Zurn Elkay Water Solutions Corp (ZWS) 2007 Q2 法說會逐字稿

Good day, everyone, and welcome to today's Rexnord Corporation conference call to report second quarter fiscal year 2007 results. Today's call is being recorded. With us today is Bob Hitt, Chief Executive Officer, and George Moore, Chief Financial Officer. Please go ahead, gentlemen.

Good morning, and welcome to the Rexnord investor conference call to discuss our second quarter financial results for fiscal 2007. My name is Todd Adams, Controller and Treasurer of Rexnord. With me this morning are Bob Hitt, President and Chief Executive Officer, and George Moore, Executive Vice President and Chief Financial Officer of Rexnord.

During today's call, Bob will highlight our accomplishments this quarter and also provide additional commentary about the industry. George will then discuss the financial results for both the quarter and year to date.

After this discussion, we will open up the call to your questions. Both Bob and George's commentary will be based upon the quarter and year to date results contained in our earnings release and Form 10-Q, ignoring the predecessor/successor accounting presentation required under GAAP as a result of the Apollo acquisition. We'll be limited in our comments during the Q&A session regarding our pending acquisition of Zurn, as that transaction is subject to Apollo's acquisition of Jacuzzi.

A replay of this call will be available for a period of one week, and the phone numbers for the replay can be found in the earnings release we filed and an 8-K yesterday with the SEC, which is also posted on the Company's website at www.rexnord.com.

Before we start, I'll refer everyone to our earnings release and form 10-Q filed yesterday regarding our view on forward-looking statements and risks. I'd also like to remind everyone that any forward-looking statements made on this call, including the Company's current expectations with respect to the completion of the proposed Zurn transaction, future market conditions, future operating results and other plans, represent management's best estimate as to what may occur in the future and are intended to fall within the meaning of the Private Securities Litigation Reform Act of 1995. Even though the Company believes the expectations reflected in such forward-looking statements are based upon reasonable assumptions, it can give no assurance that its expectations will be attained. Finally, our business is subject to various risks and uncertainties, so please refer to the risk factors outlined in our reports filed with the Securities and Exchange Commission.

Additionally, within this call, we may use some non-GAAP measures, such as adjusted EBITDA, as an indication of underlying operating performance. The Rexnord definition of adjusted EBITDA starts with EBITDA as defined in the Company's credit agreement and is defined as earnings before interest, taxes, depreciation and amortization, with additional provisions for add-backs of certain restructuring expenses, other income and expense, LIFO income or expense, stock option expense, as well as certain adjustments to reflect the benefit of cost savings implemented in prior periods that weren't included in our prior period reported earnings. Other companies in our industry may calculate EBITDA differently. EBITDA is not a measure of financial performance under GAAP and should not be considered as an alternative to cash flow from operating activities or as a measure of liquidity or an alternative to net income as indicators of operating performance or any other measures of performance derived in accordance with generally accepted accounting principles. Because EBITDA is calculated before recurring cash charges, including interest expense and taxes and is not adjusted for capital expenditures or other recurring cash adjustments-- cash requirements of the business, it should not be considered as a measure of discretionary cash available to invest in the growth of the business.

With that, I'll turn the call over to Bob Hitt, President and Chief Executive Officer of Rexnord.

Good morning, and thank you for joining us on the call today. I'm sure you have already reviewed our press release, outlining our second quarter and year to date results. But let me emphasize how pleased we are with this positive performance as we continue to drive our growth through intense customer focus, the margin expansion and cash generation that we've been going after for quite some time.

I would like to take a few minutes to review some of the highlights for the quarter and then give you an overview of the industry as we see it and provide some insights into our accomplishments. First, if you look at some of the highlights, our sales grew 9.1% from last year's second quarter, really as a result of the strength in our industrial product end markets, such as the natural resource extractions, metal processing and infrastructure expansions, as well as strong demand for our aerospace products. The adjusted EBITDA increased 14.9% to $54.8 million, and margins expanded from 90 basis points to 18.4%. That's due to synergies in fixed cost reductions achieved from the integration of the acquisition of Falk last year. Also, with the Rexnord Business Systems, we've continued emphasis on that as well. In addition, we reduced debt by $29.2 million since the July 21 acquisition from Apollo; and, therefore, our leverage declined from 6.8 times to 6.3 times as a result of debt reduction and from the strong earnings growth in the quarter.

