Zurn Elkay Water Solutions Corp (ZWS) 2009 Q2 法說會逐字稿

Good morning and welcome to the Rexnord second-quarter fiscal 2009 earnings results conference call with Mr. Bob Hitt, Chief Executive Officer, and Mr. Todd Adams, Chief Financial Officer of Rexnord.

This call is being recorded and will be available on replay for a period of one week. The phone numbers for the replay can be found in the earnings release the Company filed on an 8-K with the SEC yesterday, which is also posted on the Company's Web site at www.Rexnord.com.

At this time, for opening remarks and introductions, I will turn the call over to Todd Adams, Chief Financial Officer of Rexnord. Please go ahead, sir.

Good morning. Before we get started, just a brief reminder that this call may contain certain forward-looking statements that are subject to the safe harbor language contained in yesterday's press release as well as in our periodic filings with the Securities and Exchange Commission. Additionally, Rexnord Holdings, the ultimate parent of RBS Global and Rexnord LLC, continues to be in the public offering process with the Securities and Exchange Commission. However, based on overall market conditions, the timing of the initial public offering is not imminent. We will continue to work through the registration process with the SEC while we continue to monitor overall market conditions.

On today's call, we will provide an update on our overall performance across the Company as well as some further detail on the financial results. After this discussion, we will open the call up to your questions, but please note that we will not answer any questions related to the IPO process.

With that, I'll turn it over to Bob Hitt, CEO of Rexnord.

Thanks, Todd, and good morning, everyone. Thank you for joining us on the call today. Yesterday, we issued a press release outlining our second-quarter and first half-fiscal 2009 financial results, which I'm hopeful everyone has the opportunity to review.

First, a quick summary of our operating performance in the quarter and first half of the fiscal year. Second quarter sales were a record $510.6 million, which represented an increase of 12.5% over the prior year second quarter. The core sales growth, which is year-over-year sales growth in existing businesses adjusted for divestitures and excludes currency, was at 7%. And for the first six months, our sales increased 11.6% from the prior year with core sales growth of approximately 6%.

On the adjusted EBITDA in the quarter was a record of $101.6 million and increased 8.4% from the prior second quarter. When you exclude the out-of-period business interruption proceeds, we recorded in our second quarter fiscal '08 of $5.8 million, our adjusted EBITDA increased 15.6% in the second quarter. For the first half of the year, adjusted EBITDA was $197.3 million, an increase of 14.4% from the first half of last year when excluding the $8.3 million of out-of-period business interruption proceeds, received in the first half of fiscal '08. And finally, we continue to reduce our leverage as net debt leverage was 4.7 times at the end of September compared to 5.7 times a year ago and 6.8 times approximately two years ago at the time of the acquisition of the Company by Apollo.

Both of our platforms delivered solid growth during the quarter and throughout the first half of the fiscal year. Our acquisitions continue to contribute to our growth and profitability in line with our expectations and as we continue to successfully implement our business system, which you know as RBS, which focuses on growth, quality, delivery and cost.

Next, I'll take a few minutes to walk you through the operating performance in each of the platforms, as well as what we're seeing in some of the key end markets in each of our platforms in terms of demand and market growth. Starting with Power Transmission segment, the sales growth in the quarter was 8.5%. Currency was favorable to the prior year by 280 basis points, and the divestiture of a noncore businesses at the end of last year adversely impacted growth in the quarter by 130 basis points. So, on a net basis for PT, this equates to a 7.0% core sales growth in the quarter.

From a profitability perspective, adjusted EBITDA in the quarter was $69.7 million, or 19.7% of sales, compared to $66.4 million, or 20.4% of sales, in the prior year second quarter. And there are two important items to understand when you analyze our second quarter margin. First, the prior year second quarter included $5.8 million of insurance proceeds related to the Canal Street accident business interruptions we incurred in fiscal '07. So excluding these proceeds, prior year adjusted EBITDA would have been $60.6 million or 18.6% of sales. So, on a apples-to-apples basis, we saw 110 basis points of margin expansion year over year in the second quarter. And second, the apples-to-apples margin increase of 110 basis points was delivered despite material cost headwinds. So clearly, our continued emphasis on overall productivity and cost reductions paid dividends in the second quarter.

