Zurn Elkay Water Solutions Corp

F:4RX0

Earnings Call Transcript 2020-Q3

[Operator]

Good morning, and welcome to the Rexnord Third 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 the 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, January 28.

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 third quarter of our fiscal 2020 and our outlook for the remainder of the year. We'll cover some specifics on our 2 platforms, followed by selected highlights from our financial statements. Afterwards, we'll open up the call for your questions.

And 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. I trust everyone has had a chance to review our earnings release from last night. And hopefully, you've also seen the release we issued Monday, regarding our enhanced capital allocation strategy. We've got a lot to cover, so I'll just get right to it.

Our overall third quarter results were broadly in line with our expectations and a continuation of the trends we saw across our first half, modest core growth, inclusive of our product line simplification actions coupled with solid margin expansion that reflects our high level of operational execution. Our core growth was up 1% and is net of a roughly 150 basis point impact on our sales growth from our 8020 simplification initiatives. Despite what I would call a generally stagnant growth environment, we delivered year-over-year growth in our adjusted EBITDA and another quarter of more than 20% growth in our free cash flow, which brings our year-to-date increase in free cash flow to more than 25%.

Please turn to Slide 3, and I'll quickly review our third quarter results. Our net sales finished at $492 million, up 1% from last year net of the impact of the stronger U.S. dollar and our product simplification actions. Our adjusted EBITDA increased year-over-year to $107 million and margin expanded 50 basis points. Our incremental drop-through exceeded 50% and was higher yet on a core basis, and we continue to track to another record year of free cash flow.

Turning quickly to our operating platforms. Core growth in our PMC platform was flat and up almost 2% after adjusting for our product simplification actions. OE applications across most end markets in North America and Asia were broadly in line with what we had anticipated, and Europe continued to be relatively weak, but modestly better than our expectations. Our growth in the quarter through the North American distribution channel improved slightly sequentially from the September quarter, and we expect a little more improvement in demand from the channel in our upcoming fourth quarter.

Our North American channel inventories are bumping around at all-time lows and inventory turns with our channel partners continue to be at all-time highs. So we'd expect any fundamental improvement in MRO demand to be almost immediately reflected in our order rates.

PMC adjusted EBITDA margin was 22.7%, and we continue to benefit from the broad-based 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 3% in the third quarter as Zurn continued to benefit from steady demand in commercial and institutional plumbing end markets as well as success with our strategies to grow our share of the adjacent fire protection site works markets. Zurn's core growth was slightly below our target for the quarter as we saw an unusually quiet last 2 weeks of December and channel partners managed their inventories a little more aggressively into the year end. We think that impacted Zurn's sales in the quarter by about $2 million to $3 million.

Zurn delivered 40 basis points of margin expansion in its adjusted EBITDA margin over the record established in last year's third quarter as we continue to manage the ongoing tariff structures and price/cost equation, while sustaining our investments in innovation and market adjacencies.

Turning to our financial outlook. With 9 months behind us and 3 months to go in our fiscal '20, we're narrowing our prior end -- our prior range of adjusted EBITDA to primarily reflect the estimated impact of Boeing suspension of 737MAX production. While we will be able to mitigate a portion of the near-term impact, the reality is that the upper end of our guidance is now less likely to be achieved and we are moving our revised adjusted EBITDA range for the year to $460 million to $464 million. We're also affirming low single-digit core growth for the year, this is inclusive of more than 1.5 point impact of our simplification initiatives. And finally, we expect another record year of free cash flow that exceeds our net income.

On Monday of this week, we announced that our Board has approved an enhanced capital allocation strategy that includes our first ever quarterly common dividend starting at $0.08 a share, which equates to $0.32 annually and a yield of approximately 1%. Our expectation is to grow the dividend rate on an annual basis and by a double-digit rate for at least the first few years.

Our Board also authorized expanding our share repurchase authorization to $300 million, and we intend to allocate between $75 million and $150 million annually for regular share repurchases. We believe that our equity offers a compelling value that does not yet reflect the full impact of the changes we've made and continue to make in our growth profile, the resilience of our earnings and our improving free cash flow profile, all things that I'll come back to you in a couple of minutes.

While we will continue to invest both internally and externally on a disciplined basis to drive growth and shareholder returns, and we intend to execute our strategy while maintaining a relatively conservative balance sheet and keeping our net debt-to-EBITDA ratio within the target range of 2 to 3x that we established 3 years ago.

