Zurn Elkay Water Solutions Corp

F:4RX0

Earnings Call Transcript 2022-Q3

[Operator]

Good morning, and welcome to the Zurn Elkay Water Solutions Corporation Third Quarter 2022 Earnings Results Conference Call with Todd Adams, Chairman and Chief Executive Officer; Mark Peterson, Senior Vice President and Chief Financial Officer; and Dave Pauli, Vice President of Investor Relations for Zurn Elkay Water Solutions. This call is being recorded and will be available for one week. The phone numbers for the replay can be found in the earnings release the company filed in the 8-K with the SEC yesterday, October 25.

At time for opening remarks and introductions, I will turn the call over to Dave Pauli.

[Dave Pauli, VP of IR]

Good morning, everyone and thanks for joining the call today. Before we begin, I'd like to remind everyone 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 are helpful to investors and contain reconciliations to the corresponding GAAP information.

Consistent with prior quarters, we will speak to certain non-GAAP metrics as we feel they provide a better understanding of our operating results. These measures are not a substitute for GAAP and we encourage you to review the GAAP information in our earnings release and in our SEC filings.

With that, I'll turn the call over to Todd Adams, Chairman and CEO of Zurn Elkay Water Solutions.

[Todd Adams, Chairman and CEO]

Thanks, Dave, and good morning everyone. And really appreciate everyone taking the time on the call this morning.

The earnings release that we issued last night contains some perspective on the approach we're taking with respect to the fourth quarter outlook. And we'll go through that in some detail in just a bit. We'll also spend time taking everyone through the significant progress we've made on the integration of Elkay over the first 90 days. And finally provide some color on how we're thinking about 2023.

There are obviously a number of moving parts as we bring Elkay into the fold but in the end, the view and perspective we'll be sharing this morning is essentially aligned with the view that we had from the beginning, which was to bring these two amazing businesses together that streamline and simplify the businesses into two significant product categories that from a performance perspective, we're very concerned like. We've done the work and the path is now clear, and we'll share what that looks like this morning.

As it relates to the third quarter, our results were very much in line with our expectations heading into the quarter, solid core growth, the first quarter of Elkay on track, and solid margins and free cash flow. Our leverage ended the quarter at 1.5x and we expect further reduction in December and in the year between 1.2x and 1.3x.

You'll see a chart on the right stacking our core growth for the past three years, inclusive of our fourth quarter guidance and for 2022 this equates to 12% core growth for the year, which is in line with our expectations for the double digit core growth we communicated and I've reiterated throughout the year. Mark will provide some additional color and unpack the growth for both the third quarter, as well as the outlook in just a few minutes.

If you can move on to Page 4. The reality is that it's not even four months since we closed the Elkay transaction. But the amount of progress our team has made is significant. And in doing so it really sets us up to start 2023 as a single integrated business. We'll be wrapping up our first integrated strategic plan over the next several weeks, which will fully embed all of the growth and synergy expectations into our normal business cadence as opposed to developing a plan for Zurn plus a plan for Elkay. We start 2023 as one business and we have one plan that we're executing.

In the first 90-days, we've completed all of our plans third party rep changes, which is a huge undertaking because we're asking independent business organizations to change or change significant portions of their agencies from competitive lines to the new Zurn Elkay while learning new or different products, transacting and putting in different systems while harmonizing around a set of common commercial practices. Having that behind us 90 days in with the quality of the third party representation we now have is a huge thing and will create a lot of leverage as we head into 2023.

The other significant change we made is with the organization. We already have a single sales organization across the entire business, a single marketing organization across the entire business as well as organizations around supply chain and distribution. We've established general manager roles over drinking water, sinks with engineering and product management aligned with these categories, essentially mirroring the Zurn model to organize, align and focus the business on profitable growth.

Without question, the single most impactful thing we've done in the first four months is a rigorous deployment of 80:20. The thing to remember is that as a privately owned business, Elkay had its own rationale for doing the way things the way they did, whether it was serving certain channels or customers or being in certain product lines or SKUs, it made sense for them at a point in time.

As we went -- as we came together, we went through a very detailed and much needed fact based 80:20 review, to put ourselves in a position to evaluate where we wanted to focus and deploy resources to drive profitable growth, and where we needed to do something different or simply not to do it at all. I'll go on to say that the details I'll share, ended up deferring all that much more initial touchdown assessment, but getting the teams to engage with the data and the details and then framing it all to allow us to understand all the downstream implications of our simplification work took a little bit of time. Whether it was customer, employee or supply chain related, we needed to make sure that we got it right so that we can make decisions and move forward with a conviction and confidence it takes 80:20 -- it takes to do 80:20 the right way, which is a relentless prioritization around profitable growth.

The punchline on the integration is that it's quickly becoming a single core business as we head into 2023. which bodes well -- which bodes well in terms of realizing the expected synergies, and even more importantly, being in a spot to leverage our unrivalled product portfolio and solutions to drive better long term growth and profitability by only focusing on what's core to us.

