Zurn Elkay Water Solutions Corp (ZWS) 2017 Q2 法說會逐字稿

Welcome to the Rexnord Second-Quarter Fiscal 2017 Earnings Results Conference Call with Todd Adams, President and Chief Executive Officer; Mark Peterson, Senior Vice President and Chief Financial Officer; and Rob McCarthy, Vice President of Investor Relations for 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 in an 8-K with the SEC yesterday, November 2, and are also posted on the Company's website at investors.rexnord.com.

At this time for opening remarks and introduction, I'll turn the call over to Rob McCarthy.

Good morning and 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 the 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, why we use them, and why we believe they're helpful to investors, and contain reconciliations to the GAAP data.

Consistent with prior quarters, we will speak primarily to core growth, adjusted EBITDA, adjusted net income, and adjusted earnings per share as we feel that these non-GAAP metrics provide a better understanding of our operating results. However, these measures are not a substitute for GAAP data, and we urge you to review the GAAP information in our earnings release and 10-Q.

Please note that we were excluding from the presentation of our operating results the impact of a non-core product line in our Water Management segment that we are exiting in order to enable investors to better understand and assess our continuing core operating results.

Today's call will provide an update on our overall core performance for the second quarter of our fiscal 2017 and our outlook for the rest of the 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, and good morning, everyone. I'm going to start on slide 4. Our overall execution in the quarter was solid as our adjusted EPS was in line with our guidance, even though our sales were a little bit behind what we had anticipated heading into the quarter. While clearly not satisfied, we were still pleased to see our overall consolidate revenue increase year over year in the quarter as the contribution from our Cambridge acquisition more than offset a modest core sales decline.

We also continued to leverage RBS to drive productivity across our business while managing our costs carefully, allowing us to reinvest in new products and market expansion initiatives that we've discussed in previous calls. Cash flow performance was in line with our expectations for the quarter and consistent with our historical seasonality.

In summary, we continued to make solid progress against our strategic priorities with enhanced organic and overall growth while leveraging the Rexnord Business System to deliver against our operational and commercial excellence objectives.

Including the impact of the non-strategic product line exit that we announced at the end of last year, our consolidated total revenue returned to positive growth in the second quarter, increasing 2% year over year. Cambridge contributed about 5% to total growth, while currency translation was only a minor headwind.

Core sales were down 2% after adjusting for the RHF product line exit, which was a function of 1% core decline in our process and motion control platform and a 4% core decline in our water management platform.

For the quarter, our adjusted earnings per share was $0.38 and adjusted EBITDA was in line with our expectations.

Looking at the performance of our platforms. Process and motion control delivered a strong quarter with cores sales down only 1% while posting year-over-year and sequential improvement in EBITDA margins.

Our global MRO revenue increased year over year by about 3% on a core basis as the stabilizing pattern of sell-through rates in our North American distribution channels continued in our second quarter as year-over-year comparisons benefited from the lack of channel destocking. We continue to generate solidly positive core growth in our consumer-facing end markets and positive core growth in our aerospace end markets during the quarter.

The reality is that we continue to see project deferrals in our process industry end markets based on end users not committing to new CapEx projects. Our first fit focus continues to yield share gains, but not yet quite enough to completely outrun the impact of this weak sentiment overhang that exists in the market. And as a result, we expect the overall industrial demand environment to likely be a little bit more difficult in the second half of our fiscal year.

PMC margins in the quarter were in line with our expectations as our productivity and cost controls offset increased spending on our strategic initiatives around innovation, market expansion, and core growth. Cambridge contributed positively to margins, plus overall results were on track with, to a bit better than, our base acquisition case. Integration continues to progress smoothly, and we continue to be enthusiastic about the incremental core growth potential we believe the acquisition brings to the PMC platform.

Despite some of the clear challenges we faced in certain PMC end markets and the weak CapEx environment we've been living in, we think our PMC platform is starting to turn the corner, largely driven by the positive impact of organic growth initiatives and end market diversification we've implemented to date. Even more encouraging is the fact that we add even more of that in the funnel as we head into next year.

We also have long-term structural cost reductions that provide an incremental catalyst for earnings growth next year. While we're not yet calling for an end market recovery, our business is clearly performing, and we're confident that accelerates as some of our end markets level out.