Please turn to Slide 4, and we'll talk more about our enhanced capital allocation strategy and why now is the right time to execute this strategy. I'd like to start by helping everyone understand that when we buy Rexnord shares in the open market, we're capturing an underlying 17% return on our investment for shareholders. This isn't readily apparent to investors that may not realize that our capital structure is distorted by our unique private equity heritage. When one private equity investor, namely Apollo, purchased Rexnord in 2006 from another PE firm, that being, Carlyle, there was a substantial portion of the purchase price, $1.7 billion to be specific, that represented a change of control premium that was unrelated to investing in productive assets and took the form of goodwill and intangible assets. The incremental debt that was required to fund that premium became an element of our capitalization and depresses our conventionally calculated ROIC. When we adjust our capital structure to eliminate that distortion to our total invested capital, you can see that this is a measure -- that this measure actually yields 17.1%, not the 10.5% that calculates based on our unusual back-to-back PE acquisition phenomena.

Two points to make about this. First, I think many investors have understood this issue and understand this level of return is obviously more consistent with our overall financial profile, including our high margins, our history of disciplined investing, both internally and externally and our increasingly asset-light operating model. Second, these calculations have been made using our unadjusted GAAP operating results and a normalized tax rate that reflects statutory rates across our geographic footprint, and which exceeds our periodic effective tax rate. In other words, we believe 17.1% is, in fact, a conservative estimate of our normalized underlying return on invested capital.

Please turn to Slide 5. Over the last 4 years, we've worked hard at executing a change in the composition of our portfolio to produce higher financial returns with reduced cyclicality. In prior calls, I've detailed the shift in our portfolio toward more stable consumer-facing end markets by exiting relatively project-dependent businesses and investing in the expansion of our food and beverage footprint through product innovation and our acquisition of Cambridge, a leading supplier to the food processing industry.

Last quarter, I provided an update on our DiRXN digital strategy and shared our excitement about the progress with our introduction of digital customer interfaces and families of digitally enabled and IIoT connected product solutions. We're compounding the impact of these improvements with our 8020 work and associated product line simplification that increases our focus on high potential products and customers.

On this slide, we're illustrating the current state of our transformation in another way by highlighting the progress we've made in repositioning our overall product portfolio to drive above-market growth in both operating platforms. The green bars represent discrete and absolute product line revenue that, we believe, is positioned to deliver above-market growth as we go forward. And as you can see, these specific product lines represent almost 3/4 of our revenue today as compared to less than half of our revenue just 4 years ago.

Turning to Slide 6. I'd like to quickly review the progress we've made with critical levers of fundamental value creation. Moving clockwise from the top left, as you're likely aware, our platform margins are well above those of most of our competitors. And the discipline of the Rexnord business system is helping us convert our improved operating profile into a stronger and more sustainable free cash flow profile.

Starting with this year, we expect the cumulative cash -- free cash flow over the 3 years through our fiscal '22 will be approximately 40% higher than the preceding 3 years. Contributing to our success to date and our confidence going forward is the progress we're driving through our supply chain optimization and footprint repositioning initiatives, which are on track to deliver a cumulative $60 million of permanent structural cost reduction as we exit our fiscal '21 next year, while also structurally reducing the capital reinvestment required in our business.

As we stated since the outset, and once we complete our scope for initiatives, we expect to operate with annual capital expenditures below 2% of annual revenue. We've executed the structural changes, freed up the internal resources to fund our digital transformation and continue to execute our disciplined and strategic approach to acquisitions, while expanding our margins, bringing our net leverage down to less than 2x our EBITDA and driving our ROIC to above 17%.

Moving to Slide 7. Here, we're simply profiling our growth over the last 3 years against several industrial companies that garner premium valuations based on their growth and return profiles. As you can probably guess by looking at this chart and with the conviction we have around our future cash flows, we believe the intrinsic value of Rexnord is considerably higher than what it's being valued at today. While this isn't a phenomenon that we believe makes a lot of sense, we're more than happy to invest an appropriate portion of our free cash flow to buy back Rexnord shares with the certainty of earning a 17% plus return on invested capital that we believe will grow to 20% plus in the coming years.

If you turn to Slide 8, we're simply illustrating one of the more obvious competitive advantages that we think is relevant to shareholders and that is the difference in the operating performance and profitability of our Water Management platform relative to that of some of -- relative to that of some leading pure-play water businesses and also command premium valuations.

