Zurn Elkay Water Solutions Corp (ZWS) 2007 Q3 法說會逐字稿

Good day, everyone, and welcome to this Rexnord LLC conference call to report third quarter fiscal year 2007 results. Today's conference is being recorded and to get us started with opening remarks and introductions I am pleased to turn the conference over to Mr. Todd Adams. Mr. Adams, you may begin, sir.

Good morning, and welcome to the Rexnord Investor conference call to discuss our third quarter financial results for fiscal 2007. My name is Todd Adams, Controller and Treasurer of Rexnord and with me this morning are Bob Hitt, Chief Executive Officer and George Moore, Executive Vice President and Chief Financial Officer of Rexnord. During today's call Bob will discuss the events of the quarter, and provide additional commentary about the industry. George will then discuss the financial results, both for the quarter and year-to-date. After this discussion we will open up the call to your questions. Both Bob's 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.

A replay of this call will be available for a period of one week, and the phone number and replay can be found in the earnings release we filed on an 8-K with the SEC which is also posted on the company's website at Rexnord.com. Before we start I will refer everyone to our earnings release and form 10-Q filed last week regarding our view on forward-looking statements and risks. I would also like to remind everyone that any forward-looking statements made on this call, including 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 assumption, they 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 expense, LIFO income or expense, stock option expense, charges associated with the Canal Street accident, as well as certain adjustments to reflect the benefit of cost savings implemented in prior periods that were not reflected in the prior period reported earnings.

Other companies in our industry may calculate EBITDA differently. EBITDA is not a measure of financial performance under generally accepted accounting principles 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 charges, including interest expense and taxes and is not adjusted for capital expenditures or other recurring 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 introduction I will turn the call over to Bob Hitt, Chief Executive Officer of Rexnord.

Thank you Todd, and good morning and thank you all for joining on the call today. Last week we issued our press release outlining our third quarter and year-to-date results which I am sure everyone had the opportunity to review. Before we talk about the specific results let me explain that this has not been a typical quarter for us at Rexnord. While we are pleased with our financial results, operationally our management team and employees have been working very hard over the past several months to recover from the accident that occurred at our Canal Street facility in Milwaukee on December 6th.

I am sure you are aware, an explosion destroyed approximately 80,000 square feet of a warehouse, storage and nonproduction buildings and damaged a portion of the production area including the gear productline and some portions of our large coupling productline. It is important to note that the company's core production capabilities were not affected by this accident. To date we have not had any material customer order loss as a result of the temporary inability to produce and deliver products from this facility.

We have commenced production and shipments from the Canal Street operations, which I am pleased to say. All our employees have been recalled and are working at the facility in the same roles prior to the accident on some cases assisting in the restoration process. Also pleased to report production shipments continue to increase every day and consistent with what we've been communicating all along, we continue to estimate that we will be able to reach pre-accident shipment levels from the Canal Street facility during the first half of fiscal '08, which is the summer of '07 is what that is.

This certainly is all very good news, but the accident did take its toll in other ways. To remind everybody that three employees lost their lives and approximately 45 employees were injured in this incident. We continue to extend our sympathies to the families of those impacted by the accident, and many people, those in the community, suppliers, contractors have rallied to help us sustain our goal of serving our customers. In particular our employees showed great courage, resilience and teamwork as we continued the recovery process in the days immediately after the accident and certainly through today.

I would like to take this opportunity to thank everyone, especially our employees for their tremendous support. I firmly believe all those positive forces and the spirit of cooperation have helped us recover quicker than we certainly anticipated. Despite the fact that the third quarter business interruption impacted our results by approximately $15 to $20 million in sales and $6 to $10 million of operating income, I can report that sales grew 7% from last year's third quarter; certainly as a result of the strength in our industrial product and market such as natural resource extraction, metals processing, infrastructure expansion, food and beverage, as well as strong demand for our aerospace products.

Our order growth in the quarter was 4.6% and through the first nine months of the fiscal year '07 orders were up 13.2% as compared to the first nine months of last year. This year to date order growth has translated into an order backlog that currently sits at almost $386.5 million up 25.8% compared to the end of March and up almost 34.5%, 34.4 to be accurate, compared to a year ago.

Our adjusted EBITDA increased 5.6% to $52.2 million or 18.1% of sales and includes the impact of Canal Street accident and the corresponding impact of lost sales, which we estimate the impact of adjusted EBITDA as I mentioned earlier of approximately $6 to $10 million.

In addition to that, though, we did reduce debt by $27.3 million in the third quarter which is $56.5 million since the Apollo acquisition on July 21st. So therefore our debt to EBITDA ratio has now declined to 6.2 times at the end of December '06, down from 6.3 at September '06. And it was 6.8 times at the Apollo acquisition date. As a result of solid earnings growth and cash flow we have been able to take that down.

