Zurn Elkay Water Solutions Corp (ZWS) 2017 Q4 法說會逐字稿

Good morning, and welcome to the Rexnord Fourth 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 2 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, May 17. At this time, for opening remarks and introduction, I'll turn the call over to Rob McCarthy.

Thank you, John. 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 corresponding GAAP data. Consistent with prior quarters, we will speak to core growth, adjusted EBITDA and adjusted earnings per share, as we feel 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 or 10-K.

Please note that the presentation of our operating results includes adjustments to GAAP reporting for the impact of the RHF non-core product line in our Water Management segment that we exited during our fiscal 2017 in order to enable investors to better understand and assess our continuing core operating results.

Today's call will provide an update on our strategic execution, our overall core performance for the fourth quarter of our fiscal 2017 and our outlook for our fiscal 2018. We'll cover some specifics on our 2 platforms, followed by selected highlights from our financial statements 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 hope everyone has had a chance to read our release from last night. And Mark will take you through the financials and our outlook for the coming year in just a minute.

To start, I'd say that overall, we're pleased with the progression shown in our fourth quarter results. We saw broadly improved industrial order rates, built backlog in both platforms and executed well as fourth quarter, EBITDA grew over year for the first time in frankly too many quarters. Most importantly, we think the combination of a slightly better macro environment and the progress we've made on internal growth and productivity initiatives position us really well over the coming years, and also in future periods that could include more volatility and uncertainty.

Fourth quarter sales of $504 million were a bit better than we had guided primarily due to improving core growth in PMC. Adjusted EPS came in at $0.35 for the quarter, including a $0.01 for the conversion accounting that we hadn't assumed in our guidance. Mark will review both the consolidated results and the performance of each platform as part of his comments a little later in the call.

Turning to Slide 3. We continued our strong focus on strategic and operational execution in our fourth quarter. And I'm pleased to report that we are close to wrapping up our 2-year supply chain optimization and footprint repositioning program. We've essentially completed the last plant move and we're currently focused on bringing the last pieces of equipment online, fine-tuning our processes and bringing our production rates up and just generally driving efficiency and productivity improvements.

This process was and is incredibly difficult and complex for a variety of reasons, not the least of which is the impact it's had on literally thousands of people. There's been a million and one details that had to be done right, on time and on budget while limiting any disruption to our customers. And I want to thank all of our associates that have been true professionals over the last 2 years to make this happen. Finally, the ultimate measure of success is and will be whether it puts us in a position to perform better than we did before we started this initiative 2 years ago. And I'm confident we've been able to accomplish that.

Just to recap the program briefly. This series of initiative reduced our overall square footage of manufacturing space by about 20%, lowered our fixed cost base and reduced our ongoing capital requirements. The improved cost position is also expected to enhance our opportunities to deliver stronger core growth with our new mid-tier bearing product line being just one example. In addition to the changes in supply chain and footprint we've been engineering over the last 2 years, we've also invested in increased automation and advanced machining capabilities, which we believe could ultimately help build on the improved competitiveness of our cost position.

As you'll see in our outlook, we expect to see a significant impact on our margins as we complete the program and realize an approximately $25 million year-over-year impact in our annual EBITDA. And over the longer term, we expect to continue to leverage the benefit for this plan into creating growth. Finally, we think our timing has been pretty good as we took the time to do this during a period where the end market demand served by many of the facilities was well below where we think it's heading.

All that said, we're definitely on track to deliver our formal target of $30 million of annual savings. And I'm increasingly optimistic that with the amount of daily, weekly and monthly continuous improvement that's simply part of our culture will ultimately drive incremental savings above that as we get settled into our new footprint and we leverage the Rexnord Business System to drive further improvements in supply chain, process efficiencies and overall productivity.

At the same time, we've been gaining momentum with our commercial excellence initiatives within PMC to capture a greater share of new first-fit applications. By improving the size and quantity of our sales funnels and improving our win rate, we expanded our installed base, which through high rates of like-for-like replacement can ultimately drive a higher share of available aftermarket requirements as the engineered components that we supply to OEMs and end users wear and use and are rebuilt and replaced several times over the life of the users' application.

We exceeded our $30 million target for first-fit wins in our fiscal '17. And we're targeting a 50% increase for this year. We're going to continue to invest in this strategy going forward. And I expect that the muscle that we've been building and are continuing to build will enhance our ability to extend our competitive advantage as we roll out families of connected products that we'll formally launch on May 31.