The bar graph simply compares Zurn's adjusted EBITDA margins with the comparable margin profile of these companies. What's also important is the fact that when coupled with our aerospace operations, over half of the profit of the company comes from these 2 parts of our business, where we believe we have created particularly significant competitive advantages. Additionally, with all of the portfolio work we've done over the last 3 to 4 years, almost half of power transmissions earnings are generated in consumer-facing end markets.

Together, the 5 slides I've just taken you through, are intended to support our view that our equity represents an excellent value and that our enhanced capital allocation strategy represents a balanced and sustainable approach to delivering shareholder returns.

Please turn to Slide 9, and I'll summarize and close. We believe our free cash flow profile supports a moderately leveraged balance sheet and that we can drive attractive shareholder returns with modest volatility, if we maintain our leverage in the 2 to 3x range. We are initiating a common dividend that we intend to grow annually. We expect to allocate between $75 million and $150 million of annual free cash flow to share repurchases, which leaves room to be more aggressive and capture an enhanced return if the stock price suffers a major dislocation, or if we don't invest as much as we'd like in acquisitions in a given year.

We will continue to invest internally and externally to drive innovation, productivity and core growth, and we plan to continue our disciplined and focused approach to M&A that requires a double-digit return on our investment in a reasonable period of time, generally 3 years or less. So while we're committing a return to shareholders -- so while we're committing to return a substantial portion of our free cash flow to shareholders through dividends and repurchases, we retain ample financial capability and capacity to execute acquisitions that can enhance our competitive advantages, our core growth and free cash flow and total shareholder returns.

Our objective is straightforward. Deliver top quartile shareholder returns among U.S. industrials and continue to make progress towards earning an enterprise value that is a better reflection of Rexnord's intrinsic value.

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

[Mark Peterson, executive]

Thanks, Todd. Please turn to Slide #10. On a consolidated basis, our third quarter of fiscal '20 financial results were broadly in line with our expectations. On a year-over-year basis, our total and core sales growth were both up 1%, net of the impact from our product line simplification actions. Currency and acquisition contributions to growth were offsetting. Our adjusted EBITDA increased by 4% to $107 million, and our adjusted EBITDA margin expanded by 50 basis points year-over-year to 21.8%.

Please turn to Slide 11. Our outlook for our fiscal year 2020 continues to incorporate low single-digit core growth, which is net of an approximately 150 basis point impact from our product line simplification initiatives. We expect our adjusted EBITDA to be in the range of $460 million to $464 million, representing 4% 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 the expected impact of Boeing's decisions to suspend assembly of its 737MAX aircraft in mid-January.

On Slide 12, we summarize our consolidated results for the quarter.

Let's turn to Slide 13 to discuss the first of our 2 operating platforms, Process & Motion Control. Total sales were essentially flat year-over-year in PMC, with core sales growth also flat and a 1% acquisition contribution, offset by roughly 1% adverse impact from currency translation. PMC's top line growth was reduced by the approximately 200 basis point impact of our product line simplification, or PLS actions.

Breaking PMC down by major end markets, we continue to see good growth from our aerospace operations, and we believe we continue to outperform the broader industry in our global food and beverage end markets in terms of both OE and MRO demand generation. Demand in our process industry end markets was generally stable with demand trends we experienced in our second quarter.

In our North American distribution channels, we saw overall sell-through generally stable sequentially and more in line with our sales to distributors, as we expected. All in, and with one quarter to go in our fiscal '20, our broader end market growth assumptions as seen on the slide are unchanged.

Turning to profitability. Ongoing strong operating execution, combined with the benefits of our SCOFR actions of over 40 basis point expansion in PMC's EBITDA margin despite the flattish top line. We continue to expect PMC margins to increase year-over-year in our fiscal 2020, as the structural savings we're realizing from our PLS and SCOFR initiatives, ongoing growth in our aerospace operations and operational execution to the Rexnord business system are expected to more than offset our ongoing investment spending.

One driver of a relatively stronger growth in our food and beverage end markets has been the development and introduction of our premium services offering. Premium service is built on our DiRXN architecture and leverages our Smart Tag technology. The QR codes that we attach to all of our products provide immediate shop floor access to valuable resources like product identification, technical literature, and how-to videos covering installation, maintenance and replacement.

The service starts with a complete line survey performed by one of our technical experts and covers the overall line condition for our products as well as competitor products. We analyze the chain life, configuration and speed to enable a complete line condition optimization report with opportunities to improve the timely product identification and operating performance that will ultimately avoid costly unscheduled downtime because of the enhanced capabilities we provide with our Smart Condition Monitoring and Smart Tag technologies.

