Zurn Elkay Water Solutions Corp (ZWS) 2014 Q3 法說會逐字稿

Good afternoon and welcome to the Rexnord third-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, January 28, and are also posted on the Company's website at www.rexnord.com. At this time for opening remarks and introduction, I'll turn the call over to Mark Peterson, Senior Vice President and Chief Financial Officer of Rexnord.

Good afternoon. Before we get started, just a brief reminder that this call contains certain forward-looking statements that are subject to the Safe Harbor language contained in the press release we issued today, as well as in our filings with the SEC. In addition, some comparisons refer to non-GAAP measures. Our earnings release and the SEC filings contain additional information about these non-GAAP measures and why we use them.

Today's call will provide an update on the overall performance for the third quarter of fiscal 2014, including details on our two platforms, followed by an overview of our financial statements and the quarterly highlights. Afterwards we will open the call up for your questions.

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

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

Starting on Page 4. We are pleased with our results this quarter and overall levels of core growth, profitability, and free cash flow. We delivered exceptional profitability and cash flow in the quarter in light of the adverse impact of some shipments that pushed through our Q4 based on our customer's request. As I will cover in just a few minutes, you'll see that we picked those sales up in our fourth quarter, which is factored into our increased full-year outlook for 4% core growth.

Through the first nine months of our fiscal year, our overall performance is on track with our expectations and overall strategy, which is focused on driving above-market core growth, strong incremental margins, free cash flow, and earnings per share, while both deleveraging and executing our bolt-on M&A strategy. As it relates to our third quarter, we are confident that again our core growth continues to outpace the growth in our served markets as we delivered 4% consolidated core growth in the quarter. That 4% core growth is comprised of 12% growth in our water management platform, and nearly flat core growth in process and motion control, which rounds to minus 1%, inclusive of the shipments the pushed through our March quarter.

Our adjusted operating income increased 9% from the prior-year as our incremental margins of 35% drove a 50 basis point increase in our adjusted EBITDA margins, with an expansion in each of the platforms. With respect to earnings per share, our adjusted EPS increased 79% year-over-year to $0.34, $0.02 above the high end of the guidance range we gave in October, due to a cash tax benefit that was worth $0.02. Finally, we had a strong free cash flow in the quarter of $72 million, which allowed us to both de-lever while making an important acquisition within our process and motion control platform.

Turning to the highlights for the quarter within the platforms, the momentum in water management remains strong. We clearly feel the non-res market is now past the inflection point and the go-forward market growth is sustainable, with non-residential construction backlogs continuing to build in the US and Canada. To add a little further color on the end markets and group performance within the platform, Zurn sustained double-digit core gross sales growth again in the quarter, continuing to clearly outpace the still moderate but strengthening overall market growth. This trend, combined with the strategic growth initiatives we began several years ago, continues to give us confidence that Zurn will be a major driver of our overall growth and value creation over the next several years.

Within VAG, our backlog continues to grow as our book-to-bill ratio was again above 1, despite the timing of certain orders that we will book in our fourth quarter, which sets us up for a solid fourth quarter of fiscal 2014 and provides a strong foundation heading into fiscal 2015. The global fundamentals for water infrastructure continue to be very solid and provide a nice runway for growth over the coming years, with particularly strong core growth coming from the Middle East as well as South and Latin America.

To close on water management, we posted another solid quarter. Our visibility and access to an ever improving set of end markets is as good as it has been in years. And our profitability continues to accelerate toward the higher teens in terms of EBITDA margins over the coming years.

Moving to process and motion control. Our core sales growth continues to hover around flat and our book-to-bill ratio around 1. While demand continued to be choppy of the course of the quarter, we saw improved momentum in our shorter-cycle order rate activity at the end of the quarter, which underpins our expectation of stronger core sales growth in our fourth quarter. Our solid execution enabled us to increase our adjusted EBITDA year over year, despite the nominal sales decline resulting in a 60 basis point increase in our adjusted EBITDA margin to 25.3%.