In terms of our overall business conditions to the end markets we serve in Power Transmission, we continued to see solid demand in the second quarter across the majority of our end markets with the growth being driven by our key end markets of mining, energy, aerospace and cement. And we experienced good order activity during the quarter and our backlog remains healthy as we're starting the third quarter with a backlog position similar to the backlog we had at the start of our second quarter.

I'll also add that we continued to experience good growth out of our international portion of our Power Transmission business, which today compromises approximately 40% of our total Power Transmission sales.

One other key element to mention in the Power Transmission segment is the health of the overall US industrial distribution channel. Through August, US industrial distributors posted calendar year-to-date sales growth of 4.5%, and inventory trends in the channel remain solid at 9.0 times, up from 8.7 times three months ago and 7.6 times at the end of calendar year 2007.

Now, I will turn my comments to the water management platform. Sales growth in the water management platform in the quarter was 22.7%. Our core sales growth in the second quarter was 6.5% which increased from basically flat core growth in our first quarter of 2009. And the balance of the growth in the quarter is the result of the GARH acquisition as well.

From a profitability perspective, water management adjusted EBITDA in the quarter was $31.8 million or 20.3% of sales, which compares to $29.6 million or 23.1% of sales last year. Our adjusted EBITDA growth and margin was impacted by two primary items. First, commodity cost pressures in the second quarter adversely impacted our margin by approximately 160 basis points when compared to the prior year. In addition, we've been consciously making some target investments in our water management platform to fund specific sales growth initiatives which have been delivering the results we certainly expected.

In terms of the overall water management business, we break the business down into three end markets when we analyze performance. The infrastructure and water wastewater treatment market, which represents between 45% to 50% of our total water management business, continued to see decent overall market conditions during the second quarter. Our GA acquisition continues to perform well and the backlog for the business has grown all year on strong order rates.

Approximately 35% of the water management business serves the commercial construction market. Within commercial construction, consistent with that we've been expected, based on some of the architectural [billing] data, and as well as the McGraw-Hill data, which, by the way forecasts -- if you look at '08 to '09 on a square footage basis, are now forecasting residential down 5%, commercial and manufacturing down 15%, institutional, which we play -- [we've got a] fair percentage as I mentioned earlier -- down 6%, and clearly on infrastructure this would be based on dollars versus square footage, down 9%. So the overall market has clearly been slowing. Despite the slowdown, overall we have experienced high single digit growth in the commercial construction market in the quarter driven by continuous sales growth of new products in our water conservation product lines.

The balance of our water management business, or between 15 and 20%, is residential construction. And within the residential part of the business, depending on which source you choose to look at, all signs point to a 10 to 15% decline in the residential market year over year during the quarter. As you compare that to the portion of our business that serves the residential market, we experienced declines between 1 and 6% in the quarter compared to the prior year -- meaning we actually grew relative to the market as we did in the first quarter as well.

So, as I wrap up the second quarter, just a couple of final thoughts. Again, we're pleased with the core growth in the quarter of 6.9% and a 220 basis points improvement in our core growth from the first quarter. It was consistent with our expectations. And secondly, Rexnord, along with everyone else, experienced rapid material cost inflation during the first half of our fiscal year. Although we mitigated some of the margin pressure through selective price increases, driving productivity improvements and looking at ways to reduce material costs, either to alternative materials or product design, it did have an impact on our margins in the second quarter and first half of the fiscal year.

That being said, we're confident that our diligent and discipline approach to our procurement processes focus on driving cost reductions, coupled with the improvement in commodity markets, will result in improved material costs outlook in the second half of fiscal '09 when compared to the first half.

The other end of improving material costs is clearly the weakening global economy that's accelerated over the past several months. As we look ahead we're planning for a challenging economic environment. We're proactively communicating with our customers, focusing on their needs and delivering world class products and services. And our Rexnord business system will remain a major focus as we invest and drive growth opportunities while proactively taking appropriate cost reduction actions, all of which we believe makes us well positioned to outperform.