Besides the progress we've made on our self-help efforts, I'm also encouraged by the broad improvement in industrial order rates we saw in our fourth quarter. On a core basis, new order bookings for our Process & Motion Control platform were up about 7% year-over-year in the March quarter and we saw a good follow-through in April. There's no question that consumer sentiment has improved. And like others, we saw a stronger willingness to go forward with new capital projects, including some that had been delayed from prior quarters. We do, however, think it's prudent to maintain a cautious approach to forecasting externally, recognizing the still high level of uncertainty around the sustainability of improved demand in our process industry end markets, the potential impact of trade policy changes on global demand patterns and the fact that we're providing an outlook through March of 2018.

Having said that, it appears clear to us that if the recent strength in our order rates is sustained throughout our fiscal 2018, then we would expect our initial financial guidance for the year to have been proven to be too conservative. Either way, we expect PMC to return to positive core growth in our fiscal 2018 as our strategy is to broaden our industrial end market diversification and improve the balance between our process industry exposure and our participation in relatively less volatile, consumer-facing end markets have, in our view, enhanced our ability to achieve and sustain positive core growth.

Together, our aerospace and consumer-facing end markets were the source of more than 60% of total PMC sales in our fiscal 2017. And we expect to sustain positive core growth in these end markets in our fiscal '18. With most of the process industries we serve appearing to have either bottomed or in the early stages of a recovery and given the relative high market shares we have in those end markets, we feel really good about the prospects for PMC to deliver improving core growth as we move through the year.

Within our consumer-driven end markets, our Cambridge acquisition continues to perform quite well. Operating results in the quarter were again in line with our expectations and new order bookings at Cambridge again increased by a double-digit percentage on a year-over-year basis. We continue to see significant growth opportunities across global food and beverage end market verticals as we leverage the leading engineering and service capabilities of the historical Rexnord in combination with Cambridge's leadership position in the woven wire mesh belting for food production and packaging applications.

Turning to our Water Management platform. The forward look remains quite positive even as the financial results in the quarter were a little behind our expectations. Mark will go through the details in a few minutes, but we experienced strong order and backlog growth in the quarter, and we're confident in our initial outlook to start the year. One specific reason we're excited is about -- is due to the fact that our new product introductions will contribute to our financial results in 2018 and beyond, and we're committing to sustaining an elevated level of investment in innovation and market expansion as we go forward.

While we experienced significant project shipment delays in our water and wastewater infrastructure markets over the course of fiscal '17, particularly in the Middle East, that translated in a weaker-than-expected core growth for the platform for the year. We've worked hard at winning new business and most of the increased order backlog in our water platform addresses end market applications that the market needs. And we're excited about where the core growth takes us in fiscal '18.

Looking at our balance sheet. We finished fiscal 2017 with free cash flow of $141 million, which helped push our net debt leverage to 3.1x at the end of the fiscal year. That brings us close to the 2.5x to 3x range that we expect to operate in and our lowest financial leverage as we've been public. As Mark will point out when he takes you through his comments, our outlook puts around 2.5x within the next 12 months.

Before I move on to the next slide, I'd like to highlight some of the changes we'll be making in our practices around providing financial guidance. Going forward, we plan to focus our guidance on our annual core growth, our adjusted EBITDA and our free cash flow, which are exactly the primary metrics that we use internally to grade our strategic and operational execution. When we meet with investors, most questions are aimed at understanding the drivers of our core growth, EBITDA and our free cash flow. As we sat back and evaluated our past practices of providing detailed quarterly guidance, we came to the decision that the best way to provide insight and comfort to investors on our absolute and relative performance was to provide details on the things we consider most critical, provide it annually and with an appropriate amount of conservatism built into it and finally to do it at the start of the year when we felt the level of stability in our business, so investors and the sell side don't read more into the change than actually exists.

Before I turn the call over to Mark, please turn to Slide 4. You may recall from last quarter, we highlighted an RBS case study from our internal knowledge management system, where everybody in the company has access to a variety of continuous improvement activities and ideas so that as we solve challenges, everyone, regardless of the location or function, can learn from the work that's been done. It's also creates a way to rapidly deploy really good ideas quickly across the organization. The impact is measured in several ways.

