Zurn Elkay Water Solutions Corp (ZWS) 2011 Q3 法說會逐字稿

Good morning and welcome to the Rexnord third-quarter fiscal 2011 earnings results conference call with Todd Adams, Chief Executive Officer, and Mike Shapiro, 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 3, and is also posted on the Company's website at www.Rexnord.com.

At this time for opening remarks and introductions I will turn the call over to Mike Shapiro, Chief Financial Officer of Rexnord.

Thank you. Good morning, everyone. Before we 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 in 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 our financial statement and liquidity highlights. After this discussion, we will open up the call to your questions.

Now I will turn the call over to Todd Adams, Chief Executive Officer of Rexnord.

Thanks, Mike, and good morning, everyone. Thank you for joining us today for an overview of our fiscal 2011 third quarter. As we highlighted in our release, we are pleased with our performance in the quarter. Our consolidated core sales growth accelerated to 15% in the quarter, driven by continued strong performance in our Process & Motion Control platform and is inclusive of the flat sales performance in our Water Management platform, where we are clearly outperforming the fundamental market growth in our served markets.

EBITDA and margins improved 40 basis points year-over-year despite commodity headwinds and without the benefit of price increases that we've recently implemented. Through the first nine months of the fiscal year, our core sales growth has been 13%; our EBITDA margins have expanded 180 basis points; and we have generated $57 million of free cash flow.

In terms of color commentary on our demand and outlook, our incoming order rates over the course of the third quarter and early in the fourth quarter are broadly trending in line with our expectations. With respect to the Process & Motion Control platform we are seeing relatively stable and solid demand patterns across many of our North American and European vertical markets; very strong demand in emerging markets; and improving inquiry, quotation, and order patterns in many of our longer cycle businesses and markets.

Not surprisingly, the markets we serve within our Water Management business remain challenging and will continue to be in the near term. However, we are encouraged by some of the trends we are seeing in the forward indicators, like architectural billings and construction loan activity, which point to a solid market recovery that we are well positioned to capitalize on over the coming years, based on the work we have done within our businesses.

With that as a backdrop, let's move to page 4 and I will review the operating performance on a consolidated basis for the third quarter. Third-quarter sales were roughly $420 million, an increase of 15% from the prior-year third quarter. Our core sales growth was also 15%, as the impact of the foreign currency was minimal.

EBITDA was $80.1 million or 19.1% of sales, as margins expanded 40 basis points compared to the prior year. Operating income in the third quarter increased nearly 36% to $50.4 million and as a percentage of sales increased 190 basis points year-over-year to 12%. Given our relatively high level of depreciation and amortization as a result of our LBO history, operating income margin expansion is a more accurate measure of the real operating leverage we are getting on our organic sales growth, which gets diluted a bit when you look at it solely on an EBITDA basis.

Free cash flow in the third quarter was $12.7 million, which is after roughly $55 million of cash interest paid in the quarter. Our liquidity position remains solid at about $521 million.

Finally, our net debt leverage at the Operating Company level was 5.8 times at the end of our third quarter compared to 6.7 times at March 2010, and 6.8 times four years ago at the time of the Apollo LBO.

Next I will take a few minutes on slide 5 to walk through the operating performance in our Process & Motion Control platform. Sales in the quarter were just under $300 million, an increase of 22% from the prior-year third order. Currency adversely impacted our sales growth by 1 point, resulting in core growth of 23%.

From a profitability perspective in the quarter, our adjusted EBITDA increased over 28% to $66.3 million; and our adjusted EBITDA as a percentage of sales increased 120 basis points to 22.1%. The year-over-year margin expansion was driven by productivity gains and the operating leverage on the increased sales volume, partially offset by material cost headwinds, and are inclusive of the substantial investments we are making in expanding our global footprint, significant new product development activities, and other capabilities we are investing in to drive sustainable future growth and profitability.