Turning to some economic environment, what is going on and how it impacts Rexnord, as we announced in our earnings release last week the overall positive trends in our business continued in the third quarter. Many of our core end markets remained solid, particularly the energy, mining aggregates and food and beverage and aerospace, as I said previously. We did see some of the growth across the broader general industrial sectors, though, moderate in the third quarter as our overall (indiscernible) growth rate of 4.6% when it is less than the high-single, low double-digit order growth through the first two quarters of the fiscal year.

In addition, the broader economic indicators that we monitor support this trend. Data from the Institute of Supply & Manufactures as you know first declined since May '03 after 42 months of expansion, (technical difficulty) turned negative November to 49.9 and was again negative in January at 49.3.

In December U.S. industrial output grew only 0.4%, and capacity utilization fell to 81.8% versus the 82 that it was in September. Additionally from our power transmission industry perspective the PTDA member sales were up 10.2% in calendar '06, down by a 10th from 10.7% in calendar '05 but were particularly soft throughout the last four months of the calendar '06 as sales declined sequentially from September through December. Still up, but at a lower rate. December for example was up only 4% versus the prior December.

Finally, the industrial distribution channel as far as inventory remains very healthy as the sales inventory ratio ended at December 9 times, solid but slightly below last December of 9.6 times. So putting all that together we get a sense while there is growth left in the industrial economy things are slowing to some degree. Despite this slowing, though, we feel that our overall diversification exposure to many of the markets with longer visibility and good growth opportunities for example as I mentioned natural resources and extraction and those type of industries leaves us well positioned heading in the fourth quarter and I should say aerospace, as well.

Turning and switching to some internal activities, we are certainly pleased to report that on February 7th of this year Rexnord completed the acquisition of Zurn's water management business from an affiliate of Apollo management. We welcome them to the Rexnord family and believe this acquisition is excellent strategic fit within Rexnord, and will enhance our growth potential as a high-quality, multi-industrial company. Zurn's market leadership, its leading brands and high margin businesses are extremely complementary to Rexnord's power transmission platform.

As we have said earlier, there will be minimal integration work for us since this acquired business will operate as a separate platform to the company with facilities located in six states. The existing Zurn management team will continue to run the water management platform providing leadership continuity.

So in conclusion, as we look at the first nine months of fiscal '07 I am pleased with the favorable results we've posted and thank all our hard-working employees for their efforts in driving this positive outcome. Our underlying performance and sales growth of 8.3% and adjusted EBITDA growth of 13.3% compared to the first nine months of last year certainly demonstrates the progress we have made on critical commercial and operational initiatives we have instituted.

Despite the impact of the Canal Street impact as far as the accident incident itself, which was significant, and then heading into the final quarter of fiscal '07 our focus will continue, will be to the excellent progress we've made on the recovery at Canal Street and the execute operation throughout the company by continuing to implement the Rexnord business system. And finally, we look forward to executing the minimal integration work required for the Zurn acquisition as we bring Zurn into the Rexnord family.

So with that, I will turn it to George to provide some in-depth financial information regarding our third quarter.

Thanks, Bob. As Bob mentioned earlier, our third quarter reported results were impacted by the accident at Canal Street on December 6th. We estimate that sales were adversely impacted by $15 to $20 million with a corresponding decrease in operating income of $6 to $10 million, as well as a $7.9 million of other charges associated with the Canal Street accident.

Now I would like to provide you with a financial overview of the third quarter and some insight into our debt reduction activity. Let start with sales. For the quarter sales were $283.1 million or 7% higher than the third quarter of last year. As Bob mentioned much of this increase is a result of strength in our industrial products and markets from energy, mining, aggregates, food and beverage and aerospace. However, foreign currency translation added approximately 2% to the growth compared to the prior year quarter.

Gross profit in the quarter was $84.1 million or 29.7% of sales compared to 31% in the third quarter of a year ago. Whereas profit margins in the third quarter of fiscal 2007 were negatively impacted by decreased leverage on fixed cost as a result of the Canal Street accident and the non-cash adjustments made to the fair value of our inventories as a result of the Apollo acquisition. The impact of non-cash purchase accounting adjustments reduced gross profit margins in the quarter by 90 basis points.

Our reported Gross profit includes the impact of the Canal Street accident and the corresponding adverse impact of 15 to $20 million of lower sales and $6 to $10 million in lost earnings, which would have primarily been recorded as gross profit. Included within gross profit in the third quarter is the benefit of a change to the company's vacation policy which favorably impacted gross profit by $3.6 million.

