Zurn Elkay Water Solutions Corp (ZWS) 2016 Q2 法說會逐字稿

Welcome to the FY16 Q2 earnings release call.

(Operator Instructions)

Please note, the conference is being recorded. Now, I will turn the call over to Rob McCarthy.

Thank you, John. Good morning. Welcome everyone.

Before we get started, I need to remind you that this call contains certain forward-looking statements that are subject to the Safe Harbor language contained in our press release that we issued yesterday afternoon, as well as in our filings with the SEC. In addition, some comparisons will refer to non-GAAP measures. Our earnings release and SEC filings contain additional information about these non-GAAP measures and why we use them. Consistent with prior quarters, we will speak to 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.

Today's call will provide an update on our overall performance for the second quarter and our outlook for the fiscal year. We'll cover some specifics on our two platforms followed by selected highlights from our financial statements, our liquidity and our cash flow. Afterwards, we'll open up the call for your questions. With that, I'll turn the call over to Todd Adams, President and CEO of Rexnord.

Thanks, Rob. Good morning, everyone.

I will start slide 4. Our second-quarter results were in line with our expectations for core growth, profitability and free cash flow. Our core sales declined 6% year over year, which is a function of a 1% core growth in our water management platform and an 11% core decline in our process and motion control platform, which I'll cover in more detail in just a few minutes.

Acquisitions added 3% to sales. Adverse currency translation was a headwind that reduced our reported top line growth by approximately 500 basis points. Adjusted earnings per share was $0.34 in the second quarter, as our adjusted EBITDA margin was slightly better than projected and accounted for a modest upside to our EPS guidance. Free cash flow was robust and consistent with our expectations. Moreover, we continue to be well-positioned to execute perspective bolt-on acquisition activity.

In terms of color on the quarter, I want to start with water management. The conviction we've had and the progress we've made in the margin opportunities continue to track well, as we posted record margins in the quarter and overall, are now running around 18% for the first half of the year. In the quarter, we advanced a number of critical milestones in our overall supply chain and footprint optimization plan, enough to pull into this year two actions, both in water that were originally planned for next year.

The incremental cost to implement the plan will hit over the back half of this year. But more importantly, we get the benefits and the run rate beginning less than five months from now. Over the second half, we expect water management to continue to be a source of solid core growth in margin expansion, with the actions we've accelerated adding to the margin trajectory we're currently on, which is in the higher teens to 20% range over the next several quarters.

Turning to demand. The water management platform continues to perform well, as core growth was in line with our expectations and what we outlined heading into the quarter and reflects the comparability impact of large project shipments in last year's second quarter. The US non-residential construction market continues to be a key positive, as growth continues to be solid despite some lengthenings in project schedules due to the weather issues experienced earlier in the year and the ongoing tight supply of available construction labor.

Our outlook for the balance of the fiscal year and next year as well is that we will continue to benefit from robust fundamentals in the non-residential construction market. US spending growth continues to run at elevated levels. Leading indicators like the ABI and the Dodge Momentum Index continue to support our expectations for robust activity levels heading into next year and beyond.

In our water and water infrastructure end markets, we are continuing to see solid order growth, as our first half book-to-bill totaled 1.18 times and first-half core sales growth was 6%, which is a combination of up double-digits in Q1 and down single-digits in Q2. As we've discussed, quarterly sales comparability year-to-year is often impacted by project shipment timing because of what happened in Q1 and Q2 and is simply inherent in the business in the end markets we serve.

Looking forward. With a solid backlog in water infrastructure, we expect to see stronger reported core growth in margins for that part of the platform in the second half. Water management in total is and should continue to be a real positive for us moving forward in terms of core growth and in particular profitability, as it will now account for about 40% of Rexnord consolidated earnings as we exit this year.

Moving to process and motion control. I will spend just a minute providing a little detail on several key end markets, as well as our industrial distribution channel. Like for most industrial companies, I think it's fair to say that it's not a rosy picture out there in many end markets.