Turning to page 6 I will make a few comments on our Water Management platform. Third-quarter sales in the Water Management platform increased 1% from the prior year to $120.2 million. The impact of currency was minimal, resulting in core sales growth of 1% as well.

Within our Zurn businesses, core sales were roughly flat year-over-year. Given the market basket of the various sectors within the infrastructure and commercial construction end markets we serve, posting double-digit declines in the quarter, we're confident that we are taking market share in the new construction market as well as successfully penetrating and growing in alternative markets.

With respect to our water and wastewater treatment businesses, sales in the quarter were up in the low single digit range compared to the prior year, and our inquiry and quotation activity remains strong. However, we have seen an increase in the lead time from order quotation to order placement.

We remain confident that our water and wastewater treatment businesses will provide steady growth over the long term, given the aging infrastructure in the developed countries and an increasing need for water and wastewater management in emerging markets.

From a profitability standpoint, third-quarter adjusted EBITDA declined $2.4 million from the prior year to just under $21 million or 17.3% of sales. Our adjusted EBITDA margins declined 210 basis points year-over-year in the quarter, primarily due to material cost headwinds and the impact of the variability of the profit margins of certain water and wastewater treatment project shipments in the quarter compared to the prior year.

To close on Water Management, despite the fact that we are seeing some encouraging signs in the leading indicators, we expect that our Zurn business will continue to face challenging market conditions over the next calendar year. That being said, we remain confident in our ability to outperform the markets through our focus on driving increased specifications of our products in both our core and alternative markets, as well as accelerating new product developments. When we look at the water and wastewater treatment end markets, the fundamental market characteristics remain solid over the long term, and we feel that we're well positioned to capture the market growth we see coming down the road.

To close on the third quarter, just a few final comments. As pleased as we are with the financial results this year, I am even more encouraged with the pace of innovation, global expansion, and investments in capabilities we're making to create value for our customers. From our vantage point, the global economic recovery is still in its relatively early stages.

Given the fact today that the majority of our businesses serve mid- to late-cycle vertical markets, over the past couple years we have taken the opportunity to reposition our businesses to drive more stable and consistent growth over a business cycle. That fundamental growth capability and gradually improving end market dynamics, coupled with our continued deployment of the Rexnord business system, put us in a position to deliver solid financial results over the coming years.

With that I will turn it over to Mike to cover certain financial statement and liquidity highlights. Thanks, Mike.

Thanks, Todd. I'm on page 7 of the presentation, and I will start with a few cash flow and liquidity highlights. As Todd commented earlier, we generated $12.7 million in free cash flow in the third quarter and $57 million year-to-date. Working capital was reduced by approximately $7 million in the quarter and as a percent of sales improved 90 basis points year-over-year to 23.5%.

We continue to focus on working capital efficiency, and I expect to see further improvements in our fourth quarter and beyond. With respect to capital, we have spent approximately $20 million through the first nine months of the fiscal year and expect capital spending to be approximately 2% of sales for the full year.

Moving on to debt and liquidity, during fiscal 2011 our cash balances have increased nearly $55 million and totaled $318 million at the end of the third quarter. Our liquidity position remained strong at $521 million, an increase of $50 million from March of 2010.

Our total debt at the end of the third quarter $2.222 billion, an increase of $93 million in fiscal 2011. There were no meaningful changes in the composition of our debt during the quarter, which is detailed in the notes to our financial statements in the 10-Q.

On a net debt basis, we ended the quarter at approximately $1.904 billion of net debt, an increase of $38 million from March of 2010. Again, the increase is due to the April 2010 debt refinancing, net of the cash we have generated in fiscal 2011.

At the end of the third quarter the Company's net debt leverage ratio was 5.8 times compared to 6.7 times at March 31, 2010. Overall, I am very pleased with our cash flow generation, liquidity position, and improving leverage profile.

With that I will turn the call back over to the operator and open it up to any of your questions.

