Zurn Elkay Water Solutions Corp
F:4RX0
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Zurn Elkay Water Solutions Corp
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Good morning, and welcome to the Rexnord Fourth Quarter Fiscal 2018 Earnings Results Conference Call with Todd Adams, President and Chief Executive Officer; Mark Peterson, Senior Vice President and Chief Financial Officer; and Rob McCarthy, Vice President of Investor Relations for Rexnord.
This call is being recorded and will be available on replay for a period of 2 weeks. The phone numbers for the replay can be found in the earnings release the company filed in an 8-K with the SEC yesterday, May 14.
At this time, for opening remarks and introduction, I'll turn the call over to Rob McCarthy.
Good morning, and welcome, everyone. Before we get started, I need to remind you that this call contains certain forward-looking statement 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 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. We urge you to review the GAAP information in our earnings release and in our filings with the SEC.
Please note that the presentation of our operating results includes adjustments to GAAP reporting for the impact of the RHF noncore product line in our Water Management segment that we exited during our fiscal 2017 in order to enable investors to better understand and assess our continuing core operating results. This is the last quarter in which the RHF product line exit will have an effect on our year-over-year comparisons.
Today's call will provide an update on our strategic execution, our overall core performance for the fourth quarter of our fiscal 2018 and our initial outlook for our fiscal year 2019. We'll cover some specifics on the 2 platforms, covered by selected highlights from our financial statements and our cash flow. 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.
Thanks, Rob, and good morning, everyone. As you hopefully saw in our release last night, our fourth quarter results capped what was a strong year for Rexnord. With our core growth accelerating through the year, our adjusted EBITDA exceeding our guidance and our free cash flow growing 33% year-over-year to $188 million. We're seeing reasonable growth in most of our served end markets, and more importantly, our organic initiatives around innovation, cost reduction and commercial excellence are beginning to read through.
Incremental to that and as we've been previewing with you the past couple of quarters, this morning will take you through the next phase of our supply chain optimization and footprint repositioning initiative, one that will reduce our structural fixed cost by another $15 million over the next year with a very high return and with less complexity than SCOFR 1... Finally, we're initiating our financial outlook for fiscal '19 that includes the decision to prioritize our focus within the Water Management platform around our Zurn business and exit VAG.
Our outlook for fiscal year '19 includes: mid-single-digit core growth, both acquisitions and currency will be on top of that; EBITDA in the range of $420 million to $440 million; and another year of robust free cash flow. Again, just for clarity, our guidance excludes VAG, which we think will generate about $230 million of revenues with a high single-digit EBITDA margin over the next year.
Looking at the fourth quarter in isolation, sales were $575 million, including core growth of 7%, and were up 14% on a reported basis and were at the higher end of our expectations for the quarter. We sustained 6% core growth in our PMC platform, and the core growth in our Water Management platform accelerated to 8% and 7%, excluding VAG. We were able to leverage that growth in the 13% adjusted EBITDA growth, which increased to $111 million. A strong incremental margins in PMC led the improvement. Adjusted EPS in the quarter was $0.42. Mark will review both the consolidated results and the performance of each platform as part of his comments a little later in the call.
If we can turn to Slide 3. Looking at our operating platforms, our PMC platform had a strong quarter with order and revenue growth across most of our process industry, consumer industry sectors as well as our aerospace end markets. We also experienced an acceleration in the sell-through of our products through our distribution channels as we wrapped up the year and to start fiscal year '19.
We continue to aggressively move the ball forward with our DiRXN digital strategy, and customer feedback is validating our significantly differentiated and practical approach to the industrial Internet of Things. In fact, we intend to accelerate the pace in which we are introducing additional categories of products that can be easily plugged into a customer's existing control system and, thereby, immediately enhancing the customer's process reliability and productivity with minimal incremental investment.
Our success with our commercial excellence initiatives in the fourth quarter enabled us to exceed our fiscal year target or 50% growth in first-fit wins to right around $50 million, which is our third year of traction on this key initiative to drive long-term market share. As we win a stronger share of initial specifications, which we can, in turn, leverage into a growing share of MRO requirements as our components wear and use and our service can replace multiple times over the life of the customer's application.
PMC margins were solid as adjusted EBITDA margin improved 150 basis points year-over-year to 23.8%. Margins benefited from past SCOFR actions and our core growth, delivering a core incremental margin exceeding 60% for the quarter. Centa, which we acquired in February, delivered good results over the partial quarter, and I'll provide an update on our early progress there in just a few minutes.
Results in our Water Management platform were solid with fourth quarter core growth, excluding VAG, at 7% as contributions from our innovation pipeline continue to accelerate. We continue to see positive underlying trend in Zurn's primarily North American nonresidential construction markets, particularly within the institutional verticals, and we continue to invest in core product and adjacency innovation while the digital initiatives are beginning to accelerate within Zurn.
Our free cash flow finished the year strong, increasing to $188 million and delivering another year of conversion in excess of 100% of net income. At the same time, our leverage ratio declined to 2.7x EBITDA, inclusive of the Centa acquisition in the quarter, and demonstrates our ability to execute a disciplined acquisition strategy while maintaining our leverage ratio in the 2 to 3x range.
Overall, we finished our fiscal 2018 with another year of steady operational execution, strong free cash flow and improved [ trajectory ] on innovation, growth and cost reduction and completed 2 very complementary strategic acquisitions that expand our addressable markets and then offer substantial value-creation opportunities as we deploy the Rexnord Business System.