However, there certainly are some bright spots that are worth talking about. In our case, both aerospace and food and beverage continue to perform well. These end markets comprise about one-third of the overall platform revenues and more than that when you look at it from an earnings perspective. We're seeing solid orders and continue to have decent visibility to what looks like low to mid single-digit growth over the second half of the year. This is after a decent first half.

When you look at the remainder of process and motion control, there is a big piece of the aftermarket that we serve through the industrial distribution channel. This is the part of our business where we've seen the channel inventory reduction significantly impact our growth rates over the first half, which again, we're pretty much in line with what we had expected heading into the second quarter. To mention the impact of the destocking, that alone has impacted process and motion control growth in the first half by 4 to 5 percentage points and overall Rexnord core growth by about 2%.

The next piece of the equation is what happens with the ID sell-through and direct OEM and end-user shipments. Here is where we've seen some end market demand weaken slightly in September and October. The thing to point out here is that while sales were a bit less than we had been expecting and down year over year, it was relatively stable sequentially from the first quarter.

As we think about this part of our business over the second half and in particular, the December quarter, we believe that we could see some volatility and uneven demand over the next couple months, as many industrial companies that need and use our products temporarily defer spending heading into the end of the calendar year. Balancing that is the fact that this is the part of the business where we do carry some backlog.

The process and motion control in totality -- all of this can be summed up in the following way: one-third of the platform is aerospace, food and beverage growing nicely with a reasonable outlook; next, the first half was largely impacted by destocking, which we believe is mostly behind us at this point and impacted first half growth by between 4 and 5 percentage points; and finally, direct sales and sell-through weakened somewhat in the quarter and a little in October. We are assuming there's a likelihood that could continue to slip as we head into the end of the calendar year.

As it relates to our outlook, the net result of all of the end market updates is, that with six months left to go in our fiscal year, we're electing to become even more realistically cautious with respect to short cycle industrial demand. We're also incorporating an incremental $0.04 of expense from the acceleration in our strategic footprint initiatives into the P&L. The net impact of these two assumptions results in an adjusted EPS range for the year of $1.43 to $1.48.

While we're not exactly happy with the absolute result, we are pleased with the way the overall Rexnord portfolio is setting up to perform over the coming quarters and into next year. Water, aerospace and food and beverage exposed end markets now comprise over 60% of revenues and earnings for the Company. In the remaining end markets, we have absorbed the brunt of a channel destocking over the course of the first half. This had a significant impact, not only on growth but overall margins.

On the self-help side of life, we've made substantial progress on the initiatives embedded in the $30 million of annual savings that we planned for during last year and began implementing just in the past six months. I will remind everyone that we will begin to see some of the benefits beginning in early FY17, which at this point is only five months away.

In the meantime, we are leveraging the Rexnord business system to drive efficiencies and reduce cost to mitigate the impact of a lower top line, while continuing to protect investments in areas that will enable us to drive above market core growth going forward. As an example, in our PT end markets, we are on track to deliver $30 million of first fit order opportunities to new customers by the end of FY16. We've been investing in tools, adding talent and implementing new processes and are seeing the measurable impact that will accelerate and amplify our growth moving forward.

Now, let's move on to slide 5. Consistent with what we have shown you for the past couple of quarters, this slide outlines our growth assumptions for our largest 10 served end markets that account for about 85% of our annual revenue. As I already highlighted, the most impactful change to our market view is a more realistically cautious outlook for sell-through in our US industrial distribution end markets, where we are revising our forecast by 2 to 3 points or from a mid single-digit decline to a high single-digit decline, which reflects weaker sell-through in the US plus a couple million more dollars for potential corresponding channel inventory reductions.

We've also tweaked our market forecast slightly lower for our direct sales into a couple of our process end market verticals. But these minor changes were mostly accommodated within the existing forecast ranges from a quarter ago. This lowers our overall end market growth forecast to between down 2% and down 4%. For reference, our first half core growth was minus 3% and was impacted by 2 percentage points related to the channel inventory destocking. Over the second half, we expect our core growth to improve modestly.

Before I turn it over to Mark to provide a little more detail on the financials, I hope you take-away the following this morning. Overall, we believe our second-quarter results reflect another decent quarter of solid execution in a highly volatile and challenging market environment. We have reviewed and revised our assumptions to reflect an incrementally more cautious view of likely direct sales and sell-through rates in our US industrial distribution channel, taking a prudent view that we believe limits further downside.