As examples, cash savings from a more efficient or even eliminated manufacturing process greatly improving quality; enhanced associate safety through changes in work practices; or improved customer satisfaction to reduce order-to-delivery lead times. Roughly 50% of this year's 1,000 posts involved manufacturing. The other half, which were from functions like sales, human resources, supply chain and customer care. In today's example, our associates in a FlatTop plant in the Netherlands were able to free up more than 10% of the existing footprint to support future growth in Europe from the Cambridge product line with a focused application of continuous improvement principles, leveraged with selective investments in increased automation and advanced manufacturing technologies.

I'll start by saying that this is a relatively mature, high-performing facility that's been leveraging RBS for a while. We engaged the team with the challenge less than a year ago to create the space for production and logistics while we finalize some of the product modifications and cultivated customers with direct relationships in Europe. In less than a year, with great engagement throughout the organization plus some collective imagination and ingenuity, the team has been able to improve and/or eliminate certain process steps, identify opportunities for the selective and high-impact application of robotics, improve quality, reduce cost and reduce lead times. The benefit is that we can now enable the growth of Cambridge in Europe in an outstanding environment. And it's all replicable and scalable.

What I hope you take away is that RBS runs deep in our organization and is truly the enabler of large strategic things, like our SCOFR plan we talked about earlier, or the 50 things that happened in the Netherlands in less than a year to deliver a great result. Over the course of the year, I expect us to be ready to announce and begin to execute another set of initiatives that will continue to improve our margins, operational flexibility and cash flow in yet another significant way. And this will happen while we relentlessly work every day to create sustainable incremental value through the practical application of continuous improvement.

Now I'll turn the call over to Mark.

Thanks, Todd. Please turn to Slide #5. On a consolidated basis, our fourth quarter of fiscal '17 financial results were broadly in line with or just slightly better than our full year guidance. Adjusted earnings per share was $0.35. And our adjusted EBITDA of $98 million increased on a year-over-year basis and was also consistent with our guidance.

Our initial outlook for fiscal '18 incorporates low single-digit core growth and adjusted EBITDA in a range of $365 million to $385 million. The range implies year-over-year growth in adjusted EBITDA of 5% to 11% from the comparable $347 million we delivered in our fiscal '17. Our guidance incorporates our target of $25 million of year-over-year benefit from the completion of our supply chain optimization and footprint repositioning program plus incremental margin on sales growth that are consistent with our traditional 30% target. Partially offsetting will be incremental spending in our innovation pipeline and higher incentive compensation expenses. All-in and at the midpoint of our guidance, the consolidated incremental adjusted EBITDA margin calculates to approximately 60%.

Slide 6 presents a bridge that quantifies the puts and takes in our guidance for year-over-year growth in our adjusted EBITDA, as I just described them. And Slide 7 summarizes our consolidated results in the quarter.

So let's move on to Slide 8 and discuss the first of our 2 operating platforms, Process & Motion Control. Total sales increased 7% at PMC as the core sales comparison improved to flat year-over-year and Cambridge contributed 7%. Currency translation was a nominal drag. PMC posted another quarter of positive core growth in its consumer-facing and aerospace end markets, which is offset by the ongoing but moderating headwind in our industrial process end markets. Global aftermarket revenue demonstrated solid sequential expansion in line with typical seasonality but was still down slightly on a year-over-year basis. Distributor sell-through in North America continued its general stable trend in the quarter. And year-over-year comparisons generally get easier as we move into our second quarter of fiscal 2018.

In the bottom right corner of the slide, you can see the end market assumptions that support the outlook for low single-digit core sales growth at PMC that is incorporated into our fiscal '18 guidance. We believe that we can continue to generate growth in our consumer-facing and aerospace end markets. And our recent order rates appear to confirm that we have indeed seen the worst in our process industry end markets. However, we believe there are good reasons to maintain a cautious approach with our guidance, including the ongoing uncertainty about potential changes in U.S. trade policy, uneven global economic growth and the ongoing volatility in global energy markets.

PMC's margins were slightly ahead of our expectations as solid operational execution offset the somewhat stronger mix of OEM and end user revenue as well as our ongoing investment spending and enabled a modest year-over-year margin expansion. Despite our plans for incremental investment in innovation and market expansion in our fiscal '18, we expect PMC's margins to expand by roughly 150 basis points as we complete our supply chain optimization and footprint repositioning initiatives.

As we turn to our Water Management platform, summarized on Slide 9, please recall that we are excluding the financial impact of the RHF nonstrategic product line exit from the calculations of core growth and adjusted earnings metrics in order to focus on our core operating results. Exiting this product line was completed during our fourth quarter and it will have a diminishing effect on our year-over-year reported sales comparisons as we move through fiscal '18.