Before I move on to the next slide, hopefully, many of you recall last year, that we modified our approach to external financial guidance at the start of the year, focusing on core growth, adjusted EBITDA and free cash flow, all in an annual basis and then updating any change to those elements as we report earnings throughout the year. From an approach perspective, we also made a concerted effort to start each year with an appropriate amount of conservatism built into these elements of guidance. Given that our objective, both then and now, is to provide what we hope investors appreciate, projections that are meant to be somewhat durable over the course of the next 12 months. The way to interpret this year's outlook is that we've intended to do the very same thing as we start our fiscal 2019, which extends to March of 2019.
With that, please turn to Slide 4. As we disclosed in last night's release, we plan to focus and prioritize our Water Management platform around our Zurn operations that provide an enhanced water quality, safety, flow control and conservation in primarily North American nonresidential building applications. As a result, we have initiated a process to divest our VAG operations that serve global water and wastewater infrastructure markets. After a thorough review, we decided that VAG does not have as strong strategic fit as was contemplated when it was acquired during our time as a controlled company, and we have concluded that shareholder's capital is more productively deployed elsewhere.
VAG has significant capabilities in Europe, China and the Middle East, a globally recognized brand and an experienced and dedicated team that we're confident makes it an attractive business to both strategic buyers as well as financial buyers. We're not going to say much more in the planned divestiture, given that the sale process is underway, and we'll provide more updates as we're able. We expect to report VAG operating results as discontinued operations when we report our first quarter, and we're targeting a transaction in the first half of our fiscal 2019 with the proceeds available to reduce our financial leverage and enhance our strategic flexibility.
One effect of our updated strategy for the Water Management platform is that investors will now have a clearer view of the growth and profitability characteristics of our Zurn business. Zurn is a leader in the specification-grade plumbing products market in North America with a strong competitive position in later-cycle institutional markets, which are currently strengthening. In our fiscal 2018, Zurn delivered $610 million of revenue with core growth of 4% and closer to 6% in the second half of the year. For the full year, adjusted EBITDA margin increased by 120 basis points year-over-year to 25.1% while absorbing increased investment in our innovation pipeline and including development work on making our products digitally connectable.
The slide highlights 4 important new product launches of Zurn that occurred in our fiscal 2018: first being a new series of stainless steel backflow devices for compact installations types; second, our installation timesaving EZ1 lineup of floor drains; our contractor-friendly expansion PEX system; and finally, the Sundara line of solid surface integrated handwashing systems. These products all contributed to Zurn's core growth in fiscal '18, but we expect a more significant impact in our fiscal '19 as more model choices are becoming available and stronger channel inventories are broadening the product availability.
Additionally, we began putting Smart ID Tags on most of Zurn products during the year in order to bring the same, enhanced convenience and productivity to Zurn customers that we're delivering to PMC customers through our DiRXN initiative. Our initial designs of fully connected valves are in field test, and we expect to begin commercial shipments during our fiscal 2019.
Turning to Slide 5, I'd like to review the next wave of actions within our strategic Supply Chain Optimization and Footprint Repositioning initiatives. We're calling this SCOFR 2.0, and we have already launched certain actions in our fiscal 2018. We plan to invest a total of approximately $20 million and expect to structurally reduce our annual fixed cost by $15 million. These set of actions will affect both platforms, and we expect our adjusted EBITDA to include a modest net positive contribution in our current fiscal year 2019 with most of the earnings benefit accruing in our fiscal 2020. On the slide, you can see an artist rendering of our new Aerospace Center of Excellence, which is currently under construction and represents the largest single investment in the current set of actions.
Turn to Slide 6. Let me briefly highlight the impact of this new facility that we expect will deliver value to both our customers and shareholders. The facility is not -- designed to operate as an entirely digital environment with integrated processes that will link initial product development to the order process, the product engineering and onto the plant floor for manufacturing, assembly, inspection and shipment. This closed loop set of digital processes will enhance our customer's operating productivity by promoting and simplifying joint collaboration in design and engineering and by eliminating inefficiencies and ensuring accuracy through the value chain. Besides the facility itself, the investment also includes advanced manufacturing and material handling techniques that we expect will enhance asset utilization, reduce product development and order lead times and, ultimately, deliver best-in-class customer satisfaction.
The slide includes an aerial photo from about 1 month ago, which you might not be able to tell that the manufacturing space is fully enclosed, and we've been installing and programming equipment and developing production and assembly cells in order to ensure a smooth transition as we move into the facility later this year and begin to deliver the targeted benefits in our fiscal '20. Other initiatives involving product line simplification, reconfiguration of plant layouts and facility rationalization within SCOFR 2.0 are also underway, and the Rexnord Business System supports our confidence that we can deliver the targeted benefits on the identified time line.
Moving to Slide 7. Let me bring in a quick update on our 2 recent acquisitions, Centa in our PMC platform and World Dryer in our Water Management platform. As you may recall, we closed the Centa acquisition in February, adding about $100 million of annual revenue and a leading position in the global market for torsionally soft flexible couplings that are used to protect the power source and downstream components in engine-driven applications. Centa has no overlap with our existing product lines, broadens our end market diversification and our addressable markets and generates the majority of its sale from MRO requirements in its large installed base. Integration is well underway and though -- and through our initial deployment of RBS, they're validating the significant margin expansion and growth synergies that we identified during our due diligence. We're off to a good start at Centa, which contributed 5% to PMC's growth in the fourth quarter with its margins ahead of the year earlier quarter.