We will continue to be aggressive and nimble in the markets -- as market conditions evolve. We're leveraging the business system to eliminate waste, improve productivity and keep ourselves ahead. Finally, we've also accelerated certain elements of our significant and structural self-help initiatives, while capturing additional productivity gains and margin expansion in our operations serving global water markets. The net result of that means that earnings over the next six months will end up being a little bit lower than we thought, which is something we're not pleased about and we'll continue to work to improve upon.

Secondly, as you think about Rexnord's portfolio and future performance, it's essential to understand that the shift in our overall earnings mix is accelerating in a significant way this year and will position us very differently as we enter the coming fiscal year. With the expected benefits from just the first stage of our supply chain and footprint optimization coming into our numbers as we move through next year, we are increasingly upbeat about our relative financial prospects in our FY17.

Last but certainly not least, our business model generates significant free cash flow in good times and in not so good times. This year will be no different, as we expect to generate approximately $100 million in the second half of our year to either delever or to execute upon smart M&A that will add growth, future earnings and cash flow to our core businesses.

With that, I will turn it over to Mark to review some of the numbers.

Thanks, Todd. I'm on slide 6 of the presentation, where it states reported results and reconciles to the adjusted results. Recall that beginning in our first quarter and is reflected in this reconciliation, we revised our definitions of adjusted net income and adjusted earnings per share to exclude non-cash amortization of intangibles and to include stock options and LIFO expenses.

Turning to slide 7. I'll just comment on a few key metrics from our consolidated results in the quarter. First, as Todd has covered, our revenue was in line with our expectations for the quarter. Adjusted EPS is slightly better. With respect to profitability, the increased drag from our US distribution channel pushed our overall decremental margin to 45%, which is actually a bit better than forecast.

Given our reduced outlook for US distribution, our decremental margin will remain above normalized levels in our third quarter, while we continue to see the full year coming in around the 30% level we historically expect. Furthermore, we continue to expect that destocking will be essentially complete in the current quarter. Our cost reduction initiatives are on track to deliver our targeted savings for this year.

Turning to cash flow. Our free cash flow declined year over year but was in line with expectations. The year-over-year change reflected the decline in our net income, partially offset by improved working capital management, as well as the expected increase in cash tax payments in this fiscal year.

Next, as we look at the operating performance in our process and motion control platform on slide 8, you can see the strong year-over-year impact on our margins from the accommodation of 12% revenue decline and the adverse mix effect created by weaker distributor sell-through and the concentrated destocking in the quarter. Whether we experienced last quarter, food and beverage and aerospace revenues were again up on a year-over-year basis.

As we look at our third quarter, we expect adverse year-over-year mix from weaker distribution sales levels and higher investment spending associated with our footprint actions to hold PMC's third-quarter EBITDA margin to around the second-quarter level. For the full year and incorporating our incrementally more cautious outlook for the US general industrial demand, we now project that PMC's EBITDA margin will be in a 21% to 22% range.

Turning to slide 9. I will make a few comments on our water management platform, where we continue to generate strong year-over-year margin expansion, as our adjusted EBITDA margin expanded by 90 basis points to reflect ongoing RBS-lead process improvements, productivity initiatives in our valve and gate group and leverage on the sales growth in our non-residential construction end markets.

As we look ahead for water management, I would like to remind everyone that the timing of project shipment can create significant variability in quarterly core sales growth comparisons in water management. Having said that, we continue to expect platform core growth to accelerate to the end of our fiscal year supported by favorable non-residential construction demand, the phasing of product shipments in our current backlog and the sequential moderation of private shipment levels in last year's second half.

With respect to water management margins, we expect to deliver ongoing year-over-year margin expansion through year end and particularly in our fourth quarter. Overall, our confidence in water management's full-year outlook remains high. We now expect water management adjusted EBITDA margin to exceed 18% in FY16.