From an economic environment and its impact on us, from a commercial perspective, we continue to see solid underlying order demand in the second quarter, albeit at a slightly lower rate than we experienced through our fiscal year '06. But, before I talk about Rexnord specifically, let me give you some industry data. It's true that we experienced some softening within broad economic indicators that we watch closely, and I'm sure all of you do as well. For example, the data from the Institute of Supply Manufacturers continues to show strength, having grown for 42 consecutive months through October. However, as you know, the index was only at 51.2, the lowest mark since the index turned positive, which is anything above 50 in May of 2003. We've also seen the U.S. industrial output fell slightly in September, 0.6%. And, also during September, capacity utilization fell somewhat, to 81.9% from 82.5%. But, it's still 2 points above the prior September. Yet, despite all that, much of our end market demand remains good. For our industry, the Power Transmission Distributor Association members, which we watch very closely, sales were up 11.1% through the first eight months of 2006. I will note July and August specifically were strong. In fact, I believe those months were in the 14-point range. So, it's up still very handsomely.

Also, our channel remains healthy, with sales to the inventory ratios up 10.1 times at the distributor channels versus 9.1 times a year ago. So, in fact, it's the highest rate that I personally have seen. This is a positive trend we have seen during the last four months versus the prior year. Also, the mining and cement industry outlooks remain favorable, with mining expected to grow at plus 6% in '07 and cement an additional plus 3% in that same period.

So, what's this all mean for Rexnord? Generally, business conditions in most of our industry markets remain strong. Natural resources, energy, aerospace, and food and beverage are all performing well. We continue to see robust demand in our aerospace products with orders currently running ahead of last year's record pace. Some areas, such as forest and wood products, as well as some construction equipment, are moderating, as you would expect with the residential construction housing market softening. But, overall, Rexnord's order growth in the quarter was 9.4%, and, through the first half of fiscal 2007, orders were up 10.8% compared to the first half of fiscal '06. The numbers were adjusted to include Falk for the entire six months in the prior year, so that is in there. And, the solid order growth has translated into an order backlog that currently sits at almost $377 million. In fact, it's up 22% compared to the end of March and up 38% compared to one year ago. In fact, in the quarter, our backlog went up by $28 million.

Let me now reflect on some business accomplishments we've had. You can see that the market is still growing, maybe not as robust in some segments. But, Rexnord's long term outlook remains positive.

Now let's take a look at some of our other accomplishments in the quarter that will help us in terms of the trends. As we discussed on our last call, we acquired a business in China during the quarter. We're very excited about the longer term prospects that this acquisition provides us. More specifically, we believe we'll gain additional manufacturing capacity, adding to our growing presence in China; and it gives us a solid low cost country manufacturing capability, giving us the ability to serve our U.S. customers and provide manufacturing to the Chinese market as well.

Additionally, on October 11, we announced that Rexnord is in the process to acquire Zurn's order management business from an affiliate of Apollo Management, pending, of course, Apollo's successful acquisition of Jacuzzi. We'll be buying this business for approximately $950 million, which will be separated from the Jacuzzi bath and spa business, which affiliates of Apollo are purchasing separately for approximately $450 million. The transaction is expected to be [inaudible] neutral for Rexnord, and we're pleased about the prospects this acquisition brings and see it as an excellent strategic fit within Rexnord. Zurn's market leadership, its leading brands, high margin businesses are extremely complementary to Rexnord's power transmission platform and will significantly enhance our profile as a high quality, multi-platform, industrial company. We expect this transaction to close some time in the first quarter of '07.

Also during the quarter-- We're pleased to announce that George Moore joined our organization as our Chief Financial Officer. George's prior experience at Danaher and, most recently, as CFO of Maytag really truly a welcome addition to the Rexnord team. We're delighted to have someone of his caliber on our team.

So, as we look at the first six months of '07, I'm pleased with the favorable results we posted and really thank all of our associates for their efforts in driving this positive outcome. Our underlying performance of sales growth of 8.9% and adjusted EBITDA growth of 17.5% compared to the first half of last year truly demonstrates the progress we've made on critical commercial and operational initiatives that we've instituted. Heading into the second half of '07, I feel we're well positioned to expand our growth and drive margin expansion by continuing to implement the Rexnord Business System throughout the Company. And, yes, we continue to see positive results with that. One example of that, for example, would be on our productivity side. We improved productivity an additional 6.4% year over year in the quarter.

With that, I'll turn it over to George to provide some in depth financial information regarding our second quarter performance.