Moving on to Water. We acquired World Dryer in October, and our experience there is also validating our investment case. The integration is mostly complete, and the customer base is receptive to a more aggressively managed and innovative competitor and to the value of sourcing more commercial washroom content from a single supplier. Margins are in line with the Zurn average, and we're continuing to use voice-of-the-customer inputs to guide our simplification of World Dryer's previously overcomplex product line in order to free up and enhance productivity, improve customer experience and free up incremental resources to support product development and innovation.
Before I turn the call over to Mark, I'll briefly touch on the price/cost equation that's probably at the top of most people's minds. I'll start by saying that, inherently, our fundamental business model performance are very well in periods where we see inflation with the very high like-for-like aftermarket element of PMC sold through distribution, discipline and practices that allow us to increase prices in a matter of days or weeks on a very targeted basis, a well-developed, high-performing supply-chain function with true global reach and not to mention best-in-industry brands and the broadest portfolio of component products with true pricing power, which applies both to PMC and Zurn.
Finally, by leveraging the Rexnord Business System, we get a near real-time view of trends and countermeasures that we're confident keep us in front of the price/cost curve because it's being actively managed every day and is actually something we expect to work in our favor over the course of fiscal year '19. So we're not taking it lightly. And as we look out a year, we're going to continue to stay ahead of the curve with what is likely a SCOFR 3.0, but only as we wrap up SCOFR 2.0 by late this year and into early fiscal 2020.
With that, I'll turn the call over to Mark
.
Thanks, Todd. Please turn to Slide #8. On a consolidated basis, our fourth quarter of fiscal '18 financial results were certainly ahead of our expectations: our core sales increased 7% on a year-over-year basis, our adjusted EBITDA increased 13% from the prior year fourth quarter to $111 million and our adjusted earnings per share increased by 20% to $0.42. For the full year, our total revenue grew 8% with core growth improving to 5%, adjusted EBITDA increased 13% year-over-year to $390 million and our margins increased by 70 basis points to 18.9%. Adjusted EPS increased to $1.39.
Let's turn to Slide #9. Our outlook for fiscal '19 incorporates mid-single-digit core growth -- sales growth and 9% to 14% growth in our comparable adjusted EBITDA to a range from $420 million to $440 million, and we expect to deliver another year with free cash flow ahead of net income. Please note that our outlook excludes our VAG operations, which we anticipate reporting in discontinued operations when we report the upcoming first quarter of our fiscal '19.
Moving to Slide 10, here, representing a bridge to the midpoint of our fiscal 2019 outlook for adjusted EBITDA. As you see on the slide, the jumping off point to the adjusted -- for the required adoption of our -- in our fiscal '19 on accounting standard that changes the P&L geography of certain pension accounting items and requires a restatement on the prior year to report each quarter was an overall annual drag of approximately $3 millions to our fiscal '18. In addition, we are removing VAG from the FY '18 reported EBITDA number as our fiscal '19 outlook excludes the VAG operations.
The key elements of the bridge include the incremental year-over-year benefit from the fiscal '18 acquisitions of Centa and World Dryer and overall net increase in our EBITDA from our operations. As Todd highlighted in his earlier comments, we are following the same approach we established last year with respect to our annual outlook and that is to provide an outlook that is meant to be durable over the course of the 12 months.
Turning to Slide 11. We summarized our consolidated results for the quarter.
Let's move on to Slide 12 and discuss the first of our 2 operating platforms, Process & Motion Control. In PMC, total sales increased 15% year-over-year with core sales growth of 6% in the fourth quarter, in line with PMC's core growth in the third quarter. Currency translation added 4%, and the acquisition of Centa added 5%.
PMC experienced solid growth in the aerospace end market and in most of the process industry and consumer facing end markets during the quarter, and we saw improving growth in our distribution channels, including a flow-through of somewhat stronger retail sell-through in North America.
In the top right corner of the slide, you can see the end market assumptions that support the outlook for mid-single-digit core sales growth to PMC as incorporated into our fiscal '19 guidance. Our fiscal '19 outlook assumes positive growth across PMC's primary end market, from the process, consumer industry and aerospace sectors and in our distribution channels.
PMC's EBITDA and margins were certainly ahead of our expectations as adjusted EBITDA increased 22% year-over-year and margin improved year-over-year by 150 basis points to 23.8%. PMC benefited from strong operational execution, pricing was positive and we were successful in managing the modest impact of material cost inflation in the quarter.
The structural benefits from the first wave of our Supply Chain Optimization and Footprint Repositioning initiatives were fully reflected in PMC's fourth quarter results, and the first half of our fiscal '19 will benefit as we fully annualized the benefits of SCOFR 1. As Todd discussed, we also expect to be somewhat modest net benefit in our fiscal '19 for the second wave of SCOFR actions while we fund the incremental investments we are planning to further accelerate the introduction of our more digitally connected product families as well as [indiscernible] opportunities.
We're also aggressively managing our input cost. We're confident in our ability to stay in front of the price-cost curve. So on a net-net basis, we're confident that PMC can deliver additional margin expansion in our fiscal '19. As you expect, PMC's margin is expected to decline sequentially in our first quarter, reflecting normal seasonality and lower absolute dollar value core sales when compared with our March quarter.
I'd also like to provide a brief update on the progress that we have achieved with our digital customer productivity platform that was formally launched a year ago this month. In our first year of implementation, we successfully launched and built out our DiRXN digital portal through which our customers can improve their productivities as they manage their entire life cycle with our projects in a digital environment. We're handling a growing share of our customer interactions and transactions through this platform, where customers can access technical files and other engineering resources, configure product to fit an application, quickly acquire pricing and delivery information, place an order and later register product and access how-to videos as well as maintenance support. The majority of PMC's products are now being shipped with Smart ID Tags that provide instant, on-the-spot access to all the support and to the e-commerce portal, where you can order a replacement when necessary.