Turning to our water management platform. Revenue was somewhat weaker than we expected as our core water management operations experienced a 4% revenue decline on a core basis. Deferred shipments to our water infrastructure markets, and to a lesser extent somewhat uneven growth in certain regions and verticals within our North American nonresidential end markets, together reduced our core growth by several hundred basis points. Despite this, the platform was still able to deliver an adjusted EBITDA margin of 19%.

The primary change we saw in the quarter was a more broadbased deceleration in the pace of investment in water projects across our markets in the Middle East. More specifically, we've been asked to delay shipments by anywhere from weeks to months to accommodate a broader schedule change to active water infrastructure projects that are being stretched for a variety of reasons.

As a result, we've revisited the production and shipment schedules for all project orders in our backlog, as well as expected near-term order activity, and are now assuming a mid-single digit core decline in global water infrastructure-related revenue for the full fiscal year.

We also experienced modestly slower growth in our North American non-res end markets in the quarter, which factors into how we're thinking about the next six months. Leading indicators remain supportive of further end market growth with recent new starts actually stronger than year-ago levels. We remain optimistic that we can continue to benefit from a positive trajectory for our nonresidential building markets into our next fiscal year, particularly institutional verticals where activity appears to be much earlier in its cyclical recovery.

Taking into account this sort of view on project timelines, and a perhaps cautious but realistic perspective at certain of our CapEx-dependent end markets, offset by our still positive outlook for North American nonresidential construction, our continued expectations for stability within our industrial distribution channel, and solid demand in our aerospace and consumer-facing end markets, we now project our overall core revenue will decline by approximately 3% in our fiscal 2017, which is broadly where we've been running over the last two quarters.

Given the reality that our fiscal year extends through March of 2017, and given the likelihood of decision makers to delay existing project schedules and new CapEx decisions amidst the end of the calendar year, and there's really no other way to say it, but the general grind we're seeing across almost every end market, we are choosing to adopt a broadly more cautious outlook for the second half of our fiscal year.

Our guidance for full-year adjusted earnings per share is between $1.32 and $1.38. And for context, this implies $0.59 to $0.65 in the second half of the year with a tax rate in the mid-30% range compared to $0.73 in the first half with the tax rate of about 17%. Based on the midpoints of the relevant ranges, our revised guidance incorporates a roughly 6% reduction in expectations for our full-year adjusted EBITDA.

Finally, a quick update on our supply chain optimization and footprint rationalization program. As we've previously outlined, this program is expected to deliver $30 million of annualized savings beginning in our fiscal 2018. The year-over-year impact in fiscal 2018 for our next fiscal year will be a function of eliminating the 2017 expenses to execute the program, plus capturing the incremental benefits as we achieve the full run rate of the expected savings.

Although we are extending the project timeline by roughly 60 days into the early part of the first quarter of our fiscal 2018, there will be little impact seen in this year's consolidated financial results, the targeted benefits are not affected, and the total positive year-over-year impact on our fiscal 2018 adjusted EBITDA is still expected to be approximately $25 million. We still have significant work to do, but the program is entering its final stages, and we remain on track to deliver the planned rate of savings in the upcoming year.

Now I'll move to slide 5. Consistent with what we've presented last quarter, this slide outlines our growth assumptions for our largest served markets that account for more than 90% of our annual revenue. As I've outlined, we've reduced our outlook for overall growth in our end markets for the remainder of our fiscal 2017. As a result, our revised weighted average market growth forecast based on our shipments has been reduced by about 150 basis points at the midpoint to a range between a 2% and 4% decline.

The largest change is the double digit decline we project for the rest of world water and waste water infrastructure markets, primarily to reflect the broader and more significant impact of the deceleration in project construction schedules and order rates that we're seeing in the Middle East.

We're also slightly trimming our outlook for sales to our process industry end markets to reflect weaker OEM order trends, as well as for some of the institutional verticals within non-res construction to reflect some of the uneven nature of how we think the next six months plays out. Against a somewhat weaker macro backdrop, we're going to continue to focus on the value creation levers within our control, while deploying our strategy to enhance our organic growth profile.

With that, I'll turn it over to Mark to review the numbers.

Thanks, Todd. Slide 6 of the presentation takes our quarterly results and reconciles to the adjusted results. Please recall that we intend to exclude the financial impact of the Rodney Fontaine non-strategic product line exit from the calculations of our core growth and our adjusted earnings metrics in order to focus on our core operating results. We expect the impact of this product line on our consolidated GAAP financial results to rapidly diminish in the second half of the current fiscal year.