Now I would like to provide you with a financial overview of the second quarter and some insight into our debt reduction activity.

Let's start with sales. For the quarter, sales were $298 million, or 9.1% higher than the second quarter of last year. As Bob mentioned, much of this increase is the result of the strength in our industrial products and markets of natural resource extraction, metals processing and infrastructure expansion, food and beverages, as well as strong demand for our aerospace products. However, a favorable currency translation added approximately 1% to the growth compared to the prior-year quarter.

Gross profit in the quarter was $90.8 million, or 30.5% of sales, compared to 31.8% in the second quarter of a year ago. Gross profit margins in the second quarter of fiscal 2007 were negatively impacted by non-cash adjustments made to the fair value of our inventories as a result of the Apollo acquisition. The impact of these non-cash adjustments to gross profit margins in the quarter reduced reported margins by 170 basis points. In the prior year second quarter, the 31.8% reported gross profit margin was favorably impacted by 70 basis points as a result of LIFO income recorded in the quarter.

SG&A in the second quarter was $55 million, or 18.5% of sales, compared to $48 million, or 17.6% of sales, in the second quarter of last year. The increase as a percentage of sales is driven by higher stock option expense, $1.2 million, or 40 basis points, from the adoption of FAS-123R and higher depreciation expense, $1 million, or 30 basis points. The remaining increase in SG&A as a percent of sales was driven by higher severance costs in the period as compared to the prior year.

We incurred a loss from operations in the quarter of $18.7 million, driven by $46.1 million of transaction-related costs associated with the sale of the company from Carlisle to Apollo and Rexnord management.

Adjusted EBITDA in the second quarter was $54.8 million, or 18.5% of sales. Included in the add-backs to arrive at adjusted EBITDA are transaction expenses, stock option expense, the impact of purchase accounting fair value adjustments, required reserve adjustments under predecessor/successor accounting, and other income and expense.

Interest expense in the quarter was $32.3 million, reflecting the additional interest on the increased indebtedness arising from the Apollo acquisition. It is worth noting that in the quarter we did fix and hedge $330 million of the total $610 million variable rate term debt outstanding through a combination of interest rate swaps and interest rate collars, resulting in a total debt structure that is currently approximately 80% fixed and 20% variable.

An income tax benefit of $14.9 million, or 29% of pretax income, was recorded in the quarter. This compares to a tax rate of 42% in the prior year second quarter. The tax benefit in the quarter was reduced by an increase in the valuation allowance for foreign tax credits generated and state NOLs incurred that are not likely to be realized.

Looking at our balance sheet as of September 30, 2006, you will note that it reflects the preliminary purchase price allocation associated with the Apollo acquisition. We anticipate that in the one-year period after the acquisition, we will continue to refine the purchase price allocation and make the appropriate adjustments to the balance sheet in future quarters.

A few notable purchase price and fair value adjustments that you should take note of include the following. A net $15.6 million non-cash adjustment was made to increase inventories to $229.9 million at September 30 to record inventories at their estimated fair values. Pension and other employment benefits, or [OPEV] liabilities were increased $13.5 million. That is $11.1 million for OPEV and $2.4 million for pension to $128.2 million to reflect the combined plan's funded status on the Company's balance sheet as of the date of the acquisition. We recorded an incremental $411 million of identifiable intangible assets, bringing the total to $547 million as of the acquisition date. We've subsequently begun to amortize this throughout the quarter, bringing the balance at September 30 to $539.6 million. Fixed assets were adjusted upward by $24.5 million to $374 million. We subsequently reported capital expenditures and depreciation against the adjustment to net $371.6 million worth of property, plant and equipment on the balance sheet as of September 30. Finally, we currently recorded $984.6 million of goodwill on the balance sheet as of September 30, an increase of $314.2 million since the end of fiscal 2006.

From a trade working capital perspective at the end of second quarter, receivables were up $183.9 million, inventories were $214.3 million on a pre-purchase accounting basis; and accounts payable were $118.1 million for a net of $280 million trade working capital, or 23.5% of sales on an annualized basis. This is slightly better than the 23.8% in the second quarter of fiscal 2006 but higher than the 22.5% in the first quarter. Our $280 million of trade working capital as of the end of the second quarter is 7.6% higher than the $260 million in the second quarter of fiscal 2006. This is compared to the year to date sales growth of 8.9% and order growth of 10.8%, which includes Falk in the prior year.

Our goal remains to drive working capital as a percent of sales to under 19%, and we believe that we will come-- that this will come from improving the velocity of our inventory turns.

