Zurn Elkay Water Solutions Corp (ZWS) 2010 Q3 法說會逐字稿

Good morning and welcome to the Rexnord Third Quarter Fiscal 2010 earnings results Conference Call with Todd Adams, Chief Executive Officer and George Moore, Chief Financial Officer of Rexnord. This call is being recorded and will be available on replay for a period of two weeks. The phone numbers for the replay can be found in the Earnings Release the Company filed on an 8-K with the SEC yesterday, February 4, and is also posted to the Company's website at Www.Rexnord.com. At this time for opening remarks and introductions, I would like to turn the call over to Mr. George Moore, Chief Financial Officer of Rexnord. Please go ahead.

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 the Press Release we filed yesterday as well as our filings with the SEC. Today's call will provide an update on our overall performance for the quarter including details on our two business segments, followed by an overview of certain financial statements and liquidity highlights. After this discussion we'll open up the call to your questions. Now I'll turn the call over to Todd Adams, Chief Executive Officer of Rexnord.

Thanks, George. Good morning, everyone, and thank you for joining us today to provide an overview of our Rexnord Third Quarter results. As we get started, I want to make a few general comments on the quarter. If you've had a chance to read our Earnings Release and 10-Q, you will notice that the overall economic and operating environment has trended generally in line with our expectations. We're seeing stability in the end markets we expected to in our execution and operating performance of delivering the margin expansion and strong cash flows we had targeted.

Just to expand on those points a little bit. As we look at our power transmission businesses, we're seeing stability in the MRO and short cycle portions of our businesses as inventory levels at our customers and channel partners have been right sized to current demand. While the CapEx or longer cycle portions of our businesses remain challenging and will likely continue to be over the next couple quarters as industrial production and capacity utilization operate at historically low levels, within our Water Management businesses, we are seeing pace of recovery and volume in our order and quotation activity as we had expected, while the infrastructure, commercial and residential construction markets we serve within our Zurn business continue to be predictably challenging, but as we'll talk on the call we are clearly outperforming the market and increasingly well positioned to drive growth through a tough cycle that will run its course over the next 12-18 months. So broadly I would characterize our view of the environment and end markets as becoming more stable or at least more predictable compared to any significant recovery.

With that, I'm going to start on slide four and go over a summary of our consolidated operating performance in the third quarter. Third Quarter sales were $365.7 million, which represented a 17.5% decline from the prior year Third Quarter. Core sales which is year-over-year sales in existing businesses and excludes currency contracted 20.4%. Our Third Quarter adjusted EBITDA margin excluding the impact of pensions increased 230 basis points year-over-year as adjusted EBITDA, again excluding the impact of pensions contracted only $5.1 million on a sales decline of $77.4 million resulting in a detrimental margin of 6.6%. Our free cash flow continued to be very strong as we generated just over $56 million of free cash flow in the quarter increasing our free cash flow to $127 million through the first nine months of fiscal 2010 compared to $80 million in the same period last year, and finally our net debt leverage at the operating Company level was 6.7 times at the end of our Third Quarter compared to five at the end of our Fiscal 2009 and 6.8 approximately three and a half years ago at the time of the Apollo LBO.

While sales in our Third Quarter were basically flat with the Second Quarter, we were encouraged by the sequential increase in daily order rates of 9%, which drove our backlog up approximately $3 million more than it had been at the end of the Second Quarter, the first increase in our backlog since September 2008. As our end markets continue to recover over the course of 2010 and into 2011, we believe that the work we're doing now will position us to deliver sustainable core growth while driving solid operating margin expansion and free cash flow over the long term.

Next I'm going to turn to slide five and take a few minutes to walk through the operating performance of our power transmission platform. Sales in the quarter were $246.4 million a decline of 21.9% in the prior year Third Quarter. Currency was favorable to the prior year by 390 basis points, which equates to a 25.8% contraction of core sales in the quarter. From a profitability perspective, adjusted EBITDA in the quarter was $51.6 million or 20.9% of sales compared to $61.7 million or 19.6% of sales in the prior year Third Quarter. Excluding the impact of pensions on the current and prior year Third Quarters, our Third Quarter adjusted EBITDA margin expanded 230 basis points from the prior year as the benefits at cost reduction actions we've taken, lower material prices, and productivity gains more than offset the unfavorable impact of lower year-over-year sales in our operating leverage.