I think it is equally important to find out that despite the realities at a lower growth industrial environment, we have continued to invest in our businesses for the long-term and have been very disciplined in our approach to drive sustainable productivity and efficiency in our businesses, that has allowed us to protect and invest in growth initiatives that enhance our long-term sustainable competitive advantage within process and motion control.

In the quarter we completed the acquisition of Precision Gear Holdings, which expands our presence in both the aerospace and energy markets. Consistent with our other acquisitions this year, we are excited about the basket of both cost and growth synergies that we have already begun to leverage, which along with implementation of the Rexnord business system will deliver double-digit return on invested capital in a short period of time. I'll further say that at the moment we are pleased with the status of our acquisition funnel, and that we should continue to be smartly acquisitive moving forward.

Turning to Page 5, I will cover our outlook. For the fiscal year, we are raising our adjusted EPS range to $1.35 to $1.39, as well as our core sales growth to 4% for the year. Translating that to what it means for the fourth quarter, we anticipate sales to be the range of $575 million to $590 million, with core growth of approximately 6% and adjusted EPS in the range of $0.46 to $0.50. Consistent with our prior practice, all of our guidance excludes the impact of future or pending acquisitions.

One final point before I turn the call over to Mark, as you are aware we announced the stock offering this afternoon. We're not able to get into the details of the offering on this call, I'll refer you to the press release registration statement, and prospectus that we filed with the SEC. With that, I'll turn it over to Mark to cover the financials.

Thanks John. Consistent with 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 6 of the presentation takes out our quarter results and reconciles to the adjusted results.

Turning to Page 7, I'll discuss our operating performance highlights the third quarter. Third-quarter sales increased 4% from the prior-year period to $499 million, driven by core sales growth of 4%. Adjusted operating income increased 9% from the prior year to $71 million in the third quarter, or 14.6% of sales.

Year-over-year, our adjusted operating income margin increased 80 basis points, driven by a 35% incremental margin on the sales growth in the quarter. Our adjusted EBITDA was $98 million or 20% of sales, a 50 basis point increase in the margin year-over-year. Third-quarter adjusted net income was $34 million, resulting in adjusted earnings per share of $0.34, which increased 79% from the prior year due to the increase in operating income and the benefit of the debt refinancing we completed last quarter. Cash flow was solid in the quarter as we generated $72 million of free cash flow, effectively funding the acquisition of Precision Gear.

Next I'll take some time on Slide 8 to walk through the operating performance in our process and motion control platform. Sales in the third quarter decreased 1% year-over-year to $301 million. The low single-digit core sales growth in the majority of our end markets was basically offset by a decline in sales to our bulk material handling markets, resulting in core sales down 1% year-over-year.

Turning to profitability, adjusted operating income was $59 million, and our adjusted operating income margin improved 60 basis points to 19.6% on a slightly lower year-over-year sales. Adjusted EBITDA was $76 million in the quarter and our adjusted EBITDA margin also increased 60 basis points from the prior year to 25.3%. We continue to focus on effectively managing our cost structure and driving productivity gains in this low-growth environment while investing in our strategic growth initiatives.

Turning to Page 9, I'll make a few a comments on our water management platform. Water management sales in the third quarter increased 12% from the prior year to $188 million. Core sales growth was 12% in the quarter, driven by market share gains in the majority of our served markets, and increased alternative market sales in our non-residential construction end markets.

Third-quarter adjusted operating income increased 36% year-over-year to $19 million, and our adjusted operating income margin increased 160 basis points from the prior-year of 10%. Adjusted EBITDA was $28 million in the quarter. And our adjusted EBITDA margin increased 100 basis points year over year to 15% as we drove productivity gains in the platform and effectively leveraged the sales growth.

Moving to Slide 10, I will touch on a few cash flow and liquidity highlights. We finished the quarter with $192 million of cash and $520 million of total liquidity. Total debt at the end of the quarter was $1.95 billion, and net debt was $1.757 billion, resulting in a net debt leverage ratio of 4.2 times, which improved from 4.3 times at the end of our second quarter, inclusive of the Precision Gear Holdings acquisition.

