Zurn Elkay Water Solutions Corp

F:4RX0

Earnings Call Transcript 2020-Q2

[Operator]

Good morning, and welcome to the Rexnord Second Quarter Fiscal 2020 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, October 29.

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

[Rob McCarthy, executive]

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, adjusted earnings per share and free cash flow, 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 in our filings with the SEC.

Today's call will provide an update on our strategic execution, our overall performance for the second quarter of our fiscal 2020 and our outlook for fiscal year 2020. We'll cover some specifics on our 2 platforms, followed by selected highlights from our financial statements. And afterwards, we'll open up the call for your questions.

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

[Todd Adams, executive]

Thanks, Rob, and good morning, everyone. Our overall second quarter results were broadly in line with our expectations with a little less top line, mostly due to currency, and offset by better margin expansion delivered through our sustained high level of operational execution.

Overall, our core growth was flat, which is mostly in line with our outlook and does include a roughly 150 basis point impact on our sales growth from our 8020 simplification initiatives. Despite a stronger headwind from currency translation, we delivered year-over-year growth in our adjusted EBITDA to $118 million, which is a record for any second quarter for us.

My takeaways from the quarter are essentially more of the same. With the Rexnord Business System and our relentless focus on continuous improvement as the foundation, our strategies are delivering against the objectives we set out 3 years ago: to sustain strong earnings and free cash flow in a slowing macro environment, to strengthen our balance sheet and to deliver substantial structural fixed cost reductions, while investing in areas to drive better growth over time.

We've been tested by an unprecedented wave of tariffs, and our teams have responded with aggressive countermeasures that have not only neutralized the profit impact to our earnings and cash flow, but have also enabled us to sustain an elevated level of investment in a series of growth initiatives, including DiRXN, our digital enterprise strategy. I'll share an update on our progress with DiRXN in a few moments.

As quarters click by, it's sometimes easy to forget the magnitude of the tangible and foundational changes we've made to our business. We've dramatically improved our end market exposure, led by the important strategic additions of Cambridge and Centa, both substantial businesses with leadership positions in far more stable end markets that are both performing today and continue to have upside. We've also exited large project-dependent and lower-return businesses that introduced significant volatility into our results.

Finally, we've reduced our fixed cost structure by $40 million from just 3 years ago, as we've executed our SCOFR 1 and 2 plans. And just to reiterate, SCOFR 3 is well underway and will deliver another $20 million of savings.

Our leverage has never been lower, and our free cash flow has never been higher and will continue to grow based on the actions we've taken. These accomplishments are the very real and dynamic changes we've made to our business that makes it far more resilient than it's ever been and positions the company to deliver solid financial results across a far wider range of macro environments.

At the same time, we focused on restructuring and strengthening our commercial capabilities to better leverage our legacy of engineering excellence. More recently, we launched an 8020-based simplification initiative to reduce some of the inherent complexity that exists in every business, and that is allowing us to better focus our resources around differentiated product and service solutions directed at high-potential customers in high-potential end market verticals to drive growth.

We're still early in the journey. We are very confident that our early successes will only be upside to our financial performance and further distinguish Rexnord as a high-performing concentrated multi-industry business, with 2 great platforms that can grow above their markets while delivering very high returns and strong free cash flow that we believe can be leveraged into a $3 billion to $5 billion enterprise over time.

Please turn to Slide 3. We'll review our second quarter results. Our net sales finished at $521 million, down 1% from last year, but up 1% before factoring in the higher-than-anticipated 2-point impact with the stronger U.S. dollar. As planned, our product line simplification actions reduced our sales by another 150 basis points. We had anticipated that the second quarter was going to be our toughest comparable to last year given that we delivered 9% top line core growth a year ago.

Our adjusted EBITDA expanded year-over-year to $118 million, and margins expanded by 80 basis points. Sequentially, our incremental margins were 55%, and we delivered record free cash flow in our second quarter. Year-over-year free cash flow or year-to-date free cash flow was up 27% through the first half, and we're well on our way to another year of record free cash flow.