Please turn to Page 5. To ground everyone on this page, when we closed the transaction and announced Q2 earnings, we talked about okay for the full year of 2022 and again, this is for the full year, not the half that will end up consolidating, having about 600 million of revenues and EBITDA margins in the 14% to 15% range. In our detailed work over the past 90 days, we went through each of the primary categories specifically drinking water, commercial things, and residential things and accessories, customer-by-customer and SKU-by-SKU. We then had the internal debates, conversations with customers and evaluation of our competitive position and long term strategy, along with the detailed understanding of any collateral impact from our conclusions.

What this page highlights is that basically, inside the $600 million revenue business is a growing and profitable $485 million base business with real sustainable competitive advantages. And then as we execute our simplification and rationalization initiatives, is actually more profitable at $485 million than it is at $600 million. And then there are synergies on top of this run rate. The whole Zurn Elkay will be drinking water and commercial sinks. In both cases where the clear market leader with above average -- with above market growth and terrific margins. We'll be selective in where and how we play in residential, but it'll be niche areas where it supports our overall strategy.

I want to be clear about the portions of the residential market that we are exiting and also what's left. The pieces we're exiting really have no strategic value in a Zurn Elkay context. None of it conveys anything or carrying the Elkay brand, or sold through our current set of wholesalers and reps. It's made of a private label white label source sinks and accessories of all different types of materials. And finally products done for other OEMs sold through home centers. That makes no sense for us to continue to support.

The sales of residential sinks will stay in calling roughly 70 million will be Elkay branded, sold through our existing channels, reps and wholesalers, where we believe we do have strategic relationships and products that when paired with our commercial lines make a tonne of sense in the market. The other thing to highlight is, this isn't going to all happen overnight. We've got some contractual obligations we have to fulfil. And we also want to maximize the value of the assets and inventory associated with the exit but this is the core of what we're going to build around. And it's our best estimate that we can exit this level of business and started this run rate sometime in the second quarter of 2023.

Hopefully, it's also more clear that the drinking water and commercial sink product areas categories share the same characteristics and look like the core Zurn Business from a growth, profitability and returns point of view.

If you turn to Page 6, I'll share a view of how we think the pro forma mix of the business looks after the rationalization. On the left, you'll see we're still aligned around the four highly profitable categories of specified water solutions, that we have real competitive advantages in significant market shares in. On the right, we have a nice balance between new construction and retrofit replace with significant U.S. institutional and commercial construction exposure. With institutional and the sub verticals of education and healthcare being our largest exposure.

We have residential comprising only 15% of the pro forma revenues and leverage primarily to our packs product offering where we have a tightly focused strategy and are leveraged to material substitution trend in both residential and commercial. All-in-all, not wildly different than before but we do think that by focusing 100% of our time on the strategic parts of our business will serve as well. When you look at this over 95% of our revenues come from a number one or number two position. The reality is that being a number five or six in residential sinks, sold through home centers or online isn't something that we built our business case around.

I'll turn it over to Mark to walk through the third quarter, and the fourth quarter highlight.

[Mark Peterson, SVP and CFO]

Thanks Todd.

Please turn to Slide number 7. On a year-over-year basis, our third quarter sales increased 82% to $418 million. The recently completed merger with Elkay and the prior year Wade Drains acquisition contributed 67% year-over-year growth and the core business drove 16% growth, with price realization contributing high single digit growth year-over-year, and the balance of the core sales growth coming from our non-residential markets and our strategic share capture initiatives. This growth was partially offset by softening residential market, water safety and control, hygienic environmental and flow control product categories all contributed to the core sales growth. Foreign currency translation reduced sales by about 100 basis points.

With respect to Elkay I'll provide some color on the third quarter. Our non-residential business which is comprised of drinking water and commercial sinks, below double digits on a year-over-year basis driven by solid market demand in both product categories and improving price realization as we've quickly implemented ZEBS price realization standard water across all product categories within the Elkay product groups.

The residential sink product group declined mid-single digits in the quarter as the improved price realization was more than offset by the overall softening in the residential market, as well as the $5 million of product line exits as we started our 80:20 simplification actions in the quarter began to exit certain residential commodity, private label and OEM sink SKUs I just discussed.

Turning to profitability, our adjusted EBITDA excluding corporate costs totaled $91 million in the quarter and our adjusted EBITDA margin was at the high end of our expectations for the quarter at 21.7%. As Todd discussed earlier in the call, we move quickly to integrate these two businesses into one. That said, we can only provide directional color on margins between the legacies earned business and Elkay as the cost structures are quickly becoming one.

Starting with the legacies earned business, margins did decline approximately 100 to 150 basis points year-over-year, as we anticipated, as the benefits of the sales growth, inclusive of price realization, our productivity actions was partially offset by the increase in material and transportation costs, as well as our investments in our growth and supply chain initiatives.

With respect to Elkay, margin saw a substantial improvement from low double digits in the prior year third quarter to mid-teens in the 2022 third quarter driven by the accelerating price realization I discussed earlier, as well some early benefits from an integration actions partially offset by some investments needed in the business, as well as the adverse impact on material and transportation related inflation. With respect to corporate costs, they totaled 7 million in the quarter as we had expected.

Please turn to Slide 8 and I'll touch on some balance sheet and leverage highlights. Our net debt leverage end of the quarter in line with their expectations at 1.5x, pro forma for the adjusted annual expense run rate of approximately $27 million and inclusion of cash utilization to pay off a legacy Elkay term loan close, as well as transaction costs related to the combination.