In our fiscal 2018, we successfully launched connected versions of our flagship V-Class gearbox, and PMC met their initial targets for commercial orders across a range of end market applications. As Todd discussed earlier, we expect to introduce digitally connected versions across several other product categories during our fiscal '19.
We're also leveraging a common digital architecture at Zurn in support of tags and connected products. Zurn has expanded its e-commerce capabilities. It now has digital capabilities in place to support [indiscernible] products as well.
Let's turn to Slide 13 and discuss our Water Management platform. During our fourth quarter, our Water Management platform delivered a 13% net sales increase. That was a function of 8% year-over-year core sales growth, a 2% contribution from World Dryer and a 3% contribution from foreign currency translation. Top line result is in line with our [indiscernible] expectations and benefited from high single-digit year-over-year core growth at both Zurn and VAG.
In our fourth quarter, sales of Zurn commercial grade plumbing products increased by 7% on a core basis, plus a 2-point contribution from the World Dryer acquisition. Zurn's growth benefited from the launch of several important new products during the year, including those profiled earlier, as well as Zurn's new threshold and elevator drain system as pictured on this slide.
As illustrated by our underlying end market outlook, we expect Zurn's momentum to carry into our fiscal '19, and we feel confident that Zurn can deliver mid-single-digit core growth in what is shaping up to be another strong year for U.S. nonresidential construction activity. Although the year-over-year comparisons for Dodge preliminary estimates for U.S. nonres start weakening in the March quarter. The Dodge Momentum Index, which measures projects in the design space and development and the leading indicator for starts, has resumed its upward trend in March and April.
Turning to VAG, our product-oriented business serving water and wastewater infrastructure markets. Fourth quarter results include high single-digit core growth, the adverse project mix when compared to our expectations coming into the quarter. Water Management's overall EBIDTA margin was modestly below our expectations for the fourth quarter, as the benefits from volume growth in the quarter and a positive price/cost gap were more than offset by the adverse mix of VAG ,which is amplified by the stronger euro, plus higher incentive compensation accrual and accelerated investments in our innovation initiatives. For the full year, Water Management adjusted EBITDA margin was up 20 basis points, driven by the 120 basis point increase delivered by Zurn.
We remain confident to Zurn's ability manage rising material costs through a combination of material cost actions, supply chain management and selected price increases, and we anticipate a favorable growth environment to support additional margin expansion for Zurn in our fiscal '19.
Moving to Slide 14. You can see the chart at top left that our financial leverage, as measured by our net debt leverage ratio, benefited from a strong free cash flow and declined to 2.7x despite closing the Centa acquisition in the quarter.
For the full year, we delivered free cash flow of $188 million. Our short- term liquidity remains robust. We refinanced our debt during the year to reduce interest expense and extend maturity, and our forward outlook supports our expectations for free cash flow to grow further in fiscal '19. Given our expectations for free cash flow to expand in fiscal '19 and given our strong overall liquidity, we believe we have ample resources to continue to execute our bolt-on acquisition strategy while maintaining our leverage ratio in a range between 2 and 3x.
Before we open the call up for questions, I'd like to comment on our accounting for VAG and speak to our restructuring expenses and our effective tax rate as well as call your attention to the slides in the appendix to our earnings presentation. First, our fourth quarter included $111 million impairment charge to eliminate goodwill associated with the VAG operations as a result of our plans to pursue a potential sale of the business. As we discussed, we anticipate reporting VAG as discontinued operations in our first quarter of fiscal '19. Second, and in terms of our cost-reduction initiatives, we anticipate total restructuring expenses of $11 million to $13 million in our fiscal '19. We saw [indiscernible] severance costs and will be excluded from our adjusted operating results.
Next, our effective tax rate will fluctuate by quarter, given variable pretax income as well as the timing of our planning initiatives. We anticipate our fiscal '19 adjusted net income will incorporate an effective tax rate of approximately 29%. Excluding our VAG operations, we were anticipating effective tax rate of approximately 26% for fiscal '19. But during our continued analysis of the new tax law, we determined that we will be adversely impacted by a provision in the new tax law known as GILTI, or Global Intangible Low Tax Income, that will increase our effective rate by approximately 3 percentage points. Long story short, this provision was intended to tax foreign earnings in the U.S. that were in tax jurisdictions with a rate at or below approximately 13.1%. While we do not have any foreign earnings in that type of jurisdiction, the way the law is currently written, we, and other companies with a similar profile, have gotten caught up in the section of the new law, and as a result, certain foreign earnings are now also getting taxed in the U.S. Over time, we expect to identify discrete tax planning strategies that can help reduce our effective tax rate. With respect to our first quarter, we anticipate tax rate of 30% to 31% to be applied to our adjusted net income.
Turning to slides in the appendix. First, we've included certain other assumptions incorporated into our guidance for fiscal '19 on a separate slide. I need to remind you that our guidance excludes the results of VAG going forward, the impact of potential acquisitions, including potential accounting gains or losses, and future nonrecurring items, such as restructuring costs. Second, we've included [indiscernible] the fiscal '18 platform sales, excluding our VAG end markets, broken down by served end markets and by geographical location and pro forma to include our acquisition of Centa and World Dryer. Third, we've attached a reference table to help you determine the appropriate incremental quarterly share contribution, modeling our adjusted earnings per share under the if-converted method, if applicable. As you're aware and as illustrated on Slide 16, the if-converted method was dilutive to adjusted EPS by a $0.01 on our fourth quarter, but was not dilutive for our full fiscal '18 and, therefore, did not apply. Lastly, we included schedule of pretax and after tax impact of future adjustment in our calculation of adjusted net income, plus the reconciliation tables related to adjusted EBITDA and adjusted earnings per share that are included in our earnings release each quarter.