Moving to slide 10. You'll see our strong free cash flow enables us to rebuild our cash position, after allocating $40 million for cash repurchases in the first quarter. While liquidity position remains strong, we have a patient capital structure given our maturity profile. Going forward, we will continue to evaluate our capital allocation opportunities, in the context of our overall capital structure, liquidity requirements and our longer-term objective to reduce our financial leverage.

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. In addition to the outlook highlights Todd covered earlier in the call, slide 11 of the presentation also highlights our assumptions for interest expense, depreciation and amortization, our effective tax rate, capital expenditures and fully diluted shares outstanding for FY16.

In addition, our guidance assumes we do no incur any non-operating other income or expense, as we do not forecast realized and unrealized gains or losses from foreign currency fluctuations, gains or losses on the disposal of assets or other items that are recorded in this P&L line item. Our guidance also excludes the impact of potential acquisition and divestitures and future non-recurring items such as restructuring costs and potential intangible asset impairment charges we may incur as we assess certain branding strategies in our water and wastewater infrastructure end markets.

With respect to restructuring, I want to take a minute to provide you with an update. First, the supply chain optimization and footprint repositioning program is expected to impact our FY16 results as follows. We've increased our forecast for costs that will run through our operating results from approximately $7 million to approximately $13 million in the fiscal year.

This change reflects the acceleration of certain elements of the plan into our FY16 and FY17. The incremental impact is about $0.04 and is included in our revised outlook for adjusted EPS. We now project $14 million to $16 million in restructuring expense, primarily made up of severance costs, up about $1 million from last quarter.

Unchanged in our forecast is approximately $5 million of accelerated depreciation in the year, which is also from adjusted EPS. As the result of the accelerated actions Todd discussed, we'll incur approximately a $3 million fixed asset impairment charge in our third quarter. Our forecast for CapEx in FY16 related to this project is unchanged and is included in our CapEx outlook of approximately 3% of sales. Second, and in addition to this project, we now anticipate incurring restructuring costs of approximately $5 million to $6 million related to other cost reduction initiatives during the year, up about $1 million from our last quarter.

Before we open the call for questions, I want to make one final comment on our effective tax rate. Our effective tax rate will fluctuate by quarter, given the varying levels of pretax income, as well as the timing of our tax planning initiatives. We currently anticipate that our second-half tax rate will be between 25% and 27%, with a third-quarter tax rate that will be between 10% and 12%.

With that, we will open the call up for your questions.

(Operator Instructions)

Charley Brady, SunTrust Robinson.

I just want a key on the destocking, just so I understand the outlook. The tenor as you went through the second quarter, did it -- you were seeing it decelerating? Or was it steady? Then as you come into October, have you seen a change that gives you the confidence that we go through the third quarter and we're kind of done with it?

That is absolutely correct. When you look at the year, it sort of unfolded a significant destocking really over the first half. What we're seeing in September is the more majority of that destock, frankly, abate. What we've got in our outlook is maybe absorbing a little bit more, if in fact, we do see a weakening in sell-through rates within distribution.

So I think we feel good, Charley, about the balance of the destocking really being behind us. Obviously, there is a risk that if demand take a big step down that could create further destocking. But at this point, we don't see it happening in October. We don't think we see it going forward.

Okay. Then just one more sought out, a clarification on the restructuring commentary. The pull-forward into 2016 from 2017, is that largely in the water platform? Or is any of it go into PMC?

The two actions are primarily in the water platform. So these are two things that we had been planning for. But as we started the year, we looked ahead and said, where can we pull activity forward to gain a benefit to get in to the run rate by 2017. These were two areas where we had made substantial progress, we had the chance to do, so we did it.

So, you'll see those unfold really over the back half the year. We'll begin to get that run rate as we start 2017. So, I think what underpins our conviction around the margins is not only the current core performance, but what we have behind that. So, yes, those are both water related.

Great, thanks.

Julian Mitchell, Credit Suisse.

Just wanted to follow-up on the restructuring comments. As you said, there's a bunch of different initiatives going on, supply chain and severance and so forth. I just wondered if you could roll it all up together and maybe help us understand what kind of incremental savings you expect this year versus last year? Then what is incremental in FY17, taking all the measures combined?

