just highlight some of the other things you guys are working on the growth side of things, on the Elkay piece that you think you're going to gain traction as we work through the area?

[Mark Peterson:]

Well, I mean again I think we are leading with safe drinking water and obviously, adjacent that filtration. And so, I would say the thrust of what you're going to hear us talk about what we're focused on are really those two things. Obviously, we've got some other opportunities, particularly around building upgrades at MRO now that we have the entire package between all the hygienic products that we had historically and now pairing that with drinking water in sinks. So, the way to think about what we're focused on is really that drinking water piece, but also the leverage we're getting out of having this broad portfolio that we have sort of unrivaled the ability to specify that spec it -- pull it through it's an advantage for building owners, it's been a hit with the wholesale community and we're really excited about that first turn of traction we're getting with our newly instituted third-party rep network. But as relationships and in territories where we went through a lot of change over the course of the last year. But now six to six months in, we're really starting to see the traction of driving change and preference in share opportunities with the new fully constituted portfolio.

[Mike Halloran:]

And then -- thanks for that. And then the last one if I may. So, the share buyback commentary makes a lot of sense. And I just wanted to clarify something from your prepared remarks, it sounds like you feel comfortable that given the cash flow situation and the leverage levels on the balance sheet that you'd be able to do a complement of buyback as well as strategic M&A. And then just flex the buyback piece if the M&A opportunities ramp. Is that a fair thought process?

[Mark Peterson:]

Yes. I think the way to think about it, really, over the course of the -- at least as we start the year here is we said a minimum of $100 million. If you think about the earnings sort of range that we've provided, and then the $200 million of cash flow you can see that you end up in a leverage scenario that is frankly below where we are today at the end of next year. And so we do have room to do more on the buyback, and we also have room to continue to cultivate some of the bolt-on tuck-in activity that we historically do. And so, I think that this framework at least initially accommodates sort of a very balanced view of the world with the opportunity to do more on the buyback than clearly the $100 million.

[Mike Halloran:]

Appreciate that. Thanks.

[Mark Peterson:]

Thanks.

[Operator:]

Our next question will come from Joe Ritchie with Goldman Sachs. Please go ahead.

[Vivek Srivastava:]

Thanks, good morning. This is Vivek Srivastava on for Joe Ritchie.

[Mark Peterson:]

Okay.

[Vivek Srivastava:]

My first question is just on the residential side. So, now that you are exiting the residential sink business on Elkay. Can you help us understand how much residential exposure is left in Elkay? And then on the Zurn side given the demand for residential is lower this year, help us understand how you're managing factories throughput in this demand environment?

[Mark Peterson:]

Sure. Vivek, really I have just one company. And so, we're not going to talk about it as Zurn or Elkay. It's one company. The residential exposure of the entire company is probably in the 12% range of total sales, maybe 13% today. So, all that sort of non-Elkay branded home center, private label business is the stuff that we've decided to walk away from. And if you were to look at how are we managing the production of that portion of our business, we're managing it very much like we manage the rest of our business. We have a combination of third-party suppliers. We do some assembly and test, we do some late point modification. And so, just like we manage the rest of our business we're flexing those product categories, those cells to meet what we see as the current demand. So, nothing different and frankly just sort of one business in aggregate.

[Vivek Srivastava:]

That's helpful, thanks. And then maybe just zooming in within the non-residential vertical, how much office exposure do you guys have? And the demand for days like in the office vertical days lower build rate and occupancy. So, any concerns on demand this year on the office side?

[Mark Peterson:]

Yes. I mean, I don't think there is a specific call out there. I mean if half of the business is institutional. There is a sliver of office and I don't think that there's anything that I could sort of give you qualitatively that makes me excited one way or the other. It's not been a big part of our business for really at any point in time, and obviously, the somatic no one's ever going to work again. So that part is dead, it's sort of played itself through. So, I'm not sure exactly how to characterize what you're trying to zoom in on there, but I wouldn't think of it as a significant headwind or frankly tailwind to our business whatsoever.