Turning to slide 7, I'll just comment on a few key metrics from our consolidated results in the quarter. First, please note that we have excluded $5.5 million and $8.6 million of Rodney Hunt Fontaine product line revenue from our analysis of the second quarters and fiscal years 2017 and 2016, respectively. The earnings adjustments for Rodney Hunt Fontaine appear on slide 6, and the Rodney Hunt Fontaine sales and EBITDA comparisons are also detailed in our earnings release.

Turning to our core operating results, we reported 2% revenue growth in our second quarter, which includes a 2% year-over-year decline in core growth and Cambridge's 4% contribution. Currency translation remained a slight headwind.

Next, as we look at the operating performance in our process and motion control platform on slide 8, you can see that PMC sales increased by 7% year over year as the core sales declined moderately to 1% and Cambridge contributed 8% in its first full quarter within PMC. Currency translation was modestly negative.

The core sales comparison benefited from ongoing stabilization in our North American distribution channels and overall global MRO demand, plus positive growth in our aerospace and consumer-facing end markets.

PMC's adjusted EBITDA margin of 21.2% improved by 260 basis points sequentially as core execution and Cambridge's contribution largely offset the impact of sustaining our investments in our innovation, market expansion, and cost reduction initiatives.

Our full-year outlook for PMC has been trimmed a bit to reflect a mid-single digit core sales decline that incorporates our more conservative second half forecast for our served process industries, while maintaining our outlook for continuing positive growth in our food and beverage and aerospace verticals. PMC's total sales are still expected to increase year over year after incorporating a roughly 600 basis point topline contribution from Cambridge.

Our expectation for full-year PMC margins are essentially unchanged at flat to down slightly as our ongoing RBS-led productivity and cost reduction initiatives, and a positive contribution from Cambridge, are expected to mostly offset the ongoing topline pressures in this year's increase in investment spending and cost related to our supply chain and footprint initiatives.

Turning to slide 9, I'll make a few comments on our water management platform where, as previously stated, we're reflecting the Rodney Hunt Fontaine product line exit in our analysis.

Core revenue declined 4% in the quarter as sales in our nonresidential construction markets could not overcome a mid-double digit core decline in shipments to our global water and waste water infrastructure markets. Adjusted EBITDA margin was a solid 19.1%, despite the softer top line.

Our full-year outlook for water management is being revised to incorporate primarily a substantial impact from the ongoing lengthening of water system construction timetables that will push several shipments beyond our fourth quarter particularly in the Middle East, but also some modest near-term deceleration in our nonresidential construction markets. As a result, and despite even comparisons, we now project year-over-year water management core growth will be roughly flat in the second half as reduced shipments for infrastructure projects could offset our outlook for low-single digit growth in our nonresidential construction end markets.

Considering the results from our second quarter, we now expect platform growth to be approximately flat for the full year. Given this revision to our second half outlook, we now project flat from adjusted EBITDA margin to contract modestly as adverse project mix and increased new product development investments will likely offset the positive impact of relatively stronger growth in our nonresidential construction end markets.

While we are obviously disappointed by these developments, we must continue to caution the timing of project shipments can create significant variability in quarterly year-over-year core sales growth comparisons in our water management platform.

Moving on to slide 10, you'll see that our cash position has begun to grow again in our second quarter after having internally funded the Cambridge acquisition and also repaid $100 million of outstanding debt during our first quarter. Our liquidity position remains strong. We have a patient capital structure, given our maturity profile.

One highlight relevant to that topic, we announced earlier today that the extension of our revolving credit facility has been completed, moving that date from March 2017 to March 2019. Going forward, we will continue to evaluate our capital allocation opportunities in the context of our overall capital structure, the liquidity requirements, and our long-term objective to reduce our financial leverage.

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, slide 11 of the presentation also highlights our assumptions for interest expense, depreciation and amortization, effective tax rate, capital expenditures, and fully diluted shares outstanding for fiscal 2017.

In addition, our guidance assumes we do not 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 acquisitions and divestitures in future nonrecurring items such as restructuring costs.

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 now expected to impact our fiscal 2017 results as follows. We now expect to incur approximately $12 million in net costs that run through our adjusted operating results.

We expect to report restructuring expenses of $16 million to $18 million, which are primarily made up of severance costs and are excluded from our adjusted operating results. Also excluded from our guidance for adjusted EPS is approximately $9 million of accelerated depreciation in the year. Our forecast for capital expenditures in fiscal 2017 related to this program is unchanged, and is included in our CapEx outlook of approximately 3% of sales.

