Zurn Elkay Water Solutions Corporation

At this time, for opening remarks and introduction, I'll turn the call over to Mark Peterson, Senior Vice President and Chief Financial Officer of Rexnord.

Good afternoon and evening. Before we get started, just a brief reminder that this call may contain certain forward looking statements that are subject to the Safe Harbor language contained in the press release we issued today, as well as in our filings with the SEC.

In addition, some comparisons refer to non-GAAP measures. Our earnings release and SEC filings contain additional information about these non-GAAP measures and why we use them.

Today's call will provide an update on our overall performance for the third quarter, including details on our 2 platforms, followed by an overview of our financial statements and liquidity highlights. Afterwards, we'll open the call up for your questions.

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

Thanks, Mark, and good afternoon, everyone. Thank you for joining us for an overview of our fiscal 2013 third quarter financial results.

Before we get started, I want to briefly comment on the announcement we made earlier today regarding the exploration of strategic alternatives. As we discussed in the release, the company's Board of Directors has initiated a review of strategic alternatives to enhance value for shareholders and has engaged Goldman Sachs as part of that process.

It's important to note that no decision has been made regarding any transaction, and that we remain completely focused on executing our business strategy.

I would like to remind everyone that the purpose of today's call is to discuss our third quarter financial results and outlook for the balance of the fiscal year. Therefore, we will not comment further or take any questions on that topic.

I thank you all in advance for your understanding and cooperation.

With that, let's turn to Page 4. There's been a lot of interesting commentary as people have reported December quarterly earnings over the past few weeks, but one common theme has been the industrial end-markets were tough in December -- in the December calendar quarter.

As it relates to our third quarter, starting with PMC, on balance, I characterize demand in our short-cycle industrial business as choppy as we rolled through quarter. I'm not going to try to ascertain how much of that was the fiscal cliff or year-end window dressing, but I will say that we saw some unusually erratic order patterns that we frankly don't believe are sustainable, given the nature of our businesses and types of applications our products go into.

Four weeks or so into our fourth quarter, we've seen an improvement in order rates in many of our short-cycle businesses compared to the order rates we experienced in November and December, but we remain cautious with respect to our near-term outlook, given the volatility we have experienced over the past 9 months.

In the longer-cycle industrial part of our business, we're actually encouraged with the level of inquiry and quotation activity we're seeing and expect that we'll see those opportunities begin to convert to orders over the next couple of quarters, which, in turn, would set up a sales recovery in the second half of our fiscal 2014.

Turning to our Water Management platform. The end-market environment is clearly brighter, and the combination of Zurn and VAG is really starting to deliver the results we expected.

And for the first time in 5 years, there's no meaningful market headwind, which actually makes it feel like a tailwind given where we've come from. As we look ahead, we see the market continuing to improve over the next 2 to 3 years and believe all the work we have done to reposition the businesses in the platform will allow us to disproportionately capitalize on the market recovery.

From a performance perspective, we continue to do a solid job on controlling the control over [ph], delivering $92 million of EBITDA and an 8% increase in adjusted operating income, which translates to a 38% increase in our adjusted net income, while continuing to invest in our business and despite a weak industrial market that drove a reported sales decline of 3%.

As we look ahead, in the near term, we anticipate Process & Motion Control growth accelerating from the low to mid-single digit range over the next 6 to 12 months as the industrial markets slowly recover, a trend that we feel pretty positive about.

In Water Management, the progress we've made strategically over the past couple year positions us to benefit from the improving market fundamentals and deliver strong growth moving forward.

Looking at our fourth quarter, we anticipate sales to be in the range of $535 million to $555 million and adjusted EBITDA to be in the range of $110 million to $120 million, respectively, which implies sales between $2 billion and $2.020 billion and adjusted EBITDA between $400 million and $410 million for our fiscal year 2013.

Moving to Page 5. I'll give a little color on each of the platforms, starting with Process & Motion Control.

In the quarter, we expanded our adjusted EBITDA margins 60 basis points year-over-year to 24.7% on a 3% core sales decline. The margin growth was driven by cost-reduction initiatives we began earlier in the year, which offset the impact of the lower sales volume.

From a market perspective, we continue to be cautious on the OEM and end-user activity we see but do see improvement in the outlook, and we're starting to see some of the benefits of our self-help growth initiatives, all of which is broadly consistent with what we communicated at the end of our second quarter.