SG&A in the third quarter was $49.4 million or 17.4% of sales compared to 46.7% or 17.7% of sales in the third quarter of last year. The increase in SG&A dollars is driven by higher stock option expense, $1.5 million or 50 basis points, higher depreciation expense, $400,000 or 10 basis points. As a percentage of sales these dollar increases were offset by $3.1 million benefit within SG&A as a result of a change to the company's vacation policy partially offset by higher severance costs in the period as compared to the prior year.

Aside from business interruption impact we talked about our third-quarter result also included the net impact of Canal Street accident and asset impairments, cleanup and restoration costs, insurance deductibles and professional fees associated with the accident and subsequent recovery offset by expected recoveries under our property insurance policy. The total of the charge is $19.9 million, which is offset by $12 million and expected recoveries under our property insurance policy (indiscernible) to a $7.9 million charge on the income statement in the third quarter.

Income from operations in the quarter was $18.2 million compared to $16.8 million in the third quarter of last year. Adjusted EBITDA in the third quarter was $51.2 million or 18.1% of sales, included in the add backs to arrive at adjusted EBITDA are stock option expense, the impact of purchase accounting fair value adjustments, required reserve adjustments under predecessor successor accounting and other income expense, as well as a $7.9 million net charge related to the Canal Street accident, offset by expected recoveries. Adjusted EBITDA in the third quarter does not include the 6$ to $10 million of earnings related to the $15 to $20 million in lower sales as a result of the Canal Street accident.

Interest expense in the quarter was $35.3 million reflecting the additional interest on the increased indebtedness arising from the Apollo acquisition. Other income expense in the quarter was $7.6 million of income and includes benefit of $8.8 million of income and cash recovered under the Continued Dumping and Subsidy Offset Act or CDSOA. This relates to a claim the company had filed for prior years and is cumulative, and we cannot reasonably estimate any future recoveries under this act, if any.

An income tax benefit of $5 million or 29% of pre-tax income was recorded in the quarter. The effective rate in the third quarter was 52.6%, an improvement over the six months of fiscal 2007 as a result of favorable change in the estimate of realization of certain foreign tax benefits compared to prior estimates. Looking at our balance sheet as of December 30, 2006 you will see that we continued to refine 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 to make appropriate adjustments for the balance sheet in future quarters.

In the quarter we made only small adjustments to the purchase price allocation resulting in a net increase of $3.1 million of additional goodwill. From a trade working capital perspective at the end of the third quarter, receivables were $162.4 million. Inventories were at $204.1 million on a prepurchase accounting basis, and accounts payable were $97.8 million for a net of $268.7 million of trade working capital or 23.7% of sales on an annualized basis. Slightly above the 23.5% in the third quarter of fiscal 2006 in the second quarter. We continue to see working capital as a significant cash opportunity, particularly within inventory. Our goal remains to drive trade working capital as a percent of sales to below 19%, and we believe that will come with improving the velocity of our inventory turns.

Capital spending in the third quarter was $8.4 million or 3% of sales and through nine months capital spending was $29.9 million or 3.4% of sales. Our total debt at the end of the quarter was approximately $1.380 billion, after reducing debt by $27.3 million in the third quarter and $56.5 million from the date of the acquisition. Our liquidity at the end of the third quarter remains strong as we had cash balances of $17.9 million and had no borrowings outstanding on our $150 million revolving credit facility. However, $22.2 million of the facility is considered utilized from letters of credit, leaving approximately $128 million of additional borrowings available under the revolver as of December 30th.

As of the end of the third quarter we had $590 million of term loan B borrowings, $485 million of 9.5% senior unsecured notes, $3 million of 11 3/4% senior subordinated notes and $5.5 million of other debt. Since the end of the quarter we incurred additional indebtedness to finance the Zurn acquisition, totaling $660 million. The debt was incurred in the form of $200 million in additional term loan B borrowings, $310 million of additional 9.5% senior unsecured notes and $150 million of 8 7/8% senior unsecured notes. Our leverage at the end of the quarter was 6.2 times debt to EBITDA, down 6/10 from the 6.8 times at the July 21st acquisition date.

As we previously disclosed, we expect to recover the majority of the nonrecurring expenses associated with Canal Street, as well as the business interruption impact. The timing and amounts of recovery will be over future quarters and will likely be lumpy within the P&L as we incur additional charges and business interruption offset by recoveries. However, we do not expect this accident to have any material impact on our overall financial position or liquidity.