(Operator Instructions) Tom Klamka, Credit Suisse.

Good morning. You mentioned commodity prices quickly in the beginning, but can you talk about what impact they have had on you? Given that you guys buy a lot of components as opposed to raw steel, will there be a lag before you feel the impact of rising copper and metals costs?

No, I think in terms of -- have we seen the impact within the financial results that we have posted? I think the answer is yes. I think we have gone out with price increases over the past several months that we expect to begin to allow us to recover a good portion, if not all, of the headwind.

We have been through a period of I would say substantial commodity inflation in an environment where the market conditions have been very tough. So it's only very recently that we have been able to get price increases passed through, and we expect that to start to play out over this first half of calendar 2011.

What is the level of price increases you have been able to push through into the market? Is that the same at PMC and Water?

No, it's not. It really varies by product and market. I would characterize the price increases in our Process & Motion Control businesses at 5 or below. I would say that our price increases within our Zurn business are 5 to 10, depending on the product and really what is happening with competition and things like that. So it is different in each of the segments.

Okay, and if you look at the PMC earnings, it looks like the incremental margin was somewhat below your overall gross margin. Actually we don't have gross margins for PMC; but your incremental margin at PMC looked like it was in the high 20%s. How does that compare to your gross margin in that business, and how does it compare to where you want to be?

I think when we look through it, Tom, through on an operating basis, within Process & Motion Control our target is going to be 35% to 40% incremental margins. I think it's a little bit lower this quarter as a result of commodities and where we are in terms of crossing over between reflecting the increased commodity costs without necessarily having the price.

I think there is obviously always going to be some mix issues within the quarter. And it also includes, as we pointed out in the opening remarks, a fair amount of investment in new product development -- that we have done a substantial amount of work on new product development over the course of the last year. We have expanded our global footprint, and we are putting in a lot of commercial capabilities in this year that are going to set us up for growth down the road.

So our target hasn't changed the fundamental mix and some commodity costs that are going to sort themselves out, and we are really taking the opportunity to invest in that business for growth and profitability down the road. So that is really, I think, when you look at the incremental margins, what you are seeing in this particular quarter.

Are those costs -- are they going through COGS? Are they going through SG&A? Or where can we see those costs?

It depends. Some of the commercial activities are going through SG&A. The new product development is primarily going through SG&A. But there is a fair amount of footprint and other capabilities that we are putting in that are going to the gross profit line.

To give you an exact split, I am not sure that I have that with me or in front of me. But fundamentally it's a little bit of both.

Right. Then in the 8-K you make reference to on the Water Management side alternative channels, which I guess is more sort of the aftermarket. Can you just talk about what you have done in that market and what the growth is there, versus more at the OE side of the business?

Sure. You know, I think it's -- obviously for the last four years the new construction markets have been very, very tough. What we have done there over the past several years is really identify alternative markets around the retrofit opportunities that are available, and spent an enormous amount of time and effort penetrating that particular market, which actually is growing and has the potential to be quite large over time.

So that focus on that alternative market and looking at retrofit has paid dividends. Our Zurn business is notionally flat in the quarter, maybe up a point or two over the course of the fiscal year. Clearly the new construction markets that we serve are down well into the double digits, high to mid teens.

And so for us to come in on a flat basis, it is a couple things. One, we are successfully penetrating the retrofit market and driving growth. And secondly we are taking market share even in that new construction market.

So it's a lot of work by our teams to identify it, get after it, build the tools, the go-to-market, and the value proposition to make it happen. But as exciting as it is now, it really positions us well when the market starts to turn.

Because if we have that fundamental relationship and specification in a down market, when the market flattens out to starts to grow, you are going to accelerate the fundamental growth that you're going to deliver, based on the work that we have done in the bottom here.

So it is paying dividend today, but I think the real measuring stick is going to be over the next three to five years, as we see some gradual recovery to a more normalized rate of new construction, as well as continued growth in the retrofit market.