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

Thanks, Bob. I'll start by quickly going over a few of the details in the second quarter income statement.

As Bob mentioned, sales in the quarter were a record $510.6 million, which represents 12.5% growth over the prior-year second quarter. That growth breaks down again -- these are all rounded numbers, but 7% core growth; 5% from acquisitions; approximately 2% from foreign currency translation, offset by a 1% decline as a result of a divestiture we made at the end of last fiscal year.

Gross profit in the second quarter was $163.2 million, or 32% of sales, compared to 32.9% of sales in the second quarter of last year. In the quarter, higher year-over-year material costs adversely impacted our gross margin by approximately 120 basis points in total.

SG&A expense in the second quarter was $81.5 million, or 16% of sales, a 60 basis point improvement compared to the 2008 second quarter.

Income from operations in the second quarter was $69.3 million, or 13.6% of sales, compared to $65.1 million, or 14.3% of sales in the second quarter of last year. However, the prior-year second quarter included a $3.7 million gain associated with the Canal Street accident which benefited the prior-year second quarter by approximately 80 basis points. So if you exclude this prior-year non-recurring gain, our second-quarter income from operations as a percentage of sales actually increased 10 basis points from the prior year despite the material cost headwinds during the second quarter.

Interest expense in the second quarter was $44.7 million, which compares to $48.5 million in the prior-year second quarter and reflects primarily the benefit of lower LIBOR rates on the Company's term loan facilities when compared to the prior year.

With respect to taxes in the quarter, our effective income tax rate for the second quarter was 44.1% which is roughly in line with our first quarter, as well as our full year expectations for 2009.

And finally, our net income in the quarter was $14.3 million, which compares to $7 million in the prior-year second quarter.

Moving to adjusted EBITDA, our adjusted EBITDA in the second quarter was a record $101.6 million, or 19.9% of sales, which compares to $93.7 million, or 20.6% of sales, in the prior-year second quarter. However, as Bob outlined, in the prior-year second quarter, we did record a $5.8 million benefit from the business interruption proceeds we received in the second quarter of last year that related to the Canal Street accident business interruptions we actually experienced in 2007. So when you adjust the prior-year second quarter to exclude that benefit, out-of-period benefit, adjusted EBITDA was actually $87.9 million, or 19.4% of sales.

Quickly touching on our balance sheet cash flow highlights, our cash balances at of the end of September totaled just under $165 million, an increase of nearly $23 million from the end of March and $13 million from the end of the June quarter. From a trade working capital perspective at the end of September, our receivables were just over $299 million. Inventories were approximately $371 million, offset by accounts payable of approximately $171 million, for a net trade working capital balance of just under $500 million.

In the second quarter, we reduced trade working capital by approximately $17 million. And as we look at the second half, we continue to see trade working capitals and opportunities to generate cash, particularly as it relates to inventory and this is across both of our platforms.

Cash flow from operations in the first half of 2009 was $45.7 million, which compares to $61 million through the first six months of last year. Just one note, included in the prior-year cash flow was $15 million of insurance proceeds related both to the business interruption and property and casualty proceeds related to the Canal Street accident.

From a free cash flow conversion perspective, which is cash flow from operations less CapEx compared to our net income, the ratio was 106% in the second quarter, bringing the conversion ratio to the first half to just under 100% through the first half of fiscal 2009.

Capital spending in the first six months was $22.6 million, or 2.2% of sales prospectively. And consistent with what we've communicated I think all along, we anticipate capital spending going forward to be in the 2.5% to 2.9% range of sales.

Our total debt at the end of the second quarter was $2.023 billion after having reduced debt in the first half by $1.4 million. Our liquidity continues to remain very strong. At the end of the second quarter, we had cash balances of $164.6 million and had no borrowings outstanding on our $150 million revolving credit facility or our $100 million AR securitization facility. However, $29 million of the revolving credit facility is considered utilized from letters of credit.

The remaining availability under our revolving credit facility has been temporarily reduced by $7.5 million as a result of the Lehman Brothers Holdings bankruptcy filing in September. Certain subsidiaries of Lehman had a 5%, or $7.5 million credit commitment, under the $150 million revolving credit facility and we do not expect Lehman to fund their pro rata share of any of our borrowing requests.