With that, we'll open the call up for questions.
[Operator Instructions] And our first question is from Jeff Hammond from KeyBanc Capital Markets.
So just -- I think you highlighted the aerospace piece as part of SCOFR 2 and PMC. But can you just talk about the split between Zurn and PMC in terms of the spend and savings for SCOFR 2.0? And then just as you look at Zurn on a standalone margins, very good out of the gate as we see them alone. What's kind of a long run margin opportunity for Zurn from your perspective?
Sure. The way to think about the split between the cost and the benefit amidst the 2 platforms, it's probably 2/3 PMC, 1/3 Water Management, both on the cost and the benefits side, Jeff. And in terms of the long-term margin runway, we continue to see, I would say, reasonable demand. The combination of that with the SCOFR reductions and ongoing new products, we think, gives us runway for a bit. And I don't know, the top is another 200 basis points or another 300 basis points. But clearly, the business is performing well, and the things we're doing around the cost structure as well as with new products, we think, give us pretty good confidence in our ability to continue to expand margins over time.
Okay, great. And then how should we think about incremental margins in PMC within the fiscal '19 guidance?
Jeff, this is Mark. I think the incrementals, well, we talked about PMC in the past being 30% to 35%. I think on a core basis, still see us a little better than that on SCOFR 1 benefit coming through and some early benefit from SCOFR 2. So think about incremental above that 30% to 35% range for the full year in PMC, Jeff.
And Jeff, you'll recall, the margins will be more pronounced in the first half of the year as we pick up the full run rate in our first half. And so that's what's driving the incrementals for the year, but it's more front half of the year-weighted.
Yes. And [indiscernible] core [indiscernible] incrementals Jeff, yes.
Correct, correct.
And what's the carryover savings from SCOFR 1 that goes into PMC and into fiscal '19?
Approximately $7 million, and the majority of that in the first half.
Our next question is from Mig Dobre from Baird.
Yes. If we can, I'd like to talk a little bit about VAG and maybe kind of doing a little bit of a postmortem of fiscal '18. Obviously, this business has been uneven through the year and EBITDA contribution is lower than the way you're kind of talking about the business contributing into fiscal '19. So I guess 2 questions, maybe some color as to what happen in fiscal '18. And then it looks like Zurn has performed maybe better than you were initially expecting to be able to sort of crowd out the noise from VAG. What kind of happened there? And how sustainable is that performance?
Mig, in terms of the performance of each of the pieces, I'll step back and say VAG had an uncharacteristically difficult sort of second half of the year, really driven by, I think, a couple of decisions that we've made to accelerate some restructuring pull-forward [indiscernible] recognize some cost over the course of our second half and into our fiscal '18 to really set us up to think about what the business could look like on a clean basis into '19, and that's where we -- my initial comments, we talked about high single-digit EBITDA margins where it had been, if you look back over time, and actually probably a little bit higher in particular years. And so the run rate into '19 is clearly supportive of that high single-digit rate, and we did some, I would say, modest cleanup of different things that would result in the margins in our fiscal '18 probably being depressed relative to the underlying historical and projected performance. If we look at Zurn, the way we've run the business for a long period of time has not really surprised us in anyway. So I don't think it surprised us to the upside. It's sort of tracking very much with what we expected. It was just difficult to see when you had the VAG business aggregated with it in terms of performance quarterly, in terms of growth and also levels of profitability. So I think we're optimistic that with more focus and probably some more investment, both organic and inorganic in Zurn, we've got what we think is a best-in-class Water Management platform. And we also think that VAG is an attractive asset, given its global footprint brand and reputation. So we're -- we think we're making the right decision and excited about the future.
I see. And then maybe to ask Jeff's margin question differently. The incremental margins at Zurn, how do we think about that going forward? Because you've got quite a bit of margin expansion in fiscal '18. That's why I am asking.
I think the way to think about fiscal '19 that would be embedded in sort of the outlook we've given is sort of 25% to 30%.
On incrementals, okay.
Let me just add to Todd's comment. That range has been historically true. This year, I'd say we could probably tend to be in the mid to higher end of that range from an incremental standpoint.
Got it. And lastly for me. Obviously, there is going to be some capital generated here with the sale of VAG. How do you think about capital deployment beyond delevering the balance sheet? I guess I'm wondering what's sort of the balance between M&A or potentially removing some of the dilutive impact of the convertible preferred?
Mig, it's a great question. I think it's something that we're obviously thinking a lot about. I think we're sort of too early to give you the -- what we expect the proceeds to be, but we think they'll be significant. And obviously, we do have a chance to delever the balance sheet. We do have a chance to invest in our business organically and inorganically, as the opportunities arise. And then as we move leverage down with this core plan plus from proceeds, you get to the leverage area that's right around 2x at the end of the year and we have to start thinking about other ways to return capital to shareholders. So I think it's moving from a pure delevering story with episodic M&A to more balanced capital deployment strategy. And this year, I think you'll see that come to fruition.
Our next question is from Julian Mitchell from Barclays.