Before I discuss some of the details on our outlook, I want to comment on our effective tax rate. As we discussed on our last call, we anticipate our full-year effective tax rate, excluding nonrecurring items like the loss on debt extinguishment, to be the range of 31% to 33%, and that range remains unchanged. Our effective rate, excluding the loss on debt extinguishment, in the first nine months of the fiscal year was approximately 30%, and was impacted by recognizing certain discrete tax benefits in our first and third quarters. Because these items were recognized in the first nine months of our fiscal year, we will have a tax rate of approximately 35% to 37% in the fourth quarter, 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'll make a few final comments on our outlook. In addition to the outlook highlights Todd covered earlier in the call, Page 5 of the presentation highlights our assumptions for interest expense, depreciation and amortization, stock option expense, our effective tax rate, capital expenditures, and fully diluted shares outstanding for fiscal 2014. In addition, our guidance assumes we do not incur any nonoperating other income or expense, as we do not forecast realized and unrealized gains or losses from foreign currency fluctuations, gains or losses on disposal of assets, or other items that are recorded in this 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 over to the operator and open up to any questions.

(Operator instructions)

Julian Mitchell, Credit Suisse.

Hello, good afternoon. Just firstly on the -- you had a 200 bips acceleration in organic sales growth sort of year on year from the December to the March quarter. What is driving that? Is some of that PMC turning positive again? And is water kind of pretty steady year on year?

It is Julian. The 12% growth in water that we had in our third quarter, we expect a similar number in our fourth quarter. And if you look at PMC, a couple of things.

We had a couple of shipments that moved from the December quarter to March and I also referenced some improving I'll say shorter-cycle MRO sort of business. So from a core growth number, I think you'll see, I will say a meaningful difference from our December quarter to our March quarter in our PMC growth. Moving to that low to mid-single-digit number and that is what is embedded in our 6% consolidated core growth number.

Got it, thanks. And then, within PMC, you had a little bit of restructuring and historically you had good incremental margins there. As we start to see better organic growth in that business on the top line, what kind of incremental margins do you think that business can generate?

We did do a little restructuring in the quarter, really consolidating two aerospace facilities to be super confident in the ability to execute an increasing backlog going forward. We have always characterized the incrementals in process and motion control in that sort of 30% to 35% range. So we are hitting that now with I will say flattish sort of growth environment, and so as growth returns, we expect the margins to be there as well.

Thanks. And then just lastly, on the sort of acquisitions that you have announced in the last few months, you take them in the aggregate, what is the average kind of margin on those acquired businesses?

They are right around, maybe slightly less than the PMC average.

Got it. Thank you very much.

You bet Julian.

Mig Dobre, Robert W Baird.

Good afternoon guys, thank you for taking my question. First, can you provide a little more clarity on the shipments that have been pushed to the fourth quarter?

There is not a ton to clarify other than as we got towards the end of December a couple of customers in certain end markets decided that they would prefer to receive shipments beginning in January. And so obviously for us, we want to do what is right for our customers and we moved it. So that is nothing more than that.

I understand. I guess I'm just wondering if maybe, I presume that this is in PMC, and I'm wondering the size or anything like that that you can be talking about.

Yes the size, I don't think it's worth while getting into the details, but it is in the order of magnitude of $5 million.

Okay. That's helpful. And I realize that you guys put out the fourth-quarter guidance and everything else, but considering the circumstances, I'm wondering if you would like to sort of maybe craft the way we should be thinking beyond the fourth quarter as far as growth in both PMC and water management.

I think it is a little early for that. Obviously, as we refine our thoughts on that over the next couple of months, we will be in a spot to I think provide an update. But at this point, just at a high level, water continues to accelerate.

So I think the clip that we are running out now, next year should be at or around that. So I'm thinking high-single, low double-digit sort of topline growth. And I think at this point, we would be thinking about PMC in that sort of low to mid-single digit growth heading into next year.

Excellent. And PMC, if we can talk about a couple of end markets specifically. Bulk materials has been a challenge, I know that over the last few quarters.

And I am just wondering, when are we going to see frankly easier comps going forward? And any sort of comment that you can provide as far as aftermarket versus OE demand in that end market?

Sure. We'll just hit it head on Mig. I think if you look at PMC at minus 1%, if I were to strip out the impact of bulk material handling, we're plus 3% or 4%. So that is sort of the relative impact in the quarter.