Our Water Management platform experienced a 4% net sales decline in our fourth quarter that included core sales down 1%. Sales of commercial-grade plumbing products increased year-over-year by a solid low single-digit core growth rate in our fourth quarter as we saw growth across our product portfolio. We believe that overall end market growth can strengthen in fiscal '18 as the reacceleration in growth new U.S. nonresidential construction starts that emerged in the second half of calendar '16 will extend into the current calendar year. As we highlighted last quarter, contractor backlogs have grown and our project funnels have continued to develop favorably. We expect to leverage the somewhat steadier end market growth that we anticipate in fiscal '18 with key new product introductions in our drain and finish plumbing product offerings.

Turning to our project activities in our water and wastewater infrastructure markets. We did experience minor changes in certain project schedules as our fourth quarter progressed, reflecting incremental changes in our customers' construction schedules and related shipment request dates. Given these changes and combined with a strong double-digit year-over-year order growth we experienced in the quarter in these end markets, we entered the new year with increased backlog and expectations for return to positive core growth in our water infrastructure end markets in fiscal '18.

With our expectations for positive core growth across the majority of Water Management's end markets, as seen on the slide, our fiscal '18 outlook includes low to mid-single-digit core growth for overall Water Management platform in the fiscal year. EBITDA margin increased sequentially and year-over-year but was modestly below our expectations, reflecting the volume shortfall on the infrastructure side. We expect margin to expand by around 100 basis points in fiscal '18 and to make good progress towards the 20-plus percent EBITDA margin that we believe can be achieved on the platform longer term.

Moving on to Slide 10. You can see in the chart to the top left that our financial leverage as measured by our net debt leverage ratio has declined to 3.1x, in line with my comments last quarter. Given normal seasonal patterns for our free cash flow, we expect our net debt leverage ratio to remain in a range of around 3x until we reach the second half of our fiscal '18. But excluding any impact from potential acquisitions in the coming year, we would expect our net debt leverage ratio to approach 2.5x by the end of our fiscal year.

In the chart to the top right, you can see that we finished our fiscal '17 with free cash flow of $141 million, including a drag of roughly $42 million from our SCOFR initiative. Looking at our earnings growth expectation for fiscal '18 and considering the remaining cash investments of about $50 million required to complete our SCOFR activities, we expect our free cash flow to exceed our net income and be in the $175 million range. In other words, we expect our free cash to be approximately $190 million in our fiscal '18 before factoring in the $15 million of cash required to complete our SCOFR projects. Given that we expect our free cash flow to expand in fiscal '18 and given our strong overall liquidity, we believe we have ample resources to continue to execute our bolt-on acquisition strategy while maintaining our leverage ratio in a range between 2.5x and 3x.

Next, I'll make a few comments on our restructuring and cost reduction initiatives and on the expected cadence of our sales and earnings in fiscal '18. First, the supply chain optimization and footprint repositioning program is expected to impact our fiscal '18 results as follows. We expect to generate a roughly $25 million year-over-year increase in adjusted EBITDA. We separately expect to report restructuring expenses of $5 million to $7 million, which are primarily made up of severance and exited facility costs and are excluded from our adjusted operating results. Our forecast for capital expenditures in fiscal '18 related to this program is immaterial and will be included in our CapEx outlook of approximately 2% to 2.5% of sales. In addition to this program, we currently anticipate incurring restructuring costs of approximately $2 million to $3 million related to other cost reduction initiatives during the year.

Next, I'll make a few comments on our effective tax rate. Our effective tax rate can fluctuate by quarter, given the varying levels of pretax income as well as the timing of other planning initiatives. That said and going forward, we currently expect substantially less quarter-to-quarter volatility in our effective tax rate than we've experienced in the recent years. We currently anticipate our fiscal '18 adjusted net income will incorporate an effective tax rate of approximately 32% with effective rate in the 33% to 34% range for the last 3 quarters of the year. Given that we finished our fiscal '17 with a comparable adjusted tax rate of about 24%, a higher effective rate in '18 is expected to be an approximate $0.17 headwind to our reported year-over-year adjusted EPS growth. And we further expect that 75% of that year-over-year impact to be realized in the first half of fiscal '18. Recall that our adjusted tax rate during the first half of last year, fiscal '18, [sic] (fiscal '17) was only 16%.