Sequentially, adjusted EBITDA margins expanded 120 basis points from the Second Quarter as we've increased our adjusted EBITDA by $4.6 million on an $8 million sequential increase in sales. To close on power transmission, we're encouraged by the sequential improvement in both sales and order rates during the quarter. Our teams continued to deliver solid operating performance as evidenced by the 11.6% detrimental margin in the quarter excluding the impact of pensions while improving our inventory turns. We are increasing our level of investment in new product development and innovation taking action to enhance our global position of our businesses in this segmental lo indicating resources to drive sustainable market share gains. As a success of our strategic actions materialize, we believe that we will enhance the ability of our power transmission businesses to deliver solid core growth and profitability over the long term.

Now I'll turn to page six in the presentation and provide comments on our Water Management platform. Sales in the Water Management platform were $119.3 million and contracted 6.4% from the prior year Third Quarter with core sales declining 7.1% as foreign currency benefited sales year-over-year by 70 basis points. In looking at the pieces of our platform, within our Zurn businesses, our core sales contraction was in the mid to low teens but only in the high single digits if you exclude the impact of the distribution channel exit that we consciously made earlier in this fiscal year. Given the overall end market declines in certain sectors of the infrastructure end market, as well as the commercial and residential end markets, we're confident that we're continuing to gain share in our Zurn businesses and as we've previously discussed our water and wastewater treatment businesses performed well in the quarter. Our order flotation activity in the water treatment businesses remain strong and we saw our order rates increase significantly, really for the first time since September 2008, as municipalities had been holding off on orders waiting to see how the economic crisis and stimulus package would impact the much needed expansions and new installations of water and wastewater treatment facilities.

From a profitability perspective, Water Management adjusted EBITDA in the quarter increased $2.6 million from the prior year quarter despite a 6.4% sales decline to $23.2 million or 19.4% of sales. As a result, our adjusted EBITDA margin expanded 320 basis points year-over-year as a result of our cost reductions, material costs, and productivity gains.

Stepping back and looking at our Water Management segment, we're very pleased with the performance. We actually generated more earnings in the third quarter than a year ago despite lower sales, which is a testament to the flexible operating model we have in our Zurn businesses and the benefits of the end market diversity we added to the platform through the acquisition of our water treatment businesses over the past two years. As we look ahead in the Water Management platform, it's clear the market we serve in our Zurn businesses will be challenging over the next 12 months given the lead lag impact of the historically low architectural billings we've seen over the past 18 months. However we believe we've positioned ourselves to penetrate and serve alternative Markets through driving specification, new product development and enhancing our service levels in overall Zurn model.

On the water and wastewater treatment side of our segment, we are well positioned to capture the market growth we'll see over the next several years as the much needed investment in new and expanded facilities is finally spent after a year or so of uncertainty that have kept municipalities from moving forward on projects.

Before I turn the call over to George to discuss the financial statements and liquidity highlights, just a couple of final thoughts on the quarter. Like you're probably hearing from many industrial companies, we think for the most part the worst of the economic crisis is past. We're also grounded in the fact that the collateral impact of the past couple of years is going to have an impact on many of our end markets over the next 12 months. Overall we're pleased that the trends of the way the Company is performing and I'm extremely proud and appreciative of the way our associates have worked to focus and deliver on the needs of our customers in what has been a difficult environment to say the least.

Moving forward our focus will continue to be on controlling what we can control. Continuing to focus on our customers while driving our free cash flow and operating performance so that we can continue to invest in our businesses & Associates to drive the long term growth and success of Rexnord. With that I'll turn the call over to George to cover the financials.

Thanks, Todd. I'm on page seven of the presentation and we'll start with a few cash flow highlights. As Todd commented earlier, we generated $56.2 million of free cash flow in the third quarter increasing our fiscal year to date free cash flow to $127 million, which compares to $80 million in the same period one year ago. Included in our year-to-date free cash flow is $14.4 million of cash restructuring costs and $6 million in fees incurred as part of the debt exchange offer we completed in April of 2009. Over the past 12 months, we have generated almost $164 million in free cash flow, which includes $19 million of cash restructuring costs and $6 million of debt exchange offer fees. Excluding these cash out flows our free cash flow over the past 12 months was $189 million with over $97 million coming from inventory reductions.