Please turn to Slide 14 to discuss our Water Management platform. During our third quarter, our Water Management platform delivered a 4% increase in net sales growth with 3% core growth and a relatively 1% contribution from StainlessDrains.com, which we acquired in our first quarter. Our PLS initiatives impact the Water Management's core growth by just under 100 basis points in the quarter. Our underlying North American nonresidential construction markets remain supportive of core growth and as illustrated by our unchanged end market outlook, that is summarized on the slide.

Growth in overall U.S. nonresidential building construction spending improved in our third quarter, although new starts growth has moderated somewhat against more difficult year-over-year comps. Based on our relatively greater exposure to institutional verticals like public education and health care and our strategic investments in adjacent market growth and the growing momentum we're seeing in our sales funnel for our digitally enabled products, we believe we are well positioned to continue to outperform overall construction sector growth.

Earlier this week, we closed on our strategic bolt-on acquisition in our Water Management platform with the acquisition of Just Manufacturing, a leading manufacturer of stainless steel sinks, it represents a natural addition to the Zurn finish plumbing product line. Adding Just Sinks to our Zurn business strengthens our position in several key institutional construction verticals, notably including education and health care, and it expands our ability to provide more complete solutions in the commercial markets like food service and hospitality. Just is expected to be accretive to Zurn margins and was acquired for about 8x trailing EBITDA after factoring in certain tax benefits. Just will add over $20 million of annual revenue to our Water Management platform.

Looking at profitability. Water Management's adjusted EBITDA increased by 5% year-over-year in the third quarter with a solid 37% incremental margin, as a result [ has earned over ] 40 basis points of year-over-year margin expansion as we continue to leverage our core growth, while funding our market expansion, connected product development and cost reduction initiatives.

Moving on to Slide 15, and starting with the chart from the far left, our free cash flow continued to grow by more than 20% year-over-year in our third quarter and has increased by more than 25% on a year-to-date basis. We remain confident in our expectations for a record level of free cash flow in fiscal 2020.

Moving to the chart in the center, you can see that our financial leverage, as measured by our net debt leverage ratio, declined to 1.9x and finished the quarter just under the low end of our long-term targeted range of 2 to 3x. During our third quarter, we allocated $20 million of share repurchases under our existing authorization. Earlier this week, our Board authorized expanding our existing share repurchase authorization to $300 million of available capacity. The Board also authorized initiation of an $0.08 quarterly common dividend, which translates to about $39 million of annual dividends based on the roughly 122 million shares outstanding at the end of our fiscal third quarter.

During our third quarter, our mandatory convertible preferred shares converted into approximately 16 million new shares of common and eliminated the associated $23 million of annual preferred dividends.

Separately, we also repaid $100 million of the outstanding term debt under our credit facility, which we refinanced during the quarter and secured a 25 basis point reduction in the effective interest rates. The combination of the debt paydown and lower interest rate will reduce our annual interest expense by approximately $5 million, though August 2024 maturity is unchanged.

Before we open the call for questions, I'll touch briefly on restructuring expenses and our effective tax rate. First, and in terms of our cost reduction initiatives, including our SCOFR 3 initiatives, we expect total restructuring expenses of $12 million to $14 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 2020 adjusted net income will incorporate an effective tax rate of approximately 25%. In our fourth quarter, we anticipate the rate will be approximately 27%.

Turning to the slide deck appendix, we've included certain other assumptions incorporated into our financial guidance for our fiscal 2020 on a separate slide. I'll remind you that our guidance excludes the impact of potential acquisitions, potential accounting gains or losses and future nonrecurring items such as restructuring costs.

One last note. After further analysis, it has been determined that the if-converted test is still required when calculating our EPS in our third quarter and for our full fiscal year, even though the mandatory convertible preferred has converted to common shares. As you recall, this requires a calculation that assumes the convertible preferred had converted at the beginning of the period and that no preferred dividends would have been paid. This method was used in our third quarter, and it was $0.01 dilutive to our EPS as it was in the first 2 quarters of the year. The same method will be necessary for our full fiscal year when the if-converted test will be performed with all preferred dividends as [ vast ] net income and using a share count is expected to be approximately 124 million shares.

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

[Operator]

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

[Jeffrey Hammond, analyst]

Just on Slide 5, you showed the shift from kind of non-growth to growth and just want to get a sense in that other remaining 26%, how much do you think of that can kind of shift into the green? Or if there's any other pairing that you would see in the portfolio that in markets maybe where there isn't the growth profile?