As we fine-tune our financial models for fiscal '18, you may want to consider the following observations regarding the likely cadence of our sales and adjusted EBITDA. Consistent with history, we expect PMC will generate about 49% of its sales in the first half of the fiscal year. We currently expect Water Management to generate about 51% of sales in the first half of fiscal '18.

Turning to earnings. PMC adjusted EBITDA will be more weighted to the second half of the year, given that we are wrapping up the SCOFR program during our first quarter while Water Management earnings are expected to be more weighted to the first half, consistent with the seasonal trends in our U.S. nonresidential construction end markets. We anticipate PMC margins will be expanding year-over-year throughout fiscal '18 with stronger margin expansion in the second half of the year, given the timing of the SCOFR savings.

With respect to Water Management, we do expect Water Management margins to expand sequentially from Q4 of fiscal '17 but to be slightly down year-over-year in our first quarter, reflecting some expense timing, coupled with the year's most difficult year-over-year top line comparison. We currently expect the year-over-year Water Management margin comparison to turn positive in our second quarter as well as the second half of the fiscal year.

Before we open the call for your questions, I'd like to call your attention to the sixth slide in the appendix to our earnings presentation. First, we've included the other assumptions incorporated into our guidance for fiscal '18 on a separate slide as you've come to expect. I need to remind you that our guidance excludes the impact of potential acquisitions and divestitures and future nonrecurring items, such as restructuring costs. Second, and for your convenience, we have included a table that provides the specific after-tax impact of each individual adjustment we have made in our calculation of adjusted net income.

Third, we've attached a reference table to help you determine the appropriate incremental quarterly share count to use for modeling our diluted earnings per share under the if-converted method if it is applicable. As described on the slide, our diluted earnings per share will be calculated under the if-converted method only when it's dilutive to our diluted earnings per share after first calculating our EPS by simply deducting the preferred dividend from our net income and dividing by the average diluted shares outstanding.

In the fourth quarter and as highlighted on Slide 15, our adjusted EPS was calculated using the if-converted method, which resulted in a $0.01 of adjusted EPS dilution compared to the base calculation. As seen over the last 2 quarters, the method of calculating our fully diluted EPS converted from 1 quarter to the next based on levels of income as well as on the average stock price being used to determine the number of converted shares assumed for the if-converted EPS calculation. Lastly, the appendix to our presentation includes the reconciliation tables related to adjusted EBITDA and adjusted earnings per share that are included in our earnings release each quarter.

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

(Operator Instructions) And our first question is from Jeff Hammond from KeyBanc Capital.

So just on water, I mean, I just wanted to kind of -- you get the 30% backlog growth. Certainly, you've had some project timing deferrals. But just help me kind of -- how that translates only into low to mid-single-digit growth as you kind of think about quoting visibility and some of these projects that slowed.

Well, I guess if I take it in 2 pieces, Jeff, if we look at our businesses of certain nonres construction, we saw sort of low to mid-single-digit growth in the quarter. And I think we're sort of projecting that growth probably maybe slightly better mid-single-digit growth as we start off '18. On the infrastructure side, it's been a year with probably an above-average amount of volatility. We tried to sort of mitigate that. But we provided the second half update a couple of quarters ago. And I think as we take a look at our outlook, we've tried to perhaps incorporate an equal amount of that volatility heading into next year, recognizing that we do have a nice backlog and that there should be some opportunities to do a little bit better.

Okay. That's helpful. And then can you just talk about a couple of things on the U.S. distribution channel? I think you still have that as yellow. So what are you seeing there specifically in terms of trend and maybe why a little more caution there versus international? And then just talk about the response to your new product introductions in the mid-tier within distribution.

Sure. I think the -- and just to clarify, the stoplight charts and the color coding is sort of what's reflected in our guidance. So I think what we've reflected in our guidance is sort of stable to low single-digit growth in industrial distribution. I think we continue to feel confident that the channel inventories are probably too low relative to sort of the incoming demand that we see. But that being said, I think from a guidance standpoint, we're taking maybe a slightly more cautious view on industrial distribution. If I think about mid-tier, obviously the mid-tier product category has targeted really 2 things, being able to go into OEMs and end user at an initial price point and provide the highest-quality service, lead times and reputation of a Rex product on that first-fit application so that we open up a broader market, we're having really good success with that category. And if you follow it to its next logical conclusion, distribution is going to need to carry it because the demand will be there. And so I think we're excited about, number one, getting it off the ground over the course of the year, and then as we look into fiscal '18 and beyond, continue to add categories of products under the strategy. And so it's really helping drive our first-fit win rate and ultimately will result in a bigger aftermarket for these products as well.