Turning quickly to our operating platforms. Core growth in our PMC platform was down 2% and essentially flat after adjusting for our product line simplification actions, which reduced PMC sales by 2%. That being said, frankly, being flat was a little bit light to our internal expectations. OE applications across most end markets in North America and Asia were broadly in line with what we had anticipated, and Europe continue to be relatively weak, but generally in line with our views heading both into the quarter and for the year. We're a little disappointed by our growth in the quarter through the North American distribution channel, as their demand from us lagged the actual sell-through in the quarter. On the positive side of things, inventory turns with our channel partners continue to be at all-time highs, and I'd say we're generally confident this levels out over the back half of our fiscal year.

PMC's adjusted EBITDA margin was 23%, as we benefited from the growth in our aerospace business and the structural cost reductions that are being delivered by the second wave of our SCOFR initiatives that we completed last year.

Core growth in our Water Management platform came in at a solid 4% in the second quarter against 12% core growth last year as Zurn continued to benefit from steady demand growth in commercial and institutional plumbing end markets as well as success with our strategies to grow our share of the adjacent fire protection and site works markets. Zurn delivered 30 basis points of expansion in its adjusted EBITDA margin over the record established in last year's second quarter, as we continue to manage the ongoing tariff structures and price/cost equation while sustaining our investments in innovation and market expansion.

Turning to our financial outlook. With 6 months behind us and 6 months to go in our fiscal '20, we're narrowing our prior range of adjusted EBITDA to reflect the realities of $4 million of incrementally adverse currency translation, with the balance of the refreshed view resulting in taking up the prior low-end of our guidance range by $4 million and reducing the top-end by $4 million, taking our adjusted EBITDA range for the year to $460 million to $467 million. It's a long way of saying that from an operating point of view, the midpoint of the adjusted EBITDA range is essentially unchanged.

We're also affirming low single-digit core growth for the year. This is inclusive of almost 2 points of impact from our simplification initiatives. And finally, we expect another year of free cash flow exceeding net income.

Qualitatively, as we continue to monitor all of the demand trends, both internal and external, the only real change in our top line outlook is that PMC core growth over the back half of our year looks to be a touch lower than we originally thought necessary to achieve the higher end of our prior range. And our revised outlook assumes that it'll probably be closer to what we just grew in the first half of the year.

The good news is that our organic initiatives are filling in most of the gap, and we feel like our original outlook, combined with this midyear tweak, keeps us very much on track towards another record year despite the somewhat weaker macro environment. Mark will review both the consolidated results and the performance of each platform in more detail as part of his comments a little later in the call.

Please turn to Slide 4, and I'll provide an update on the important strides we've been making with DiRXN, our digital enterprise strategy. When we embarked on this journey in 2017, a key objective was to build upon the competitive advantages inherent in our business by improving our customers' productivity, starting with just a conceptual framework to developing unique and scalable solutions in close partnership with our customers to where we are now, which is aggressively commercializing the solutions.

The initiative included building significant organizational capability as well as developing key partnerships that are enabling us to bring best-in-class solutions to the marketplace. I'm pleased to report that we've made major strides in just 2 years with a few highlights shown on this slide.

Within PMC, we've made significant investments in digital resources to transition what had been traditionally manual processes and resources -- and resource-intensive to the web, which translates to intuitive and more productive interactions with our customers. The response has been overwhelmingly positive and is reflected in the broader use of our web-based digital resources, including configurators and automated quoting and ordering processes that are increasingly becoming a solution platform.

Our 8020 work, including our product line simplification initiatives, dovetails perfectly with DiRXN by amplifying our focus on our strongest capabilities being applied where they can have the most impact. It seems fair to say we've come a long way in 2 short years, but we still have the greatest share of the value-creation opportunities ahead of us.

I'd say the same about the connected product strategy, which is about leveraging our strengths in application engineering and customer mind share to create a set of differentiated growth opportunities over the long term. We've gained a massive amount of learning as we've learned how customers explore the applications of our technology and the challenging range of applications that exist when your end markets range from bottled -- beverage bottling to lumber production to grain processing.

Over the last 2 years, our connected gear drives have proven their value in the most critical and demanding applications like supporting 24/7 operations in a potash mine that is more than a mile underground. By focusing initially on the most demanding applications, we've developed capabilities that can be more easily scaled to fit the amazing range of applications and duty cycles where our industrial components are installed. Related to that, we've made steady progress over the last 2 years in lowering the cost to connect, and we are very much on track to achieve a key threshold as we exit our fourth quarter.