[Todd Adams, executive]

Jeff, I think it's a great question. I think there is room to move it. I think we've focused on the things that we could do both organically and inorganically that we felt had the biggest opportunity. And so there are always going to be elements of the portfolio that aren't positioned to grow above market. Maybe just grow with the market, but I do think there's some room that we can -- to wiggle that percentage a little bit higher. I think we'd love to see it at 80% plus, primarily through a combination of things that we're doing strategically as opposed to just sort of selling something or divesting something. So I think we're targeting to move it a little bit forward, but I think the lion's share of the lifting over the last 4 years has put us in a pretty nice place.

[Jeffrey Hammond, analyst]

Yes, absolutely. And then, Todd, you mentioned Zurn kind of having a quiet end of the year and channel destocking, can you just kind of talk about trends into January, if that's normalized, where you think inventory levels are? And then just kind of a comment on -- I think there's some increasing worry that the nonres cycle is maturing and just what you're seeing there from a quoting and project activity?

[Todd Adams, executive]

Sure. I think the end of the year phenomenon had a lot to do with the holidays falling in the middle of the week. So people took the opportunity to really dial things back. The other thing to point out is that January is not a great barometer because it's cold across most of North America. And so I would tell you that I don't see anything abnormal in the way we're starting the fourth quarter relative to maybe what we expected. But as you get through February and March and things warm up in parts of the country, that's when we see things accelerate. So nothing unusual from the way we're starting the quarter and Feb and March are always where the majority of our fourth quarter comes when it relates to Zurn.

Back to your second question on what we're seeing in terms of demand, I would tell you we feel pretty good about where starts are, particularly on some of the institutional verticals as we start our fiscal '21. And I think we would sort of point to, albeit, slower growth, market growth over the course of the next 12 months, still positive. And I think when you couple that with some of the things that we're doing around 8020, we're seeing outsized market growth in those areas as well as player protection and [ site works ], which are both growing substantially above the market. The other thing that Mark mentioned was this acquisition. And if you think about what we've been doing in a pretty methodical way is adding to the size of our available markets. And so it just opens up another $100 million, $150 million market opportunity, where we have a chance to really grow the business through what we have in place, tremendous spec share, our third-party reps and the ability to bundle and package this product with all the other water and labor savings products that we already have. So I think we're pretty excited about where Zurn sits. And again, I think that the market itself is absolutely in the process of slowing, but I think the resilience of the business through all the things we've done and also this retrofit business that we've built and are building, we think, put us in a great spot, even if the market slows. So that's sort of a long-winded answer to your question, Jeff, but I think that's the way we would hope people would think about it.

[Operator]

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

[Joseph O'Dea, analyst]

First question just on the cash flow. I think, year-to-date, you're up $30 million year-over-year. The prior framework was thinking about free cash flow growth kind of mirroring what we might see in EBITDA growth here ahead of that pace. So just what's your thinking for the fourth quarter, whether that's a little bit of a giveback on the year-to-date gains or whether we should just be thinking that free cash flow might come in a little stronger?

[Mark Peterson, executive]

Yes. Joe, this is Mark. I think if you look at the fourth quarter, obviously, it's always our strongest quarter. I think if you look at the kind of levels that we did last year, we'll be in that similar ZIP Code of the free cash that we did last quarter, obviously, plus or minus $3 million to $4 million to $5 million, but Q4 will be strong. We'll finish a record year this year with momentum going to our fiscal '21 when it comes to free cash.

[Joseph O'Dea, analyst]

Great. And then there were a couple of comments in the press release about progress on the connected product DiRXN side of things, both within PMC and Water Management. And was looking for any additional context in terms of what you see as a revenue run rate or what you see as a revenue growth opportunity over the next 12 months or so?

[Todd Adams, executive]

Sure. We just wrapped up our strategic planning cycle. And as we went through, we see a 3-year goal of, in excess of, $100 million. And so the revenue run rate, I think, it's probably been a little bit slower than we would have liked out of the gate. And I think our fiscal '21 will be sort of a catalyst year as we have modified, I would say, some of the offerings we've had. We've built the go-to-market. We've established the solutions that our customers are really wanting. And so we think the run rate beginning in our fiscal '21 ramps pretty considerably over the course of the next 3 years, and it's really opening up incredible conversations in both parts of our business that we weren't able to access without this solution. And so things like connected retail stores that provide perfect visibility into the water, safety, quality, flow control, things touching water inside of the building, these are solutions that customers are really excited about. And I think the traction we've gotten and the learning cycles that we've been through across the entire portfolio, and I think that's the important thing to keep in mind when you look at our connected product solutions is it covers the broadest portfolio of products that serve the markets that we go after, which is very, very difficult. And it's also a solution that works with whatever customers have chosen to use, whether it's a building control system, a factory automation system, or having us look at it through our cloud. It's a very flexible, scalable solution that covers the broadest gamut of product. So we're excited about it, look for the inflection in '21 and think about it as on $100-plus million opportunity over the next 3 years.