One final point on liquidity -- in early October we decided it was prudent to borrow under our revolving credit facility in order to increase our cash position in light of the current uncertainty in the capital and credit markets. As part of that, we submitted a request to borrow $50 million from our revolving credit facility and ultimately received only $47.5 million as a result of Lehman failing to fund its obligation of 5%, or $7.5 million of the total $150 million. So 5% of the commitment did not get funded.

As of the end of the second quarter, we had $767 million of Term Loan B borrowings; $803 million of 9.5% senior unsecured notes; $150 million of 8.875 senior unsecured notes; $300 million of 11.75% senior subordinated notes; and just over $3 million of other debt.

As Bob mentioned, finally we continued to delever. As of the end of the second quarter, our leverage ratio is 5.1 and 4.7 times on a net debt basis, both down two-tenths from where we ended March and down from 6.8 times at the time of the Apollo acquisition, just over two years ago.

With that, I'll turn it back over to the operator to take your questions.

Thank you. (OPERATOR INSTRUCTIONS.) Please allow one moment for the first question. Our first question comes from the office of Mr. Tom Klamka of Credit Suisse. Please proceed with your question.

Hi, guys. This is Basil Hamadeh, actually, filling in for Tom Klamka. Congratulations on a good quarter. I was wondering if you can comment on how October looks?

I would classify October as [orders booked] slowing somewhat. I would classify it on PT being -- still having good results and not surprisingly seeing some softness in water management.

Okay. And can you also comment on the Zurn going forward and non-residential construction, commercial construction going forward?

Sure. If you look at what I cited on McGraw Hill, for example, clearly residential is -- we keep thinking it's down to its lowest point but it's getting close to that. Our percentage of residential composition within that keeps getting lower and lower and it's probably down in that 18 to 16% of sales. Then if you look at the other side of it, infrastructure, which is declining but at a lower rate, it's about 44% of the business. But clearly you continue to see the data in terms of commercial -- anything related to commercial retail are down much higher -- 12, 15 points. But if you look -- so that's the conditions we continue to see. But we have outperformed those numbers, if you look, within our quarter, our last quarter. And some of that, again, is related to that we have a higher percentage in infrastructure and secondly, we believe our breakthroughs in product performances are working. But that doesn't say that we don't expect to see slowdown, particularly going into next year.

I think, Basil, if you look at the square footage put in place either year to date or the projected, it's down anywhere from 5% to mid-teens in the commercial space and we're clearly still growing inside that. I think Bob quoted sort of mid to high single digit growth in the second quarter and first half. As we look out, we're not planning for any bounce. I mean, we're planning for 12 to 15% market declines next year, next fiscal year for us. And so I think how we grow through that really is a combination of the Zurn package that we have as well as funding the breakthroughs. And the breakthrough growth is -- we talked about some investments we've made. Clearly that's paying off. You saw the core growth in the quarter. But our market assumptions going into next year are stiff. It's down 12-15% on a square footage basis.

Understood. And what about the benefits of copper and lower costs? When do you really expect to see those benefits and what are really your competitors doing as far as that is concerned?

We'll start to see some benefit -- I'd say trickle in would be my classification -- in the third quarter with more benefits in the fourth quarter. I'd say probably we'll get 50 or 60% of the benefit on copper, particularly in water management within the fourth quarter. And then the rest flowing through right after that.

I think we saw the run up was pretty severe. The decline has been pretty severe. I think what we're seeing is generally competition being pretty disciplined in the marketplace. I think we're going to certainly continue to be disciplined in terms of pricing, so we're hopeful that we have the opportunity to stick with price. But the benefit of the lower price we really don't expect to see in mass until the start of the fourth quarter.

Okay. Thank you. And last question, gentlemen, I was wondering if you could comment on inventory and whether or not that will be going down going forward or whether you expect it to remain relatively stable?

No, we clearly see and continue -- we'll always work on that anyways as part of our RBS, but with some of the softening, we clearly see an opportunity to reduce inventory. And it'll be commensurate to what -- between our improvement processes and what the market turns down.