As I mentioned in my earlier comments, the short-cycle MRO sell-through in the industrial distribution channel was unusually weak in November and December. And when you analyze the trends, you have to look back to the depths of the recession to see an 8- or 9-week period as weak as what we experienced in the last 2 months of our third quarter.

Thankfully, we've seen an improvement in January and remain cautiously optimistic that we'll see steady progression of an improving macro environment over the next 6 to 12 months from where we are today, and that a good portion of the adverse impact of what appears to be a mid-cycle industrial production pause is behind us.

Moving to our Water Management platform. Core sales growth in the third quarter was 1% as the strengthening of the underlying market fundamentals is progressing as we've said and is beginning to give us some lift.

Our adjusted EBITDA margin expanded 210 basis points from the prior year to 14% as productivity gains and the favorable impact of the prior year consolidation of our North American manufacturing footprint benefited margins.

When you look underneath the covers, you start to get excited as the 1% core growth was driven by a Zurn top line growth of 8% and a 1.4 book-to-bill ratio in VAG, setting up a strong fourth quarter, and, at this point, a strong first half of fiscal 2014 for VAG. This dynamic is very consistent with what we've been saying for the past 2 quarters.

Zurn is driving well above market growth and taking share from competition, and all of the integration and commercial opportunities of playing the water infrastructure game globally simply took some time to work its way through the inquiry and quotation phase and, ultimately, into our backlog.

The upside of having Water Management in the Rexnord portfolio is clearly coming into focus. Many of the indices, such as ABI, McGraw-Hill, as well as other forecasts around starts and spending are encouraging, all of which is upside for us down the road.

The results today are being driven by our actions to advance our product innovation and excellence initiatives while driving increased specification of our products and broadening distribution.

Turning to the water infrastructure market, it's clear that it's a global game that has to be played with a broad product portfolio. Fortunately, VAG gave us both, and we are really pleased with the acquisition 1 year in.

We're seeing the benefits manifest themselves at inquiry and quote volume and anticipate the order rates and book to bill will continue to be strong.

With that, I'll turn it over to Mark to walk through the numbers and then come back to talk about our outlook in a little more detail.

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

Slide 6 of the presentation takes our reported results and reconciles to the adjusted results that exclude these items.

Turning to Page 7. I'll discuss our operating performance highlights for the third quarter.

Third quarter reported sales decreased 3% from the prior year to $472 million. Core sales declined 2% as foreign currency translation adversely impacted growth by 1%.

Reported operating income for the quarter was $60 million, or 12.6% of sales. Excluding current and prior year restructuring costs, as well as unfavorable prior year impact of inventory fair value adjustments recorded in connection with our acquisition of VAG, our adjusted operating income grew 8% year-over-year despite lower sales and increased 130 basis points as a percent of sales to 13.1%.

Third quarter adjusted EBITDA increased 3% to $92 million, and our adjusted EBITDA margin improved 110 basis points year-over-year to 19.5%. Adjusted net income from continuing operations increased 38% to $19 million in the third quarter versus the prior year, and diluted earnings per share from continuing operations was $0.19 in the quarter.

Reported free cash flow was $32 million in the quarter, which includes a $3 million noncash use related to the excess tax benefits recorded in connection with the stock option exercises in the quarter.

Next, I'll move to Slide 8 and walk through the operating performance in our Process & Motion Control platform. Sales in the quarter were $303 million compared to $317 million in the prior year period.

Core sales decreased 3% in the quarter as sales growth in energy and non-U.S. mining markets were more than offset by softness, primarily in [ph] the North American short-cycle MRO portion of our business, as Todd previously discussed.

Currency impacted growth negatively by 1% in the quarter.

Turning to profitability. Reported operating income in the quarter was $54 million and includes $2 million of restructuring expense in the quarter compared to $1 million in the prior year.

Excluding restructuring, despite the lower sales, adjusted operating income increased 1% from the prior year, and the margin improved 100 basis points year-over-year to 18.6%.

Adjusted EBITDA was $75 million, and our adjusted EBITDA margin improved 60 basis points from the prior year to 24.7% as a result of productivity gains and cost savings associated with our previously implemented restructuring programs.