As a result of the leverage reduction, we did trigger a 25 basis point reduction in our base terminal rate that goes into effect during the fourth quarter. As we looked at the end of the year, we continue to anticipate ending the year at 1.2x to 1.3x in net debt leverage.

Please turn to Slide 9 and I'll cover some of the highlights of our outlook for the fourth quarter. For the fourth quarter of 2022, we're projecting consolidated Zurn Elkay sales in the range of $350 million to $365 million and our consolidated adjusted EBITDA margin to be between 20% and 21% in the quarter inclusive of our corporate costs, which we expect to be approximately $7 million in the quarter. I'll come back to some of the details on Page 9.

Let's move to Page 10, and cover some of the items that are on the walk of our third quarter sales to our fourth quarter outlook. As you know, our fourth quarter traditionally has fewer shipping days, as well as a seasonal slowdown and non-res construction activity as we enter the fall and early winter season in certain regions of the country. The seasonality primarily impacts the legacies earned side of the business given the product categories and to a lesser degree the Elkay product groups.

Note, the last year was unusual year in Zurn as approximately $10 million in scheduled third quarter shipments shifted to the fourth quarter due to certain container delays. But if you just apply your third quarter and fourth quarter for that timing issue, the usual Q3 to Q4 decline did take place. As well Todd might have discussed earlier in the call, we have accelerated our 80:20 simplification actions. Over the past 90 days, we've been able to thoroughly review the Elkay sales volume at a SKU level and customer level, and finalize the plan to simplify that business to focus on better growth, better margins and better returns on invested capital.

In late July, we align to say to at least 10 million to 20 million of exits in the second half of 2022. With the completion of our analysis, we will be exiting 25 million in the second half of 2022, with 5 million already taking place in the third quarter, and 20 million occurring in the fourth quarter for an incremental 15 million of exits on a sequential basis from Q3 to Q4.

Lastly, the residential market has softened from where we were 90 days ago. In the third quarter we experienced a low double digit decline in our served residential market. As we look ahead to the fourth quarter, we anticipate further declines in the residential market and built that into our outlook as a year-over-year contraction of approximately 20% in the fourth quarter.

It's important to note that our products that serve the residential market tend to be more of a stock products for the client we experienced in the third quarter and our assumptions for the fourth quarter include market decline, as well as destocking.

By items I'll just cover -- walk our third quarter sales to the high end of our fourth quarter outlook. And given the fact that we are entering into the end of the calendar year, the macro environment appears to be deteriorating, we believe customer sentiment and market behavior could be more volatile. And as a result, we're adding some additional conservatism into our outlook as highlighted on the right side of the slide.

Turning to profitability in the third quarter. At the midpoint of our guidance range for adjusted EBITDA margin and the midpoint of our sales range, the sequential decremental margin from the third quarter of the fourth quarter is less than 20%. Exits of lower margin SKUs improving price realization to the Elkay product groups, cost controls and our continued actions to integrate into one business are all contributing to improve margins, despite the lower sales.

Before I turn the call over to Todd for some closing comments, I'll touch on a few additional outlook items that were on Page 9. We anticipate our interest expense to be approximately $9 million. Our non-cash stock comp expenses should be about $8 million. Depreciation and amortization will come in at around $22 million. Our tax rate on adjusted pre-tax earnings will be about 27% to 28%. And diluted shares outstanding will be approximately 179.5 million to 180.5 million in the quarter.

With that, I'll turn the call back to Todd on Page 11.

[Todd Adams, Chairman and CEO]

Thanks, Mark.

Before we turn it over your questions, I just wanted to cover a little bit about 2023 and some perspective. Hopefully everyone appreciates the level of transparency we went through this morning. In an ideal scenario, we would have been able to lay off this entire simplification story last quarter or perhaps even before, but the reality is you the amount of work and decisions and conversations that needed to be had just took a little bit of time.

You know, we pride ourselves on simplification. And I think as we reflect on and I reflect on how the last core quarter went, you know, we're not happy with it. And so hopefully we're providing the amount of clarity with purpose this morning that you can -- you can appreciate. Obviously, the changes will have a huge impact not only the dollars of profit, but a dramatic impact on the margins on a pro forma basis as we exit '23 -- exit '22 and look to '23.

We believe we're taking an appropriate cautious view on the fourth quarter. But I wanted to spend some time on 2023. From an end market perspective, we see record levels of non-residential construction backlog and strong confidence indicators in the contractor community. The momentum around institutional construction continues to be very strong. Commercial construction as always will be more mixed and super hyper-local. In aggregate, we think the market will still be up next year, probably more so in the first half, or at least more confidently in the first half than the second. So we'll continue to watch on how that develops.

Our quotation volume, however, continues to be strong and we're not seeing any material slowdown in demand whatsoever. Residential as Mark highlighted without question be impacted. Near term we're seeing a near jerk reaction across the board. A lagging impact from where mortgage rates have gotten to and are going is having an adverse impact on the residential side of things. But as you saw earlier, it's now only 15% of our business. And inside of that multifamily should continue to see growth and we have a highly variable model inside our residential serve product lines. So the impact on profitability is relatively muted relative to the other markets and product lines we have.