Ronnie Weiss on for Julian. So if I look at the guide from last quarter to this quarter, I guess one of the only places that really changed was the European industrial distribution. So I just wondered if you could go on to little more color of what you're seeing there and then kind of what's maybe stepped down from the last time you guys gave an update.
I would say it's more nuance, Ronnie. It's just a little bit less growth than may be we had in our mind's eye for the next 6 months or so. So it had been performing pretty well. I think we're sort of stepping down the expectation just a touch. So I don't think there's any materially we could point to, other than just a modest week to really what we're seeing.
Got it. And then back on the VAG divestment. I guess was this part of a broader portfolio or view? And as you look at the portfolio now, is there still kind of items out there that -- or assets out there that you could potentially divest going forward that might not be noncore to what you're trying to do going forward? Or is this kind of isolated incident within the portfolio?
If you look back, we do a very strategic planning process every year. I think this year, like every other -- every business we have gets reviewed in -- through the lens of do we have a sustainable competitive advantage here that we want to continue to invest in. And I think we came to the conclusion this year that, in the case of VAG, we felt like we had a good plan, we had a reasonable backlog and if you look at the fundamentals of the business, it just doesn't match with the other parts of Rexnord, and so we made a decision based on the facts and circumstances and the work that we have done. But it's part of a normal ongoing review that we do with all parts of our business. I would say that is getting tougher and tougher to find things that don't match that. And so I don't anticipate you'd see anything else like this at this point. But again, it's part of the review process that we undertake every year.
Got it, makes sense. And then lastly, just really quickly. On the incremental margins for Water, little low this quarter. Can that all just be explained away by the negative mix you called out?
Yes. It's the negative mix in -- on the VAG side. On the Zurn side, as we anticipated going to this year, we knew we'd have a little higher incentive comp over the course of the year, particularly in our fourth quarter, and some accelerations from investment in our fourth quarters. [indiscernible] we anticipated and knew, had planned for in the quarter. The VAG mix was now also a negative that drove that incremental down in the quarter.
Our next question is from Jim Giannakouros from Oppenheimer.
Centa, forgive me if I should know this, but can it get to PMC margins? Or are there structural barriers there that cap their margin to a few hundred basis points lower than what PMC averages?
Without any question, the basis of our investment thesis is that the Centa margins can migrate clearly to the PMC level as it exists today and probably actually a little bit higher over time. So I think we're very confident in what the margin profile looks like for Centa after we finished integration, which happens over the course of this year.
And is there any sense as far as the timing of that ramp? Would it take 2 years, 3 years? Or it could be even quicker than that? Or is it much...
Yes. I think the way to think about it is we've got some work to do that really happens over the course of this year. But within 12 months to 18 months, it should be at that run rate and probably not at the -- not above it at that point. But clearly within 2 years, we think we have the opportunity to be above what the current PMC margin profile looks like.
Okay. And one more, if I may. You guys are set up to meet or beat expectations. You were pretty clear about that, Todd. You exhibited that, and you did very well last year. But just looking at the lower end of guidance, I mean, what are the bigger variables that would drive guidance to the lower end or below it? Is it macro, potential disruptions from SCOFR 2.0, pace of sales traction of new products? Any color on what -- where the -- where your pressure points are, internal or external, that would drive to the lower half of guidance would be helpful.
Sure. I mean, just to be clear, I think the lower end of the range is not our base case. But are there scenarios out there that could result in getting to the bottom end of the range? I think there are. I think they're largely macro, and I think they're largely sort of second half of our fiscal year thing. So think about the December and March quarters. So from where we are today, the trajectory would clearly point you towards the upper half of the range. But if you think about a variety of things that are outside of our control, you could find yourself below the midpoint. But I don't think that's our base case. And I think as we sort of highlighted in our comments, our view is to provide something we think is pretty durable and lasting, and we'll update it accordingly. But I don't think that we're going to endorse the bottom end of the range with a set of facts or circumstances other than to say, are there things out there in the world that could happen that drive our numbers as low as everyone else's, lower -- particularly given the second half uncertainty in this relatively short cycle world. I think the answer is, of course, but that's not our base case and clearly not the trajectory we're on.
Our next question is from Charley Brady from SunTrust Robinson.
This is actually Patrick Wu standing in for Charlie. Just going to DiRXN for a little bit. Just wanted to -- as you guys continue to Smart Tag products on both segments, how should we think about the contribution from sales, I guess in fiscal '19 and then possibly beyond that, the growth rate that you guys are expecting from just sort of having that digital platform, if you will?
Again, I think we'll get a little more clarity as we go through the year. But in less than a full year, revenues related to DiRXN were right around $20 million. The growth trajectory on that is very high. We think that as we continue to roll out new families of products, plus they will go and start to attack the installed base, we think that the growth rates for the DiRXN initiative can be very high. We're not going to break it out for obvious competitive reasons. But if you think about from 0 to $20 million in essentially 9 months with a better growth trajectory heading into next year, I think we feel very confident with the adoption. Customers have really embraced the technology. The learning cycles that we're going through continue to accelerate, and I think you're going to hear us talking about how do we then go back and start to monetize this technology with our installed base, which is important because in periods of uncertain economic times, the ability to go back and refresh and renew the installed base will be a powerful growth and margin opportunity when end markets aren't as good as they are today. So we're looking at it both ways, but really nice traction to start the first year, and we think that builds over time.
That makes a lot of sense. And then don't -- not sure if you mentioned this. But for your mid-singles core growth guidance for 2019, how should we think about it for the PMC segment and Water Management? Are they pretty balanced? And then your expectations for Centa for fiscal '19 as well, is that tracking in line with the legacy PMC business or above or below? Can you just speak a little bit more about that?