Okay, great. Thank you.

Yilma Abebe, JPMorgan.

Thank you. Good morning. In the Water Management business, it looks like EBITDA margins declined about 210 basis points. Like you said, it looks like part of it is due to raw materials and part of it is due to mix.

Can you talk about the mix issue here? What is going on there?

Sure. I think when you step back and look at our Water Management platform it is two fundamentally different businesses. I would characterize our Zurn business as very much a short cycle flow business, and the margins there are relatively consistent and stable. Obviously, impacted by the crossover between our ability to pass on price increases compared to commodity cost increases. So I think that is a simpler one to understand.

Inside of our water treatment businesses, however, these are for the most part larger projects. When you look at it over any given quarter or any given year, there are certain projects that go into our backlog based on competitive dynamics, based on market conditions, based on commodity costs, at different profit margins. So when they actually ship out of backlog in a given quarter you do have some variability, Yilma, in the overall profitability of the segment based on that.

I will tell you that it's not bad; it is just different than it was perhaps a year ago. A year ago, projects that were shipping out of our backlog were put into the backlog during a time when the pricing environment was very good and delivered at a time when the commodity environment was very favorable to us. So the margins that we were generating last year inside of the water treatment portion of our Water Management platform were very good.

This year they are still good; they are simply not as good as they were last year. So I think educating people a little bit on the composition of the segment and how things will flow in and out of there is important. So I am glad that you asked the question, but that is really fundamentally the mix issue that we talk about.

Thanks. That's good color. So if I look at this 210 basis point year-over-year margin decline in quarters [and halves], how much of that is raw material, how much of that is really the mix issue you just discussed?

Yes, I would characterize it as probably roughly two-thirds material and a third mix.

Okay, okay. Thanks. That's helpful. Then my final question is in the Water Management business, what is the exposure? Is there any way to tell the exposure to municipalities? Obviously it's been topical these days.

When you say exposure to municipalities --?

Yes, municipal in a bond, local expenditures and so forth.

Sure. Within our Water Management segment, notionally $75 million to $100 million of that is in our water treatment businesses that are exposed to municipal water, wastewater. So inside of that almost all of our exposure is really in North America.

It's fundamentally user rates, so it's not a matter of bond issuances or anything else. The funding mechanism inside water treatment is state revolving funds. So it is low- or no-cost loans between the EPA and the municipalities to upgrade the water treatment and water supply side. And the payback of the loans is done through really effectively user rates, as opposed to municipalities having to go out and raise bonds or things like that.

So it's a fairly steady funding stream, Yilma. It really just comes down to the timing of certain projects, the competitive situation in certain areas and regions, who the contractors are, and things like that. So the funding is there; it simply comes down to the timing.

Okay. So I think it would be fair to say that given all the local problems a lot of municipalities are having, it is not really showing up in terms of a direct impact to your business?

No. I mean, I guess not directly. I think it doesn't manifest itself in us seeing wastewater treatment facilities not being built. Clearly the health of municipalities is important to the overall economy; but it is not really impacting, I think, our fundamental trajectory in this segment.

Great. That's all I had. Thank you very much.

Matt Vittorioso, Barclays Capital.

Good morning. Good quarter. Just maybe a little bit more color on your ability to generate some more cash in this coming fourth quarter. You gave some guidance around CapEx for the fourth quarter. What is your high-level expectation for working capital?

Are you ramping up there on the power transmission side? Or should we expect to see any major movements in working capital this next quarter?

I think we're going to be working capital is going to be a source of cash for sure in our fourth-quarter. When you look at the year-to-date results of $55 million of free cash flow, that is net of $120-ish-million of cash pay interest. So fundamentally we are generating very solid cash flows from an operating standpoint.

