Zurn Elkay Water Solutions Corp (ZWS) 2012 Q3 法說會逐字稿

Good morning and welcome to the Rexnord third-quarter fiscal 2012 earnings results conference call with Tom Adams, President and Chief Executive Officer; and Mark Peterson, 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, January 31, and they're also posted on the Company's website at www.Rexnord.com. At this time, for opening remarks and introductions, I'll turn the conference over to Mr. Mark Peterson, Chief Financial Officer of Rexnord.

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 in our filings with the SEC.

Today's call will provide an update on our overall performance for the third quarter, including details on our two platforms, followed by an overview of our financial statements and liquidity highlights. Afterwards, we'll open the call up for your questions. With that, I will turn the call over to Todd Adams, President and Chief Executive Officer of Rexnord.

Thanks, Mark, and good morning, everyone. Thank you for joining us today for an overview of our fiscal 2012 third-quarter results. Before I get started, I wanted to provide a brief update on the status of our S1 registration process.

As some of you may be aware, we filed an amendment to our S1 with the SEC on November 22 to refresh the financial information for the second quarter, and in the coming weeks, we expect to refresh the S1 again for the third quarter numbers we reported yesterday. Given that we continue to be in registration and in a quiet period, we won't make any further comments on the filing itself or the timing of any anticipated public offering.

Just a few opening comments to start. As we highlighted in the earnings release, we are pleased with a solid 17% growth in the quarter, led by 11% for growth and our Process & Motion Control platform and a 41% increase in sales in our Water Management platform, driven by the inclusion of the VAG acquisition and inclusive of a 3% decline in the core water management businesses.

Consolidated core sales grew 7% in the quarter, while core orders grew 11%m with Process & Motion Control posting 10%-plus core order growth and Water Management orders rising 61% and 13% core. We exited the quarter with a backlog of $491 million, up 30% from March.

As we look at the quarter, there are a few key takeaways. First, the results in the Process & Motion Control platform are really solid. The core growth order rates, margin expansion, and outlook are all tracking to our expectations, and we're well positioned for those trends to continue into our fourth quarter. The growth investments we've made in our exposure to key growing vertical markets, coupled with our operational execution, gives us confidence that the platform can deliver and sustain outstanding performance in fiscal year '13 and beyond.

Secondly, and as we discussed last quarter, we are making strong progress on positioning our Water Management platform for sustainable long-term growth to enhance profitability. I'll spend just a minute on the things our team has accomplished in the quarter.

Looking at the pieces of the Water Management platform, starting with the Zurn business. We continue to grow the top line in the mid-single digit range. This is in spite of being in the final stages of an unprecedented five-year non-res market decline. The growth is due to our efforts to grow in alternative markets, drive broader specification of new products into key vertical markets, and simply take market share in a choppy environment. In addition to growth, we've maintained a flexible operating model and have continued to reduce our fixed cost structure, including the consolidation of two product lines over the course of the third and fourth quarters.

The Zurn business continues to be resilient, performing, and poised to deliver outstanding results as the non-res markets recover. Inside the water and wastewater treatment businesses, it is no secret that the North American municipal markets are tough. To deal with this market reality, we initiated a factory consolidation in the quarter that will be completed by the end of March and will deliver over $5 million of savings heading into our fiscal year '13.

Additionally, as we looked at our product portfolio and geographic reach, we felt in order to capture the long-term secular growth of the water markets, we needed to truly globalize the business, which led us to the VAG acquisition, which closed in early October. Since then the teams have worked through their strategic plan process and are deploying our first global water and wastewater treatment plan that delivers substantial growth and profitability over the next several years.

With that introduction, let's move to page four and I will review our consolidated operating results for the first quarter.

Third-quarter sales were $492 million, again, an increase of 17% from the prior-year third quarter. Core sales increased 7% in the quarter as the VAG acquisition contributed 12% of the growth in the quarter, which was offset by two points due to our fiscal '12 second-quarter divestiture.