I think maybe I will start at the end and what we are trying to accomplish from an outcome standpoint. Then Mark can sort of feather in, what's in 2016, what's in 2017. What we have on the table and announced -- this is only the stuff we have announced to date. There is more that is in the pipeline for finalization and development, really over the course of the next six months. But we see $30 million to $35 million of savings as we exit our FY17. So that is the ultimate goal.

As we look at all the projects, I think at this point, every one of those is underway. So it's not something that needs to be developed. It's not something that needs to be started. Each of these are absolutely underway. We are currently absolutely on track to that $30 million to $35 million of savings as we exit our FY17.

So you would see the run rate beginning, call it, April 1, 2017. Mark can take you through some of the details of what we'll see in 2016. What we'll see in 2017. But that is sort of where we end up, Julian.

Yes. So, Julian, from a cost standpoint, let me kind lay out the pieces of the puzzle to what is going to hit this year. As you look into next year, we will see approximately another, call it, $10 million to $13 million or so of operating expense that will be incurring as duplicative costs, as we're ramping down -- ramping up this initiative. But it this different next year, it will start getting savings, as Todd mentioned.

We'll have savings that will not entirely offset but offset a meaningful portion of those costs. So on a year-over-year basis, you will see an improvement sequentially year over year in our overall EBITDA. So think about costs in the P&L similar to this year, but savings next year that's offsetting a majority of those costs, whereas this year, we really aren't just earning any saving, we're just incurring the duplicate of cost this year.

So when you roll it forward, order of magnitude, it's an excess of 150 basis points of margin at the Rexnord level. We've talked about where we are in water and obviously some of the actions that we've talked about this morning, get us rolling over that 20% EBITDA margin mark. What is even more exciting we think is that a lot of the savings come in our PMC platform, specifically on the industrial end market side of things, where we are currently seeing relatively close to trough, if not trough conditions.

So we're at or near the bottom, we've got a whole bunch of self-help on the way. Even a lack of any headwind, I think you're going to see us produce really nice margins as you head into the end of 2017 and into 2018. So that's all the overall plan, Julian. How it bakes through the next couple years.

Thank you for the thorough response. Just a quicker follow-up perhaps, capital deployment? Things have been a little bit quite there I guess for Rexnord the past few quarters. Is that a function of a tougher organic top-line environment? So you'd rather spend management time and attention on restructuring the existing business? Maybe talk through why things have gone quiet? Maybe when they might liven up again?

It's not because we haven't chose to focus on it. I think we've focused probably more on it over the last 12 months than we had in probably the prior couple years. Our funnels are building -- the proprietary funnels are building in a way that I think we're going to be very pleased with the outcome. Whether it's in the first half of next year, the second half of this year, it's a little bit challenging to predict.

We won't predicted it. But I can tell you, the quality of the funnels, the level of effort and the focus is greater over the course of the last 12 months than it's been probably any time in our history of being a public Company. So I wouldn't get too focused on, nothing's happened in the last 9 or 10 months. Just know that the quality of the funnel is building, the level of effort is -- continues to be very high. We do that as a super-high priority for us moving forward.

As we talked, we've got substantial cash flow coming out of the business, both this year and next. In the meantime, it allows us to continue to delever. But over time, what we want to do is leverage that free cash flow to buy better growth and increase the margins and cash flow of our core businesses. So, we're not disappointed. We are investors. We are going to continue to be disciplined on that as we move forward.

Great. Thank you.

Jeff Hammond, KeyBanc Capital Markets.

Just back on the decremental margins in PMC. I think you mentioned, they will be above normal in this upcoming quarter and then should be better. Can you just talk about what changes other than maybe the destocking to shift those decrementals to more normal or better than normal into the fourth quarter?

Yes. Jeff, just this is Mark. As we've talked about on our last call -- a couple things worked to our favor, as you mentioned, pull as the destocking decelerates half over half. What's been punishing our margin in the first half benefits our margin in the back half. Obviously, that's a big piece of it. Then we've done a lot of things on the restructuring side of costs and the other side of productivity, that's driving -- that's going to drive a big improvement in the back.