After three years of challenge I think we start 2023 with supply chain dynamics that are a lot more stable. Lead times are back to normal. Container costs are down dramatically understanding on how all that changes ordered behavior is something to watch, that we don't have all that much inventory at all sitting on shelves and wholesale or retail distribution. We're generally seeing live demand in our order rates. And we'll end the year with a smaller backlog than we started.

But I think the net impact of all of that heading into next year is a positive. Particularly we monetize some of the higher cost inventory we have throughout Q4 and Q1, which means cash flow should be very strong.

In our design, procures assemble test model will benefit from lower input costs and a strong U.S. dollars as we procure through our supply chain. And we're quite confident the combination of lower input prices, lower freight, and the inventory reductions will be -- will end up being a positive for the year. And a scenario when markets slow, we really don't have any much -- we don't have much in the way of fixed costs to absorb, and the vast majority of our selling expenses tied to variable rep commissions.

And finally, we've got the benefit of $50 million of synergies flowing through the next two years, with a great balance sheet and our ESG profile continues to improve. As we focus our business on the four key pillars of water.

We're going to continue to monitor all this over the coming months. But our takeaway is, that as we look at next year, we think that the overall setup for our business is a lot more half full than half empty and a lot of other years at this point in time. Coupled that with our resilient business model, the Zurn Elkay Business System add a great team. We sit here and believe we can deliver a tonne of value both from the marketplace and to shareholders over the coming years.

With that, we appreciate everyone's time on the call this morning. And we'll open it up to your questions.

[Operator]

[Operator Instruction] Your first question comes from the line of Bryan Blair with Oppenheimer.

[Bryan Blair, Oppenheimer]

I appreciate the perspectives on 2023 setup. And I guess, if we can and maybe offer a little more detail on how your team is thinking about the setup for growth on the non-residential sides are -- of course, interested in your core verticals of education and healthcare and how those projects are progressing as we approach the New Year. And then, the resi-side, I guess the key question is just you know, how much pain is ahead after the channel reset of Q3, Q4?

[Todd Adams, Chairman and CEO]

Yes. Look, I think as we look at non-residential, taken as a whole, you know, institutional is approaching 50% of our overall business. And when you look at backlogs across the country, they're at end near record levels. And when you think about the amount of time that it's going to take for that to roll through the build cycle, it's really all of '23 and probably part of '24. Our quotation levels are continuing to be really good. And so, you know, we believe that the market is going to be up next year, in aggregate.

I think commercial construction will continue to be more mixed. Obviously, the office segment of that is, you know, muted. But we're seeing growth in retail for the first time in 25 years. So, I think that's a really a very hyperlocal game.

So, you might see a lot of activity in Florida and Texas and Southern California and maybe not as much in the Upper Midwest to the Northeast. So, taken as a whole, we think the market is up next year, one to three points. I think we're going to monitor it over the course of the next four months and into next year. But I do think that the market growth in non-residential is going to be there, as well as in waterworks.

And so far as it relates to residential look, we took some of the pain in the third quarter, we're going to take some more in the fourth quarter as more highlighted. But when you take a giant step back, you know, housing is still under built. There is going to be some level of new construction, perhaps it's not at the same level as everyone thought six months ago, but you know, the trend around multifamily which, frankly, is sort of critical in the product lines that we have, things should continue to be strong as people need places to live.

And so, I would say that for the next quarter or two, I think residential is going to be a little dodgy. But hopefully by the time we get to the second half next year, we're sort of on play and it's not as big of a headwind as it was in the third quarter and the fourth quarter and likely will be you know, as we start 2023.

[Bryan Blair, Oppenheimer]

I appreciate that color. And with regard to Elkay and maybe, offer a little more detail on how we should think about the cadences continued 80:20 rationalization seems extremely first half weighted in terms of 2023 impact then on a net basis how should we think about base earnings growth outlook, cross-selling synergies and letting netting against the plan rationalization going?

[Todd Adams, Chairman and CEO]

Yes. I think what we recognized Bryan is that, it's going to be something that we have to over communicate. I think what we tried to do with this morning was basically give you a full form of look at 2022 if we were to have accomplished this all from there. What we'll do prospectively is take that 45 million and that 92 million to 95 million of EBITDA and articulate our results around that. As we go through the quarter we'll obviously have some revenue related to the stuff we're exiting but we'll try to isolate that and articulate how much is left to go, what did we exit in the quarter.

And what you'll see, I think, is the margin profile for that core Elkay business continuing to grow. And so, you'll see the growth in the core Elkay happening real time, quarter-by-quarter. So, it won't be, we'll try to be transparent around of the 485 million what's growing from a market standpoint, what's growing from a pricing input, what's growing from a strategic initiatives and cross-selling opportunity that may show up either on the Zurn side or the Elkay side.

I mean, I think the big takeaway, it's starting '23, is it really is just one business with two additional really, really dynamite product lines that are now structured and being run, like we're running the Zurn business. So, we're going to do our very best to communicate and articulate around that kind of framework as we get into 2023.

[Bryan Blair, Oppenheimer]

Okay. That detail is very helpful. And I guess, just the level set of bit more by how much does your planned rationalization now exceeds the initial deal plan? And then where on the commercial side is there some 80:20 taking place that seems mathematically implied?