Additionally, as many of you are probably aware, we are in the process of concluding the financing transaction that we announced last week at the Rexnord Holdings level. Rexnord Holdings is the indirect parent of both Rexnord LLC and RBS Global which comprise all of the operating subsidiaries of Rexnord. This financing transaction at the Rexnord Holdings level has no impact on the financial position, cash flows, liquidity or outlook of our operating companies, which are RBS Global and Rexnord LLC. This financing transaction represents our majority shareholders financing decision, our focus at the operating company level is to continue to run the business, grow earnings and reduce debt at Rexnord LLC and RBS Global level consistent with what we've communicated.

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

(OPERATOR INSTRUCTIONS) Yilme Abebe, JPMorgan.

Thank you. Good morning. My first question is related to the order book; I know you gave us some data in your -- for the order book in the third quarter. If you can, can you give us a sense of what the order book is looking like and your 4Q in the March quarter?

Yes, if you look at order book for the quarter in the March quarter at this point it is looking to be as good or slightly better than what we'd reported in the third quarter.

And any particular lines of businesses stronger than others so that is different from --

I think we seem to consistently be in the industries that we mentioned earlier as far as the strength of where those are taking place, those industries continue to have the long legs that we continue to predict and I do not see anything different from that perspective.

Thanks. And looking at synergies for the Zurn acquisition I know you disclosed the transaction and it may be a little bit early, but any indications of how you are doing in terms of realizing the synergies that you have laid out so far?

The fact that we just closed, we haven't gotten after much in the synergies. As we said, there is really very little in the way of integration as it relates to operation. Most of the synergies are really going to come from the back office and the public company called that Jacuzzi Brands Inc. had, which will not be needed on a consolidated basis. But we see really no change from what we stated when we were on the Roadshow.

My last question is are you giving guidance in terms of where you expect leverage to go over the next twelve months at this point?

No, we are not.

Thanks.

(OPERATOR INSTRUCTIONS) Sarah Thompson, Lehman Brothers.

I just had a quick question -- sorry if I missed this -- but what is the $6.7 million for the vacation policy change, it is that something that continues or that was just a onetime?

That will be -- it is a onetime change. If you will, we changed the policy to basically go to a use it or lose it policy, in there where that flows through on a GAAP basis that will ultimately be cash over future periods.

Okay, and it's not a huge number but future periods meaning like the next year or two?

I'm sorry?

Future periods meaning like the next year or two?

It will be over the next several years. As people leave and that rolls off, that cash will come back in. It is not immediate cash.

And then just one clarification. I guess the way I heard you talking about the economy in the beginning it sounded like you guys were a little down on it. Is it -- I just want to make sure that I am getting the right concepts from you. Is it that you are seeing growth slowing so we are not (multiple speakers) as opposed to something negative?

Clearly we are seeing the rate of growth slowing would be the best way to say it.

Terrific but you're not seeing anything negative anywhere?

No, as I said in the previous question I would anticipate the fourth quarter order book rate is going to be slightly better over the third quarter.

Perfect. That's all I had to clarify. Thank you.

(OPERATOR INSTRUCTIONS) George Williams, Bear Stearns.

At the initial Roadshow you mentioned that you would be comfortable at the target leverage of about 5.5 times. Is that still the case here? With the total notes that you came through yesterday it is going to be difficult to reduce debt -- I am just trying to get a sense of what your plans are for debt reduction.

There's no change from what we said on the Roadshow. We intend to use the cash flow to continue to pay down debt. The most recent note that you saw at the Rexnord Holdings level is at the holding company. It is not at the operating company and there is no cash demands on the operating company for that. So the cash flow generated at the operating company will continue to be used to reduce leverage the same as we had talked about.

Okay. Thank you.

Philip Volpicelli, Goldman Sachs.

I think I just heard you say that the pick toggle note at the holdco will be pick interest or cash interest; can you clarify?

At this point the intent is that that would be pick interest.

There are no further questions in the queue at this time. Mr. Hitt I will turn it back to you for any closing or additional remarks, sir.

Thanks. I would like to thank everyone listening for your attention on the call today and also for the support that everyone provided when we had the Canal Street incident, as well. As you can see we have turned in another solid performance for the quarter and for the nine months with strong topline growth, margin expansion and continued focus on reducing our debt. And we look forward to reporting our fourth quarter results sometime in early spring and with the great work of everyone at Rexnord we expect to continue the excellent progress on the recovery at our Canal Street facility, continue our dedication improving customer service levels, driving better operational performance and improving productivity for the Rexnord business system. And we do expect to continue moving our business forward with results in our fourth quarter to exceed those posted in the prior year when adjusted for the impact from Canal Street.

Finally I would like to express to the Zurn employees how excited we are to welcome them to Rexnord and that we are looking forward to working with such a fine organization. So again, thank you very much, and have a good day.

This does conclude today's teleconference, and we thank you all for your participation. You may now disconnect your lines.