So you saw us take restructuring actions in the first half of this year. We've been working really hard at getting aggressive on material costs. You'll see material cost benefits in the back half. So we had to put it really into three buckets. It's the destocking piece that you talk about. It's the restructuring actions that we've taken in our first half of the year benefited in the back half of the year and we've gotten pretty aggressive material costs.

We are going to see a much improved -- from our benefit an improved run rate in our material costs, second half versus first half. No. Those are the three big buckets that I've put in that, that drive the margin improvement. As you know, in our fourth quarter, it's always been a traditionally higher volume quarter for us because there's just, quite frankly, better leverage in the fourth quarter that you see every year.

Okay. Then on water, it seems like you are very happy with orders and backlog in water. The trend is still favorable but some timing issues. What is the risk that as we get into the second half ramp, you continue to see lumpiness or choppiness or some of these issues that are maybe holding things back near-term?

Just to be clear, we don't see anything being held back. I think if you look at our non-res piece of water management, it is growing in the mid, high single-digit area, right, over the first half. If you look at our water infrastructure side, you saw double-digit growth in the first quarter. You saw single-digit declines in the second quarter.

It has nothing to do with level of activity. It has everything to do with the timing. So we don't see, to be perfectly honest, Jeff -- we don't see anything holding up being abnormal. It is just really a function of year-over-year comps, in particular in that water infrastructure piece. In this case, in particular, large shipments in Q2 last year. Oddly enough, no one asked us about the up double-digits in Q1 but you get the point.

Book-to-bill is 1.18 through the first half. It gives you a sense that we feel pretty good about the second half, as it relates to the growth in the water infrastructure side. I think you've heard our comments on non-res and where we think that trend line looks. In both cases, they're positive. So we don't see say, I would say, significant hurdles to delivering what Mark talked about as a pretty solid growth second half for water in total.

Great. Thanks, guys.

Mig Dobre, Baird.

Just a clarification maybe on the restructuring to make sure that I understand this. Mark, you mentioned $10 million to $13 million in expenses potentially for next year. As I understand it that those would be excluded from adjusted EBITDA. But there is an associated benefit with the actions that you have undertaken this year that will be flowing through. Most of that would be in PMC. Am I thinking about this correctly?

It's a good question -- why you asked to clarify, no. What I was talking about, this year -- so in our operating results, in our EBITDA, we've got about $13 million of expenses that are rolling through. Then we said, we're going to have severance and retention costs. There's going to be restructuring of $14 million to $16 million. If you look at next year, we'll have in that $10 million to $13 million range of costs running through EBITDA again, as we are accelerating -- as we're moving through other pieces and phases of the project.

But we are going to start generating savings next year that will offset a meaningful portion of those costs. So, year on year, we'll get an EBITDA benefit. Okay? Just from where we are in the phase of these projects. In addition to that, we will be incurring additional restructuring next year. It will probably be in a similar range, $13 million to $15 million or $16 million range of restructuring costs that would not be in the EPS number.

Yes. Just for clarity, if $1.43 to $1.48 has $13 million of expense in it --

Correct.

This is sort of transitory cost related to duplicate production facilities, outsourcing and things like that. So the $1.48 -- $1.43 to $1.48 has $13 million of expense in it, this year and no benefit. Next year, we begin to get the benefit into the run rate and it probably has some approximate number like $13 million in it next year as well.

Got it. Okay, that's helpful. Then can we get a little bit of color on pricing? There are a lot of moving parts here. Price cost, that's really what I'm getting at.

Obviously, material costs are probably coming down across the board. How much of that can you keep? How much of that do you have to give back to the customer? Maybe some color on both segments, if you would?

Yes. I will start with water. We see pricing in holding. We think price cost is favorable in the second half relative to where it ran in the first half. In PMC, remember, a good piece of this goes through industrial distribution, where we see the ability to increase prices, albeit modestly every year. So we don't see that abating. On OEM and end-user side, it is very difficult to ascertain how much is priced.

But again, we're not seeing significant price pressures at this point anywhere. That's not really something that we have historically ever bumped into, to be perfectly honest, not even in the great recession. So what we see now is a balanced view that, we are going to be smart on price, not leaving it on the table but not get too aggressive. We're going to be super-aggressive on the commodity side of things. You'll see that roll through our second half. That's how we see the end markets shaping up from that perspective.