From a working capital standpoint specifically, we see a very good reduction coming in our fourth quarter. We have very, I'd say, high targets -- or low targets, depending on which way you want to look at it -- of what we think working capital can be inside of our business, particularly around improving the velocity of our inventory turns. So I would expect, Matt, for us to have a record cash flow quarter in our fourth quarter, based on really us getting after the trade working capital that we should be getting after.

Great. That's good color. Then I would have to ask; you are building up a pretty substantial cash balance here. I think we ask every quarter, but would you consider paying down any of this bank debt?

I know you wanted to maintain some flexibility around some bolt-on acquisitions. Maybe just discuss your expected uses of t his cash and what you are seeing in the acquisition pipeline.

Sure. Again I think our response and my response is going to be somewhat consistent in that I think over time we clearly have to deliver the Company through reducing our debt. We have used the cash as an offset to our debt balances really because it is a nice insurance policy to our overall liquidity, and also to maintain some flexibility around any potential bolt-on M&A that we would look at.

So I don't think our position has changed in the near term. But I think as we get into the next fiscal year, I think it is something we are going to have to continue to evaluate and look at even harder.

Your second question was around the acquisition pipeline. Again we are not going to make any direct comments on the pipeline other than to say -- I would say we are very active in a number of situations that make a lot of sense for us and create value for our customers and our shareholders. So that is really what we're always going to be doing.

I think they all fall inside the scope of the Company doing them inside our existing platforms, and that is probably all we are going to comment on. But we see that as a meaningful part of how we can create value for our stakeholders.

Fair enough. Just since you are somewhat active in looking at the pipeline, any high-level color around what you are seeing from a valuation standpoint? Are sellers looking for higher multiples now that we are sort of entrenched in this recovery? What are you seeing from that standpoint? Any general color?

You know, again, it really varies by situation I think. I would say that -- I am not sure that we ever saw valuation expectations from sellers really decline all that much, because I think the assets that we are looking at are I'd say very attractive and strategic to us. So we are buying I would say very good assets or looking at very good assets.

So I don't think that we have seen much in the way of an increase in seller expectations, really just based on the targets that we are looking at.

Sure, and just lastly maybe a couple housekeeping things for Mike. Would you be -- if you have it in front of you, do you have the balance of your HoldCo debt as of December 31?

Also I was curious where you are on your fixed charge coverage ratio as far as being able to use your RP basket to its fullest, and what that RP basket might be today. And that's it. Thanks.

Sure, Matt. The HoldCo notes, again those PIK interests, they are approximately $90 million at the end of the third quarter.

The fixed charge coverage ratio is 1.92 as disclosed in the documents. So obviously we are still restricted from utilizing the RP basket, which is approximately $300 million at the end of the quarter.

Great. Thanks, guys.

Julian Mitchell, Credit Suisse.

Hi, this is actually Sheila Kahyaoglu on behalf of Julian. Good morning. I just wanted to follow up on Tom's question a bit with regards to raw material costs. Do you have a breakdown of what percentage of COGS raw material purchases versus secondary suppliers and components?

Also, what percentage of that is direct raw material purchases versus long-term contracts and hedging?

I guess finally could you give us an idea of what the value gap looks like in terms of price and raw material headwinds?

So I think there's a number of questions there, Sheila. I am not sure we have or we are going to get into the details in terms of the overall breakdown in the procurement spend, other than it does vary by segment. So to give you a blanket answer, it is very different.

In our Process & Motion Control segment we are little bit more vertically integrated and we do have -- material is a lesser component of our cost of sales. Inside of our Water Management platform we are less vertically integrated and do more sourcing; so the material impact I guess is perhaps greater and hits us more quickly.

Got it.

So from a process standpoint I think you can take away the fact that we have got a global sourcing organization that is constantly looking at where is the best cost. We have got a number of processes that we have in place that hedge, lock in spot pricing over extended periods of time. And there is a constant rolling of that over the course of time.