[Todd Adams, Chairman and CEO]

Sure. When we made the announcement we said approximately 700 million, Elkay had a budget of roughly 690 million, obviously the backlog reduction and all the noise that we talked about to get to the 600, that sort of happened before we owned the business and obviously, what's happening in real time. When we went to our Board and we evaluated this, we felt very confident that 60 million of revenue with stuff we were going to walk away from in and there was another, call it 60 million under review.

And I think that the details over the last three months have given us that conviction that, that 60 that was under review was really something that we should walk away from. So, when you look at the analysis and the business case and the approvals that we went through, when you look at year three, and year four, our return on invested capital is within 50 basis points of what we had using the base Elkay numbers. And the difference really being nothing to do with the walkaway decisions because we felt like we would be able to do a combination of synergies and reducing fixed costs make that a net positive. It really has to do with that maybe lower starting point than, then maybe the 690.

So, I think our business case is very, very much on track. The push is probably less than six months, when you look at the timing of when we get on the returns on invested capital run rates that we had anticipated initially, relative to where we are today. And that's with -- that's something that we've looked very carefully at because, the returns on invested cash capital deal on the industrial logic, the strategic logic, the financial logic is off the charts and it's -- it probably just gets even incrementally better when you strip away some of the things we're walking away from.

But I appreciate you asking the question, because we continue to see the return targets very much, very much in line with what we said when we hit the deal.

[Operator]

Your next question comes from the line of Mike Halloran with Baird.

[Mike Halloran, Baird]

Just to follow-up on one of the last couple of questions there. So, you're talking about 80 million or so of called revenue having been executed on by the end of the year. And the incremental 35 million or so is what's going to be left to be executed on the front half of the next year as far as a run rate goes. Is that fair thought process?

[Todd Adams, Chairman and CEO]

No. It's a little bit different than that, Mike. So, we think we will get net 25 million by the end of 2022 with the remaining 92 to go in 2020.

[Mike Halloran, Baird]

Was that 25 an annualized number or quarterly number?

[Todd Adams, Chairman and CEO]

No, it is in the quarter.

[Mark Peterson, SVP and CFO]

In the quarter.

[Mike Halloran, Baird]

Okay. So, as I guess I'm confused and -- why wouldn't you be able to annualize that number to get to the 115 million?

[Todd Adams, Chairman and CEO]

[indiscernible].

[Mike Halloran, Baird]

So, you're saying in the fourth quarter, you've called 20, 25 million of revenue or 20 to 25 million revenue, right?

[Todd Adams, Chairman and CEO]

Yes.

[Mike Halloran, Baird]

So, is that an annualized number that represents the annual number? Or is that the revenue that is attached to that fourth quarter?

[Todd Adams, Chairman and CEO]

That is the revenue attached to the fourth quarter.

[Mark Peterson, SVP and CFO]

So, yes. So, [2005] this year, Mike, 115 in total, so you watched 22.9 to 23, there'd be 90 more that would come out in 23 and all - as you walk year-over-year.

[Mike Halloran, Baird]

Right. But what I guess what I'm saying is, if you've got a 20 or so run rate from the fourth quarter, you've executed on the 80 or so because that's the run rate from a full year perspective. And then what you're executing on from remainder perspective is like 35 or?

[Todd Adams, Chairman and CEO]

I think the issue, Mike, is you've got to start at 600, right? When you look at the reported revenues for the year that we saw 90 days ago, it was roughly 600 million. From there, we'll walk away from out of that revenue run rate basis, we'll walk away from 125 or 150.

[Mike Halloran, Baird]

Yes.

[Todd Adams, Chairman and CEO]

So, I think what Mark said is exactly right. The 25 is specific to the quarter. The 90 will come next year off of that $600 million run rate. So, the numbers that we're going to be reporting will have the absolute impact of the walkway that happens in the quarter. Had we done, we could have done it a different way, saying if you would have started 21, it would have looked, maybe more in line with the run rate that you're talking about but since we're doing it from a static starting point, that's the level of walk away.

[Mike Halloran, Baird]

Yes. I actually think we're saying the same thing, just different phrasing I'll take it offline, it's not a big deal.

[Todd Adams, Chairman and CEO]

Yes.

[Mike Halloran, Baird]

So, you talked about the balance sheet being in really good shape, the allocated piece, you feel comfortable that you've made the right kind of strategic decisions to be execute on it. So, what's the willingness to bring stuff in today? How does that pipeline look? And has the environment changed? What that pipeline looks like multiples, anything like that?

[Todd Adams, Chairman and CEO]

You know, I think it's probably very early to say, but I think look, if we look at our pipeline of opportunities, it's pretty extensive and expensive. I think that, we're going through an understanding of, okay, so how do these businesses and their outlooks get impacted by maybe what's in front of us? There are certain things that, you know, are going to convert over the next six to 12 months because they look exactly like what it is we do, we have confidence understanding what the market outlook is like.

So, I think it's relatively unchanged. I think the pace of the integration and the capacity and the team that we've built and have added to over the last six months gives us a lot of confidence that we can continue to do M&A, we think we can do it at the right levels to create great returns. And I think things that fit really, really well inside of our core. And so, I think there'll be a period of time where, expectations need to get reset, we really have to understand in terms of value but I think we're going to continue to do what we've been doing for a long time, which is cultivate things that fit inside of our core transact at reasonable levels and integrate it well and then grow from there.