So you feel comfortable providing some sort of a price cost gap that we should keep in mind?

I don't think is -- at the Rex level, I don't think it is something that's significant enough to worry about. Because I think when you look at the diversity underneath and the variety of end markets and the brands and how much is aftermarket versus new, it really becomes a blended number. I think it's fair to say that it's positive. But I don't think that we're going to start to get guidance on that piece of the equation.

All right. Appreciate it. Thanks.

Kevin Bennett, Sterne Agee.

Todd, if I think about your end market outlook for the rest of this year, if there was any upside risk to one of those buckets, I mean what do you think that would be? Where do you think that would be, I guess, is a better question?

I don't think we're going to get into the habit of calling a bottom or short of outlining upside at this point. I think what we are trying to do, Kevin, is give you a realistically cautious view, right? Which is what we outlined of what we think we can do. I think as you look through it, obviously, water is going to be a source of very good growth over the second half. We have good visibility too, we are going to get it done.

The first half was impacted significantly by a destocking period that is behind us. Offsetting that is -- you wake up every day and you hear different sorts of bad news that doesn't really impact us to dramatically, but it impacts behavior and sentiment. I think how that translates through is tough. I think if there's anything that could be maybe a modest opportunity is sell-through in Q4. We've gotten the inventory out.

We are planning for maybe a little bit of a chop in December just because it's year end for people. There could be some window dressing or deferrals. But, eventually that comes back. Because everything we make in our power transmission business wears out and gets placed like for like. I think we are in a reasonable spot, the place that could surprise us maybe to the upside.

I'm anxious to even say -- to say it. But we've got to just watch sell-through in Q4. We're away from there, so we'll keep you updated. Nothing would make us happier than to be able to take our guidance up. But at this point, we're giving you a view that we think is realistically cautious. We're going to go out and execute that.

Fair enough. I appreciate that. I guess the question for either you or Mark. Given what is going on in the industrial economy and the uncertainty that is out there. I'm wondering if you guys are rethinking your views on leverage? It may shift some of the cash flow to actually paying down some debt? Or if -- I know you guys are comfortable with leverage, but just wondering if you're thinking it's changed there?

Look, Kevin, I don't think there's any doubt that the stock price has been hit really over the course of the quarter as we screen frankly just very high with respect to leverage. The thing I will comment on is in a period of volatility, leverage is always going to be a negative. If you think through the world in a trough mentality, leverage is going to be a problem. What we see is a good portion of our business, over 60% in water aero and food and bev growing nicely into next year.

We also see a set of industrial end markets that is a fair bit of aftermarket component to it. That we've taken the brunt of the destocking. We've got $30 million to $35 million of self-help not on the table but in process. So when we think about leverage -- in the moment, leverage feels high. If you talk about cash flow over the second half, we're going to generate over $100 million. That puts your leverage at 3.7, 3.8 times exiting next year with the end market backdrop and self-help that I talked about.

So the short answer is, we can always pay down debt. We know we screened high for that but we're not looking like things in a trough mentality. We are thinking out one to two years.

If we can use free cash flow to do smart M&A that ultimately puts core growth into our Company and we can generate future earnings and cash flow with the acquisitions, we think that is a win for investors. If something were to change in that equation, we can always pay down debt. But at this point, we think we're pretty well-positioned from where we've stood.

Okay. Fair enough. Thanks.

Joe O'Dea, Vertical Research.

Over the course of the first half of the year, you added more conservative outlook for sell-through versus what distributors were looking for. I think that could have exacerbated some of the destock effect. But could you talk about in into the back half of the year. Now, do you find that your views is a little bit more aligned as distributors have come down. So that creates a little bit more stability around inventory changes moving forward?

Hey, Joe. I think it's a great observation. If we -- if you look back really over the course of the last three to four quarters, in each case our distributors that either public or a part of public companies, have substantially reduced their growth outlooks. At each interval, we tried to get below them. I will remind you that when we set our guidance, we set it below what our customers or channel partners were saying. In each successive quarter, they've come down.