In addition, we continue to closely monitor our capital spending. In the nine months of fiscal 2010, our capital spending was $13.6 million or 1.2% of sales compared to $29.9 million or 2.1% of sales last year. We have reduced our capital spending by nearly 55% year-over-year through nine months of fiscal 2010, which demonstrates our ability to flex capital spending with the changes in our sales volume. Despite the curtailed spending, we continued to make delivered investments in key areas to drive growth and improve productivity.

Moving on to debt and liquidity. Our cash balance at the end of the Third Quarter was $258 million. During the nine months of fiscal 2010, our cash balance declined $19.3 million, as free cash flow we generate was more than offset by the $116 million of cash we used to repay outstanding balances on our revolving Credit Facility, Accounts Receivable facility and miscellaneous other debt as well as the $30 million dividend RBS Global will pay to its indirect parent Company Rexnord Holdings in, the which a majority was used to purchase apportion of Rexnord Holdings outstanding. The Rexnord Holdings indebtedness was $84.1 million at the end of our Third Quarter.

Our total debt at the end of the Third Quarter totaled approximately $2.131 billion, which is basically unchanged from the outstanding balance at March 31, 2009, as the aforementioned debt repayments to date were all set by the additional debt incurred from the debt exchange offer completed in April 2009. As of the end of the Third Quarter, we had $765 million of term loan B borrowings, $979 million of 9.5% senior unsecured notes, $79 million of 8.875% senior unsecured notes, $300 million of 11.75% senior subordinated notes and approximately $9 million of other debt. We had no borrowings under our revolving Credit Facility or our asset securitization program as of the end of the Third Quarter.

So, on a net debt basis we ended the quarter at approximately $1.9 billion of net debt, an increase of only $10 million from March 31, 2009, despite the April 2009 exchange offer that increased RBS Global's debt by approximately $105 million. When you look at the net debt at the Rexnord Holdings level, we've reduced our net debt by $282 million from March 31 2009 and just over $330 million from the same period one year ago due to cash flow generation, PIK note buybacks and our debt exchange offer. At the end of the Third Quarter, the Company's net debt leverage ratio was 6.7 times compared to five times at March 31, 2009, and 6.8 times as of the date of the Apollo acquisition of July 21, 2006.

With respect to liquidity, we continue to strengthen our position as we have increased our liquidity from $374 million at March 31, 2009, to $453 million at the end of our Third Quarter. Before I turn the call back to the Operator, I just want to touch on our effective tax rate in the quarter. In the third quarter, we had a recorded tax benefit of $19.4 million on a pretax loss of $16.6 million. The effective tax benefit is substantially higher than the statutory tax benefit due to two main events. First, an IRS examination of the Company's US federal income taxes, which began in January 2009 and was completed during the quarter. The conclusion of the examination resulted in recognizing an income tax benefit for the reduction of a liability related to certain unrecognized tax benefits with no corresponding impact on our pretax loss.

Second, we chose to participate in a new Brazilian tax settlement program that effectively reduced the outstanding liability we had recorded for certain tax obligations related to our operations in Brazil, and as a result, we recognized an income tax benefit for the reduction in this liability with no corresponding impact on our pre-tax loss. Cash payments for taxes net of refunds were approximately $9.3 million in the nine months of Fiscal 2010 and we anticipate total net cash payments for the full fiscal year to be approximately $15 million.

With that, I'll now turn the call back over to the Operator to take questions.

(Operator Instructions). We will take our first question from Tom Klamka with Credit Suisse.

Hello?

Hi, Tom, how are you?

Good, thank you. Can you go back to the Water Management business? First of all I guess how much of that business is wastewater management part of it and percentage wise and how much is commercial construction and talk about what you're seeing on the construction side in that business?