[Mike Halloran, Baird]

Appreciate that. Last one just under destocking side, based on the positive commentary in the non-residential businesses sounds like there's no destocking needs there, if anything, maybe the opposite. Confirm that one way or another and then also, how long do you think the destocking is going to take to get to the right normalized level of inventory and the channel perspective on the residential side?

[Todd Adams, Chairman and CEO]

So, you're correct. I mean, from a non-residential side there's really not that much inventory at all throughout all the various channels. And so, what we're seeing now is probably a little bit of lead times coming in people being more cautious with order patterns and a little bit of backlog reduction, we think the vast majority of that is behind us in the fourth quarter.

On the non res-side, I think that when you look at residential, I think we're taking a big whack out of it in the third and fourth quarter, there may be a little bit in the first quarter, but I don't think it's material in the grand scheme of things. So, I think we get clean shelf through the demand numbers, late Q1 and in the Q2.

So, I think, our business is not a push model, where we have a lot of stuff on the shelf, it's really a spec pulls through. So, nobody's really procuring this before they need it. And there's really not much in the way of shelf inventory. So, I think, we'll see this channel dynamic changed dramatically, the impact of lead times coming in people being more cautious, I think that's going to be a case-by-case basis.

But all that being said, as long as we're driving specification and preference and we see this backlog continuing to be stronger than non-residential side, I think, you know, the growth rates that we'll deliver are, broadly speaking real time demand.

[Operator]

Your next question comes from a line of Jeff Hammond with Keybanc Capital Markets.

[Jeff Hammond, Keybanc Capital Markets]

Just as we go back to kind of the '23 look, just can you give us a sense of how you're thinking about carryover price, as well as kind of outgrowth momentum in the core?

[Mark Peterson, SVP and CFO]

Yes. In terms of a carryover standpoint, yes, if you think about next year, there's only [indiscernible] obviously go ahead of the pricing gain faster. We didn't allocate, we've made a lot of progress in Elkay back half. So, if you think about pricing, I'd say on the Zurn type product categories. You probably think about a low single digit type number in the next year, given the comps, on the Elkay side, given the fact that our debt capital was a little bit stronger. In the first step, if you think about that as more of a mid-single digit on the Elkay as we're going to blend it together, it's that low to mid-single digit range from a price realization going into next year, Jeff.

[Todd Adams, Chairman and CEO]

At this point, Jeff, we don't really -- we really don't have a view on pushing a lot more price heading into '23. We'll obviously continue to evaluate it. But as is the world sits today with input costs coming down and everything else we've got a -- I would say a sizeable tailwind of lower input costs. And so, we want to leave ourselves the room. If we need to get a little bit sharper on pricing areas, we certainly have the carryover and we certainly have the tailwind. So, if you think about March number in aggregate of low to mid-single digit carryover, we think that the market on the non-risk side is clearly up.

We think res, call it down a touch and then, you know, some outgrowth and so you can find your way to, I think, pretty reasonable growth over the course of '23. How it shakes out by quarter, will be impacted by some of the dynamics that we've talked about. But, you know, it's more -- it's in my comments a little more half full than it is more half empty. When you look at the really concentrated simplified business posts some of these rationalizations.

[Mark Peterson, SVP and CFO]

Yes. And, Jeff, I missed your comment of course I'll mark ultimately, if you think of what we're doing strategically we feel any given year, we're trying to get two to three points, right on the share capture side. So, that we won't feel any different about that vision that we have in the prior years and our ability to execute on strategic growth initiatives.

[Jeff Hammond, Keybanc Capital Markets]

Okay, great. And then, it looks like the water fountain in the commercial sink business grew pretty well. I think you said low double digits, just talk about kind of the order in quoting activity and does that align with kind of the legacy Zurn commercial or just how's that trending?

[Todd Adams, Chairman and CEO]

Commercial things, yes. I think it looks very similar to that element within our -- with our Zurn business raised on our product categories and it would -- we've seen already the power of having both brands in our portfolio. So, I think, from a growth standpoint, that category both brands so our low double digit growth in the quarter for sure in the third quarter. We expect that to be very similar in the fourth quarter.

[Jeff Hammond, Keybanc Capital Markets]

Okay. And then, just last one. I mean, certainly with some of the Elkay resets the stocks been under some considerable pressure here. Just how are you thinking or you have you revisited share buybacks as a use of kind of cash for free cash flow generation?

[Todd Adams, Chairman and CEO]

We have. We have -- what's the number, roughly 200 --

[Mark Peterson, SVP and CFO]

Yes, 168.

[Todd Adams, Chairman and CEO]

-- 168, 170 million left on our repurchase plan. We also have, a year of very, very strong free cash flow ahead of us. And so, the combination of all of that, you can work your way to a leverage number of a half a turn by the end of next year --

[Mark Peterson, SVP and CFO]

Without doing anything.

[Todd Adams, Chairman and CEO]

-- without doing anything.

[Mark Peterson, SVP and CFO]

Yes.

[Todd Adams, Chairman and CEO]

And so, as we talked a little bit earlier, we've got some M&A that we want to do, we want to keep the balance sheet pretty conservative as we go through this period of uncertainty. But share buybacks should we feel appropriate are definitely on the table.

