Zurn Elkay Water Solutions Corp (ZWS) 2013 Q2 法說會逐字稿

Good morning. My name is John and I will be your operator for today's call. At this time, I would like to welcome everyone to the Rexnord second-quarter fiscal 2013 earnings results conference call with Todd Adams, President and Chief Executive Officer and Mark Peterson, Senior Vice President and 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, November 7 and are also posted on the Company's website at www.rexnord.com.

At this time for opening remarks and introduction, I will turn the call over to Mark Peterson, Senior Vice President and 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 issued yesterday, as well as in our SEC filings. In addition, some comparisons refer to non-GAAP measures. Our earnings release and SEC filings contain additional information about these non-GAAP measures and why we use them.

Today's call will provide an update on our overall performance for the second quarter, including details on our two platforms, followed by an overview of our financial statements and liquidity highlights. Afterwards, we will open up the call 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. I want to thank you for joining us for an overview of our fiscal 2013 second-quarter financial results. Turning to page 4, overall, we are pleased with our second-quarter results, which were slightly ahead of what we communicated in early August. Reported sales growth was 11%, core sales growth was 2%, our adjusted EBITDA was $101 million, or 20.1% of sales and our adjusted EPS was $0.24.

In the second quarter, we implemented the cost reductions we articulated and continue to be vigilant on managing our costs while protecting long-term growth initiatives. In general, the market conditions we anticipated back in August for the balance of our fiscal year have broadly been as we expected with some puts and takes that I will discuss as we go through the platform results. We are affirming our full-year guidance of sales between $2.020 billion and $2.060 billion, adjusted EBITDA between $412 million and $425 million and free cash flow greater than net income.

Moving to page 5, I will give a little color on each of the platforms starting within Process and Motion Control. Overall, the platform posted 3% core growth and an adjusted EBITDA margin of 25.1% with strong execution and enhanced growth initiatives off setting what I would characterize as incrementally slightly weaker industrial market trends, which has broadly been discussed over the past several weeks.

We are particularly pleased with the traction we have made on delivering gross profit improvements as our gross margin was 39% in the second quarter, up 210 basis points over the prior year, which drove a 140 basis point increase in our adjusted EBITDA margin and allowed us to deliver $4 million of incremental adjusted EBITDA year-over-year on reported sales that are effectively flat.

From a market perspective, our business through distribution continues to be solid with only a slight sequential moderation in the sell through growth in the quarter, but still in the low to mid-single digit range. OEM and end-user growth reflects the continued caution we discussed in August, which is a trend we don't anticipate to change quickly. However, we are seeing some progression in a number of end markets. We believe we are beginning to see the order rates in our mining business stabilize and our broad industrial European demand recovered as we had expected in the quarter. I think it is very clear that within Process and Motion Control, the overall OEM and end-user sentiment is difficult with low visibility likely to continue for the next several quarters.

Our focus has been and will continue to be ensuring that our service levels are the very best, continuing to aggressively invest in new products and innovation to provide our customers with superior solutions that improve their overall reliability, productivity and ultimately make them more profitable while continuing to leverage RBS to eliminate waste, to create the funding to allow us to invest back into our business and extend our leadership positions.

Moving to our Water Management platform. As we had expected and communicated, core growth improved sequentially to flat in the second quarter compared to the prior year after having declined by 9% in our first fiscal quarter. Reported growth was 38% reflecting the VAG acquisition and our adjusted EBITDA margin was 16%. If you look at the chart on the lower left part of the page, you will see the elements of our core growth broken down by platform and ultimately by the two components of our Water Management platform. As we have discussed, our Zurn business continues to truly outperform the underlying market and competition as we posted 5% core growth in the quarter driven by the traction of our growth initiatives.

Within the Water Infrastructure component of Water Management, VAG constitutes the majority of that group and continues to perform very well. In fact, we have essentially been integrating the legacy Rexnord Water Infrastructure product lines into VAG over the past year. When you break down our Water Management flat core growth in the quarter, it includes the legacy Rexnord Water Infrastructure product lines that were down 25% for the quarter, but the reality is those products lines represent only a fraction of the Water Infrastructure business and are not indicative of how we are managing the business.