If I look at what is happening there, clearly the production side is stabilizing. We are seeing that in our numbers and we see the progressing over the course of the next quarter and into next year as well.

From a capital side, I think it is well documented and understood that is going to be another tough year. So from a capital perspective, I don't think we see easier comps really for another year.

From a production standpoint, I think we begin to see favorable comps, call it in our June quarter from an easier comps standpoint. So the good thing is I think we have substantially diversified and our other core businesses are really starting to accelerate. I think that is the message underneath.

That's great. And the last one for me is really on the general industrial portion of that business. I am wondering specifically, what are you seeing as far as distributor demand progression? Some other companies in your industry have commented on slightly better demand coming out of the group. Are you seeing something similar?

I think we are. If we look at our first half of our fiscal year really through September, we saw relatively stable demand. We saw a little bit of a step down in the middle part of our December quarter, followed by an acceleration throughout the month of December and the same acceleration we're sort of seeing today. So I think that is the pattern from a distribution standpoint.

Great. Thanks guys.

You bet

Andrew Obin from Bank of America.

Yes, thank you. The comments around bulk materials was actually quite helpful. So just to make it clear, so you sort of think that the comps start getting better sometime this summer, is that a fair statement?

We do.

Is that what I have heard?

You have, yes.

Okay. Can we just talk about the water? And a couple of questions. A, what gives you -- because it seems this non-residential recovery is a fairly sort of controversial topic. What gives you confidence that you have seen the bottom? And second, if you can just provide some color on water outside of North America. Thank you.

I think the root of your question is what gives us confidence that we have seen the bottom and we're seeing the inflection point in the water management or really non-res growth.

This is something we do tremendous amount of work on, and we understand all of the end markets, we look at the projects, where they're happening, where the backlogs are building. And if I look at that, it's clear to us that perhaps last quarter and definitely this quarter we have passed through the period in which we were declining to actually seeing very low-single digit market growth.

If you look at the Dodge Momentum Index, I think that really captures where that backlog is. So we're very comfortable that the market is growing.

If I look at the second part of your question, which is what is happening in water outside of North America, we are seeing really very good growth in a number of geographies. We outlined the Middle East and really South and Latin America as two great growth end markets. And we see that continuing for the next several years.

I would characterize Europe as stable and China as improving. So hopefully we covered everything you were looking for. But that's how we would answer those questions.

Terrific. Thank you very much.

You bet

David Rose, Wedbush.

Good afternoon. A couple of follow-up questions. On the delayed order, was it in bulk handling?

It was not.

Okay. So if we strip that out, then your orders would have been higher outside of bulk handling? Is that right?

That is correct.

Okay. And then if you could, the corporate expense declined year on year, was there any particular reason for it? Any initiatives?

No, I think it was just timing. If I remember correctly David, it was down I think $300,000 to $400,000 year over year, so it's really nothing specific on the materials, just timing of those expenses.

The one thing to point out is that when you look at corporate expenses sequentially, factored into our guidance is an increase in corporate expenses really around M&A, and levels of diligence activity that we see in our fourth quarter.

Into our fourth quarter, yes.

Yes, year on year we don't think there's anything significant, but I think it is worthy of pointing out that as we look to our fourth quarter, expect the corporate expenses to be little bit higher in support of some acquisition activity that we are pursuing.

And can we think about it on the same lines as the [PTNH]?

We're not going to comment on anything other than to say we are seeing an increased level of activity, and as a result of that you will see some diligence and related expenses in the fourth quarter that are higher than what we have been running in the last quarter.

Okay. And then the other expense side, about half of which I think you accounted for, the other half wasn't accounted for, I think a little over $2 million. Can you provide a little bit more color on that?

The $4 million of other expense in the quarter? $2 million of unrecognized foreign-currency loss, was about $1 million in round numbers of some retention costs in the balance. There are some losses recognized in disposal of assets, and there's really nothing outside of that extra $1.5 million, there's really nothing that is of materiality. It's some plus and minus $300,000 or $400,000 here and there, I don't have the details with me right now but there's nothing material in that number.