Now let's turn to the progress we're seeing at Water Management. You may recall last year, Zurn launched the proprietary digital tool named inSpec. This tool makes it far easier for engineers to develop the complex plumbing specifications necessary for a new building or major retrofit project. We've continued to enhance the product based on voice of the customer input, and adoption continues to grow rapidly. Through the first half of our fiscal '20, the cumulative value of all project specifications developed with inSpec is already about 75% greater than was for all of fiscal 2019.

We're also making rapid strides with our connected product strategy and gaining critical insights into how our customers think about their water usage and efficiency. The bottom line is that 2 of our core strategic beliefs are being validated: that the close collaboration on application development is deepening our relationships with strategic customers and with critical specifiers; and that our unparalleled ability to address the entire potable water system is going to be an important competitive advantage.

Another reason we're particularly excited about the potential we see in the near and intermediate term is that certain customers are arriving at the conclusion that the benefits of connecting major elements of a building's water management system can be significant enough to consider large sale retrofit initiatives. This should provide an increasingly relevant source of incremental growth when new building construction inevitably slows.

Overall, our funnels are growing quickly. We're seeing the progression from demonstration of concept to pilot installation to initial order, which increases our confidence. We are gaining line of sight to our investments in our connected product strategy and in DiRXN, more broadly, generating meaningful incremental growth in financial returns. Bottom line, our DiRXN's experience to date has been incredibly positive.

Where we're behind our original expectations, the offset is, frankly, priceless knowledge that we've gained and the increased focus our learning path has brought to our development path. Where we're ahead, the voice of the customer is directly influencing our development roadmaps and accelerating our progress. Our ongoing digital transformation, combined with our 8020 simplification work and our investments in solutions-oriented innovation, commercial excellence and in our scope for cost reduction initiatives, are together delivering increasing influence over our top and bottom lines. As a result, we're seeing steady progress towards a higher growth, higher return and higher cash-generating business model with the flexibility to perform in all stages of the business cycle and to deliver strong shareholder results over time.

With that, I'll turn the call over to Mark.

[Mark Peterson, executive]

Thanks, Todd. Please turn to Slide #5. On a consolidated basis, our second quarter of fiscal '20 financial results are most in line with our expectations. Year-over-year, our total sales were down 1%, but up 1% if you exclude currency translation. As our product line simplification actions held our core sales to a flat year-over-year comparison, our adjusted EBITDA increased by 3% to $118 million, and our adjusted earnings per share increased by 11% to $0.51.

Please turn to Slide 6. Our outlook for our fiscal year 2020 continues to incorporate low single-digit core growth, net of a 150 to 200 basis point impact from our product line simplification initiatives. We expect our adjusted EBITDA to be in a range of $460 million to $467 million, representing 5% growth at the midpoint and for our free cash flow to exceed our net income.

Our revised outlook for our fiscal '20 adjusted EBITDA incorporates 2 elements: a $4 million increase to our estimate for the adverse impact of currency translation and a narrowing of our operating forecast range around an unchanged midpoint.

On Slide 7, we summarize our consolidated results for the quarter.

Let's turn to Slide 8 and discuss the first of our 2 operating platforms, Process & Motion Control. Total sales decreased 3% year-over-year in PMC, as a 1% contribution to growth from M&A was more than offset by a 2% impact of the stronger dollar and a 2% decrease in core sales growth, nearly all of which is due to our product line simplification actions. As Todd noted earlier, the sequentially lower core growth number at PMC was in part a function of the strong core growth generated in last year's second quarter when PMC delivered its strongest quarter of core growth during our fiscal '19.

Looking at 2-year stacked core growth, PMC's growth in this year's second quarter was actually 1 point stronger than in the first quarter. Putting aside the 200 basis point impact of our simplification actions on our core growth, PMC core growth was basically flat in the quarter.

Breaking it down by major end markets, we continue to see good growth from our aerospace operations, and we believe we outperformed the broader industry in our global food and beverage end markets, where our order growth strengthened in the quarter. Overall, OEM and end-user demand in the process industry end markets softened modestly in the quarter, and as a result, we've adopted a more cautious outlook for our OEM and end-user activity in our global process industry end markets for the second half of our fiscal year.