You know, we're confident in our ability to execute in '23 and '24. And if we see, you know, a situation that is a dislocation, at least in the near term, I think there's a chance that we may do something. I think the other part of it is, I think as we scale the business, we'll probably revert to a more balanced return of capital to shareholders through M&A, dividend and stock buyback just like we did prior to the RMT.

And so, I think we're probably a quarter away from that in the moment. But I think that's definitely on the table. We do have the capacity to do that with the kind of cash flow and balance sheet profile we have.

[Operator]

Your next question comes from the line of Nathan Jones with Stifel.

[Nathan Jones, Stifel]

I want to ask a question on around the stickiness of pricing. You obviously had a lot of inflation flowing through this year. You talked about monetizing some higher priced inventory late this year, early next year, which I guess implies that you have some lower priced inventory coming along. How sticky do you think pricing is likely to be from the price increases that you've already put through now in a deflationary environment? And how accretive could that be to margins in 2023?

[Todd Adams, Chairman and CEO]

Yes, it's very sticky. I think, you know, when you look at specified cleaning products, the pricing is sticky. And I don't recall a scenario in the 15 years, I've been around the business where it has not been. That being said, you know, project-by-project, opportunity-by-opportunity, you have to be aware of what's happening amongst the competitive set. And we've seen a very early market to-date, we would expect that to continue.

And so, you know, if it plays out where the prices continue to be sticky. And we're selective where we choose not to be. There is a sizeable tailwind coming through with lower input costs. And so, we've left ourselves the room in the way we've thought about 2023 to see a position to do that, but it's our position that the pricing is sticky.

And if you look at inflation that we've passed through relative to other products that go into non-residential construction, if anything, we've fallen down to afraid of because we haven't seen the doubling of prices, in some categories and our price increases have been really to offset some of the input costs that we've managed really well.

But based on our model, we don't have the fixed costs. We're not mine spot commodities. we are -- we're well positioned to capture that tailwind. And when you think about what that could mean to margins, it's significant. Even without all of that and some of it, we may see pretty strong margin accretion into next year on a maybe not even a double digit growth sort of level. So, I think our business model is built for this kind of environment.

[Nathan Jones, Stifel]

Thanks. I had a couple of questions around Elkay. So, I would assume that the revenue that you're exiting would have been lower growth than the revenue that you're maintaining. I think you'd already targeted Elkay over the long term to be a double digit growth kind of business. Does this increase the expectation other long term outside of any 2023 market disruption for the growth profile of Elkay?

[Todd Adams, Chairman and CEO]

I don't know that we would sign up to increasing that. But I think when you look at the categories that really now make up and constitute the core Elkay. We absolutely think drinking water has a longer term secular growth trend above what we have. And as Mark pointed out with the relative market share we have in commercial things, we have a terrific opportunity to outgrow the overall market just because of the size, scale, presence, and spec nature of that category. And so, I think, maybe the way to think about it is a much, much higher degree of confidence around that kind of outgrowth as opposed to increasing the absolute outgrowth.

[Nathan Jones, Stifel]

And then just last one. The exit of the residential things business, I would assume comes with a fair amount of inventory liquidation. Can you talk about the cash generation that you should see from the exit of that business?

[Todd Adams, Chairman and CEO]

Yes. It will be sizable. Obviously, the inventory investment to support that portion of the business was not generating much of any profit was outsized relative to the inventory positions, in what is core. And so I think it's, you know, at least 45 million as we liquidate those inventories and likely more.

[Operator]

Your next question comes from the line of Joe Ritchie with Goldman Sachs.

[Vivek Srivastava, Goldman Sachs]

This is Vivek Srivastava on for Joe Ritchie. Thanks for the question. Not to beat a dead horse here but the 90 million that you exit next year on Elkay as even most of it is first half. Is that the right way to think that 20 million goes away in fourth quarter '22 and then 45 million each goes in first and second quarter of '22. So sequentially, basically, like 25 million higher exit inventory '23 was of the fourth quarter '22?

[Mark Peterson, SVP and CFO]

I think the way, the way Mike was talking about is, I think more accurate, right? You got 20 in this quarter as a $20 million impact with five last quarters turning in the back half. Those actions they do annualize, right? So, as you think about the walk, yes, as I said in the walk, you got a $90 million impact year-over-year, but a big chunk of the actions have taken place as you start analyzing those numbers.

And I think Mike was describing this as accurate so. The annual walk is laid out as intact, but a lot of the actions are taking place right now that will drive the incremental impact next year in the really more so in the first half of next year I've laid out.

[Todd Adams, Chairman and CEO]

Yes. I think, maybe to make it very simple, before any market price or strategic growth initiatives, run rating Q1 at 120 million and Q2 at 120 million and Q3 at -- that's the base before we do anything.

[Mark Peterson, SVP and CFO]

Correct.

[Todd Adams, Chairman and CEO]

As we walk away from this. That's the part I talked about. We're going to try to isolate that and communicate around what is that 120 million growing year-over-year? How is -- what are the margins related to that? And then we'll give you what we walked away from and the impact of that but that's really the way to think about it.

