Zurn Elkay Water Solutions Corp (ZWS) 2014 Q2 法說會逐字稿

Good morning. My name is Christine 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 year 2014 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 today October 24, 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 for Rexnord.

Good morning. Before we get started, just a brief reminder that this call contains certain forward-looking statements that are subject to the Safe Harbor line which contained in the press release we issued today as well as in our filings with the SEC.

In addition, some comparisons are for the 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 of fiscal 2014, including details on our two platforms followed by an overview of our financial statements and liquidity highlights. Afterwards we will open the call up to your questions.

With that, I will turn the call over to Todd Adams, President and CEO of Rexnord.

Thanks, Mark, and good morning, everyone. Thank you for joining us today for an overview of our fiscal 2014 second-quarter results.

Starting on page 4, we are pleased with our results this quarter as we delivered slightly better operating profit on sales that were in line with our expectations going into the quarter. Through the first six months of our fiscal year, our performance in aggregate is on track with our expectations and overall strategy, which is focused on driving above market core growth, deliver strong operating leverage on that growth, generating significant earnings-per-share leverage through our ability to both delever and fine-tune our capital structure to take advantage of the favorable financing environment.

Additionally, given that our business model produces significant free cash flow, we have been able to invest a portion of that free cash flow to execute three smaller but strategically important acquisitions at very reasonable multiples that will quickly deliver double-digit returns on invested capital through the synergies we are able to achieve.

As it relates to the second quarter, we are confident that, again, our core growth continues to outpace the growth in our serve markets as we delivered 3% consolidated core growth in the quarter which is comprised of 6% core growth in water management in advance of the market recovery we actually see coming and 1% core growth in Process & Motion Control.

Our adjusted earnings -- our adjusted operating income increased 7% from the prior year, delivering an incremental margin of 31% and sequentially, from the first quarter, we generated $11 million of additional adjusted operating income on $6 million of additional sales. With respect to earnings-per-share, our adjusted EPS increased 29% year over year to $0.31, $0.06 about the high end of the guidance range we gave in August at stronger operating performance contributed $0.02 of the EPS improvement and the significant debt refinancing we completed mid-quarter contributed an additional $0.04.

The debt refinancing is a great transaction for us as it allows us to generate approximately $48 million of annual cash interest savings or roughly $0.30 of annualized EPS accretion. Given where we are positioned both strategically and in our transition from an LBO to a public company, effectively leveraging our free cash flow, which only gets stronger after the refinancing to both delever and execute on a solid funnel of bolt on and tuck on -- tuck-in acquisitions, two of which we closed in the quarter, will be a significant driver of value over the next several years. I will further say that at the moment we are pleased with the status of our acquisition funnel that should allow us to continue to be smartly acquisitive over the next 12 to 24 months.

Turning to the highlights for the quarter within the platforms. The momentum in Water Management remains strong as core sales grew 6% really all in advance of what we see as a market recovery that we should benefit from, beginning in calendar year 2014.

To add a little color on the end markets and group performance within the platform, the growth in operating performance in Zurn continues to accelerate, again delivering high single-digit core growth in the quarter, clearly outpacing the overall market growth while cleanly navigating through all of the low lead conversion issues required in the marketplace.

As far as the outlook for nonresidential construction, we continue to see construction backlogs build in the US and Canada. This trend, coupled with all the progress we have made over the past few years on innovation, specification, and operational execution, gives us great confidence that we will disproportionally benefit from an expected market recovery over the next several years.

Within VAG, our backlog continues to grow as our book to bill ratio in the quarter was 1.16, setting up a solid second half of fiscal 2014. As we look at the global demand for water infrastructure, we are uniquely positioned to capture and deliver on the secular growth in that market wherever it is happening in the world as a result of the product breadth, technical competence and geographic capability that we have established.

Over the past three to six months, we have seen the global projects funnel become increasingly robust and feel good about where the order rates are trending. In addition to the solid organic growth rate trends in Water Management, we completed a small acquisition in Australia within our Zurn business during the quarter, which allows us to expand both our product portfolio as well as geographic footprint.

To close on Water Management, we posted another solid quarter, a trend which we expect to continue as our serve markets improve. As we have discussed, based on the market dynamics of our water infrastructure end markets, we look at this part of our business more in half years versus quarters and through the first half of 2014, the book to bill ratio is 1.15; and we feel good about the visibility and demand environment for the balance of fiscal 2014 and into 2015.