Operating income in the quarter was $51 million or 10.4% of sales. Operating income includes a combined $8 million of inventory fair value related adjustments and researching expenses. Excluding these items, operating income would've been 12% of sales in the third quarter.

Third quarter adjusted EBITDA was $90 million or 18.2% of sales. We generated $8 million in free cash flow in the quarter and remain confident that based on some normal seasonality and lower cash interest, we'll generate solid free cash flow in our fourth quarter.

Next, I'll take a few minutes on slide five to walk through the operating performance in our Process & Motion Control platform.

Sales in the quarter were $323 million, as core sales increased 11% from the prior year due to continued solid demand and market share gains across the majority of our share of global markets. Reported sales growth again was 8%, which includes the impact of our second-quarter divestiture. From a profitability standpoint, our income from operations increased 20% year over year, and operating income as a percentage of sales improved 170 basis points to 17.1%. Our adjusted EBITDA as a percentage of sales was 23.7%. Again, up 120 basis points from the prior-year third quarter.

Turning to page six, I'll make a few comments on our Water Management platform. Water management sales in the third quarter increased 41% over the prior year to $169 million. Our acquisition of VAG impacted sales growth by 44%, while core sales declined 3% as the mid-single digit growth in our Zurn businesses, driven by market share gains, was offset by a weaker North American water and wastewater market.

On a positive note, the book-to-bill ratio in our North American water treatment business has stabilized in the quarter at around 1, and we feel that we are beginning to see the tangible signs of a stabilizing market environment. From a profitability perspective, third-quarter adjusted EBITDA was $20 million or 11.9% of sales. Third-quarter margins were adversely impacted by a nonrecurring inventory adjustment, and the frictional costs we're incurring from the plant consolidation efforts I discussed earlier, as well as the impact of the lower profitability on certain long lead time projects within our North American municipal market. We're confident the addition of VAG to our Water Management platform, coupled with the benefits from our costs and footprint reduction efforts, will drive the overall profitability improvements in the platform.

To close, overall, the quarter played out relatively consistently with what we'd been anticipating. The noise in the macroeconomic environment has diminished somewhat over the last 90 days; however, given some of the large uncertainties that remain out there -- the European sovereign debt situation, or slowing growth in the emerging markets, there will no doubt be periods of time and news headlines that will put some level of doubt and uncertainty into the continued recovery of some of our markets over the coming year. Our focus has been and will continue to be controlling the controllable, meaning deploying and executing our long-term growth objectives, profitability and cash flow.

With that, I will turn the call over to Mark to cover certain financial statement and liquidity highlights.

Thanks, Todd. I'm on page seven of the presentation, and we'll start with a few cash flow and liquidity highlights.

As Todd mentioned earlier, we generated $8 million of free cash flow in the third quarter, which compares to $13 million in the prior year third quarter. During fiscal '12 we've been making investments in facility modernization initiatives, productivity improvements, and new product development capabilities, which drove a $9 million increase in capital investments year over year.

Fiscal 2012 year-to-date capital expenditures were approximately 2.7% of sales, and we anticipate a similar ratio through the end of this fiscal year. We continued to effectively manage trade working capital in the quarter as we generated $7 million of cash flow from trade working capital and improved trade working capital as a percentage of sales by 80 basis points year over year.

Now moving on to debt and liquidity. At the end of the third quarter our cash balances totaled $220 million, and our liquidity position was $294 million. The primary driver of the reduction in our cash balance and liquidity from the second quarter was the acquisition of VAG in the quarter, which we funded through the $75 million we borrowed under our AR facility near the end of our second quarter. $90 million borrowed under the revolver this quarter, as well as $74 million in cash. Total debt at the end of the third quarter increased to $114 million to $2.404 billion, the composition of which is detailed in the [node store] financial statements and our Form 10-Q.