In our North American distribution channels, we saw sell-through moderate slightly sequentially. Sell-through activity was close to what we had forecasted, but distributor investments were slightly weaker, which we believe was isolated to the quarter with one distribution partner as our overall channel inventories remain very tight. We believe we have line of sight to a tender relationship between sell-in and sell-through in our North American distribution channels over the balance of our fiscal year.

Turning to profitability. Solid operating execution and the benefits from our SCOFR actions delivered a 70 basis point expansion in PMC's EBITDA margin despite the core sales decrease. We continue to expect PMC margins to increase year-over-year for our fiscal '20, as the structural savings we're realizing from our PLS and SCOFR initiatives, ongoing growth in our aerospace operations and operational execution for the restaurant business system are expected to more than offset our ongoing investment spending for the fiscal year.

PMC continues to innovate in the food industry with its introduction of new dual detectable plastic belt materials that enhance our customers' ability to detect any material fragments that could contaminate the product in the event of extreme conveyance belt wear or failure. Material fragments or plastic conveyance belt, as opposed to metal fragments, are historically quite difficult to detect. Our new material formulations enable the detection of any particle contamination with both magnetic and X-ray technology, which, in turn, minimizes damage product for the customer. These new materials, therefore, increase the customers' options when selecting the optimal belt material for the processing applications.

Please turn to Slide #9 to discuss our Water Management platform. During our second quarter, our Water Management platform delivered a 5% increase in net sales growth with 4% growth -- core growth and roughly 1% contribution from StainlessDrains.com, which we acquired in our first quarter.

Our product line simplification initiatives had a relatively minor impact on Zurn's core growth in the quarter, as did foreign currency translation. With weather returning to more normal patterns, we experienced a sequential uptick in stacked 2-year core growth that was expected and sustained 4% core growth in the quarter despite the more difficult year-over-year basis of comparison.

Our underlying North American nonresidential construction markets remain stable, and we continue to be confident in Zurn's ability to deliver another year of solid growth based on additional demand growth, our innovation pipeline and favorable price realization.

As illustrated by our unchanged end market outlook that is summarized on the slide, demand conditions in our core nonresidential construction end markets remain favorable. Year-over-year growth in overall U.S. nonresidential building construction spending has been pressured by slowing activity in construction verticals, where plumbing content is typically a relatively smaller portion of total construction spending.

When looking at overall commercial sector growth, deep declines in the retail sector, where the plumbing content per square foot is typically relatively lower, are detracting from the solid growth seen in office verticals, where the plumbing content is relatively larger. Our outlook continues to incorporate a more cautious posture toward the commercial sector outlook in our second half.

On the other hand, overall growth in institutional verticals like public education and health care has remained relatively more stable. Institutional sector spending, where specification grade plumbing content is relatively greater and our relative share is stronger, is expected to continue to grow at a higher rate.

Zurn continues to introduce game-changing innovations with our second quarter launch of a new family of sensor faucets that incorporate a proprietary gear-driven technology that provides superior reliability and service life when compared with the traditional and prevalent solenoid actuation. These products can be easily retrofit and extend our ability to be -- being increased water efficiency and specific economic benefits to building owners and operators.

Turning to profitability. Water Management's adjusted EBITDA increased by 6% year-over-year in the second quarter with core incremental margin above 30% year-over-year. As a result, Zurn delivered 30 basis points of year-over-year margin expansion as we continue to deleverage our core growth, while funding our market expansion and cost reduction initiatives.

Moving on to Slide 10, and starting with the chart on the far left. Our free cash flow has increased year-over-year on a year-to-date basis and in our second quarter. We remain confident in our expectations for free cash flow growth in fiscal '20. Moving to the chart in the center, you can see that our financial leverage, as measured by our net debt leverage ratio, is now at the low end of our long-term targeted range of 2x to 3x.

Before we open the call up for questions, I'll touch on restructuring expenses and our effective tax rate. First, and in terms of our cost reduction initiatives, including the nearly -- the early innings of our SCOFR 3 initiatives, we continue to expect total restructuring expenses of $14 million to $16 million in our fiscal '20. These costs are primarily made up of severance costs and are excluded from our adjusted operating results.

Next, our effective tax rate will fluctuate by quarter given the varying levels of pretax income as well as the timing of other planning initiatives. We anticipate our fiscal '20 adjusted net income will incorporate an effective tax rate of approximately 26%. In our third quarter, we anticipate the rate to be approximately 25%.