Our next question is from Charley Brady from SunTrust Robinson.

This is actually Patrick Wu standing in for Charley. Just wanted to just quickly touch base on the water products as well. I guess the deferrals that you guys saw in the Mideast in '17, is that currently embedded in your low singles to mid-singles growth guidance? As in like, are you guys expecting that to come back in '18?

Sure. I mean, I think the way to think about it, Patrick, is there's no new news on the Middle East. So to the degree we saw some of those deferrals, we've clearly moved them. There's an element of some of it has been put into '18, for sure, in our guidance. In terms of the way we're thinking about it from a demand standpoint and a want date, those want dates would be in fiscal '18 as we sit here today. I don't know that we've put them all in to the outlook we provided just to be maybe cautious on what could be happening over the course of the next 12 months in oil-producing countries. So probably not exactly what you want to hear, but we took them out of '17. We think it was prudent. We think the developments are no new news there. We put some of them into '18 from an external standpoint. But from a want date, they would currently still all be in fiscal '18. That's the way to think about it.

Okay, great. So it sounds like the guidance doesn't really have much of that so that could be potential upside that comes back a little earlier. And then the corporate expense line appears a little low, I guess, in the quarter. I think historically the fourth quarter for corporate expenses has been higher than the other quarters. I just want to square up, what is the delta here? And is this the new run rate? And I guess if not, what should we be assuming moving forward?

Yes, I'll let Mark...

Yes, this is Mark. No, it's not a new run rate. It's quite important. In the first place, if you think about corporate expense of around $33 million, we've been in that $32 million to $34 million range consistently. In the quarter here, we just made some adjustments at the year-end based upon incentive compensation in the organization based on how the ultimate year ended. So that's something that you don't really normally do end of the year. We trued up in the fourth quarter, which resulted in lower expense in our fourth quarter. So going forward, think of $33 million, plus or minus, for corporate expense in our fiscal '18.

Got it. And how much additional restructuring are you guys expecting in '18 again? I think you guys said sprinkling in a couple of -- sprinkled throughout the first and second quarter. But how much should be...

Yes, you'll see some related to the SCOFR project, we said about $5 million to $7 million, the majority of that coming in the first quarter of fiscal '18. And we think over the course of the year, just for some other potential cost reduction initiatives that could be another $2 million to $3 million over the course of the fiscal year.

Our next question is from Julian Mitchell from Crédit Suisse.

Just my first question on the PMC core sales growth guidance. Should we assume that your guidance embeds a steady sort of low single-digit-ish growth rate each quarter through the year? And maybe clarify within PMC, the process industry is assumed to be a headwind. Is that something that you're assuming is a steady headwind? Or in the second half, there's some normalization back to the flat line or something within PMC?

Julian, this is Mark. I think it's pretty consistent. I think in the first half of the fiscal year, our guidance would imply it would be at the lower end of low single digits basically. In the back half, we think it would be more to the mid- to the higher end of the low single-digit range as you think about the pace or cadence of core growth, so not too significantly different really if you look at the first half versus second half, Julian, in our outlook.

Then process industries within that, you're assuming it down throughout the year then?

You'd be assuming down in the first half of the year? (inaudible) flat, maybe down modestly by the beginning of the fourth quarter. Up modestly, I apologize, when you talk about fourth quarter.

Understood. And then maybe one for Todd, just to talk a little bit about -- I think you had alluded to potentially some further streamlining or productivity measures later in the year. So I wondered if you could give any more color on that. And also I guess within the adjusted EBITDA bridge, you have that $11 million figure for incentive comp and investments. Just wondered within that, is there any way of parsing out how much is in investments? And should we assume that, that investment step-up is an ongoing annual phenomenon?

I think -- so thanks for the question, Julian. In terms of, I would say, Phase 2 of significant cost reductions, these are things we started working on as we were wrapping up Phase 1. I think we want to ensure that Phase 1 is done completely and it's in the run rate before we would, I would say, launch a second series of initiatives. But I do think that when you think about them in terms of scope, they're probably not as big in terms of the overall savings. But the overall cost is far less as well. So I think the near-term return will be much higher on the second phase. And I think we'll probably be ready to announce those either in our -- at the end of our first quarter or probably end of our second quarter. We feel good about the progress we've made in the plan here. In terms of the investments in next year, there's a fair amount of investment in our digital interface and connected products launch that will be happening on May 31. In terms of the way to think about it, think about it as sort of half-and-half. There's a lot of heavy lifting that's being done on the infrastructure and back, I would say, the internal side of the language, the software interfaces and everything that we'll be able to leverage not just for PMC but for our water products as well. So I would say that in terms of next year, about half of that investment bucket is for direction. It's a little bit heavier than on an ongoing basis just because of that, I would say, startup phase that will get the leverage across all future connected product families as well as on the water side.