Capital spending in the second quarter was $12.7 million, or 4.3% of sales; and, through six months, capital spending was $21.5 million, or 3.7% of sales. The amounts in the quarter and the first half are higher than our long term objective of 3% to 3.5% of sales as a result of the front end loading of certain capital expenditures in the fiscal year to meet demand in the second half.

Our total debt at the end of the quarter was $1.407 billion after reducing debt by $29.2 million from the date of the acquisition. Our borrowings at the end of September consisted of $6.7 million on our $150 million revolving credit facility, of which an additional $22.3 million is considered utilized from letters of credit. This leaves approximately $121 million of additional borrowings available under the revolver as of September 30. Additionally, we have $610 million of term loan B borrowings, $485 million, 9.5% senior unsecured notes, and $300 million of 11.75% senior subordinated, and $5.5 million of other debt. Our leverage at the end of the quarter was 6.3 times debt to EBITDA, down one half turn from the 6.8 times as of the July 21 acquisition date. Consistent with what we stated on the road show and prior calls, we continue to target a leverage profile of approximately 6 times at the end of March 2007, excluding the proposed acquisition of the order management business of Zurn.

With that financial overview, I'll turn it back over to the operator to open up for any questions.

[OPERATOR INSTRUCTIONS]. We go first to [Stephen Carpell with Curtis Reese].

A couple questions, first on the Falk integration. Can you comment where you guys are in terms of getting synergies? Is everything realized on a run rate basis at least?

I would say at this point, Steve, it's realized.

Okay. I don't know how much you guys can comment. We keep seeing all these articles here about the Jacuzzi acquisition and lawsuits and such. Where does it stand? How is this playing out? Kind of what's your perspective here.

What we can comment on is we think the Zurn business will be a great acquisition platform for Rexnord. We are not in a position to comment on the overall transaction, since that is between Apollo and Jacuzzi.

Finally, on the LIFO, income was certainly pretty big. Can you talk about how that plays out? Given the purchase accounting adjustments-- how that plays out for the rest of the year?

Yes. There was-- as we did the fair value adjustment as part of purchase accounting, that was an actual write off of about-- just over $19 million. Approximately $14 million of that turned out in the quarter, but because of the way the acquisition works there with these LIFO-- it resets a new base. We had $9 million of LIFO income in the quarter. As we look at the remaining of the fair value write off for inventory turnout in the third quarter, we would expect a similar percentage of LIFO income in the third quarter as well to impact that. It's all-- Again, both the fair value write off and the LIFO income or non-cash.

Okay. And just broadly, Bob, you spent some time talking about through the markets here. I think you had mentioned in this quarter things were a little bit slower. Is that slower than you expected or just slower than last year?

I said the growth rates are slower than we-- obviously, than what's been going on, which we did expect fully anyways because the numbers were quite high when you do look at relative comparisons. But I can say, if you look at our end markets, we still see some very-- across most of them, some very robust activity.

Thanks, guys.

[OPERATOR INSTRUCTIONS]. We go next to [Yama Abebe] with JP Morgan.

A couple of quick ones for me. I don't believe you give guidance, but just give us a sense for seasonality in the back half of the year. How should we be thinking about your third and fourth fiscal quarters relative to the first half?

It's really more related to days than seasonality. We do have a few more days in the fourth quarter. But, other than that, it's pretty even.

Okay. That's helpful. You did mention some softness in the construction business based on your exposure to residential construction. Can you give us a sense for what piece of your business is exposed to residential construction, please?

It would be, of course, pretty much all of the power transmission except flat-top. Specifically, some of the product ranges might be within chain and bearing. But, it's not a big percentage of our business. In fact, it's relatively small.

So, less than 10% or more than 10%?

I'd say it's less than 5%.

Okay. Good.

And, it's a small segment of it - a very small strip of our business.

Thanks. My last question is-- I know you said you're targeting 6 times leverage by the end of the year. Do you expect this mostly from, really, EBITDA growth; or do you continue to expect to pay down debt?

Really, what we're looking at too is cash from trade working capital as one improvement where we see that we can something also out of inventory turns and EBITDA growth.

But you don't have a target level of exact debt pay downs, I guess.

What we said and what we continue to target to is leverage into the-- between cash and EBITDA growth to the 6 times leverage by year end.

Okay. Great. Thank you.

We'll go next to Ted [Haig] with ING Investment Management.