Turning to the slides in the appendix. First, we've included certain other assumptions incorporated into our guidance for fiscal '20 on a separate slide. I remind you that our guidance excludes the impact of potential acquisitions, potential accounting gains or losses and future nonrecurring items such as restructuring costs.

As has been our practice, the appendix of today's presentation also includes a reference table on Slide 14 to help you reconcile the incremental quarterly share count to use for modeling our adjusted diluted earnings per share under the if-converted method that is required under accounting for outstanding mandatory convertible preferred.

As illustrated on Slide 15, the if-converted method was $0.02 dilutive to adjusted EPS in the second quarter and therefore was applied. I'd also like to revisit my comments from last quarter to make sure everyone is clear on how to determine the correct share count to use when estimating our full year fiscal 2020 earnings per share. Given that the preferred will convert into common shares on November 15, our average full year share count will include the converted shares only after that date. For the first 6 months of the current fiscal year, the average fully diluted number of shares and equivalents actually outstanding has been approximately 108 million shares. Our current estimate for average diluted shares outstanding for the full fiscal 2020, including the new shares to be issued upon conversion of the preferred, is approximately 115 million shares.

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

[Operator]

[Operator Instructions] And our first question comes from the line of Jeff Hammond from KeyBanc Capital Markets.

[Jeffrey Hammond, analyst]

So just on PMC, I mean, it seems like macro certainly getting more challenged in global process industries. But -- and certainly, you've got the product line simplification. But do you think that business can grow at least nominally in the second half of the year?

[Todd Adams, executive]

I think adjusted for the PLS, I think the answer is absolutely yes. I mean if you look at where we are through the first half, it's sort of flattish, and that -- it's inclusive of essentially 2 points of PLS simplification. I think the way we talked about it was we think the second half looks a little bit like the first half. So I think there's a chance that even net of that is positive. But I think we're thinking about it as flattish inclusive of the 2 points. But we'll see what transpires, really, over the second half. But yes, I think in general, it's hanging in there pretty nicely. A lot of it has to do with some of these growth initiatives into more stable end markets. The verticals around food and beverage and consumer, we're having really good success penetrating those. So we're -- I think we're encouraged. I think we wish it was a little bit higher in total. But for the most part, tracking pretty nice.

[Jeffrey Hammond, analyst]

Okay. And then just over to water. I mean it seems like the outlook and visibility is pretty good. But we've seen some macro indicators like the ABI and Dodge Momentum start to slow a little bit, and some other companies have talked about some signs of project delays. Just how are you thinking about those macro indicators? Are you seeing any signs that people are just getting more cautious and pushing things to the right?

[Todd Adams, executive]

Well, I think what's reflected in the market outlook that we have and, frankly, probably the last year, are all those same things, right? Things are continually moving around. And I think that -- I don't think that we see anything on a pronounced basis or unique that would tell us that we're seeing more project deferrals than we were 6 months ago. I think what you're seeing in our growth rates is, one, the institutional side of things is still quite strong. And if you -- you can get lost a little bit watching ABI and starts flick around year-to-year.

I think what we're seeing is sort of some steady reasonable growth, big backlogs. And on the positive side, we're seeing some share wins based on both the connected products, the breadth of portfolio, the inSpec and then we've got 2 nice adjacencies in fire protection and site works that are helping us sort of grow above market, we think. So nothing unique or significant that we would call out on deferrals or other things, Jeff. Just I think pretty good execution in our strategy sort of work a little bit.

[Operator]

Our next question comes from the line of Joe O'Dea from Vertical Research.

[Joseph O'Dea, analyst]

Related to the PMC question, I think a continuation of growth in line with the first half, the comps do get slightly easier. And so just whether or not there's any sort of sequential slowing second half to first half that you're contemplating in there, how you're thinking about destock playing out for the remainder of the year?

[Todd Adams, executive]

Yes. I think what's reflected in our outlook, it clearly highlights the fact that we think it's a little slower in the second half. That being said, I think some of the organic things are going to help that. As far as destocking, we wouldn't call how to -- significant destocking in any given quarter. It does impact us a little bit in the first half because distributors were adding some inventory in the first half last year, and they didn't add as much. But sell-through has been relatively stable the whole time. As we sit here today, I think -- we think that over the second half, it plays to a tie. So we don't see any significant increase or decrease in channel inventories. And that's what's the foundation of our second half outlook. So most of the jostling around, I would call it, more than destocking, is behind us. And we've got a pretty stable outlook with the second half. And I think the sell-through rates and the alignment of inventories to that sort of make a lot of sense to us at this point.