So I think from a process standpoint we manage it I think very well. I think the impact is different based on the segment and the composition of the sale. So without directly answering your question, that is some color around it.

Okay.

In terms of the value gap, I am guessing you are referring to really what is the adverse material cost over price impact.

Yes.

Again, that would vary by segment. But I would characterize this is the first quarter that we have actually generated I would call it a positive price impact over the prior quarter in probably the last seven or eight quarters within our Process & Motion Control platform. We, however, still have adverse purchase price relative to the prior year; so we are sort of value-negative in the quarter in Process & Motion Control.

And in the Water Management platform we are clearly sort of value-negative at this point because our price increases really just went out January 1. By the time they become effective, which is sort of new orders or orders that hadn't been quoted, that will really start to read through as we start our first fiscal quarter, fiscal '12, which would be sort of an April time frame.

So I would expect we will be value-negative if you will, in your terms, in our fourth quarter in Water Management; and I would expect value-neutral to maybe slightly positive in our Process & Motion Control platform in the March quarter.

Okay, great. That's very helpful. Thanks.

(Operator Instructions) Philip Volpicelli, Deutsche Bank.

Good morning. I was just wondering, with the cash balance that you have got, $318 million, it is quite a sizable number as Matt said before. How much cash do you need to run the business? And how much of that cash is excess that you could apply to acquisitions or paying down debt?

Phil, I think when we look at it, first of all, the Company generates free cash flow every month. So we don't get into a situation where we don't have free cash flow from operations.

We keep probably somewhere between $30 million and $50 million available to really deal with the timing of our interest payments. Like as an example, our interest payment this last quarter was $55 million.

So from a -- how much cash do you need to run the business? It is a free cash flow business, so effectively you are generating cash each and every day.

In terms of timing, right around that $50 million mark is sort of the right answer for us just based on those semi-annual very lumpy cash interest payments.

Got you. So you've got about $260 million that you could apply. Would you look to make one large acquisition or just a bunch of smaller tuck-in acquisitions? I am just trying to get a sense of the scale that you are looking at.

Well, again, I don't think that we are going to make any sort of comments on what size and scope. It depends.

As you know, we have got a lot of things that we look at continually. Some things come into the funnel, some things come out of the funnel. Some things are larger, some things are smaller.

So it really depends on the situation. Our objective is to create value for all of our stakeholders.

Could they be smaller? Sure. Could they be larger? Sure.

But it's fluid and to make a comment on it is really not something we are going to do.

Okay. Two last questions and I will let you go. Is there a preference in terms of adding on to Process & Motion Control, or is Water Management the focus?

Then the last question is more housekeeping. Can you break down the liquidity between the availability on the revolver and the availability on the AR?

Sure. I will let Mike answer the liquidity question.

In terms of priorities, I think inside of Process & Motion Control our priorities are really around several key product lines, as well as geographic expansion, as well as some adjacencies.

In the Water Management platform, it really is to build out I would say some additional water or wastewater treatment type businesses, as well as expand internationally.

So there are priorities on both, within both platforms. They just happen to be different priorities by segment.

I don't know that we would characterize one over the other. The only real priority is to continue to create value for people and our shareholders.

So that it is the initial filter. Then beneath the segments there are some different needs and desires to really develop the platform to deliver the financial results that we want to deliver over a business cycle.

Hey, Phil, in terms of your question on the liquidity, obviously the cash balance is the largest source of liquidity at $318 million. In addition to that we have a few other sources, which is the AR securitization facility of approximately $80 million, and the balance would be available borrowings under our credit revolver of approximately $122 million.

Great. Thank you very much.

And we have no further questions at this time.

Thanks, Cecilia, and thank you to everyone listening on the call today. We appreciate your interest in Rexnord and look forward to providing further updates when we announce our fourth-quarter and fiscal-year 2011 results in early May. Thanks a lot.

Again this does conclude today's conference, ladies and gentlemen. We appreciate everyone's participation today.