[Joseph O'Dea, analyst]

And just a clarification, is that an incremental $100 million? And what would the base be in fiscal '20, roughly?

[Todd Adams, executive]

We do think it's an incremental $100 million, and the base is probably close to $20 million.

[Operator]

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

[Bryan Blair, analyst]

Solid quarter. Question on portfolio composition over time. You signaled and started to act on Zurn weighted M&A. Is the ideal to have a relatively balanced revenue and EBITDA contribution from the platforms over time? Or is that too rigid a construct?

[Todd Adams, executive]

Bryan, I think that we haven't said that as a sort of discrete goal. But I think our view is that adding more heft to the water platform certainly can't hurt us in terms of the way the company is valued or thought of. And so if you were to look at the priorities that we laid out on one of those pages, water-related M&A is our #1 priority with the second, 2, consumer-facing end market-related applications in PMC. So I don't think we are looking at expanding through M&A in things like process industries, because we've got such a terrific share already. And so without question, I think we're going to target those areas, but without a mandate to do it in a period of time. We're going to continue to stay disciplined. And if you look at the acquisitions that we have done over time and, frankly, the one that we just talked about in Just, we're retaining the discipline of a financial profile that creates a great return, while adding significant runway to these businesses that we can bolt-on and run with quickly.

[Bryan Blair, analyst]

All makes sense. And just a clarification point on Just. Did you say that's margin accretive to Zurn?

[Todd Adams, executive]

Yes, that's correct.

[Bryan Blair, analyst]

Yes, that's impressive. One last one, if I could, on SCOFR 3, any update you can offer on how that's progressing? And if there is further line of sight on the timing of cost savings, how much of that we should expect to hit in fiscal '21?

[Todd Adams, executive]

So we've started to make some internal announcements. You'll see some cost in our fourth quarter related to that. You'll see some incremental cost to implement. As we start our fiscal '21, we'll outline what those are, but it's sort of in the $5 million to $7 million range of cost to implement in our fiscal '21, maybe just a little bit in our fourth quarter. And we should start to see some level of benefit from those efforts towards the end of fiscal '21. So think about it as a little bit of upfront spending, just like we did in SCOFR 1, just like we did in SCOFR 2, but then that spending goes away and we begin to accrete all the fixed cost and cash flow benefits from the actions. And so a little bit in the fourth quarter, a little bit in the first part of the year, $5 million to $7 million, a little bit of benefit in the fourth quarter of our fiscal '21, with the run rate really starting in our fiscal '22.

[Operator]

Our next question comes from the line of Andrew Obin from Bank of America.

[Emily Shu, analyst]

This is Emily Shu on for Andrew Obin. So my first question. So I noticed the outlook for commercial aerospace in PMC has a green light. Has that changed, given there's some risk from Boeing 737MAX production halts in the first half of 2020 and also the coronavirus outbreak reducing basically air traffic?

[Todd Adams, executive]

Yes, we are aware of both of -- both the 737MAX production changes and the coronavirus. I think what the green light is intended to do is sort of maybe look through that a little bit. I think, we, like many people think there will be a resolution to the MAX. And it's very difficult to assess the impact, certainly the long-term impact, of the virus situation. And so look, we have a record backlog in our aerospace business right now. We anticipate that there will be some near-term headwinds as the production rate for the 737MAX slows. I think we're optimistic that there will be some resolution to the virus in China. And we've got a good couple of years left, at least, in the aerospace cycle. So that's why it's green. I don't think we're trying to ignore the 2 things that you spoke about. But I do think we're trying to be a little bit realistic that everything is likely to get resolved in a pretty short window, and there's a lot of runway left.

[Emily Shu, analyst]

Okay. Great. And just a follow-up question. Is there any January data that you could provide on your industrial distribution businesses? Are there any early signs of green shoots or anything you're hearing in the channel that would give you confidence of a short-cycle recovery in fiscal '21?