When you think about the Water Infrastructure business as a global business, consistent with how we are managing it and pro forma the VAG acquisition into the prior year, core growth in the Water Infrastructure and overall platform was in the mid-single digit range for the quarter. I point this out because this has been a reporting dynamic that has been a bit difficult for people to understand and fortunately is behind us as VAG rolls into core sales growth in our fiscal third quarter.

From a market color perspective, non-residential construction is still bouncing along the bottom. That said, many of the indices are encouraging such as ABI and other projections around starts and spending, which for us will all be upside down the road. Our results today are being driven by our actions to advance our product innovation and excellence initiatives while driving increased specification of our products and broadening distribution.

Turning to the Water Infrastructure market, it is clear that it is a global game and has to be played that way with a very broad product portfolio. Fortunately, VAG gave us both and we are really pleased with the acquisition one year in. We are seeing the benefits manifest themselves in inquiry and quote volume and anticipate the order rates and book-to-bill will continue to be strong over the second half of our year and into fiscal '14.

I will turn it over to Mark to walk through the numbers and then come back to talk about our outlook in just a little more detail.

Thank you, Todd. Consistent with the prior quarters, we will speak primarily to adjusted operating profit, adjusted net income and adjusted earnings per share as we feel these non-GAAP metrics provide a better understanding of our operating results in the quarter. Slide 6 of the presentation takes our reported results and reconciles to the adjusted results that exclude these items.

Turning to page 7, I will discuss our operating performance highlights for the second quarter. Second-quarter sales increased 11% from the prior year to $500 million as core sales growth of 2% and a 12% increase in sales from the VAG acquisition were partially offset by foreign currency fluctuations and a fiscal 2012 second-quarter divestiture that negatively impacted sales by 3%.

Reported operating income for the quarter was $66 million, which includes $2 million of restructuring costs. Excluding this item, our adjusted operating income grew 12% year-over-year and, as a percent of net sales, increased 10 basis points to 13.7%. Second-quarter adjusted EBITDA increased 11% to $101 million and our adjusted EBITDA margin was 20.1% of sales.

Second-quarter adjusted net income from continuing operations increased 50% to $24 million and diluted adjusted earnings per share from continuing operations was $0.24 in the quarter. Reported free cash flow was $28 million in the quarter, which included a $7 million non-cash use related to the excess tax benefits recorded in connection with stock option exercises. Excluding this non-cash item, free cash flow was $35 million in the quarter.

Next, I will move to slide 8 and walk through the operating performance in our Process and Motion Control platform. Sales in the quarter were $309 million compared to $310 million in the prior-year period. Core sales grew 3% in the quarter driven by growth in aerospace, energy and food and beverage end markets. Foreign currency fluctuations and a fiscal 2010 second-quarter divestiture negatively impacted sales by 3%.

Turning to profitability, reported operating income in the quarter was $57 million and includes $2 million of restructuring expense in the quarter. Excluding restructuring, adjusted operating income increased 10% from the prior year, as a percent of sales increased 180 basis points year-over-year to 19%. Our adjusted EBITDA increased 6% year-over-year to $78 million and our adjusted EBITDA margin improved 140 basis points from the prior year to 25.1%. The margin expansion in the quarter was driven by productivity gains and efficiencies, as well as leverage on the year-over-year core growth.

Turning to page 9, I will make a few comments on our Water Management platform. Water Management sales in the second quarter increased 38% from the prior year to $190 million due to the acquisition of VAG. Core sales progressed sequentially to flat in the quarter as our growth initiatives coupled with the VAG acquisition are delivering the traction we had anticipated. Second-quarter reported operating income was $18 million and includes a $200,000 restructuring charge. Excluding this charge, operating income was $19 million, or 9.8% of sales compared to $15 million, or 10.6% of sales in the prior-year second quarter. Adjusted EBITDA was $31 million or 16% of sales and that compares to $23 million or 16.6% of sales in the prior-year second quarter.