Moving to Process & Motion Control. Core sales growth was 1% year over year and we are encouraged by an aggregate book to bill ratio that progressed as we expected to 1.0. The first time we have been at 1.0 in the last five quarters. Overall, we are confident that we continue to outperform our overall served industrial end markets as a result of the strategic progress we have made over the past couple of years to both diversify our end markets, geographies and customer base.

We also believe that, taken as a whole, market growth-driven demand in Process & Motion Control will be muted over the next year based on what we see globally from our customers and end markets. We have and we will continue to position ourselves to deliver strong profitability in this lower growth environment, and you are seeing it in the second quarter where with 1% core growth we are delivering 41% incremental operating income margins and an aggregate EBITDA margin of 25%.

Finally, as we discussed last quarter the diversity of Process & Motion Control in terms of its end market, customer and geography is a real strength and one we are continually working to upgrade towards more resilient sustainable growth, both organically and through M&A.

In the quarter, we completed the acquisition of Micro Precision, a UK-based provider of specialty precision gears and core packs, key elements of content in the next generation of efficient commercial aircraft, which have become increasingly electric as compared to hydraulic or pneumatic. The acquisition allows us to further penetrate our existing aerospace customers while providing access to new customers and geographies with an expanded product portfolio and engineering capability.

Before I hand it over to Mark to go through the financials, I will quickly cover our outlook for the full year as well as the third quarter which is on page 10 of the presentation. For the fiscal year, we are bracing our adjusted earnings per share guidance by $0.20 per share, resulting in an adjusted EPS range of $1.32 to $1.38, which prices in $0.18 of the annualized $0.30 refinancing benefit we will see based on the partial year benefit over the remainder of fiscal 2014.

We are also increasing our core growth range from 2% to 4% to 3% to 4% for the year, based on our performance in the first half and latest outlook. Specifically for the third quarter, we anticipate sales to be in the range of $495 million to $505 million with core growth of approximately 4% at the midpoint and adjusted EPS and the range of $0.29 to $0.32.

As it relates to the December quarter, we do have some seasonality in our Zurn business that I would like to remind everyone of, primarily due to the slowing of the nonresidential construction season in North America due to weather, and secondly and more broadly, there are simply fewer shipping days as a result of the holidays.

Finally, our outlook excludes the impact of future acquisitions that may likely occur over the course of the year.

With that, I will turn it over to Mark to cover the numbers.

Thanks, Todd. Consistent with the prior quarters we will speak primarily to adjusted operating profit and EBITDA, adjusted net income and adjusted earnings per share as we feel these non-GAAP metrics provide a better understanding of our operating results.

Slide 5 of the presentation takes our reporting results and reconciles with the adjusted results.

Turning to page 6, I will discuss operating performance highlights for the second quarter. Second-quarter sales increased 3% from the prior year to $515 million, driven by our core sales growth of 3%. Adjusted operating income increased 7% from the prior year to $76 million in the second quarter or 14.8% of sales.

Sequentially, our adjusted operating income margin increased 200 basis points from our first quarter. Our adjusted EBITDA was $103 million or 20% of sales, a 170 basis point increase in the margin sequentially.

Second-quarter adjusted net income was $31 million resulting in adjusted earnings per share of $0.31, which increased 29% from the prior year. We generate $25 million of free cash from the quarter inclusive of approximately $30 million of incremental cash interest year over year. That was accelerated in the quarter, primarily the result of the refinancing transaction that occurred in August. Excluding this tiny impact, second-quarter free cash flow increased by $24 million year over year.

Next, I will take some time on slide 7 to walk through the operating performance in our Process and Motion Control platform. Sales in the second quarter increased 1% year over year to $312 million as a result of 1% core sales growth that was driven by low single-digit growth in the majority of our end markets, partially offset by a decline in sales for our bulk material handling markets.

Turning to profitability, adjusted operating income was $61 million or 19.5% of sales, driven by a 41% incremental margin year over year. Sequentially, our adjusted operating income margin improved 280 basis points from our first quarter. Adjusted EBITDA was $78 million in the quarter or 24.9% of sales, a 240 basis point margin improvement sequentially from our first quarter.

Turning to page 8, I will make a few comments on our Water Management Platform. Water Management sales in the second quarter increased 7% from the prior year to $203 million. Core sales growth was 6% in the quarter, driven by market share gains in the majority of our served markets and increased alternative market sales in our nonresidential construction end markets.