Sure. When you look at core growth amidst the 2 platforms is both would sort of fall into that mid-single-digit range, and the Centa margins that would be embedded in our outlook for fiscal '19 are currently below. And as we said maybe a little bit earlier, the heavy lifting, if you will, really happens over the course of fiscal year '19, and they step up in '20 and then continue to migrate to that fleet average where PMC is today and ideally above over the next couple of years.
Okay, understood. I was more referring to your expectations for Centa's growth for fiscal '19. I'm -- yes, I'm aware of the margin commentary that you already made.
I'm sorry. Yes, Centa will probably grow again in that mid-single-digit range over the course of fiscal '19, which is in line with the core platform.
Our next question is from Andrew Obin from Bank of America.
We can go to our next question, it's from Justine Ho from Mesirow Financial.
Just wanted to double check. VAG EBIT -- what was VAG's EBITDA in fiscal 2018? Because when I look at the bridge from 2018 to 2019, it only showed VAG at $1 million negative EBITDA for the bridge. So I'm -- not negative, but $1 million adjustment to carve out VAG.
$1 million of EBITDA, which we're backing out of the base jumpoff point as we bridge the '19 where we've excluded VAG from the guidance.
I see. I'm sorry, you broke up when you were -- for the answer. Can you repeat that?
VAG is delivered approximately $1 million of EBITDA, which we're then subtracting out of the base number in '18 to establish a jumpoff point to get to our fiscal '19 guidance because that excludes VAG in fiscal '19.
I see. So can you tell me what was the VAG EBITDA in fiscal year 2018?
We just finished our fiscal 2018, and it was about $1 million.
So okay. So when you said earlier about it being high single digits, is that gross margin then?
Justine, the high margin -- high single-digit margin for VAG is what we would expect the margins to be in our fiscal '19, which begins sort of April 1, '18, and runs through March of 2019. So it's more of a forward-look margin versus a -- as Mark pointed out, the reported earnings for our fiscal '18, which is in March of '18.
And our next question is from Isabelle Dawson from Goldman Sachs.
It's Sam Eisner. So along the same lines of questions, can you maybe just provide some historical detail on EBITDA dollar turnover percentages, the business associated with the VAG business? I understand that was [indiscernible]. But if we go back farther, maybe from fiscal '13 through fiscal '18, how much EBITDA was generated? You made a comment that you expected or there was a good amount of cost in the business last year, so a relative low base. I'm more interested in prior history, not just fiscal '18.
Sam, I can get -- appreciate the question, and as I'm sure you can appreciate, we are in the midst of a sale process. And so that information will be provided once we get through a sale. And in discontinued operations, you'll be able to see that, and we'll be reporting Zurn on a standalone basis starting in our first quarter here that ends in June. And so we're not going to sort of go back and recast everything because we do have an active sale process, and it'll all become sort of apparent for everyone over the course of the next, hopefully, quarter or so. I think the thing to point out is, on a recurring basis, you can see the Zurn margins where they are today. And I think if you look back over the last several years, you've seen a steady march up over time, 100-plus basis points a year of margin improvement, and that's what's the continuing operation view of the world. And we'll be able to get you all the historical VAG stuff and everyone else in time and as we're able.
Can you give us an update on where that sale process stands. Obviously, being able to move something into discontinued ops have some kind of reasonable basis for a time line. So when will you guys expect to sell this business in fiscal '19? Is there an auction process? Is it negotiated? Just kind of give us an update where that sale process stands today.
I don't know that we're going into great detail on it other than to say it's a -- it is an auction process, along with, I would say, some selective buyers that we've engaged with, and we're well into the process. It's not weeks away. It's months away, but it's clearly something we expect to have done in the first half of our fiscal '19.
Got it. And is Rodney Hunt completely written down or sold off at this point? The beginning of last year, fiscal '18, you guys have moved that to discontinued ops, I believe in expectation to either sell or wind down the entirety of that business. Where do we stand in that process?
Yes. This is Mark. That's behind us. [indiscernible] has been sold. That is no longer in the numbers, as Rob pointed out.
Got it. And maybe just lastly, as you think about the kind of multi-industry platform nature of the business, discontinuing or moving out of a business that maybe was less cyclical than some of your businesses may have enhanced the multiple or may have enhanced the business. Just how do you think about full year cyclicality now that you're getting out of [indiscernible] or some of your other [ businesses ]?
Sam, you broke up, really, over the course of the question. But I think where we are today is we think we have 2 terrific concentrated platforms with great brands, very high margins and real competitive advantages that are sustainable. And so we're -- I think we're pretty excited about where we are. I think, obviously, the decision was not taken lightly, but we think it's -- the highest return that we can provide to shareholders is focus on these 2 core businesses and run them exceedingly well. And so I didn't get every part of your question, but I think the essence of the response would be something along those lines.
Our next question is from Mig Dobre from Baird.
I want to talk a little bit about free cash flow, if we can. And I understand the guidance that is north of where your net income will be for of fiscal '19. But any more color on some of the idiosyncratic portions of free cash flow. I know there are some movements in '19 that we need to be aware of. Maybe you can remind us of that.
Well, in fiscal '19 obviously, we think our free cash flow will be better than we had in '18. The phase -- the phase in will look similar to last year, where the back half of the year tends to be stronger free cash flow than the first half from a phasing standpoint, not too different there. Cash interest, modestly better. I think outside of that...
And the old tax bill.