I wonder if you could put a little bit more commentary around Zurn with respect as to how it would fit in with your existing operations. I'm not quite sure exactly what they do and what the fit or lack thereof would be with Rexnord.

Really, it's the creation of an additional platform. What they do is-- it is an order quality management, but it's into much industrial with specifications like drains-- spec drains, roof and floor drains, trench drains, backflow preventers, strainers, shut-off valves, fire protection valves. They have a tubing and fitting, radiating heat business in plastic tubing, and then what we consider commercial valve and flush valves - automatic flush valves, commercial faucets and fittings. So, that would be the range. But it is, as we see it, an additional platform to our business that we can then apply, for example, to things like our RBS [inaudible].

Now, would this be run as a segregated business, or is this going to be tried to integrate into something else?

The business itself will be run separate. There is opportunity, as you look at Jacuzzi being a public company. The opportunities are going to be more in the back office and the synergies that would come from the overhead functions, not from plan consolidation. There's not plan consolidations. They run a very good business. They're very strong in the markets in which they perform, so they would continue going to market the same way that they've always done.

Right. That's why we called back in our press release-- we said the synergy savings are quite limited.

Two last questions, if I could, please. Where are they based out of?

Jacuzzi is headquartered in West Palm. Zurn is primarily in Erie, Pennsylvania.

And, how much of their business would you say is residential construction related? Zurn, I'm talking about.

Less than 70%. It's relatively small. Of the pieces that Bob went through, there's really only one that's really exposed of any significant size; and that would be the [inaudible] plumbing. The specification drains, the commercial brass, and the order flow or backflow preventers are primarily commercial/industrial.

I'm sorry. Was that less than 7% or 70%?

I believe it's--

I think it's about 78% or 80% would be commercial.

Okay. Great.

[OPERATOR INSTRUCTIONS]. We go to [Justine Ho with Post Advisory].

Hi. I wanted to ask about your backlog. What was your pro forma backlog for September 30, 2005?

Hold on. We might have to look that up here.

Our fiscal 2006?

Yes. I'm just trying to get-- I think you mentioned--

You're asking for one year ago?

Yes; one year ago, basically.

Backlog one year ago was $272 million, up just about $105 million versus 12 months ago.

Okay. So, how should I look at backlog in terms of duration? If I were to look at backlog on a year over year basis, it's increased 38% as far as September 30, '06. And, for June '06, you had backlog of $348, which was up about 41% year over year. And, I'm curious as to how I should look at backlog in terms of-- it seems based on backlog growth, it would seem to appear that you should have stronger top line growth. But, maybe perhaps you can talk a little bit about how that translates into the following quarters' revenues.

The way I would respond to that is we're obviously pleased with the backlog. But, if you look at it, what it gives us is increased visibility. A lot of that is project business that goes out in some time. So, that gives us the visibility. Because we have, for example, our aerospace business goes out-- as you probably know from the aerospace industry, it goes out six or seven months in terms of its length of time. Particularly in our gearing business, there are several businesses within that that have very large projects that go out, some of those as long as that as well. So, what we view it as is having greater visibility than we've had in the past in terms of what we have. Clearly, we're pleased with the trend of that and what we see. And we do have a fair amount of book and ship that takes place as well in the quarter, which ranges of about 50% of our business - 45% or 50%.

So, you said 50% of your business is what?

What I would call book and ship in the month. The order cycle would be very short - within the month.

Okay. So, what would you say is your duration in your backlog then? Is it, on average, five or six months?

You can almost get the average by taking the numbers. But, it varies pretty dramatically by business. Some with months and some, like I said, eight months to twelve months. It's quite diverse in nature, what we have.

Okay. Great. Thank you.

At this time, we have no further questions. I'd like to turn the call back over to Mr. Hitt for any additional or closing comments.

Well, thanks everybody for your attention on the call today. We appreciate that. As you can see, we've turned in another solid performance for the quarter in the first half, with strong top line growth, margin expansion and a steadfast focus on reducing our debt. We're looking forward to reporting our third quarter results to you in early 2007, and with the great work of everyone at Rexnord of all of our associates' dedication to improving customer service levels and driving up better operational performance and improving productivity through the Rexnord Business System, we expect to continue moving our business forward with results in our third quarter to exceed those posted in the prior year.

So, with that, again, thank you for your interest in Rexnord, and looking forward to the call in the next quarter.

That does conclude today's teleconference. Again, thank you for your participation. Have a good day.