Second-quarter adjusted operating income was 15% year over year to $23 million and our adjusted operating income margin increased 80 basis points from the prior year to 11.1%. Sequentially, our adjusted operating income margin improved 60 basis points from our first quarter. Adjusted EBITDA was $32 million and adjusted EBITDA as a percentage of sales was in line with our expectations at 15.8%, which is up 50 basis points sequentially from our first quarter of fiscal 2014.

Meeting to slide 9, I will touch on a few cash flow and liquidity highlights. We finished the quarter with $206 million of cash and $530 million of total liquidity. Total debt at the end of the quarter was $1.958 billion and net debt was $1.752 billion, resulting in a net debt leverage ratio of 4.3 times.

First, I will provide a little more color on the debt refinancing Todd discussed earlier in the call. During the second quarter, we entered into an amended -- amendment to our senior secured credit facilities for a new seven-year term loan in an [aggregate] amount of approximately $1.950 billion with a maturity date of August 2020.

Pricing under the new term loan is LIBOR, subject to a 1% floor plus 3%. The proceeds of the new term loan we will use to retire 100% of our $1.145 billion in outstanding 8.5% senior notes. We are retiring 100% of our $786 million [benox] term loan, fund the early tender premium on the senior notes and pay accrued interest as well as transaction expenses. In connection with this transaction, we incurred $129 million pretax loss in the debt extinguishment which is comprised of the tender premium as well as the write-off of previously recorded deferred financing fees and transaction expenses.

Looking forward, this refinancing has meaningfully extended our debt maturity profile and strengthened our perspective free cash flow. At prevailing interest rates, we expect to realize annualized pretax cash interest savings of approximately $48 million. Upon completion of this transaction, our debt structure became primarily variable-rate debt.

So, subsequent to the end of our second quarter, we have entered into $650 million of forward starting interest rate swaps to fix a portion of our available rate debt. We will continue to actively monitor this exposure and may extend our hedging program if marketing conditions warrant a change.

Before I discuss some of the details on our outlook, I want to comment on our effective tax rate. As a result of the $129 million loss in debt extinguishment in the quarter, we recorded a tax benefit in the second quarter. When you break down the pieces of our pretax loss, we have pretax income excluding the loss of that extinguishment of $44 million which had a 35% effective tax rate as we anticipated going into the quarter.

The pretax loss on debt extinguishment had a 37% effective tax rate benefit. Some of the pieces result in the tax rate benefit of approximately 39%. As we discussed in our last call, we anticipate our full-year effective tax rate is going nonrecurring items like the loss of debt extinguishment to be in the range of 31% to 33% and that range remains unchanged.

Our effective rate, excluding the loss of debt extinguishment in the first half of the fiscal year was 29% and was impacted by recognizing certain discrete tax benefits in the first quarter that drove the effective rate down. Because these items were recognized in the first half of our fiscal year, we will have a tax rate of approximately 35% in the second half of the fiscal year, resulting in a 31% to 33% rate for the full year.

Before we turn the call back to the operator to take any questions you may have, I will make a few final comments on our outlook.

Page 10 of the presentation reiterates that guidance Todd discussed earlier in the call and also highlights our assumptions for interest expense, depreciation of amortization, stock option and LIFO expense, our effective tax rate, capital expenditures, and fully diluted shares outstanding for fiscal 2014.

In addition, our guidance assumes do not incur any nonoperating other income or expense as we do not forecast realize and unrealized gains or losses from foreign currency fluctuations, gains or losses on the disposal of assets or other items that are recorded in the P&L line item. Our guidance excludes the impact of potential acquisitions and divestitures and future nonrecurring items, such as restructuring costs.

With that I will turn the call back over to the operator and open up to any questions you may have.

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

Good morning. Nice steady as she goes quarter here.

Thanks. Good morning.

First a small housekeeping item. On your acquisitions, can you remind us of revenue contribution from both micro as well as the Australian acquisition?

In the quarter, it is very minimal. You look at those acquisitions in total (multiple speakers) manual basis of approximately $27 million of revenue and approximately in round numbers, call it $0.04 or so of EPS on an annualized basis.

Okay. That's helpful. Then I am trying to clarify something on your outlook, too. Correct me if I am wrong, but your core growth outlook has increased a little bit. But it seems like your earnings guidance primarily reflects adjustments to interest costs. Am I missing something here or is that what is going on here?