These projections differ from those discussed a quarter ago in two ways. The expanded program timeline means a small portion of the projected early stage benefits that were previously anticipated in our fourth quarter this year and incorporated into our previous guidance are now pushed into the first half of next, our fiscal 2018. In addition, a portion of the restructuring expense moves to fiscal 2018 as well.

What has not changed is the level of projected savings for the overall program with a projected year-over-year benefit to adjusted EBITDA in our fiscal 2018.

Second, in addition to this program, we anticipate incurring restructuring costs of approximately $8 million to $9 million related to other cost reduction initiatives during the year, which is up about $4 million from last quarter's estimate.

Before we open the call up for questions, I'd like to make one final comment on our effective tax rate. Effective tax rate will fluctuate by quarter, given varying levels of pre-tax income, as well as the timing of other planning initiatives. Our second-quarter effective tax rate was consistent with our expectations, but our reduced second half earnings outlook results in a 200 basis point reduction in the projected full-year tax rate to 25%. Our guidance for our third quarter assumes an effective tax rate of approximately 34%.

With that, we'll open up the call for questions.

(Operator Instructions) Charlie Brady, SunTrust Robinson Humphrey.

Just a clarification on the rest of world Middle East projects that are deferred. These are deferred projects into 2018. You're not seeing cancellations or anything that might affect any kind of backlog you have, correct?

At this point, Charlie, that's right. These are active projects whereby we've got a want date. We've in some cases built the product. And when it comes time to ship it or for the final inspection, they've told us we'd like it a little bit later.

And so as a result of that, obviously we're honoring our customers' wishes and not shipping it. And as we've looked at our backlog, we're trying to look at other areas where that could potentially happen based on past behavior and experience, and making that decision as we reflected in our outlook.

I can tell you, this is slightly more than usual, given the size and the concentration in the region. So, I think we're trying to be cautious with respect to what's in our backlog. But these are not cancellations; these are deferrals into 2018.

Understood, thanks. Can you just speak a little more on the push, on the 60-day push out of the footprint rationalization, supply chain optimization program? What's going on, what's the genesis of having that 60 days?

Yes, Charlie, I think if you -- first of all, thanks for the question. If you take a step back, when we set about trying to implement this over two years ago, it was to take approximately 20% of our overall square footage out, reduce overall fixed costs, and so this was a big deal for us all along. It's still going to generate $25 million in savings.

As we get to the finish line and look at some of the things that we want to do to ensure that it's a success, not just in terms of the cost savings, but in terms of delivery schedules, in terms of service levels to our customer, we've decided to tell you that it could be another 60 days.

Our internal schedule is still pushing for completion on time. But I think it's important to just highlight the fact that this is a big deal. We've been at it for a couple years. We're not going to let 30 days or 60 days impact what's going to be a great long-term structural savings.

So, I wouldn't say it's anything other than as you get a little bit closer to the ground and you're planning the shift, we're telling you it's going to take potentially another 60 days. And so that's really it. The costs are roughly the same. The benefit is the same. The impact to next year is the same. But I think we're just trying to be communicative of what's happening because we've been at this for a while. And as we close it out, we want to do it the right way, and that's really it.

Great. Thank you.

Jeff Hammond, KeyBanc Capital Markets.

So, you said I think four things that knocked down your guidance around $0.15, $0.20. I was wondering if you could just kind of bucket or at least put them in order of magnitude -- the Middle East project, the process weakness, the non-res, and the move -- to just get a better sense of the magnitude of the headwinds.

Yes, Jeff, this is Mark. If you kind of want the piece's midpoint of our prior guidance where we are today, you have, as Todd just referenced and discussed the 60 day move from [skulfort], that's roughly call it $0.03 or so just from that impact in the year. With these projects we have, as they have some mix impact in the year, which is going to be a few pennies as well.

From there it's really volume after that point, Jeff. And it really kind of buckets into roughly -- 70% of the volume is really coming out of water with a larger piece obviously coming from these projects that are being deferred primarily in the Middle East. And then as we discussed some impact from moderating growth within the non-res end markets. And the balance -- really 30% of that revenue change that we're talking about is really coming from the process in this end market.

So, those are kind of the broad buckets, Jeff, that I'd put those in. When you kind of -- when you rough out the math on the revenue decline, our prior midpoint was roughly just below flat, call it down 0.5. And when you say approximately 3 -- 2, 2.5 points of core growth which rides that revenue decline that we've got to deal with in the back half here.