The margins in our Zurn business remain very solid and the cost-reduction actions we took in the second half of fiscal 2012 in our legacy Rexnord Water Infrastructure business are benefiting segment margins as core margin expansion in the quarter was offset by the mix impact of the VAG acquisition.

Moving to slide 10, I will touch on a few cash flow and liquidity highlights. During the quarter, our cash balance increased $47 million to $440 million, primarily due to the free cash flow we generated in the quarter. Total debt at the end of the second quarter was $2.111 billion and net debt was $1.671 billion resulting in a net debt leverage ratio of 4.2 compared to 4.3 times at the end of our first quarter.

Looking forward, we anticipate our net debt leverage to continue to decline through a combination of improved adjusted EBITDA and free cash flow generation. We had a solid liquidity position with $759 million in liquidity at the end of our second quarter and as we highlighted in our last call last quarter, we have no meaningful debt maturities until 2018.

Before we move onto our guidance for the balance of the year, I will provide a few of the financial metrics under our credit agreement and bond indenture and touch on the debt refinancing we completed in early October.

First, under the credit agreement, our senior secured leverage ratio was 1.3 times versus our covenant of 5 times and the cumulative credit basket was $522 million. Under the indenture, we finished the second quarter with a fixed charge coverage ratio of 2.5 times and the restricted payment basket totaled $487 million, inclusive of the $25 million general basket.

Regarding the debt refinancing, in early October, we refinanced our existing credit facility and reduced the effective interest rate applicable to the term loan borrowing by 50 basis points resulting in an annual interest savings of approximately $4.7 million. All other terms of the facility are unchanged. With that, I will turn it back to Todd.

Thanks, Mark. I am on page 11 of the slides looking at our fiscal 2013 outlook. As I indicated in my opening comments, we are affirming our fiscal 2013 sales, adjusted EBITDA and free cash flow guidance as outlined on the page.

With respect to our third quarter, at a high level, we anticipate our third quarter to look a lot like our second quarter. Consolidated sales dollars will generally be in line with our second quarter with Process and Motion Control sales increasing sequentially offset by lower Water Management sales when compared to our second quarter due to the seasonal slowdown in construction, which also results in a lower margin sequentially in the Water Management platform. Overall, this would equate to low to mid-single digit consolidated core growth versus the prior year. We anticipate consolidated adjusted EBITDA dollars and margin to again generally be in line with our second quarter with consolidated adjusted EBITDA margins expanding over 100 basis points compared to the prior year.

At this point, I will turn the call back to the operator and take your questions.

(Operator Instructions). Charley Brady, BMO Capital Markets.

Good morning. This is Andrew on for Charley Brady.

Good morning, Andrew.

Good morning, Andrew.

I just had a question about the divestiture of the business. I was just wondering -- you guys mentioned you were in negotiations. Does that mean that you guys have found a buyer or are you still shopping around?

It means that we have identified a couple of buyers that we are negotiating with and we anticipate concluding the transaction sometime in the next, call it, three to six months.

Do you know how -- the next question I guess is do you know how that might -- will that affect kind of the EBIT margins for PMC going forward or how it might affect it?

Well, given the fact that it is included in discontinued operations, it is already included in the margins that we are reporting. So on a net basis, if you were to look backwards, it would clearly be accretive to margins. It is not frankly that big, but it is accretive.

Okay, and I may have missed it, but have you seen any further deterioration in Europe at all?

We have not.

Okay. All right, thank you, guys.

Julian Mitchell, Credit Suisse.

Hi, guys, it's Charlie for Julian. How are you?

Good morning, Charlie.

I had a question -- you guys made some good progress on the cost line at PMC. Just wondering if you had any sense in terms of what inning you might be in and whether or not we should expect some further gains on the cost lines there.