[Todd Adams, executive]

Well, again, I think we're not looking out into fiscal '21. We're not guiding to that yet. I think the data that we have so far in January supports kind of the thesis that I spoke about, Mark laid out, which is in the fourth quarter is sort of tracking to what we had anticipated to deliver that low single-digit core growth number, EBITDA that will end up being a record and record free cash flow. So I think we'll get to fiscal '21 in a couple of months. But so far, everything seems to be tracking in line with the way we've guided and really no surprises.

[Operator]

Our next question comes from the line of Mig Dobre from Baird.

[Mircea Dobre, analyst]

Just wanted to follow-up on the 737 question. Can you maybe help us understand -- better understand the impact in the fourth quarter on the top line for PMC? And I think it's pretty clear on EBITDA, given that you said that, that accounts for your change in guidance, but, yes, I'm curious on the top line. And how you sort of think this will play out over the next couple of quarters based on what you've heard from your customer?

[Todd Adams, executive]

Sure. So the run rate, Mig, of our MAX exposure is in that sort of $22 million to $25 million range that you can look at what that is per quarter. In our fourth quarter, that gets impacted by $3 million to $4 million. And the related profitability on that is sort of the majority of the change to the top end of our prior EBITDA guidance. If we were to look ahead, we're assuming that the run rate in our fiscal '21 is substantially lower, at least through the first half, if not the full year, based on what we've been told. So we've been told to modify the production rates down to that 20 to 30 range over the course of the year. If you were just to look at it on a digital basis, it would impact next year by $7 million to $10 million. Now we think there's opportunities for us to go win some additional business with the capacity that we have. And so I wouldn't flag really an issue at this point other than to say, production rates, at least for the next 6 months, maybe 9 months are going to be a little bit less than what they were running at the first 9 months of the year. Those aircraft, we believe, still get delivered. So maybe it just pushes a little bit. In the meantime, I think we've highlighted the fact that we've got an amazing center of excellence that is a competitive weapon that we can win business with, and we're using that to try to fill some of that divot in the near term. And frankly, we're doing our best to fill some of that divot in the fourth quarter with that capacity. And so that's what we think happens. But as you can see, the relative impact is pretty low for us relative to the size of our aerospace business and the size of Rexnord. It's just a little bit of an acute issue in the fourth quarter as we dial that back very quickly and deal with sort of the incremental profitability challenges when you do that. But it's -- it hurts, but it's not -- it's certainly not something that we're overly concerned with at this point.

[Mircea Dobre, analyst]

Okay, great. Then the next question I had was on product line simplification. And I'm wondering really what you're doing here? I mean, I understand the concept, but I'm wondering what you've done through the year? And can you maybe help us understand if this is a continued drag going forward? Was there something special about fiscal '20, just the puts and takes?

[Todd Adams, executive]

Well, I think when we started, the process leads you to taking sort of your '20s customers, your '20s products and making some tough decisions around either exiting or raising price. And I would say the majority of that work is somewhat behind us by the time we get to our fiscal -- the end of our fiscal '20. There'll be some incremental drag going forward as you rerun all the way if we look at it, there'll be some -- obviously, some more pruning that gets done. But I would say that it will be less in our fiscal '21 than it has been in our fiscal '20.

Where we're at now is really pivoting towards growth. So with the resources that we have freed up by thinking more about our most important customers or opportunities with our best and, maybe, most profitable products, pointing our resources towards that. And so in its logical conclusion, 8020 certainly takes cost out, but its intent is to free up the resources and the capability to drive above-market growth. And I think that's what you're seeing as we talk about what's happening in sort of pockets of Zurn, what's happening in pockets of consumer-facing end markets inside of PMC. And frankly, that's what that chart is intended to do in the deck where you look at all the product line revenue and what we've done to it and where we believe we are positioned today relative to just 3 years ago. And so we've given you sort of the outline of what the drag is this year. Hopefully, you start to see that the market outgrowth is really starting to happen in pockets. I think we've got tons of illustrations of where it's happening. I mean, inside of our beverage business, a metal product line where we cut 60% to 70% of SKUs. We're experiencing 12% to 14% growth this year at great margins. So we've got a lot of these things happening. And I think as you get into our '21, you'll see that contribute to the incremental outgrowth that we expect from these initiatives.

[Mircea Dobre, analyst]

Great. Lastly, a question on pricing. Is there any updated thoughts there in terms of trends? And I know you're not talking about '21, but I'm going to ask it anyway, as you think about pricing into '21, is there anything different versus '20 at segment level that you'd call out?