Turning to Page 9. I'll make a few comments on our Water Management platform.

Water Management reported sales in the third quarter were flat compared to the prior year at $169 million, inclusive of a 1% adverse impact related to foreign currency translation. The resulting core growth of 1% was driven by continued market share gains and increased alternative market sales in our non-residential construction end-markets, partially offset by expected lower shipments in our North American municipal water end-markets.

Third quarter reported operating income was $13 million, or 7.6% of sales. Excluding current and prior year restructuring costs, as well as the unfavorable prior year impact of inventory fair value adjustments recorded in connection with the VAG acquisition, our adjusted operating income grew 49% year-over-year on flat sales, and the margin increased 260 basis points to 7.9%.

Adjusted EBITDA was $24 million or 14% of sales, and the adjusted EBITDA margin expanded 210 basis points from the prior year, driven, again, by productivity gains and the favorable impact of our prior year North American footprint consolidation.

Moving to Slide 10. I'll now touch on a few cash flow and liquidity highlights.

We finished the quarter with $453 million of cash, $773 million of total liquidity and no meaningful debt maturities until 2018. Total debt at the end of the third quarter was $2,110,000,000, and net debt was $1,657,000,000, resulting in a net debt leverage ratio of 4.1x compared to 4.2x at the end of our second quarter.

Looking forward, we anticipate our net debt leverage to continue to decline through a combination of incremental earnings and strong free cash flow generation.

Next, I'll provide a few of the financial metrics under our credit agreement and bond indenture. First, under the credit agreement, our senior secured leverage ratio was 1.3x versus our covenant of 5x, and the cumulative credit basket was $574 million.

Under the indenture, we finished the third quarter with a fixed charge coverage ratio of 2.6x, and the restricted payment basket totaled $503 million, inclusive of the $25 million general basket.

Before we move on to our guidance for the balance of the year, I want to touch on our effective tax rate. In the third quarter, our effective tax rate was approximately 26% and was favorably impacted by the recognition of tax benefits in the quarter due to the expiration of certain statutes of limitations, as well as the timing of certain tax planning initiatives.

We anticipate an effective tax rate of approximately 29% in the fourth quarter as we will again benefit from the timing of certain tax planning initiatives.

With that, I'll turn it back to Todd.

Thanks, Mark. I'm on Page 11 of the slides, looking at our fiscal 2013 and fourth quarter outlook.

While the market conditions within portions of our Process & Motion Control segment remain challenging, the market outlook surrounding our Water Management platform is encouraging. And we expect that trend to continue into the fourth quarter, given the solid Zurn core growth and VAG book-to-bill ratio.

Based on all of this, we anticipate core sales growth to be approximately 1% for the year, implying core sales growth of approximately 1% in our fourth quarter, led by Water Management. We anticipate our adjusted EBITDA margin to be approximately 20.1% for the full year, implying a margin of approximately 21.1% for the fourth quarter, with sequential margin improvement in both platforms.

At this point, I'll turn the call back over to the operator and take your questions.

Just a question on the water business, so I understand correctly. So core growth in the quarter is a plus 1%, Zurn is plus 8%.

Is that correct?

Yes, it is.

And what was VAG?

VAG, the core growth across the water infrastructure piece was a decline, primarily based on shipment timing. So if you look at the book to bill at 1.4, that clearly sets up really high growth in our fourth quarter.

So from -- when you look at the pieces, that's sort of something you need to sort of look at over a couple of quarters. So when you look at it half on half, it will be up in the high single digits across the water infrastructure piece.

So it really is just more timing than anything.

Okay, that's helpful. And I got on the call late, so I apologize if you've covered this at the beginning.

Just on the announcement of the strategic alternatives that you're pursuing, either sale of one or more of the platforms, I guess, in your prepared remarks here on the earnings, I'm hearing a lot of positive sentiment, things are getting better. And we also have this announcement about pursuing strategic alternatives to maybe get rid of one or more of the platforms or the whole company.

So that seems to be a little bit at odds with each other. Can you just maybe walk us through kind of the thought process on that announcement?

Charlie, we're not going to elaborate a whole bunch more, other than to say, the decision to pursue strategic alternatives is not an indictment on the current performance or the future of what we think we can do. It's really the board stopping and taking a check of what's the right long-term thing in terms of value creation for shareholders.