Tom, I think if you looked at it kind of percentage basis, I would call it the municipal water element of the business is 25% to 35% of the business, sort of has exposure to that particular end market, and the rest of the business is split between of the rest probably 75% to 80% is commercial construction, the balance being residential. If you look at even inside the commercial construction I would say we are overweight infrastructure, so I would tell you that on the pure commercial construction market you're seeing square footage put in place, starts, everything down in the 40 plus, high 40s this past year. I think the outlook is probably a little bit better, but still down. I can tell you that our businesses are somewhat more focused on municipal buildings, schools, hospitals, and so the growth rates there are the declines frankly are much more muted. So, commercial construction broadly speaking is very difficult and will continue to be, but I think our end market focus inside of that helps insulate us from the full brunt of that. But no doubt the market is challenging.

Yes, but I guess your revenues don't reflect, I mean they're down 6.5% or so which is challenging but it's not that bad considering the end markets. Is that because of growth in the Muni part of it or is it just that because it's later stage you haven't seen the full impact?

I think it's a little bit of both. I think we clearly feel like we're outperforming the market. I think as we've talked about a little bit there is some alternative market channels, we've been I think very progressive in our water conservation products that we've been talking about for a few years. So we're getting very good traction so that's driving some of the outperformance, and I think in a lot of ways based on the lead lag, 2010 is going to be the year where you see I think a more difficult market contraction. As we understand our businesses, there's elements that it cycles through. So from a time win, you start construction to the finish trim of putting in the final sensor faucets and sensor flush valves, there's a lead lag and so as we've looked at it 2010 will probably be a more difficult year from a market perspective just based on construction starts being completed.

Okay, and then when you look at the volume decline versus year-over-year margin increase here, how much of that margin and EBITDA increase is due to raw materials and how much is due to cost savings and what else is factoring into that?

There is an element, Tom of the year-over-year benefit as a result of favorable material. I don't think we're going to get into specifics about how much it was because frankly we've got a program in place that actively allows us to go out and hedge and buy materials effectively. But offsetting that, so materials are favorable but if you look through other elements that are unfavorable, the capacity utilization in our factories and facilities is far less so that's a bit of a head wind. So if you think forward and assume that the material benefit is going to unwind or at least contract a little bit, offsetting that is basic productivity gains we're driving and we can control and also the fact that we're coming off a quarter in which the factories are running at less than full capacity by a long shot, so we're going to get favorable absorption into our businesses as well.

Okay, and on the PT business, can you just talk a little bit about the OE side and what you're seeing there? I think you just talked about the MRO side.

I think it really is end market specific, Tom, so when you talk about OEMs in beverage and container and probably more early stage consumer businesses we're seeing, slight growth, if you looked at other elements in terms of our end markets around mining, energy, aerospace and aggregates, I think they're a challenge. I think if you look at aerospace over a long period of time, you're going to see nice growth. Mining, if you think when you buy into the fact that China and India are going to continue to develop, which I think is absolutely going to happen. The demand for raw materials is going to increase the amount of mining equipment required around the world and we're well positioned, so I would say that it's very early. We're not seeing those businesses turn from a Cap Ex perspective yet, but I think they're very good end markets to be in over the long term.

Thank you very much.

Thanks.

Thank you and we will now move to Matt Vittorioso, sorry about the pronunciation.

Thanks, guys.

Hi, Matt.

How are you?

Good.

Was wondering if you could just talk about inventories for a quick second. You've gotten your inventories down pretty nicely here and you've generated a lot of good cash flow. What's your expectation for 2010, can you continue to reduce inventory from here?

The simple answer Matt is absolutely. I think the pace as we move into 2010 will probably decline a bit but we're targeting continuous improvement in our ability to accelerate our inventory turns. So while the absolute magnitude of the dollars into I guess our fiscal 2011 won't be what it is. You will see turns improvement and you'll see turns improvement in our inventories for a long period of time, so the short answer is, it won't be as much but there will be continued improvement in our inventory turns.

Okay, great, and Cap Ex for 2010, do you expect it to change materially from 2009?

I think if you were to look at it as a percentage offer sales it's probably in the 2% to 2.5% range as we look forward based on some things that we're doing consciously around new product development and some global expansion opportunities that we see as key to our future, so I would take 2% to 2.5% is probably a reasonable expectation into next year, as we see it today.