Well, [indiscernible] overall cash taxes will be actually higher, given the fact that we have generated more taxable income and some timing issues. So we think we said in our call 90 days ago, our cash tax rate probably be within the low 40s as a percentage of pretax income this year, dropping to low 30s in our fiscal '21 due to some timing issues. Those are probably the 2, I think, things that really wouldn't come out of our initial guidance. We gave CapEx guidance. Cash pension should be about the same. So I think really -- it's really the earning power year-over-year driving incremental free cash flow in the business.
Okay. Are you willing to maybe put a dollar amount around the free cash flow number?
Well, I don't think it's a stretch, Mig, to talk about it being in excess of $200 million. Now it's probably not clear precision that you are looking for but -- and I think where we are is we have a great degree of comfort that everything we've been doing over the past couple of years, it really enhances the free cash flow profile permanently, and also, there's some -- there is some legacy tax liability that is in the base that anniversaries itself in our fiscal 2020. So clearly, run rating above $200 million with more to go. And so probably not the degree of precision you were looking for, but clearly in excess of $200 million.
Right. I mean, look, to be clear about what I'm asking here. I'm trying to figure out, as you're looking at '19, say, exiting fiscal '19, what your firepower essentially is going to be at that point from a M&A perspective. And I don't know if you're able or willing to provide some kind of a figure that investors should consider, but obviously, it's important to the story.
I mean, if you take the base case and use that $200 million of free cash flow, you can find your way to leverage in the very low 2s by the end of March. Incremental to that, there'll be proceeds from VAG. And so you're right at 2 or perhaps a little bit below. If you think about our desired leverage ratio of 2 to 3, that's $440 million at the high end, plus cash on the balance sheet, plus future cash flows that easily eclipsed the $200 million mark beginning in fiscal 2020. So I think our M&A wallet continues to grow, but in concert with ensuring you've got the right leverage on the balance sheet. And so I think it's a good problem to have, but the cash flow that we've been working to generate starts to, I think, accelerate over the next couple of years. And we're pretty confident that, that increases our financial flexibility and keeps the leverage ratio at a relatively conservative level.
Got it. Then lastly for me, one last clarification on guidance. Can you give us a sense for how much an incremental investment and incremental compensation '19 versus '18 is currently baked it at the, call it, midpoint?
Yes. I think from an investment -- compensation year-over-year, we should [indiscernible]. That was an issue we faced last year coming off the fiscal '17. So we feel like comps should be neutral year over year. Investment think is mid-single digits. Investment in the platforms probably, let's see, a little more on the PMC side, as Todd pointed of about 2/3 of that PMC, 1/3 on that in the Water side. But mid-single digit is the best number over the course of the year.
I see. Mid-single-digit in millions.
I guess.
And our final question is from Joe O'Dea from Vertical Research.
First question, just on the pricing side of things and to understand that segment level, I guess, within PMC and both Water Management, what you've done on pricing in response to some of the material costs and whether that's deviated from normal pricing at all, meaning were they normal beginning of calendar year pricing actions and have you done anything incremental to that and just where it stands on that front.
So the -- it varies by segment. So we do have different, I would say, historical practices of when we would institute price increases. Obviously, over the course of the last 90 days or so, we've formed what we call for an internal team called inflation task force, and that is really a multi-disciplined team that's working both the price side and the cost side. And we think we've got a pretty -- again, very real-time view of when we're implementing price and how we're managing input costs. I would tell you that in fiscal '19, it's very likely that, in some cases, we've already implemented incremental price increases to what we would've ordinarily done or we have planned future price increases that match the timing of input cost rising over the course of the year. So I think we've got what will be above average year in price, and we think it's sort of matches to -- probably is a little bit ahead of where the input cost lay out over the course of the year.
It doesn't sound like cost inflation is margin dilutive. So maybe just to confirm that's what you're getting on the pricing side is not just cost capture. But the incrementals you're talking about, it's not like cost inflation is posing an incremental margin headwind for you.
That is correct.
And then last question just on kind of philosophy around the outlook. I'm talking about the importance of the durability of the outlook and I think when you look at where there could be pockets of conservatism and some pretty good incrementals underlying the outlook, and so I don't know if that conservatism would lean more toward the top line. And we've seen an acceleration in some of the organic growth recently. But I guess also, importantly, just with some of the headlines we've been working through over the course of the past 3 months and whether or not you've seen that generate a higher degree of uncertainty in the customer base now that we've got half of May underway, just the customer behavior and I guess the strength, the kind of the acceleration in some of the end market demand that we've seen and stability there. So looking for kind of confirmation of that or anything you've seen in response to some headline uncertainty.
Yes. I don't think I can point to anything specific, Joe, from a customer standpoint where we've seen any behavioral changes as a result of the headlines. I think as we talk to our sales force, our independent reps, look at our funnels, we continue to see good activity that supports, I think, the outlook that we provided. I think our view has been let's take a really good look at the next 6 months and then assume that the following 6 months could be less. And I think that's where we've got, I would say, maybe a little conservatism. So if the trajectory of where we are sort of finishing the year and starting the new year continues, there could be upside in the second half. But that's also 6 months away. And so the way we've approached it is, take a look at the full year with a pretty sharp look at the first half, be a little bit more conservative over the course of the second half and then update accordingly based on where things are.
And we have no further questions.
So thank you, everyone. Thanks, Sean, and thank you, everybody, for joining us on the call today. We appreciate your interest in Rexnord, and we look forward to providing our next update when we announce our fiscal 2019 first quarter results in early August. Have a great day.
Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating and you may now disconnect.