[Joseph O'Dea, analyst]

And then, Todd, some of your comments on DiRXN, you mentioned lowering the cost to connect and being on track to hit a key threshold as you exit the year. Any additional commentary that you can add with respect to that? And sort of what that threshold is? What kind of revenue opportunity that opens up?

[Todd Adams, executive]

Yes. It's a very high-end when we started off 2 years ago. The cost to connect with the edge computing device and everything was over $5,000. It's come down to $2,000. And we think we're sub-$1,000 by the time we get to March. And so when you think about what that does in terms of not just the new opportunities, the retrofit opportunity expands considerably. And so the cost side of the equation is where we've made the progress. The price side is still holding. So I think we're sort of in line with our development cycle that we had laid out, which is get it into the field, get it working, get people interested in buying it and then continually perfect the cost to connect to a point where, for us, the margins on new and retrofit opportunity, specifically, as it relates to connected products, should be substantially above our fleet average.

[Joseph O'Dea, analyst]

And then just lastly, the $4 million on the currency. Any additional details on what swung that?

[Todd Adams, executive]

No. I mean it's just, really, a function of when we laid out our initial guidance for the year, we had a set of currency assumptions that were sort of based on the rates at the time. We've built a little bit of hedge into that, obviously. And the $4 million is just the incremental change in the translation effect of the stronger U.S. dollar against foreign currencies, primarily the euro. I mean it's sort of the big thing. So it's just the math of translating euros back to U.S. at a strong U.S. dollar exchange rate.

[Mark Peterson, executive]

Yes. Joe, this is Mark. Just to add on to that. If you look back, we assumed there'd be probably about a 50 basis point impact to the top line in our year. It's going to be more like 150 basis points. So when you drop that through to the profit, you can quickly figure out the math on that.

[Operator]

Our next question comes from the line of Bryan Blair from Oppenheimer.

[Bryan Blair, analyst]

Solid quarter.

[Todd Adams, executive]

Thanks, Brian.

I was hoping you could offer a little more color on the free cash outlook. You mentioned over 100% for cash conversion, maintain that record absolute level. And I believe entering fiscal '20, you said that the year-on-year step-up in EBITDA was a reasonable way of framing the dollar increase for free cash this year. Is that still the case? Or are there any moving parts in the back half that we should keep in mind?

[Mark Peterson, executive]

Yes, Brian, this is Mark. I think that's still a reasonable base case. There isn't really anything unusual or unique in the back half. Our back half is always stronger than our first half. We're running ahead year-to-date. As Todd mentioned, you look at -- if you run at that same pace, you can kind of ballpark what the number will look like. I think, again, using that proxy of the EBITDA change and the look at that in relation to our cash flow was last year wondering where it could be this year, it's still a good baseline assumption.

[Bryan Blair, analyst]

Yes. That's helpful. And with your balance sheet in good shape, as you said, low end of the target range on a normalized basis, generating a lot of cash, plenty of flexibility looking forward, is there any update you can offer on your M&A pipeline? And also, if stock valuation remains attractive given your level of cash flow, any chance you get aggressive in buying back your own shares?

[Todd Adams, executive]

Yes, Brian. I mean with respect to our funnel, again, I'm optimistic that we're going to get something done here in the second half of our year. I think we'd like to sort of err on the side of things that are probably a little bit larger, a little bit water-related. And -- but we'll have to wait and see how that all plays out over the course of the next 6 months.

With respect to our cash flow and balance sheet, I think, absent M&A, I don't think there's any question that you're going to see us begin to probably move towards that buyback. If you look at our return on invested capital at 17%, we think it's a pretty good investment. And so as we've navigated the balance sheet to where we are today, as we look at our -- the balance of our year and our outlook, particularly around our outlook beyond this year for free cash flow, we think, it's very strong. And so we've got a real opportunity to deploy some cash, both in M&A, and I would say, there's a very good chance that you'll see us think about buybacks as we move forward over the next 6 months and into next year.

[Operator]

Our next question comes from the line of Julian Mitchell from Barclays.