Our next question is from Mig Dobre from Baird.

Just a quick clarification on the prior question on Water Management. So my recollection is that there were maybe about $15 million worth of project business in the Middle East that got pushed out of '17. And I want to be clear. Is that $15 million included in the '18 guidance, not included or only partially included? And if so, how much?

In the guidance, Mig, part of it is included.

I mean, can you help us? Is it half? Is it...

It's less than half.

Okay, all right.

I think one thing, Mig, too, you may recall, we talked about the Middle East as far as everything is kind of pushed to right. Todd said a quarter, 2 quarters ago, such that (inaudible) for fiscal '18 has also pushed to fiscal '19. So there wasn't going to be a big catch-up in fiscal '18. There's really another data point behind (inaudible)

Yes. And I think what we're trying to do is protect everyone's thinking around the business a little bit because we've had, I would say, a very good couple of years of order rates. If you strip out some of these large megaprojects that we've had, we've had a solid mid-single-digit growth rate in our orders. And it's manifested itself in a pretty big backlog heading into the year. The difference has been over the last couple of years, the projects have come in smaller pieces. So where before we had these big megaprojects, a number of those in the world has gone down because they usually happen in emerging markets, oil-producing areas. So the quality of our backlog is higher, the order rate has ticked up and we feel really good about it. What we're trying to do is, I think, provide a little bit of air cover to just the realities of the volatility of the business. And so we're not talking about it every quarter. And the conventional logic is yes, there's this big quarter where everything catches up. I think Mark sort of took you through why that maybe that could be case or couldn't be the case. I think it's safe to say that our guidance excludes a big catch-up. We haven't put it all in. And we're trying to, I think, continue to work to build the backlog in the business both in terms of its size and quality.

Okay. Then going back to this bucket on your bridge for investment and incentive comp, I guess on the incentive comp, can you sort of give us some historical perspective here, vis-à-vis where you are in incentive comp versus what you would consider a normalized basis for the company? Maybe put differently, what sort of drags can we expect from incentive comp going forward on incremental margins? And I guess related to this, when you're thinking about all your initiatives, whether they are incremental investments, compensation, anything else that might come, how should we think about sort of the net incremental margins for both your businesses?

Yes. I mean, perspective on incentive comp would be this is substantially below any level of compensation that we've seen in the last 4 years. And the increment that we're talking about, which is notionally half of that investment bucket, gets us back to what we would consider to a full payout, which we haven't been in the last 3-plus years, at least 3 years, based on where we've been. So just from a context standpoint, if we deliver to what we think we can do, the incremental go-forward incentive comp is not that much in fiscal '18, for sure -- fiscal '19, for sure. If we think about -- maybe just take me through the second part of your question again, so I answer it appropriately.

Yes. So you answered part of it with the incentive comp and I guess with everything else that you're contemplating, vis-à-vis either investments or any other potential expenses for the company, what are the kind of the net normalized incremental margins from this point going forward for each segment?

Yes, again I think nothing has changed. I think we think clearly on the PMC side, with the work we've done to eliminate fixed cost and also I would say substantially increase the level of investment in new products innovation and connected products. We still believe it's 30% to 35%. I would say while it's not embedded in our guidance, to the degree we see a steeper rate of recovery, the incremental margins are going to be better. On the water side, again with the benefits of some of the cost reduction initiatives behind us and some of the investments we're going to continue to make, we think again it's 25% to 30%. So again, I think we're -- we have done a lot in the last 2 years to reduce fixed cost, increase the level of innovation, steer the business towards what we believe is more steady and sustainable growth while not losing anything on the process side, where we have, as I said, very high relative market shares and great operating leverage as that recovers. So I think we've eaten the elephant in a lot of ways in terms of the significant expenses to reposition the portfolio and provide, I think, what we think is really good incrementals to each of the platforms going forward.