[Mark Peterson, executive]

Mig, this is Mark. I'd say I think as our year progressed, obviously, the price impact has moderated year-over-year. So you're -- in the quarter, just under 1 point in PMC, a couple of points to 1.5 points in Water, so that overall impact does moderate as we cycle against the price increases we put in place last year. Assuming a tariff environment that's stable from where we sit today, I think pricing next year is very moderate for us. It won't be overweighed or worse as it has been in the past 1.5 years.

[Todd Adams, executive]

Yes, I think maybe to put a fine point on it, Mig, the incremental margins in the third quarter, were above 50%. And that's what's probably very little price to it. And so as we transition to the fourth quarter and into next year, most of the incremental profitability comes from the operating leverage from RBS and the things we're doing there, 8020, and then, obviously, the net impact of all the SCOFR initiatives that we've done and are implementing. And so we expect that to sort of keep the incremental margins in that 35% range as we've been communicating.

[Mark Peterson, executive]

Absent the SCOFR investment.

[Todd Adams, executive]

Absent the SCOFR investment. I think Mark laid it out pretty well, and I think we're optimistic that the incremental margins stay at a very high level as we make the turn to a more normalized input cost environment.

[Operator]

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

[Patricia Gorman, analyst]

This is Trish on for Julian. So just kind of looking at PMC exiting the second quarter, it seemed like you guys had kind of a more cautious tone there and that core growth in the quarter was better than we were expecting. Were there any end markets that were kind of positive surprises in the quarter? And then if you could provide a little bit more color on what you saw from your end markets kind of by geography for food and beverage, North America versus Europe and process and any trends in those through January?

[Mark Peterson, executive]

All right. I'll try to walk you through that.

[Todd Adams, executive]

There's a lot to unpack there.

[Mark Peterson, executive]

If I miss something let -- if I missed something, let me know. For us, in our third quarter, I'd say PMC's sales dollars core growth put out just as we had expected in the quarter. So there wasn't anything that was unusual in the quarter that impacted the core growth number. Again, I think on the right line with what we'd expected. We look into our fourth quarter and again, as we talked about from an end market standpoint, generally stable muted market conditions, but generally stable from what we saw in our second quarter. You kind of play it forward to the fourth quarter, and that's obviously uniquely covered here as some of the impact of Boeing in our fourth quarter. And we cycle against basically a tougher comp and with a couple of projects that shifted in the last quarter in our process industry that don't repeat this year. So in our fourth quarter, we do expect our core growth to be down a couple of points for those reasons.

You take the end markets and look at it by geography, I got to say not really different from what we talked about last quarter. Food and bev for us has been a good end market for us, not only just the market, the things that we've been doing, as Todd touched on from simplification, [ strat accounts ] some of the new product in that space, we've seen good growth out of our European-based business, which obviously serves the globe in North America as well.

In our process industries, I'd say generally, North America is stable. Europe has remained weak for us, both OE and MRO in that space. And Asia for us, albeit a smaller piece, has been in growth mode, where we're doing some things to capture some share in those regions, but again, small dollars for it. So I think that hits your question. If I missed anything, let me know.

[Patricia Gorman, analyst]

Yes. No, that's all of it. That's very helpful. And then just maybe one on Just Manufacturing. Is there any significant seasonality within that business that we should be aware of? And then maybe just from a higher level perspective, if you could elaborate a little bit more on kind of how that fits within Zurn's current distribution?

[Mark Peterson, executive]

Yes. I would say, it should follow the traditional cycle we see in Zurn. So there will be nothing different from the seasonal patterns. So it will follow Zurn's seasonal patterns that we've traditionally seen in North America. It's a great addition to our portfolio. It's a product category that fits really well into our sweet spot of education and health care in our institutional verticals. So again, it's one of those -- it's kind of a down the middle of the fairway type acquisition for us where we have a product category that fits our strongest verticals, broadens our overall product portfolio. So it allows us to -- Zurn to be just more relevant than it has -- than it was the day before we acquired and it allows us to grow that product category much faster given our established commercial front end. So again, a great acquisition for us, right down the middle of the fairway, and we're really excited about what we can do with that product category with the Zurn brand behind it.

[Operator]

[Operator Instructions] Our next question comes from the line of Joe Ritchie from Goldman Sachs.

And we have no further questions in queue.

[Rob McCarthy, executive]

So this is Rob McCarthy. Thanks, everybody, who was able to join us on the call today. And we'll look for Joe, see if we can find him. We appreciate your interest in Rexnord, and we look forward to providing our next update when we announce our fiscal year 2020 fourth quarter results in May. Have a great day.

[Operator]

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