[Patricia Gorman, analyst]

This is Trish on for Julian. So just looking at the updated guidance, low single-digit core, I know you mentioned the weakness within distribution and process industries. But can you talk about some of the other end market trends you're seeing that kind of give you confidence in maintaining that low single-digit core?

[Mark Peterson, executive]

Sure. This is Mark. I think there's a couple of things we didn't touch on in detail. Aerospace for us obviously has been a solid end market. Order growth has been solid. Backlog is in a great position. We have really good visibility to that in the back half. So we think the growth in aerospace remains a solid mid-single-digit for us in the back half as we saw in the first half and there's a lot of that's in the backlog.

On the consumer side, our food and beverage end markets, as we highlighted on the call in our second quarter, we saw some uptick in our order rates. A lot of things that we've been doing from an organic growth initiative, both domestically and with our European key OEMs that are serving global food and beverage customers, starting to gain some more traction. So I think those are 2 end markets that have been positive for us, and we have good line of sight to those staying strong in the back half as well to offset some of the mild softness we've seen in process. And as Todd also pointed out, we think that balances itself out in the back half, where we're seeing sell-through and sell-in sync up. So I think, overall, that's a...

[Todd Adams, executive]

Yes. I mean, Trish, one thing I would sort of point you to is if you look at the revenue pie for Rexnord 3, 4, 5 years ago relative to what it looks like today, specifically for PMC, we have migrated from heavy process exposure, the largest at that point in time being mining, to that being a fraction of what it was. And frankly, the market that Mark talked about like aerospace, food and beverage and unit handling being far more than 50% of the business, which I think is what gives us both the confidence going forward and what demonstrates sort of what we just went through. The follow-on to that is we've also got Zurn. And Zurn is going to grow nicely over the course of the second half. So the combination of, I think, some strategic things we did to shift our end market mix, along with just an incredibly strong position we have at Zurn in a good part of the market with share gain opportunities, it's sort of how we end up with the low single-digit core growth forecast for the year.

[Patricia Gorman, analyst]

Okay. Great. And then just kind of a quick follow-up on that. In terms of the revenue mix in PMC that you talked about has changed over time. Are you kind of where you want to be with that? Or is there more to do? What type of exposures are you looking to grow? And kind of what others are you looking to shift away from more?

[Todd Adams, executive]

Well, again, I think we've been pretty consistent in saying that we want to continue to penetrate those end markets that have more linkage to consumer demand. And so things like food and beverage continue to be at the very top of our list. And I would tell you the things that we're doing with DiRXN and continually monitoring operating environments is another wedge that we think is an important wedge to think about in PMC, both organically and inorganically. So those are the 2 primary areas that we think we're going to take specific action to outgrow.

That being said, our process end markets are in a really good spot. When you take -- taken as a whole, right, a good portion of it is MRO. We've invested smartly to drive the growth in the installed base in areas where we want to grow. And so I don't know that we're disappointed we have process industry exposure. It's just substantially less than what it was based on the actions we took, and we've been investing aggressively in areas where we want to be. So I would tell you it's a little bit more of the same. But I wouldn't say that we're going to be exiting anything from here, just continued strategic effort in areas we want to be.

[Operator]

[Operator Instructions] Our next question comes from the line of Mig Dobre from Baird.

[Mircea Dobre, analyst]

I'm just wondering if you can comment a little bit on price cost. I'm curious to hear as to how you see pricing in both your segments. I know there's a lot of products, right? But maybe sort of a general view. And input costs, I'm presuming, are coming down and starting to help a little bit going forward. How should we think about that?

[Mark Peterson, executive]

Yes. Mig, this is Mark. I think from the price standpoint, it's really unchanged from what we talked about going into the year. And we talked about 1 point of price or so in PMC. That's -- we've been consistently delivering on that. On the water side, we've talked about 2.5 to 3 points of price. And I think that's been playing through as well. So the price equation has been really consistent with what we expected going into the year. And so they really aren't having a lot of pushback on the price side.

On the input side, I think we've seen -- obviously, we all understand the tariff situation, Todd touched on earlier. For us, we've been able to make sure that everything we do from a pricing standpoint, material substitutions, moving supply chain, getting certain product categories excluded, has resulted in us not adversely impacting our overall margins in our business. So that's -- we continue to deliver on that. To your point on the input cost, a couple of things. We have seen freight costs improving. We'll see some benefit from that in the back half of the year. And some of our supply base out of China, tariffs aside, we have some opportunity to see some improvement in that in the back half of the year as well.