[Vivek Srivastava, Goldman Sachs]

Thanks. That's helpful. And I have a question on free cash flow. I think the color you provided on inventory liquidation. That is helpful anything else from the SKU rationalization, which will impact your FCF conversion. And how should we think about your free cash flow conversion longer term?

[Todd Adams, Chairman and CEO]

Well, I think specifically as it relates to the fourth quarter, we're going to see free cash flow in the $90 million to call it $100 million range. If we think about 2023 we think that the inventory reduction across the enterprise is going to be sizable. And so free cash flow next year should be I would say outsized relative to this year.

And then, you've obviously got that liquidation factor that is going to be permanent. And so, I don't think there's anything unusual. We've obviously got to pay for some of the restructuring and things like that to get these $50 million of synergies that we've signed up for. And see, but nothing else is, other than I think free cash flow next year should be very, very, very strong.

[Vivek Srivastava, Goldman Sachs]

Thanks. And then I've last one on revenue synergies quickly. Are you already starting to get some traction here and maybe, just if you can provide some color on what are the opportunities on this front and any color and timing on this?

[Todd Adams, Chairman and CEO]

Yes. I mean, we're in the throes of it right now. When you think about some of the S-4 and her funding as it relates to secondary education, you know, we're immediately adding the conversations not only around drinking water, but also around our bright shield offering. And so, we've targeted 25 school districts around the country where we're, you know, doing all the work to get at some of those funding and we're seeing that convert real time.

And so, we're leading with drinking water and then I think we're in a position to pull through some of the other more hygienic products or vice versa, where we've had a good conversation started with some school districts around creating more hygienic spaces we're not pulling through the drinking water.

The opportunity around filtration that we highlighted initially is significant. The filtration opportunity amongst the combined business over the next several years, is $50 million to $75 million of growth at very, very high margins. And so, the commercial teams are already engaged in the field on some of these things. We're going through our strategic plan on how we deploy those. But I would say that the case of bringing these two businesses together and being able to provide even more specified content to customers is working.

[Operator]

Your next question comes from the line of Brett Linzey with Mizuho.

[Brett Linzey, Mizuho]

I just want to come back to this 70 million of retained Elkay resi revenue that you're selling through the existing channels. Are these pieces closer to the corporate average, are these revenue pools that are maybe still under earning or makes negative that you think you can, you know, enhance the profitability over time and maybe review in a future date?

[Todd Adams, Chairman and CEO]

I think that they come in a little bit below the fleet average. But you know, these are with our course wholesale customers. They are Elkay branded. They do have an element of conveyance with other products. So, these are in sort of professional grade plumbing, showroom type of products.

And so, there's just without question, as we bring the two companies together, the opportunity to eliminate SKUs, work on continuous improvement to drive that up. I don't know that there's a meaningful price opportunity. But there certainly is cost opportunity as we bring the two companies together. And I think as you look at that, consolidating, manufacturing, simplifying the SKUs, combining the spend and really focusing on manufacturing all these in a more efficient way, should drive the margins closer, if not to the fleet average over time.

That was the calculus in terms of why we decided to stay in. I mean, it was branded products that have conveyance that we can improve the margins on and fit with our overall go-to-market, you know, through specification, third party reps, wholesalers that we're strategic partners with and things and like. The other stuff, really was totally detached and had a lot of resource and a lot of inventory tied up in it. And it was never going to be -- it was never going to be the kind of returns business that we wanted to create when we put these two together.

[Brett Linzey, Mizuho]

Yes. That makes a tonne of sense. And then just my follow-up, sounds like you're progressing well on the integration efforts. Just in terms of the phasing of some of those savings and how that might have, you know, now changed relative to earlier expectations. I mean, you think those ramp a little bit quicker here and, you know, Q4 and early '23. And just curious if there would be a change in any of the normal seasonal margin realization than you would typically see on a quarterly basis as you pull in these synergies, maybe a little bit earlier next year and these rationalization efforts start to ramp up.

[Todd Adams, Chairman and CEO]

Yes. No, I think we're going to hit the ground running in 2023 with the synergy realization as a result of I think the significant work we've done around on creating these as product lines and moving on some of the -- you know, costs that we had line of sight to, I'll leave it to Mark and Dave to communicate. I mean, obviously, you know, our seasonal patterns. Our first quarter is generally lower than our second and third. And our fourth is as well, based on the weather patterns in non-residential construction.

So, I think they'll all be amplified by margin perspective relative to where they've been solely because of the synergies that we're going to generate, but I don't know that it's outsized at any one quarter relative to the next.

[Mark Peterson, SVP and CFO]

Yes. That's fair. We'll obviously provide more colors at the close, but right now, it's you know, we wouldn't say that it's overweight back out or the way front, I think that a lot of the actions are occurring now what we feel pretty good about being at that run rates going into next year. So there isn't really an outsize related --

[Todd Adams, Chairman and CEO]

It will be incremental to each quarter, I think is probably the way to think about it.

[Operator]

And at this time, there are no further questions. Are there any closing remarks?

[Todd Adams, Chairman and CEO]

Yes. Thanks everyone for joining us on the call today. We appreciate your interest in Zurn Elkay Water Solutions. And we look forward to providing our next update when we announce our December quarter results in early February. Have a good day.

[Operator]

This concludes today's conference. You may now disconnect.