The way we've positioned our outlook, it is again below what they've set. So that is why we think that's it is a prudent persons view, to just continuing to get below what they've said. But the positive is, we think that the sell-through, as I said, is sort of stable; right? The comparables look difficult year to year because when you look at sell-through, it peaked last year, September, October, November. So you're coming off a tough comp as it relates to year-over-year growth.

But if you just look at, what are we selling every day? What gets sold through every day at our distributors, that number is pretty stable. Maybe down just to touch here or there, but pretty stable. That's what gives us reasonable confidence in what we provided for outlook.

Okay. Then just a follow-up. You had commented at the investor day about following some of the footprint and supply chain actions, identifying commercial opportunities and as you pull-forward some of the footprint actions, does that -- with it, mean that you are pulling-forward some of your focus on the commercial opportunities and things that could actually materialize as we move into next year?

Of course. I think when we highlighted it at investor day, the footprint and supply chain optimization plan, it was pretty comprehensive in nature. So it wasn't simply to reduce costs one time. It was to create a more sustainable flexible model going forward. As part of that, there was some commercial activities that we felt lined up nicely with having a more variable model and a reduced price point.

We are pulling those two forward concurrent with the actions we're talking about. So we are on track with that. I think from our standpoint, we are going to grind over the next quarter and the quarter after that. Then when you get to next year, you have a different trajectory in terms of opportunities for growth and our cost structure is increasingly closer to $30 million better. So, long way of saying, yes.

Great. Thanks very much.

David Rose, Wedbush Securities.

I was hoping maybe just briefly, if you can touch upon the margins in water management? How much was mix related? How much did you see in the benefits from VAG?

So in the quarter, there was -- the mix in VAG was marginal. It wasn't a big piece of it. But there was -- to your point, there was some expense. But the majority of the margin improvement was coming from the work we've been doing with VAG over the past year, year and a half. We continue to get the benefits of that.

On the Zurn side, in non-res, we grew up. We are getting very good leverage on that cost structure as we're growing. So if I had to rank on our prior statement: VAG, biggest driver; leveraging growth in non-res, number two; with a modest mix in fact being number three.

David, I think the thing we're trying to do really when you think through all of this is to create a more variable cost model -- a more asset like cost model where we are not as levered to the fixed costs. So the operating leverage that we are seeing in water today is good and will get better as we continue to do that.

I think the thing that we probably haven't touched upon is that, as we change some of the manufacturing strategy around a more asset light or more supply chain oriented model, it reduces future CapEx and increases future cash flows. So I think the combination of everything we are doing gives us better operating leverage today.

When there is a downside, we don't know when that is going to be. It makes us even more variable. Long-term, it improves our free cash flow, because we're not investing in CapEx to the same degree we have to today. So a real positive and I think water's demonstration of that going forward.

Okay. Then lastly, on the water component. Given what you saw in your ability to pull forward some of the cost takeout actions, I'm assuming your sense of the cost takeout funnel is also growing on water? Do have an updated view on what you're operating margin -- I wouldn't say, potential but target is? Or maybe even you can call out a stretch goal if you will.

We have been saying for probably two years that we had very good line of sight to high teens. I think we are at high teens today. I think as I pointed out in my comments, we are clearly on track to maybe even higher teens to the 20% range. But with what we've got in the hopper and maybe some of the things we are planning now, it is not unrealistic at all to see water in excess of 20% for the next couple of years.

As I pointed out, it's a substantial part of the Company at this point. A couple years ago, it was big, but the margins were 13% or 14%. At 18 on its way to 20 and growing. That's where we see it and that's what we've been working at. So I wouldn't -- I'm not going to give you our stretch goal, but it is safe to put a two in front of it.

Okay. Perfect. Thank you.

(Operator Instructions)

I have no further questions at this time.

Well then, I will say thank you, everyone for joining us on the call today. We appreciate your interest in Rexnord and look forward to providing further updates when we announced our FY16 third-quarter results in early February. Everybody have a great day. Thanks.

Thank you, ladies and gentlemen. That concludes today's call. Thank you for participating. You may now disconnect.