I think the gain for the year is, from last time, is up $0.20, $0.18 from the refinancing, $0.02 from the quarter. I think the core growth is up primarily due to our water business. And so, we are really trading maybe some lower aggregate margin water top line based on where we are versus a maybe slightly weaker industrial top line. So the core growth is better when you wash it through in terms of the mix and everything else. It is sort of you get to the same spot from an EPS standpoint.

That is helpful. And that goes to my next question, which -- maybe you can update us on your expectations by segment as to where you are seeing core growth this year.

I don't think we are going to give you any discrete guidance on the platform growth. But I think when you look at the water, it is clearly well above what we are seeing in Process and Motion Control. I think when you look at Process and Motion Control for the first half, I think it is roughly flat. We think it gets incrementally a little bit better from here, but still very low single digits. I think when you look at our Water Management platform, that is going to -- through the first half, it is mid- to high single digits and we think it will be there for the balance of the year as well.

And you highlighted a book to bill of 1 in PMC and, obviously, that is encouraging. Any sort of end market commentary or any other color that you can provide us there?

No, I think it is, again, it is a testament to the diversity. I think we're seeing a good growth in a number of end markets -- energy, food and beverage, as well as in aerospace. Honestly, material handling is a little bit weak, but we are seeing that stabilize relative to the book to bill as well.

So in aggregate, it is a combination of, I think, our diversity as well as the work we are doing to outrun the underlying market growth or market decline, as the case may be. So it is really a lot of effort across a bunch of different vertical markets in different geographies.

Great. And the last one before I jump back into queue, RBS, a big portion of the story of Rexnord. I am wondering if you can give us a sense for what RBS has contributed thus far in the year, and any initiatives that you might have going on currently and how you are thinking that is going to play out for margins going forward?

Sure. And I think we referenced it a little bit in the call, but we feel really good about the momentum we are getting both in the water platform as well as the industrial platform with productivity and cost reduction, significant ongoing cost reductions. And as I look forward, I would say that you will probably see us continue to accelerate those types of things for the rest of this year and into next year. Because we are looking at a -- I will call it a more muted growth from an industrial standpoint and I think that the things we are doing there around footprint, the things we are doing around ongoing productivity product design and just getting, frankly, more efficient in every aspect of our business including the back office, I think you are going to say that continue to accelerate really over the next 12 to 18 months. And you'll see a lot of that in Process and Motion Control.

As it relates to the RBS-driven margin expansion and productivity, that we have been working that really hard over the last three to four years inside of Zurn. And we are seeing that pay off. Not just in the margin, but on the growth. We are seeing high single-digit growth in a market that is still declining in very low single digits, but still declining.

So the upshot of that is that we are done in terms of the commercial positioning. And now it is just driving the productivity and service levels to the customers. And as it relates to VAG, I think you'll see that accelerate as well.

So we are, to say a specific thing would be probably disingenuous. It is a combination of really starting with the customer, working all the way back through engaging our people in the pursuit of that customer satisfaction and aligning goals, objectives, and tools to get it all done. So, we are pretty excited about where we are positioned as it relates to that and expect a lot more of it over the next 12 to 18 months.

I appreciate it. Good luck in the quarter.

Thanks.

Charlie Brady, BMO Capital Markets.

Good morning, guys. On the margin profile for the (inaudible), I guess you kind of covered that $0.04 accretive to EPS on an annual basis. I guess I could work the math on that. What is the -- on the fixed rate debt on the swap, what is the rate on the fix?

On the swap, so it is going to be about 255 basis points which has a LIBOR of 4 built into it. So if you play up for two years and LIBOR is above 1, we would be paying effectively a fixed rate on that [$650 million] about 455 basis points.

Okay. Can you comment on where you see the net debt rate going down? You are at 4.3 right now. Where do you see that going down by year end and maybe 12 months out where you get that down to?

I think you are going to see, Charley, if you look at the guidance in terms of free cash flow and backing that EPS back through EBITDA, you get to circa 4 by the end of March, maybe a 3.9 and then if you fast-forward 12 months past that, you are in the mid-3. So call it 3.4, 3.5 ZIP Code and that is -- that, again, assumes no acquisitions or divestitures or anything else. So we are looking at being mid-3s within 16, 17 months.

Great. And one more. Can you comment on how much the bulk material handling business was down in the quarter?