So I wouldn't read the strategic review as an indictment on how we feel we're performing today or where we're headed. It's more or less just the fiduciary responsibility the board is undertaking.

That's really it.

Okay. One more and I'll get back in the queue.

Just on the short-cycle MRO business, what do you think that the weakness driven in November and December was? Was it just kind of hanging end of the year all the uncertainty, kind of politically, macro, people didn't know what was going on?

Or was there other -- some kind of other driver in there?

Charlie, we don't know exactly. Right?

I think when you look at the short-cycle MRO, and this is on a sell-through basis, we're sort of in that 5% to 6% range for the last year. When you get to November, it goes minus double digit, and it gets to minus single digit in December.

And then it's frankly back to very low single-digit positive in January. So when you look at the types of things that we're selling through that channel, right, it's MRO type of things that need to be replaced.

So I think there was a fair amount of year-end window dressing. If you've got something, you can just run it a little bit longer.

You did it. I think people were a little bit cautious around spending money in advance of the fiscal cliff.

But to say, it's one thing or the other, I don't know, other than to say that you have to go back to 2008 to find a month that was as bad as November in terms of sell-through. And so I think that pause is definitely past us as we look ahead, and we're not really anticipating moving back to that high single-digit growth.

So I think we're pretty conservative in how we've thought through the sell-through, but it was a little bit of a rough patch over those 8 to 9 weeks for sure.

Just a clarification on guidance. When I'm looking at your EBITDA guidance, $400 million to $410 million versus the previous one, $412 million to $425 million, I'm trying to understand exactly where the biggest adjustment to your expectation has occurred.

Is it fair to say that most if not all has occurred in PMC?

Most of the change to the outlook is frankly behind us in the third quarter, really related to PMC. So the short-cycle order rates and sell-through that we had in the third quarter, if you sort of roll that through to the balance of the year and maybe take a slightly more cautious view in our fourth quarter, that sort of reconciles the old range to the new range entirely.

So we think we've eaten most of the adverse impact, and we've got a fourth quarter out there that we feel pretty good about.

Okay, that's helpful. And then sort of sticking with the segment here, you mentioned short versus long cycle.

I'm trying to figure out, if you're talking about your short cycle as being your general industrial exposure versus, say, for instance, mining and food and beverage and aerospace being a little bit longer cycle, can you sort of give us some flavor as to what's happening with some of these end-markets individually?

Sure. Yes, I think your characterization of it is probably close enough for this conversation.

So when we look at longer cycle, aerospace would be in there, the mining or sort of bulk material handling would be in there as well. Food and beverage, frankly, is probably a little more short cycle in its nature.

But we are seeing, I'll say, very active inquiry and quote volume on the mining side, not just in North America, not just coal but precious metals all over the world. And I think we've done a great job of expanding what it is we're providing to that sector.

So there's still a fair amount of operating capital type things that have to go on year in, year out. So while CapEx budgets may be lower than what anybody anticipated, there is a tremendous amount of operating capital.

And if you understand where we play, right, it's bulk material handling. So it's moving wearing parts, conveying materials.

And so that doesn't frankly stop. So the big capital expansions for mines or the new mines may have slowed.

We do think that, that is starting to percolate towards the middle to back half of next year, but the operating capital stuff is still flowing. And so that's better than it's been.

Same is true on aerospace. Right?

I think if you look at long term the demands for air travel, we're sort of in the sweet spot. It's lightweight, high-efficiency products that go on to these large aircraft programs, and so we keep winning more content.

We've won some programs for the C919, and we just keep adding content to the portfolio. So we're pretty optimistic that near term, while it's a little bit rough on the sell-through side, the long-term fundamentals are setting up to be quite nice over the next couple of years for our PMC end-markets.

That's great. And I guess my last question, switching to Water Management.

Zurn continues to perform very well, and I'm wondering how you're thinking about growth going forward. I don't know if you're going to have maybe a little bit tougher comp.

I'm thinking about pretty good weather that we had last year, for instance. I don't know if that's an issue to consider going forward.

And then on the margin side here, you mentioned in the past that you see Water Management margins reaching, hopefully, high teens on an operating basis. Do you still think that goal is achievable and how do you see that play out?