Okay. Thank you so much.

Thanks, Basil.

Thank you. Our next question comes from the office of [Sarah Thompson] of Barclays Capital. Please proceed with your question now.

Thank you, this is [Dory Koda] for Sarah. Nice quarter, guys. Just one question to make sure that I understood it correctly. Todd, you said that you withdrew -- that you guys drew down $47.5 million .in your revolver post- 9/30?

That's right, Dory.

And what was the rationale behind it?

I think we took a look at some of the uncertainty. I think this is before any of this stimulus and the government investing in the banks had really taken place. And it was more of a defensive move than anything. I think from a liquidity perspective, I think we've outlined the fact that we ended the quarter with $165 million in cash, ample borrowing ability, but if you just rewind to early October, there was a fair amount of uncertainty in some of the financial institutions and I think we just defensively went and borrowed some money on the side of the revolver. I think since that time things have firmed up a little bit in the overall capital markets in terms of who will survive. But it was more than just a defensive move than anything, Dory. No -- don't read anything into it in terms of our concern about our ability to generate cash or anything like that. It was purely defensive.

Great. Okay, thank you very much.

Thank you. (OPERATOR INSTRUCTIONS.) Our next question comes from the office of Jordan Hollander of Jefferies & Company. Please proceed.

Hi, guys. Just a follow up to the last question about the draw on the revolver. Can you just give us a clue where cash stands today? Has any of that been used or are you still generating cash in the early third quarter?

Yeah, we continue to generate cash, Jordan. I think we have not used any of it. We continue to invest it, so there's some negative arbitrage that is out there. I think over the course of the next month or so, we'll look to probably decide what's our feeling, what's our outlook on the capital markets, as well as the institutions in the revolving credit facility, and decide what to do. But we haven't used a penny of it.

Okay, great. And then I guess just what's the plan for cash once everything stabilizes out? Are you still looking -- are you seeing anything in the acquisitions market or just being cautious at this point?

I think a year ago we started holding cash based on some concerns we had with the credit markets. We put in $100 million AR facility in the September quarter of a year ago. So I think we've been cautious all along. I think we continue to be cautious. But that being said, we see even in a downside case our ability to generate cash is very good. And I think we'll be reviewing all the options -- acquisitions, pay back debt, depending on our view of what the outlook is. So I wouldn't say that -- I wouldn't say anything other than we'll review it on a case by case basis and decide what to do.

Okay, great. Thanks, guys.

Thank you. Our next question comes from the office of Edward [Chaikas] of [Penn and Bart]. Please proceed.

Good morning, guys. Quick question as it relates to the foreign currency effect. For the quarter, you guys reported about a 2% positive translation, right?

That's right.

In terms of growth.

That's right, Edward.

But I thought there was a disclosure in one of your prior publications that if the dollar moves against you guys, meaning if the dollar strengthened, that you would have a negative impact, that would have a negative impact to your results. Can you just reconcile the two? Or maybe I'm just misreading it.

Yes. I think that clearly, you have to look at the benefit relative to the prior year. Right? So, the run up in the euro over the course of the last year has started to retrace a little bit, so the relative benefit that we've been recording is going to decline. I think the average euro last year, on our financial results and our financial year was 1.40-ish. So anything above that we would be generating positive translation gains year on year. As the euro retraces down to one-thirty -- on a four year basis, there's probably no impact of currency on the growth side. Because we spent the first half of the year sort of at 1.50. We'll spend the back half between 1.20 and 1.30. So any gains that we've recorded to date probably get mitigated in the back half if the euro stays where it is today.

Okay. Thank you very much. That was helpful.

Thank you. There are no further questions. I would like to turn the call back over to you for your closing comments. Excuse me, sir. We do have a question. Would you like to take it?

That's fine. Sure.

Thank you. Our next question comes from the office of Mr. Jim Kelly, FCM. Please proceed.

Hi. Can you please comment on the end markets which had historically provided strength and support in the backlog?