[Mircea Dobre, analyst]

Okay. And then sort of sticking with this margin theme, looking at PMC, you're expecting flattish organic revenue, call it, in the back half, that kind of makes modeling incremental margins a little bit difficult, as you can appreciate. So what's the best way of thinking about margins, EBITDA margins on a year-over-year basis in this, call it, flattish organic environment in the back half?

[Todd Adams, executive]

Specifically as it relates to PMC, Mig?

[Mircea Dobre, analyst]

Yes, specifically on PMC.

[Todd Adams, executive]

Yes. I think the right way to do it is assume similar margins to last year for the time being. The difference -- or how you get there is we are seeing incremental benefit from the SCOFR 2 actions of last year. But we are investing a little bit, and we've got some SCOFR 3 costs in the back half of our year that are sort of getting into neutral. We hope to maybe do a little better than that. But if I were sitting in front of a spreadsheet trying to plug in a number, use the same numbers as last year, and you'll get close.

[Mircea Dobre, analyst]

That is helpful, and pretty much everybody that's dialed on this call is sitting in front of a spreadsheet. So I appreciate that. Then I'm presuming that sort of real lift on margins would have to come from Water Management. And again, you've got volume growth there, so that's good. You've got good pricing, that helps. Can you maybe help us understand incrementals? And maybe even beyond the next 6 months, how do you think about kind of the normal incremental margin run through for this?

[Todd Adams, executive]

And again, Mig, just specifically related to Zurn?

[Mircea Dobre, analyst]

Specifically related to water, to Zurn, yes.

[Todd Adams, executive]

Water, yes. Okay.

[Mark Peterson, executive]

Yes, Mig, and in the back half of the year, you will see an incremental margin in water that's very similar to what we've experienced in the first half. So you'll see incremental year-over-year margin expansion in Q3 and Q4. Again, if you look at H1 versus H2, it should be very similar. Going forward, we've always talked about our water platform in that 25% to 30% incremental margin range. I think as you model it forward, I think a high 20s, 30%-type incremental margin is a reasonable assumption to use for the water platform going forward. That's inclusive of obviously the investments we're making in the business and obviously assuming there's some modest core growth in the platform.

[Mircea Dobre, analyst]

Understood. Last question. Going back on this pricing on water, I guess how much of this pricing action you think is driven by the changes that we've seen on tariffs, input costs so on and so forth versus other items that you might be doing, whether it's DiRXN, whether there are other things that you're doing in the channel? I guess what I'm really trying to get at here is, are we seeing sort of an unusual pricing environment in fiscal '20? Or would this business just have maybe better pricing dynamics longer term given technology and everything else that you're doing?

[Todd Adams, executive]

Sure, Mig. Good. I think that, without question, the backdrop that we've been through in the last 18 months or so has provided a little bit of a window to, frankly, get more price than on a normalized basis. The magnitude of it, I would tell you, is probably not that much when you look at it long term because we are always raising price in that end market, and we typically keep it. In the last 18 months, we've had to use some of it to just fund the cost increases. But the structural difference over time, we think, allows us to get more price. I mean if you look at the brands, the specification, the portfolio we have, then you add in real competitive advantages around DiRXN that lower the overall cost to not only build the building, but to operate it long term, we think, gives us a real strategic advantage looking beyond this sort of little bit noisy window with tariffs. So again, I don't think you're going to see us have to take things and reduce price going forward if, in fact, the tariffs do roll off at some point, because the farther and farther you get away from when they were implemented, they're basically just accelerating some of the annual price increases that you would have ordinarily got.

So I think that the pricing environment heading into next year, absent any more movement on tariffs, looks probably -- probably looks a little more muted relative to where we've been in the last 18 months. But it's still, we think, a competitive advantage that we have, and we think structurally, we do get more price just because of where this business is and how we compete than our competitors.

[Operator]

We have no further questions at this time. I'll turn the call back to Rob McCarthy for closing remarks.

[Rob McCarthy, executive]

Thanks, everybody, for joining us on the call today. We look forward to providing our next update when we announce our 2020 third quarter results in late January. Have a great day.

[Operator]

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