Sure, fair enough. And maybe last question for me, you made it abundantly clear that you have embedded some conservatism in your guidance. So related to that, if I'm looking maybe at the low end of your EBITDA guidance, the $365 million, maybe you can give us a little bit of color as to what sort of an environment or scenario would be embedded at that low end just so that we understand kind of your thinking around this guidance.

Yes. I mean, again I don't know that I can paint a particular scenario for you. But we're talking about the next 12 months. We're talking about changing the way we guide to an annual basis. And I think what we wanted to do was provide or the word I used is a durable set of guidance that people can count on Rex. And then so if you look at the last 3 or 4 days, I mean, the world changes week-to-week, month-to-month, fairly volatile. What we want to do is give you that low end and say, "Look, you don't have to worry about us delivery the low end." It's more how do we get to that midpoint to the high end over the course of the year and do it in a pretty deliberate way. And so I don't know that there's an exact scenario that I can give you, Mig, but there's a scenario, right? I mean, if you think about all the things that happened in the world, every day, every month, the buying patterns, the supply chains, the levels of inventory are really low all over the place. If things are smooth, we could see upside. But if the world gets spooked for whatever the reason and investments ceases a little bit, we could be -- you could see yourself at the low end in a scenario. What that is, I'm not exactly sure. But I think that's the way to characterize the guidance. We're trying to put something that's durable, that's going to last over the course of the year. And listen, if -- it's in our prepared remarks that if the trends in the business continue, the bottom end of the range will clearly be too conservative. We can talk about the midpoint or the rest of it we go through the year. But that's, I think, the way to think about it.

(Operator Instructions) And we have a question from Karen Lau from Deutsche Bank.

Just wanted to follow up on Mig's question a little bit on the investments. So in terms of sensitivity, how should we think about that investment bucket? I mean, if things get a little worse or get a little bit better, would you be spending more or less in that investment bucket? And I guess maybe a follow-up to the net incremental or a little bit more, I mean, should we assume that, that normal 35%, mid-30s incremental margin going forward to be diluted a little bit by ongoing investment? Because I would assume you would continue to invest in new products and digital initiatives and things like that. Or is there something about this year that represents of significant step-up that is not going to repeat in future years?

Well, thanks for the question, Karen. In terms of the investments over the next 12 months, I think we're going to protect those in a pretty significant way. To the degree things would get weaker, I think, would trigger other cost-out reductions. And we're going to protect those investments because they're so critical to the future growth of our platforms to have this digital platform up and running and in place. So don't think about us as cutting those, think about us as cutting it somewhere else if, in fact, the world is worse than we think today. I'll let Mark give you details on the incrementals. But I don't think we expect any drag on incrementals. I mean, part of the SCOFR plan was to enable investment, right? So if we didn't put some of that money back in for growth, the incrementals will be better. So I think the 30% to 35% on a PMC basis and the 25% to 30% on a water basis are net of future investments. And so I don't think there's any reason to hedge the way we think about those going forward. Mark, maybe...

No, Todd's comment is spot-on. I think the one part of your question, Karen, was is fiscal '18 a bit of an overweight year? I think to Todd's earlier point, there's a lot of initial investment tied to our direction initiative. It's that type of level investment around an initiative, which should not replicate to the same degree next fiscal year. So yes, there is a bit of a push here this year around this initiative that, as Todd pointed out, we are going to protect because we need that. We need that for the future growth of our business.

Okay, that's helpful. And then just maybe a little housekeeping on the stock comp. You mentioned some of the dynamics on the incentive comp side, the piece that is included in the adjusted EBITDA that is resetting higher. Is it the same dynamic with the stock comp that is not included in the adjusted EBITDA? But I saw it, it's going from like $13 million to $19 million next year. That's a big jump.

Yes, Karen. Yes, part of that is a couple of things. One, if you back 4 years ago, we were granting stock options. We were kind of coming out of Apollo, granting options that had 5-year vesting lives. Over the past couple of years, we've modified that to be more consistent with public companies and have gone to a 3-year vesting life. So what you're getting is you're getting a year -- you saw that we had a jump last year and a jump this year, where you don't have anything rolling off from prior years and you're getting more amortization because the vesting period is shorter. That's what's driving the year-over-year increase in that noncash stock comp expense. And then of course, over time, that will start plateauing out then.

I'll turn the call back over to Rob McCarthy for closing remarks.

Thank you, everyone, for joining us on the call today. We appreciate your interest in Rexnord. And we'll look forward to providing another update when we announce our fiscal 2018 first quarter results in early August. Have a great day.

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