Okay. And then lastly on the inventory jump, is that largely related to the delayed order or delayed delivery of the order?

The inventory step up, part of it is some M&A inventory that comes in from Precision Gear Holding in the quarter. And part of it is the inventory portion that you referred to, as well as some backlog shipment time that hits our fourth quarter and we are building the inventory in December.

So, should we see better turns in Q4?

Yes. You will.

David when he look at the water growth that we are talking about, that is on top of substantial water growth in our fourth quarter last year. So in order to get to the 12% growth, it is large projects that we have begun to build for, and so you will absolutely see an improved turn number in our fourth quarter.

Okay. And as you talk about growth internationally, are the receivables going to grow as well given the more growth internationally? Or we are not going to see much growth there?

I would not see anything pronounced there.

There should be no meaningful change in the [DSO] metrics in the fourth quarter.

Okay, that's great. Thank you very much.

Samuel Eisner, Goldman Sachs.

Yes thanks, good morning everyone.

Good afternoon. It is afternoon Sam.

Yes, in terms of the long-term margin targets for you guys, I think you put out there for about 30% for PMC and about 25% for WM. Maybe you could talk a little bit about the timing of that and the steps you need to take in order to achieve those respective EBITDA margin targets.

Sam, just to clarify, the incremental margins for PMC are 30% to 35%. For water, they're in that 20% to 25%. We think that over a three to five year horizon, that translates to PMC EBITDA margins in total in that high 20%s, I think if you go little bit further out, we could stretch ourselves to 30%.

And then in water management, we are at 15% today. A couple of years ago we said that we could get to 17% to 19% within three to five years, so we are tracking to that number within that horizon. And I think again, stretching ourselves a little bit, 20% for water is not out of the question.

And in terms of the steps in order to get there, is that primarily volume leverage or is it pricing, or maybe we can just kind of put them into some larger buckets here? Where do you think the bulk of that is coming from?

This would be obviously including some I'll say reasonable growth in that number. The pricing environment is sort of stable, so that's really not it. Again, if I look at each of the two growth paths, they're little bit different. In process and motion control, we are driving continuous improvement all the time to the business system.

We also see the opportunity to continue to begin to I'll say consolidate some of our factories, be more efficient because of the productivity we have driven. So there's a little bit of a footprint opportunity as well as more value-add, value engineering, and also bringing products to market through our new product development process with better margins than their predecessors. So it is really all of the above.

If I look at water, we have made the investment, we have got the global footprint there. And really it is leveraging the volume that we see coming over the next couple of years. So there's I will say less heavier lifting to do in water. And there are some things that are laser focused that we need to get done in PMC and will get done over the next couple of years.

I really appreciate that. And then just on the backlog in WM, I think you gave it as over one, but for a year-to-date basis or nine months, where do you stand on the book to bill for water management?

We have through the first half of the year about 1.15, we're over 1 [sink] right now. Through the first nine months we're in that 1.1 ZIP code plus or minus on our book to bill in the VAG portion of water management. Remember, Zurn is really more book and turn. [That always hover] around 1, but VAG had an approximate 1.1 book to bill through the nine months.

That's great.

(multiple speakers) going into next year as well.

Very good. And in terms on capital allocation, I know you commented that you saw increased level activity in the M&A pipeline. Can you maybe just talk about valuation and what you are seeing from a bid as spread standpoint

Again without getting into any specifics Sam. We are seeing opportunities that we've worked for a long period of time, but we're not at an auction, so it is a proprietary sort of situation where we are buying comfortably in that I will call it 5 to 8 range, with both cost and revenue synergies right behind that. So you can do the arithmetic and see the return on invested capital looks very attractive very quick. Some not sure which ones fall out of our funnel and the timing, but comfortably in the 5 to 8 range is sort of how I would characterize where we are seeing the evaluation deals getting done.

Great thanks.

We have no further questions at this time.

Okay, Alexandra. Thank you and thank you everyone for joining us on the call. We appreciate your interest in Rexnord and look forward to providing you further updates when we announce our fiscal year 2014 fourth-quarter results in mid May. Thanks so much. Good night.

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