I think we clearly outlined the fact that we were going to reduce our costs over the back nine months. We took a step towards that in our second quarter. We continue to take steps each and every day through productivity inefficiencies along with eliminating sort of structural product costs. So I wouldn't want to put it in an inning, other than to say that it is a continual effort for us. I don't think that there is a massive disruptive cost expectation you should model in, but you should expect continued rigor around that just like we do each and every day.

Okay, great. And then on the Water Management side, you mentioned that VAG rolls into the core numbers next quarter. You mentioned that if VAG had been in your core numbers this quarter, you would have been kind of mid-single digit range. Just wondering if you might be willing to kind of give just a couple numbers back just kind of so we can see how the entire business may be trending on a core basis.

You mean pro forma VAG and (multiple speakers)?

Yes, so pro forma.

I think we are going to try to stay away from that only because --

Okay, that's fair.

-- it sort of dilutes the way we've recorded. We have reported core growth. Suffice it to say, it has a very positive impact on what we had been reporting on a core basis if we were to do that.

Okay, great. Thanks, guys.

John Inch, Deutsche Bank.

Hi, good morning. It's Elana Wood. Just some questions on the Water Management side of the business. Can you give us a sense of how much VAG pressured margins for the segment or maybe what the underlying margin expansion would have been without VAG?

If we were to look at it solely on a core basis, I think that the incremental year-over-year margin improvement would have been in excess of 100 basis points on the core Water Management businesses.

Okay, great. And then I wanted just to circle back to the North American infrastructure piece of the water platform. I know it is a small piece of the business, but with sales down so dramatically, I am assuming that margins are pretty low. I am just trying to get a sense of, one, I mean do you think we are at a bottom here for that business? And secondly, to what degree has that business been pressuring your margins? I mean I would assume that margins in that business could be in the low single digit range. So I am just trying to get a sense of when that business comes back what kind of margin benefit or once that business gets to sort of a normal level, what kind of margin tailwinds we may have.

So what is pressuring the top line today has been the order rates that we experienced sort of 12 to 18 months ago. So what was booked 12 to 18 months ago is what is delivering. So the fact that sales were down in the mid-20% range really is a reflection of order rates a long time ago. If we look at the book-to-bills the last two quarters in that North American piece, they were 1.8 in June and 1.2 -- high 1.2s in the September quarter. So we clearly feel as though we have seen the bottom.

As it relates to margins, when we looked at this year and what was going to be rolling out of the backlog, we took the initiative to reduce a facility in that part of our business and so we are getting the benefits of that, but clearly the margins are very low. And so with the positive book-to-bill, the restructuring actions we have taken, plus introducing those product lines through the VAG worldwide network, we feel very comfortable that the past is not reflective of what the potential is going into the future and we see really positive things over the next 18 months for that business.

Okay, that is very helpful. And then just lastly, just wanted to circle back to the $30 million of annual cost take-out that you referenced last quarter. I was just wondering if $30 million is still the right number and maybe you could just give us an update as to sort of where you are at the end of the second quarter in terms of achieving those cost takeouts?

We implemented all the cost reductions that we had communicated. Incrementally we are always looking at areas to improve efficiencies and we will tweak that as we go, but $30 million was clearly implemented and I think we will be in a spot by the time we get through the end of the year that it will be in excess of $30 million, so it is one of those things that is ongoing. We took the initiative early based on what we saw and as we move forward, as things change, we are trying to stay a couple of steps ahead. And so there was some more that we have implemented, but $30 million is sort of a not less than sort of a number.

Okay. And I have one more question about currency. So I remember last quarter you had a base case range of $1.15 to $1.20. Have you modified that?

To be perfectly honest, I think the currency assumptions that we had were at a point in time. I don't think we are going to continually modify the currency rates as it reflects into our guidance. It is a little bit better today, but the range of sales and profit is inclusive of sort of where currency is today.

Okay, perfect. Thank you so much.

(Operator Instructions). Mig Dobre, Robert W. Baird.

Good morning. This is Mig Dobre with Baird. How are you guys?

Good morning.

Good morning.