Yes. If we look at that part of our business, it is probably down high single digits, low double digits. Sort of minus 9 to call it 11.

Great. Thanks, guys.

Julian Mitchell, Credit Suisse.

It is Charlie for Julian. Had a question. Called out the incremental margins, obviously, in both segments and consolidated on the operating income line. Wondered if there is any color on why there wasn't much leverage just on the EBITDA margin line? The incremental's there, obviously, seems like the margins came down in both segments and consolidated as well.

It's frankly just lower depreciation and amortization. So we are not -- it is very tough to leverage depreciation and amortization. So when you look at the operating income, that is sort of, I think, the true things that you could influence in a relatively short period of time. And so the operating income leverage is -- I think the relevant operating statistic and the absolute EBITDA margin is still very good.

Sure. And on the M&A pipeline, any color. You obviously, talked about full things. Anything that you predict we think looks attractive or spaces are cheaper than others or maybe some color on what you are seeing there?

We do. We see a number of things. As Mark pointed out, we were able to do two deals in the quarter, revenue run rates between $25 million and $30 million, EPS $0.04 on an annualized basis. We will get probably half of that this year. So we like those size deals.

There are a number of things that look a lot like that in both of our platforms. So I would characterize the focus of our funnel and the priority of our funnel is to do things that we can stick into both of the existing platforms where we can gain significant synergies quickly, both on a revenue synergies but, more importantly, cost synergies. I think we are buying, at reasonable multiples, with the ability to sort of leverage RBS and our existing platforms to plug these things in and make them far better businesses when we own them, relative to standalone.

So we are really, I'd say, picking up the level of activity around those types of things and there are plenty to do in both platforms.

Thanks.

(Operator Instructions). Andy Noorigian, Vertical Research.

Good morning. I was wondering on Zurn with the market share gains you are making and the progress in organic growth and then some of these investments starting to lap. Do you think as you look out through past this year the bar has been raised and what the margin potential is in the business?

Certainly. I think it is a -- and, again, I will separate Water Management and say, specifically, to Zurn. The amount of effort that we've had over the last two or three years to really remake the front end of the business, as well as streamline the back end distribution and fulfillment model, has been significant.

The other thing that I think you will appreciate, which is the new construction recovery will aid in our margin performance as well. So some of the products that we would sell in a new construction environment, carry a better margin profile than some of the things we are selling through the retrofit.

So, I think a couple of things. Just the ongoing productivity and efficiency that we have already laid in and if we get a favorable market environment, that is going to read through at a higher rate than historically it has.

And secondly, when you turn on new construction in a more meaningful way, we are going to get a second leg of benefit there. So it is really well-positioned, both for the current environment and increasingly well-positioned for a non-res recovery.

So I think, historically, you have spoken to the Water Management segment as a low 20s to high 20s incremental margin. Potentially do you think that can maybe step up to low 30s now? I mean, if you get a recovery in construction?

No, not in total. I think we are going to probably wait and see what sort of recovery we get. But, at this point, I think solidly that should be the expectation and if we get non-res recovery in that double-digit running in a couple of years, I don't think it is out of line to say that you would probably see it in the 30s, but I think from a base case standpoint, a gradual recovery starting off with maybe plus a few points and then maybe high single digits, I think we are going to be in that mid- to high 20s incremental range.

I do believe at some point in the next two or three years you are going to see a double-digit recovery in non-res construction. And at that point, I think it is probable that you would see higher incrementals, no question. But from a base case standpoint, we are sort of looking at a gradual recovery over the next couple of years. But in the event, and potentially, likely event that we do get a double-digit year, I think we could probably be there. Yes.

Fair enough. And can you comment on what you are seeing in municipal markets maybe in Europe and the US, customer tone and trends there?

I would characterize it as stable. Both in those geographies, North America and Europe. What we are seeing, I think, frankly, is just a lot of growth and activities in South America and the Middle East. The project size and pace in both of those geographies is really picking up. I think our funnels from a lead time and project outlook are really strong.

So the stability in the mature markets is good. I think we are happy with that, but then we are probably start to see some of the growth markets of the Middle East and South America pick up meaningfully.

Great. Thank you.

We have no further questions at this time.

Great. Thank you, everyone, for joining us this morning. We appreciate your interest in Rexnord and look forward to our next update when we announce our third-quarter earnings in early next year. Thanks so much.

Thank you. And thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.