Okay, that's helpful. And then Todd, I think you mentioned some regions and some verticals within non-res where you're seeing choppiness. Can you just provide some more granularity where you're seeing that and maybe a little more context on why you're still feeling optimistic about the outlook?

Thanks, Jeff. If you take a step back, the leading indicator of future activity ultimately is the start information. And if you look back across I would say office, education, government, healthcare, each of those in calendar 2015 saw pretty tepid starts, particularly as you got towards the end of the year. And so in total, the starts last year were down. If you think about a bill cycle, and you fast forward anywhere from 9 to call it 18 months, that's the resulting activity we see.

And so we've been able to offset a lot of that with share gains, with the alternate end market exposure to commercial and other things. But you get in these quarters where there's just a little bit of noise and it's just down a little bit. And it's down regionally. When you look through Northeast, this quarter was a little bit weak. Midwest and Great Lakes were a little bit weak and the West was a little bit weak. But if we look at the Mid-Atlantic, the Southeast and the West and the North -- I'm sorry, the Southwest and Northwest was actually pretty good.

So when we look at what's happening with starts this year, in each of the four call it institutional segments, starts are going to be better, or projected to be better, in calendar year 2016 than they were in 2015. And if you'd think about what that means as you cascade into next year and the next 9 to 18 months, we think that that bodes well for continued growth in institutional construction.

So, I think it's one of these things where we've been able to offset some of it as starts have popped around over the last few years. This -- we're in a sort of a two to three quarter cycle here, what looks like the start information. And you can go back and look at this yourself and look at the start information. In some of these institutional verticals, a year ago, 15 months ago was weak. And as it rolls through the system and hoping it gets build, it's going to translate to weaker growth for us in these verticals. And so I think it's nothing more than that.

Obviously we're not taking it lightly. There's enough noise in the system about what's happening with nonresidential construction. We're I would say very in tune with as much information as we can gather, both what's broadly available and what we have on a proprietary basis.

And I can tell you, as we talk to our contractors -- and these are the key contractors that actually have a backlog of business that employ people that have to make spending and investment decisions to deliver upon future business -- is more optimistic over the next call it 6 to 12 months. So I think what we're seeing is that air pocket of lack of starts in the prior year, that's what we're reflecting in the guidance for the next six months.

Okay. Good color, guys. Thanks.

Joe O'Dea, Vertical Research Partners.

Just on the water infrastructure side, and what you saw and some of the weakness in the Middle East, it seems like maybe you're looking at 50% declines or so in that region. I guess just in terms of whether or not we see that continue to be a source of softening, whether these delays convert to cancellations. Or just kind of how you're feeling about comfort level with that being a bottom or that being another source of declines as we move forward.

Joe, we certainly -- well first of all, it's a great question. It's not quite 50%, but it's very -- it's significantly double digits. And I think what we've tried to do in the way we've reflected our outlook for the second half, we've tried to derisk that part of the business.

We don't think these are cancellations. And we look at the projects, these are projects that are underway for I'll call it significant events and/or requirements in various countries. So it's not just one country. It's Qatar, it's Saudi Arabia, it's the Emirates. And these are major water infrastructure projects that are ongoing that will be finished, that are simply pushing out some delays versus large scale cancellations. So these aren't sort of speculative, I would say. These are very much need to be completed, and we think it's probably a deferral.

That being said, I think it's appropriate to assume that the order activity on a go-forward basis is going to be hampered somewhat. These are economies that are generally dependent upon oil substantially above where it is today. And as you go through, the downstream impact and the ripple effect on water projects, we can debate whether it should happen. It does happen.

Near term, and I think we've got it sort of boxed in, on a go-forward basis it's clearly going to be weaker. We don't think it's a collapse. We think this is more of a push out timing, and then the rephrasing sort of pushes everything out versus there's a big year where you catch everything up. This is sort of a move out as opposed to a big deferral that we're going to catch up in one particular quarter or six-month period.

Got it. And then some of the comments around it sounds like a little bit of bigger share of the wallet. Could you just talk about it sounds like that effect is happening both on the PMC and the Zurn side. But any degree to which you can kind of frame some of the successes there or spec share and what you're capturing. But just to kind of put in context some of the successes on the share gain.