So I sort of want to focus on one of the bright spots in the quarter, which was Zurn where you guys clearly outgrew the market and you have done that for a little while and you have been mentioning that commercial construction hasn't really been there to provide a tailwind for you. And from what I can see here, this is, what, roughly a $450 million business or thereabouts annual run rate? I am wondering if indeed we are starting to see this market pick up, what sort of opportunity do you guys think you have on the top line here. And as a follow-up to that would be what would be the incremental margins on those additional revenues?

Sure, obviously, we have talked about I think the progress of the Zurn business has made over a number of years around specification and new products, as well as improving our service levels. And so all of that is sort of manifesting itself in I will call it well above market and competition growth today. I think that is in a market with starts, square footage and everything else that is still negative.

I think as we have articulated over time that, as the market turns positive, Zurn will grow at a multiple of what the market is growing. And so we are clearly optimistic that we have seen the worst of it. We are one year closer to any recovery obviously, but as that turns positive, you will see Zurn grow at a multiple of the market and what that means for margins is that you will see high 20%s to potentially low 30%s on incremental margins.

And the thing to remember about Zurn is it is sort of an asset light model around the manufacturing. It is not vertically integrated, so we don't get the same sort of leverage that you would get if you were manufacturing everything, but you do have that protection on the downside, which we have enjoyed and allowed us to retain margins at a very high level through what is arguably the worst environment in commercial construction ever over the past five years. So we are really happy about the progress. We think that the business is extremely well-positioned to deliver excellent growth and profitability as the market recovers over the next several years.

Excellent. That is helpful. And then sort of sticking with the water theme here, you mentioned the improved book-to-bill in North America water and can you comment at all on pricing of some of these orders and the potential impact that that will have on margins going forward 12 to 18 months from now?

I don't know that we have any specific sort of pricing dialogue we want to get into around some of the backlog. Suffice it to say that as the market recovers, clearly the backlog pricing improves over time and so as you go through a weak demand period, obviously, pricing erodes a little bit. As that demand picks up, the pricing environment gets a little better. We clearly feel we are on that side of the curve in North America municipal and so I think that will play itself out. Again, the orders that we are booking today deliver 6 to 18 months out, so you will see that manifest itself in improved margins moving forward along with the benefit of the cost reductions and the integration of that business into the VAG global network that we have undertaken.

Great. And my last question, looking at PMC, we know that mining remains a headwind, but you highlighted a number of other end markets that are driving some growth and I guess I am wondering is it your view that these end markets can continue growing at a pace where they can offset some of this softness in places like mining and can you give us some color about the driver here? Is it improved penetration or some of the new product introductions or what is driving that growth?

I think it is a combination of things; it is not one single thing. It is obviously new products. It is a deeper focus on customers in key vertical markets and it is also enhancing our position in relationships within distribution. So it is really all of the above. Obviously, mining -- both material handling end market for us is large, so to outrun that headwind takes a lot of effort. Obviously, you can speculate can we continue to do it going forward. I think the next six months are going to be key looking at order rates in that segment because I do think that while there is a headwind in the market, it is an awfully large market and we have got a lot of growth initiatives and new customers that we are pursuing.

So I think that we are going to remain vigilant because we think long term that is a great market to be in and we are going to stay focused on trying to grow in other areas. So we have got all of our commercial teams out being aggressive, staying true to the investments we are making in new products and vertical markets and I think that when you step back, the investments we are making now in a tough time are going to pay off big time down the road. But I don't want to speculate that we can continue to outrun a headwind in mining other than to say that we are and we are going to keep doing the same things that allowed us to outperform this quarter.

Very well. Best of luck to you guys.

Thanks.

We have no further questions at this time, so I will now turn the call back over to Mark Peterson for closing remarks.

Thank you, everyone, for joining us on the call this morning. We appreciate your interest in Rexnord and look forward to updating everyone on our third-quarter results in early February. Have a good day.

Thank you. Ladies and gentlemen, this concludes today's conference. Thank you for participating. You may now disconnect.