Yes. I think if you look at the (inaudible) of the end markets, you've got to separate the two and start with Power Transmissions. And if you look at mining, energy, aerospace continue -- our strong markets for us in fact represent somewhere around 40% of the PT sales. And then you get into food and beverage which would represent somewhere around 7, 8, 9% and then move from there to a lot of general industrial.

And I think my comments for that would be we've been saying for quite some time that we would expect some softening. And clearly with the recent economic news, you would consider the same. But one of the things, a couple of things to our benefit, we do have $580 million of backlog in those segments, particularly mining. I would classify all of them -- but it's interesting we clearly have been watching the mining very, very closely over the last few weeks. And yesterday there was some nervousness within the industry as far as what's going on and how far they'll go on some of these projects based on commodity cost.

But we continue to see activity on engineering and on (inaudible) as well and to remind everybody that we have a fair amount of business within mining, I would call it within energy and coal, which continues to be a good industry. We see gold is still continuing to be invested in and so forth. So clearly I would say again, slowdown. I don't know if I can predict more than that until we see what settles out a lot of these projects which I think is too early to know that.

Aero as we know Boeing has gone back to work so that'll help to some degree although the 787 continues to have problems with push-outs.

And then on the general industrial, clearly we'll continue to see, we believe, slowdown in that end. Anything on the residential side, the slowdowns that we're seeing now related to that are quite small in percentage since we also saw a large impact on that already in the previous year.

Now if you look at water management as I mentioned, I think I went through that with you, is that clearly we're expecting slowdown. If you look at many of the market indicators continue to decline on square footage that will be put in place. The positive side of that is that on the water wastewater control side we continue to see double digit performance of water [booked]. Now unfortunately it's probably 1 or 2% of our business, but -- we'd like to see that be bigger. But that side of the business is continuing to put that in because it's important to that side. And our [breakthroughs] I believe are offsetting some of the decline that's taking place on the water management side that we continue to work on -- water conservation, green type products and [our breakthroughs]. Does that answer your question, Jim?

Yes, that's very helpful. Two quick follow-ups. One is I don't know if you think about it in these terms but has the weighted average life of the backlog changed in any way? Obviously you've got some things that are two-week backlogs and others that are --

I would classify at this point it's flat to the previous quarter.

Okay.

Maybe, Jim, maybe one just clarifying. If you look at our backlog on the water management side, the core Zurn business has backlog of only a couple of weeks. The majority of the backlog in the water management segment really relates to the water -- wastewater treatment side of the business. So the visibility inside the core Zurn businesses is less than I would say the Power Transmission business.

Consider it a book and ship business from contractors more than anything else.

That's the way that I think about it and then I'm just curious if there's sort of a time lag, if the water management products are installed towards the end of a commercial project.

Actually they vary for us because of the breadth of products we have, from roof [drains] to start of the roof construction and the brass side of it which starts -- goes in in the final installation of the (inaudible). It's pretty much, maybe almost a 50/50 spread of what that could be.

That's helpful, thanks. And my last question is just can you talk a little bit about what flexibility you have with respect to the cost structure, to the extent that we (inaudible)?

Yes, clearly there's flexibility clearly on the labor side, for us to look at that. We continue and always look at footprint as far as what we have and will continue to do that going forward and maybe even take a harder look at that, as far as -- based on the economic climate. But a lot of it would be on flexibility is clearly on the labor side of it. Even on our water management side, our sales cost to what we have is pretty flexible because we use a network, predominantly in that arena versus a direct sales force on the Power Transmission side.

Are the Power Transmission sales force -- are they commission based or ...?

No. And recall we (inaudible) through a lot of distribution in terms of aftermarket.

That's right. Okay. Well, thank you very much for the disclosure. It's helpful.

You're welcome.

Thank you. There are no further questions in queue. I'd like to turn the call back over to you with your closing comments.

Okay, well I'd like to thank everyone for listening and for your attention on our call today. We appreciate your interest in Rexnord and look forward to providing further updates when we announce our third-quarter results in the coming months. Have a good day, everyone.

Thank you. This concludes the Rexnord second quarter fiscal 2009 earnings results conference call. Thank you, everyone, for joining; you may now disconnect.