The increase in debt was primarily driven by the $90 million of borrowings under the revolver that I mentioned earlier that facilitated the VAG acquisition during the quarter, and a $23 million loan payable as a result of our participation in the new market tax credit program in the quarter. Our Form 10-Q provides the details around this program, but in summary, through participation in this program we effectively received $6 million towards two eligible capital investment projects we currently have in process.

We and third-party financial institutions contributed $18 million and $6 million, respectively, to an investment entity. This entity then provided us with a low interest rate forgivable loan, with $18 million of the proceeds coming from our investment. As a result, our balance sheet includes an $18 million non-current loan receivable and a $23 million of long-term debt.

After seven years, the financial institutions and the Company both have the ability to trigger forgiveness of the debt which would result in a gain on debt forgiveness for the Company.

Moving onto net debt, we ended the quarter with approximately $2.184 billion of net debt. Our net debt leverage ratio was 5.7 times compared to 5.4 times at the end of the second quarter. We anticipate further delivering in the fourth quarter and would expect to finish the year in the low 5s.

Finally, I will provide a few financial metrics around our credit agreement and Bond indentures. Under the credit agreement, our senior secured leverage ratio is 1.7 times, and the cumulative credit basket was $292 million. Under the indentures, we finished the third quarter with a fixed charge coverage ratio of 2.3 times, and our strategic payment basket totaled $278 million, which includes the $25 million general basket.

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

(Operator Instructions) Matt Vittorioso, Barclays Capital.

Yes, good morning, guys. Thank you for taking my question. Todd, I'm just wondering if you could maybe help us out on the Water Management side. And that you provided some good color around what was pressuring margins in the quarter. But if you were sitting in our seats, how would you think about margins going forward for the rest of this fiscal year -- and maybe from a high-level into fiscal '13. Does the VAG acquisition make this just a lower margin business? You talked about having worked on taking market share in a tough environment. Do you think you are doing that at the expense of margins? Just how should we think about that?

It's a good question, Matt. I think the way we think about it and they way we are operating is that when you look at the pieces inside of Zurn, as I sort of detailed in the prepared remarks, the Zurn business continues to grow in the mid-to high single digit range. The fundamental margins inside the Zurn business are still in the high teens/low 20s.

If I look at the North American water treatment businesses that we had acquired over the course of the last few years, the volatility and the margins there based on projects was pretty high. And so when we looked at what we think the longer-term run rate margin profile of those businesses, it's sort of in the high teens. We look at VAG that comes in at the low teens, and we think we have the opportunity to move that up over the course of the next three years to the high teens.

So on a blended basis the portfolio is really constructed to be, I'd say, near term, high teens; over the next three years, sort of in the low 20 range.

Okay, great. And then on the Process & Motion Control side -- as you alluded to, a very solid business. It appears as though things are definitely moving in the right direction. I just wonder, as we look at the last few quarters, would you say that that business is starting to plateau a little bit, or are there specific end markets that you think can help continue to drive year-over-year growth in fiscal '13?

We very much think that the business is not plateauing at all. I think if we go back and look at the last three years inside of the business, we've got 6 points of gross margin improvement over the last three years. We think we've lived in a substantial amount of investment into growth around new products, new geographies, as well as turning our sights to being more of an expert across a series of vertical markets.

So when you think about those vertical markets around mining, energy, aerospace, food, beverage, some aggregates and some others that will turn in time, we feel like the secular growth globally, coupled with the investments that we've made, we see excellent growth opportunities heading into FY '13, and likely beyond, because we've put a new leg of growth into the business that, frankly, had not been there before.

If you look at the revenues, we're still below the '08 peak in many of those businesses and end markets. So I wouldn't think the business is peaking in any form. We feel like we are going to have a great fourth quarter, and we feel good about next year. And it's much less about a rising tide as it is purposely growing the business and leveraging the growth investments that we've made.