Okay, and then could you just provide what is I know you did a $30 million dividend during this Third Quarter. What's your total capacity to do dividends to the parent as we stand here today?

The restricted payment basket is over $200 million but it's limited $25 million under our general basket currently until some of our ratios come back up.

So $25 million today based on current ratios?

Yes.

And then just if I could just kind of synthesize in the back of Tom's questions there, as you look at Water Management and we look out over 2010 certainly it's going to be a challenging year, but the puts and takes on the margins, do you expect to be able to hold margins where they are or will they soften somewhat? What's your expectation there just generally?

I think, Matt, as we look at the margin percentage I would say it's a 20 plus percent business over the cycle and so I think the short answer is yes, we absolutely think we should hold the margins in Water Management, depending on lead lag and material cost and price increase potentially and the things like that, it will bob around a little bit but I think it's a 20% plus business on a sustainable basis.

Great. Good quarter, thanks.

(Operator Instructions). Now moving on to Yilma Abebe. Please go ahead with JPMorgan.

Thank you, good morning. I guess firstly on the order rates that you saw in the December quarter carrying on so far this year?

I'm sorry, can you repeat the question?

Yes, the general order rates trends that you saw in the December quarter, is that carrying over into the new quarter here?

We've seen relative stability as we look at January in the first part of February. So we haven't seen, I wouldn't characterize it as further acceleration. I would say we've saw continued stability in the order rates for the most part.

And then my second question is you're allowing a lot of cash. Can you comment on your use of cash and why not pay more debt now that you're long over $50 million in cash?

I think it's a good question. As we look at our Balance Sheet there's no question that over time, we need to delever, if you look at the way we viewed the world really since 2007, we've gotten very conservative in our view and so sitting here today, we believe holding cash allows us the most amount of flexibility from a overall liquidity standpoint as well as opportunistically thinking about potentially a small bolt on acquisition in the future. There's nothing on the horizon, but from a term debt perspective, if you pay that back it's a permanent payback. At this point we like the flexibility of holding the cash with a long term view of we know we have to delever the business and so that's why we think the net debt view is the right way to look at it because that's sort of at the end of the day the right way to view the ultimate success of de levering the business.

Thank you, that's all I had.

We'll now take a question from Kathy Nolan, Stone Harbor Investments.

Yes, good morning. I apologize if this is in the Press Release but I couldn't find the backlog number for quarter end, if that's available?

It would be, Kathy, in the 10-Q. We'll get it for you in the second, but I think it's right around $375 million as of the end of the quarter.

Thank you.

(Operator Instructions). We will take a question from Bob Franklin.

Hi, you mentioned your ability to upstream was restricted to the current covenants. Can you tell us what your covenants are and when you get to ease up on that?

It's a fixed charge coverage ratio and we're probably a year ago from that coming back, to where we would be restricted payment basket.

Okay, by your math what is it now?

I don't have that in front of me.

Well what does it have to get to before you can move more money up?

Two.

Okay, great. Thank you.

Thanks.

And now moving to a question from Phillip Vialpatelli, Cantor Fitzgerald.

Thank you.

It's all the Irishmen on the call this morning.

Yes, we're making it difficult on the Operator.

Good morning.

My question is with regard to the debt exchange you did earlier in the year, what limitations are there if any to another debt exchange as you look forward with your improving your Balance Sheet?

It's a similar set of covenant-type restrictions really around value to equity, right? So the fixed charge coverage ratio, the amount of exchange that would be deemed to be a benefit to the hold co would sort of be restricted, would be sort of subject to the same limitation of this $25 million basket.

Okay--

So the short answer is we could do an exchange; however there would be some covenant limitations on the type and the amount that we would be able to do.

Understood and then at the operating Company, there probably are no limitations between your two classes of senior notes?

That is correct.

Okay, great. Thank you.

At this time there's no additional questions. I will close out the call and turn the call back over to your moderator for closing remarks.

Thank you, everyone, for listening this morning. We appreciate your interest in Rexnord and look forward to providing an update on our Fourth Quarter some time in the coming months. Have a great weekend, thanks.

And with that that will conclude your conference for today. We do thank you for your participation.