Sure. I think as we've tried to outline, we've spent a lot of time amidst some tough end markets, finding ways that we could outgrow those served markets. And lot of that had to do with incremental new products, first fit opportunities with our industrial businesses, and then increased spec share and pull through with product adjacencies in our Zurn business.

In each case, we've launched a number of things in the first half of the year. And I can tell you that today that's meeting to maybe slightly ahead of what we've expected, at least through the first six months. That grows as we get to the second half. So part of the walk through our second half is incremental success along these initiatives with new products, first fit, and increased spec pull through.

And moreover, I think as we get into the next couple of quarters, you're going to hear us talk a lot more about technology-enabled products across Rexnord and each of the platforms that we think that that's an incremental growth opportunity as we look into next year and beyond, whereby we've got the broadest portfolio of products. But as we connect them and provide context and data and information to owners and operators, we think that that is a big opportunity for us to differentiate and mark the place.

I think there's more to come on that, but those are just some of the examples that I think of the success we're having early in the journey here. But that builds each quarter, and there's a lot more I think that you'll hear about in the coming quarters.

Okay. Thanks very much.

Mic Dobre, Robert W. Baird & Company.

Good morning, everyone. This is Joe Grabowski on for Mic this morning. Wanted to start with the PMC core growth guidance for the year. It was lowered a bit to mid-single digits. And it seems year-to-date core growth there is down maybe 2.5%. It was only down 1% in the second quarter, and the prior-year comparisons are sort of comparable first half to second half. So, maybe just a little more color on why core growth will decelerate in the back half.

Joe, this is Mark. As we kind of talked going into the year, we knew we were going to have -- we knew our second quarter, the core growth was going to moderate, just given the phasing of some projects within that platform year over year. And we knew -- instead of the back half, it's going to kind of revert back close to where it was in the first quarter.

It's not [a theme]; we just think it's a few points, maybe a little tougher in the back half. And the reason really being, as I said, in the process industries, you look around not just us; a lot of other industrial companies are signaling signs of not only weakness in this current quarter, but they're calling for weakness in the next quarter.

And given the fact that we have two quarters left, not just one, we think that really plays itself --. We're going to be cautious with it. We think that plays well into our fourth quarter. So we've taken what before was going to be low mid-single digit to call it mid to low digit core growth decline in the back half of our year, really again focused on those process industries that have been very difficult.

And Joe, maybe just color. If we look at our sales funnels, they're measured in the hundreds of millions of dollars. And if we talk about 1 to 2 points of core growth out in a quarter, we're talking $3 million to $6 million in PMC. That's entirely within the realm of possibility based on the, I'll say the sentiment challenges that are out there. The people committing to new capital projects in the December quarter here, there's a lot fewer today than we thought there was going to be maybe in May.

So, we're not talking about anything other than I would say just some tweaking, trimming based on I would say experience and maybe just being a little bit I'll say prudent in the way we're thinking about it. So $3 million to $6 million of revenue that we thought may be there, based on project activity, simply isn't at the present. That's not ideal. The nice thing we are seeing is the MRO spend has been very stable for almost three quarters now. We think the outlook there is reasonable. If you look at it, talk to the large major US industrial distributors, they're saying the same thing.

So, we've got the base business is now stable and beginning to improve a little bit, and the funnels are growing. The hit rates are still high, but there's a likelihood and a reluctance for those things to convert in the next six months just based on where we think the sentiment exists. And that's what's reflected in our second half guidance.

Sure. And that makes sense. Thanks for the color there. And then I guess last question. You gave good color on your outlook for US institutional construction. Took the outlook there down a little bit. But you kept the outlook for commercial construction. So maybe a little further color on what you're seeing in commercial.

Yes, I think as we look at commercial, it's a little bit more mature in its recovery. I think the starts information, if you were to look back on that, was a little bit stronger last year, modestly. And we think that that build cycle really kind of continues over the balance of our fiscal 2017 and into our fiscal 2018. I don't think it's any more complicated than that. The growth is there. I would say it's a broader set of end markets.

When you look at institutional where we're typically strong, it's education, it's healthcare, it's government building. So those are more I would say larger and episodic, and much earlier in the recovery process of these verticals relative to where commercial's been. So I think it's just a maturation of where commercial sits relative to institutional.

Great. Thanks, guys.

(Operator Instructions) Karen Lau, Deutsche Bank.