[Vivek Srivastava:]

Thank you. That's helpful.

[Operator:]

And our final question will come from Nathan Jones of Stifel. Please go ahead.

[Nathan Jones:]

Good morning, everyone. I'd like to go back to this safe drinking water for students' slide that's up there and specifically the $2.9 billion TAM that you've put up there. Elkay obviously has a very large market share of what that TAM would be. Can you talk about what kind of time period you would be looking to address that opportunity. How much of that you'd think will actually be realized? I mean $2.9 billion with Elkay's market share would be extremely needle-moving for the company. So, just any more color you can give us around that?

[Todd Adams:]

Well, Nathan, I think it's the reality of having a large aged infrastructure in this country. And I think we've been fortunate to develop products that are beginning to replace some of that large age infrastructure, but it's been done at a product level as opposed to these devices is actually provide safe drinking water and in many cases in schools for kids. And so, I think where we're headed with this is to begin to again as Mark said begin to help shape the narrative around what the opportunity is. There is some broader awareness and then obviously book and that with providing the right kind of filtration to ensure that when you drink out of these things, you know that the water is actually safe. And so, I think we've taken a cut at it three years out, and as we talked about measured in the hundreds of millions of dollars. And so, we're just going to continue to sort of go back to work and begin to build this thing out. Bolt-on, the conversion strategy as well as the filtration strategy, but I would say that we would see it in the hundreds of millions of dollars over the next call it three years.

[Nathan Jones:]

So, that $2.9 billion would be the opportunity if we kind of rated the 131,000 K-12 schools. And we got somebody to pay for it all?

[Todd Adams:]

[technical difficulty] as a country and really, really sort of had a timeline. Yes. And that's a conversion that's over I wouldn't even big to guess the number of years, but it's 10 plus years, but it's a big number. Yes. It should continually be refreshed over time. So, it's a TAM, it's going to continue to grow as we install more units. But that's a big number for sure.

[Nathan Jones:]

Got it. That makes sense. Okay. So, I'm going go back 12 months to the announcement of this Zurn Elkay deal. The deal deck that they had 2023 EBITDA target of $425 million to $450 million. Obviously, a lot has changed over the last 12 months. High rates, versus resi you've got -- this year, you've got some price cost stock in the first quarter. Can you talk about the things that need to happen to get back on to a path to that kind of number, whether they are recovering end markets, things that you guys need to do internally, or whatever else the contributing factors are to get us back onto a path to that kind of target that was laid out a year ago?

[Todd Adams:]

Sure. I think the biggest is obviously the embedded run rate. In 2002, for Elkay frankly was behind the curve, and I think it's been a well-traveled story really since we announced the deal. The combination of the change in the rep network, in the lead times coming down and a lot of different things created a little bit of a hangover in '22 that we're going to think about '23 is a really strong down payment on getting that back on track. And I can tell you that we feel very good about that. The residential piece of both our business and the combined business, we certainly didn't have that dialed into what we thought '23, '24 could look like back in February of '22. So that's obviously a piece, but I would say the vast majority of things to get us on that trajectory are in our control. There's nothing structural, there's nothing permanently off track. The $50 million of synergies are on track. Obviously, we had a double-digit top-line growth plan for Zurn at that point in time we don't have that today is what talked about, we've got a more conservative growth rate. And so, I would think about '23 is sort of a strong down payment on getting back on that kind of trajectory and obviously, a lot of it has to do with the macro side of life that is out of our control.

[Nathan Jones:]

Great. Thanks for taking my question.

[Todd Adams:]

Yes.

[Operator:]

And that will conclude today's question and answer session. At this time, I'd now like to turn the call back over to Dave Pauli for closing remarks.

[Dave Pauli:]

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

[Operator:]

And that will conclude today's conference. Thank you for your participation and you may now disconnect.