Yes. I mean, maybe just hitting your first question regarding comps, I mean, I'm frankly not that worried about the weather in the next 3 months or 6 months.

I think the growth that we're driving in Zurn is long term and sustainable, and so I think we've built -- and the team there has built a dynamite franchise that's going to continue to grow. And once you see the market recover, right -- and I mean, we're still looking at non-res numbers put in place that are low single-digit negative.

As you get 1 year, 2 years out and you see the infrastructure growth and starts translate to square footage put in place and turn positive, then I think you'll see the full power of Zurn. So we think about it maybe a little bit longer than the next 90 days.

The margin side, we absolutely think that the EBITDA margins can be in the high teens for Water Management in its entirety, and that's a combination of Zurn plus 20, and high teens in the VAG part of the business. So we absolutely think that, that's right in the fairway, and we see that happening over the next couple of years.

Guys, a question on -- continuing on Zurn for a moment. So you seemed to be talking about market share gains with a pretty high level of conviction.

And I'm just curious, what drives your -- how are so sure that you're picking up share? I mean, Mark you said it -- or Todd, rather, you said that the top-down statistics in terms of the market indicators being flat.

But are there coincidence [ph] data sets you get on real-time industry sales of specific product categories that leads you to conclude you're gaining share? Or is it more just that top-down look?

It's a little bit of both, Ryan. I think the -- what we'd be willing to talk about, it's really the top-down stuff.

Right? Because I think some of the other information is proprietary and, frankly, of high strategic value.

So we continue to outperform, I think, the peer group in the categories where we cross over. We continue to outperform the fundamental market.

We do a number of sort of quarterly check-ins each and every quarter with all of our customers, distributor partners, et cetera. And we also look at the spec share that we're driving in each of our product categories and all our geographies.

So with a pretty high degree of confidence, you can sort of triangulate all that and determine that we're taking meaningful share, and that's how, I think, we'll characterize it on the call.

Okay. So in other words, you wouldn't expect -- to the extent there are other companies out there that will be reporting numbers that you compete with, you would not expect them to show growth?

I mean, you kind of made the statement that your growth has been driven largely by share and not by the underlying market.

Well, I really don't want to determine or ascertain what someone else is doing. If you look at the put in place for the categories, the products that we sell into the markets, it's a negative.

Right? So the fact that we're growing in that negative sort of put in place environment, I think, is a clear indicator that we're clearly growing above market.

That's a combination of share gains. It's alternative distribution.

It's retrofit. It's a whole bunch of things.

It's not one singular thing. So I really don't want to opine on someone else's growth rate other than to say, I like what our team is doing.

I'll take 8% in a negative market any day of the week.

On that same topic, so I haven't heard any discussion yet of lead-free, and that's obviously a big issue this year. So if you can just talk about how Zurn is -- how your game plan there is tracking relative to your expectations and what kind of noise do you expect that to create for Zurn, if at all, as '13 plays out?

Frankly, very little. So our team has been on top of it really for the last couple of years, so actively converting the products to that low lead or lead-free, as well as working with all the channel partners to make sure that we've got the proper conversion and de-risk any sort of big issue.

So a lot of people talk about it. I think our team started on this a couple of years ago and has steadily worked through the issue.

So many of the extra costs, if you will, that have been borne to get to the point where we're at are behind us, so we feel really good about the conversion. And I wouldn't suspect that it's going to be something we're going to spend a lot of time talking about next year.

Great, that's helpful. And then the last question, Todd, just -- you mentioned you talked about aerospace a little bit in one of the former questions.

Obviously, aerospace has been in the news lately for the kind of wrong reasons. Anything in your business related to the Boeing issues that you foresee?

No. Look, I mean, obviously, we're -- we believe that the issue ultimately gets resolved.

The 787 is an important program for us longer term. I wouldn't characterize the next 12 months as terribly critical to the long-term success.

We've got a lot of content on that. We think they're going to work through the issues.

But I think we're confident that there's a lot of people that want to see this thing work and it likely will work. But to comment beyond that, I think, is probably outside of our scope of purview.

I want to thank everyone for joining us this afternoon. We appreciate your interest in Rexnord and look forward to updating you on our fourth quarter and as well as our fiscal 2014 outlook in early May.

Thanks a lot.