I was wondering if you could give us some more help on the sequential margin trajectory. If I'm doing my calculations correctly, I think your guidance implies sequentially margins would drop somewhere between a point to a point and a half. I'm talking about EBITDA margins. And you also said full-year outlook for the PMC margins has not changed. So, I'm guessing that imply pretty significant drop sequentially in water. Maybe you can guide us through what kind of sequential decremental you're assuming for both businesses. And are you assuming a ramp in both quarter?

Karen, this is Mark, no problem. I think if you look at -- we'll start with water. The PMC margins are generally intact. If you look at, if you take Q2/1 to Q3, our revenue was in a decline in Q3 as given the seasonality inherent in that business and also some of these projects that have deferred, pushed out.

So if you look sequentially within water, you're going to see a decremental margin that's going to be in the low to mid-30% range is what you'd generally expect that platform from a decremental margin standpoint. When you looked into the fourth quarter then, you'll see the revenue start to recover, the seasonality starts picking back up. And also giving some of the project timing that we have in our [B of G] business, you'll see an incremental margin in our fourth quarter in that same range; low to mid-30% range. So that's kind of how you expect the decremental and incremental margins to play out over Q3 and Q4 in water.

If you look within PMC, sequentially we'll see a mid-30s% incremental margin in the third quarter as an all-in on a reported basis. On a core basis, obviously it's going to be decremental margin, but in the range of what you'd expect -- down 35% to 40% in that quarter.

And then when you look at our fourth quarter, you'll see a sequential margin that's going to be a little bit over 50% as a lot of the restructuring that we've been doing in that business and also the productivity initiatives are going got benefit us disproportionately in our fourth quarter.

So, that's generally how you'd expect to see those decremental and incremental margins play out over Q3 and Q4 by platform, Karen.

Okay, thank you. That's very helpful. Maybe a slightly different topic. I was wondering if you can talk a little bit about the appointment of the group president in water management. I've always kind of perceived the two businesses within water running separately. They don't have much product or geographic overlap, especially after you exited Rodney.

So, I was wondering if that is some sort of a signal of maybe you're going to do more geographic expansion in both businesses, kind of bring them more overlap between the two. Or maybe is a signal of some sort of acceleration in M&A. I just want to get a little bit of a rationale into that appointment. Thanks.

Sure, Karen. So, Matt Stillings started as our President of Water Management Group Executive in very first part of October. As we looked at our long-term strategic objectives, obviously growing our water platform was of high importance to us. As well was adding just executive talent and depth to the company to allow us to scale the business as we go forward. And we were really fortunate to get Matt.

We now have Matt running water. We have Kevin Taylor running process and motion control. So we've got two outstanding executives that are, frankly, helping lead the strategy in terms of core growth and expansion. So absolutely, Matt's charged with figuring out how do we continue to grow our water business both with the existing businesses we have and through also acquisition and organic growth initiatives.

So for us it's about, again, moving the Company forward to continue to be able to grow and scale successfully. And that's what why we've got Matt on board, and that's why we brought Kevin on board two years ago.

Okay. And maybe last one on M&A. And Mark, could you remind us what kind of -- after doing Cambridge, what kind of leverage ratio are you targeting? And what's your comfort level if the right deal comes along, what kind of leverage are you comfortable in taking the Company up to?

Sure. Well, Karen, I think as we've said over time, our main objective is to delever ultimately over the -- in the long term, we want to get that leverage down closer to 3. I think this year, I won't comment on if we are going to do another deal or not, but just if you look at the cash on the business in the back half, if you didn't have another acquisition, you'd get levers down around 3.5 or 4.

So, the cash flow for us, again, it's a continued balance between the cash flow generation to get us down to 3 in a reasonable period of time. But we do have a good funnel of proprietary deals both on tuck-in deals as we've executed over the past several years that we're going to want to get into our portfolio. And it's going to be a balancing act of taking the levers down over time.

I think you're not going to see us tackle a big deal, take leverage up to some range that's going to be materially north of where we are today. We recognize that that's not in the best interest of everyone. We need to keep focused on balancing our M&A funnel and our cash flows and deleveraging over time.

Got it, makes sense. Thanks, guys.

Thanks, Karen.

And we have no further questions at this time. I'd like to turn the call back to Rob McCarthy for closing remarks.

Always catches me by surprise. Thanks for everyone -- to everyone for joining us on the call today. We appreciate your interest in Rexnord and look forward to providing further updates when we announce our fiscal year 2017 third-quarter results in February. Have a great day.

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