Great; that's very helpful. And then lastly from me, you talked about your expectation to generate additional free cash flow in the fourth quarter. Just going forward, as you generate cash -- in the past, I guess you've been kind of just building your cash balance. Now that you have financed the VAG acquisition with some debt, would you look to immediately start paying down some of that debt with the cash that you generate? And, also, I guess your term loan comes due mid-next year. As that thing starts to approach getting current, how do you think about refinancing that?

I think we're going to evaluate all of those things as we go over the course of the next three to six months. Obviously, long-term, we clearly need to delever the balance sheet. I think that's the intent with the free cash flow and, ultimately, a public offering. We've got an active M&A funnel that is more in the bolt-on range, and we also have a term loan refinancing out there.

So I think we're going to be looking at all of those options over the next three to six months and make the best decision for the long term of our debt holders and equity holders, but I do think that we'll probably end up ensuring that we take care of the balance sheet, right. Because that's number one for us. I would say, Matt, that that is something we will sort through in the next three to six months. But we clearly understand that we need to delever and also get that term loan refinanced.

Great. Thanks, Todd.

(Operator Instructions) Yilma Abebe, JPMorgan.

Good morning. Thank you. My first question is, can you tell us how the VAG business is doing, especially with the backdrop in Europe?

Sure. You know, we did diligence on this Company for about a year. And the fundamentals around the business are very strong in Europe, in part because a good piece of the business has an MRO or continued replacement part of the business. So that business continues to do well.

The project-related business in Europe -- you really can't think of it as a European business; you have to think of it as a global business. We went through a strategic plan and looked at the key projects, and these are all $5 million to $10 million projects. None of them are in Europe.

So while the business is domiciled in Germany, 20% of the headcount's there. Most of the people are distributed all over the world, and frankly, the projects and the growth that we see is not in Europe; it is in South America, it is in Southeast Asia, it's in the Middle East. It's places like that. So the core of the business in Germany is fairly stable, and it has a big MRO replacement dynamic to it.

So we're not seeing any, I would say, any significant shifts to that at this point. And you have to think about it as much less of a European business as it is much more of a global business and a global market for water as opposed to European.

Ballpark, how much of that business is driven by the local economy in Europe versus the global businesses? If you have it.

So I don't want to hazard a guess, but if I think about VAG, call half of the behalf of the business is in Europe. Of that, half of it is MRO. So there is a recurring replacement dynamic. And then there is, call it a $50 million piece of business that is subject to, I would call, some discretion in timing around projects across the continent. But it's not a huge piece. And again, it is water infrastructure projects. Hydropower, industrial applications, things like that. So it's not necessarily tied to local economies as much as it is just basic infrastructure needs across the continent.

Okay. My second question is, the facility consolidation at Zurn. Can you talk about what triggered that? Is the business becoming more and more challenging? A little more context around that, please.

It's -- frankly, business is probably getting a little better. I think we looked at a facility that was doing things that we could clearly do inside of our existing footprint based upon the progress we have made on some lean initiatives in a couple of our factories. And so it was a facility that we didn't need anymore. And so when we think about it, it's really sort of a continuous improvement issue, and we really -- it's opportunistic, right? We had a facility that ultimately we didn't need. We had made some excellent progress in two of our facilities around a lean conversion, and had some space, and we triggered it. So it wasn't a decline in business; it was actually how do we leverage some footprint that we had created over a few years and really position ourselves for even better profitability during a recovery.

Thank you. That's all I had.

(Operator Instructions)

It looks like that's it.

Yes. I see no further questions in the queue. Mr. Adams, I'd like to turn the conference back over to you for closing remarks.

Thank you, everyone, for joining us on the call today. We certainly appreciate your interest in Rexnord and look forward to providing further updates when we announce our fiscal year 2012 fourth-quarter results in May. Thank you.

Again, ladies and gentlemen, thank you for your participation. This will conclude today's conference call. Thank you for calling.