Zurn Water Solutions Corp

NYSE:ZWS

Earnings Call Transcript 2019-Q2

[Operator]

Welcome to the Rexnord Fiscal Year 2019 Q2 Earnings Conference Call. My name is John, and I'll be your operator for today's call. [Operator Instructions] Please note that this conference is being recorded.

And I will now turn the call over to Todd Adams.

[Rob McCarthy, executive]

Good morning. This is Rob McCarthy, and welcome, everyone. Before we get started, I need to remind you that this call contains certain forward-looking statements that are subject to the Safe Harbor language contained in the press release that we issued yesterday afternoon as well as in our filings with the SEC.

In addition, some comparisons will refer to non-GAAP measures. Our earnings release and SEC filings contain additional information about these non-GAAP measures, why we use them and why we believe they are helpful to investors, and contain reconciliations to the corresponding GAAP data. Consistent with prior quarters, we will speak to core growth, adjusted EBITDA, adjusted earnings per share and free cash flow as we feel these non-GAAP metrics provide a better understanding of our operating results. However, these measures are not a substitute for GAAP data, and we urge you to review the GAAP information in our earnings release and in our filings with the SEC.

Please note that the presentation of our operating results is focused on our continuing operations as our VAG operations are recorded as discontinued.

Today's call will provide an update on our strategic execution, our overall performance for the second quarter of our fiscal '19 and our outlook for fiscal year 2019. We'll cover some specifics on our 2 platforms, followed by selected highlights from our financial statements. Afterwards, we'll open up the call for your questions.

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

[Todd Adams, executive]

Thanks, Rob, and good morning, everyone.

As you saw in our release last night, our second quarter results continued the solid start to what we believe is shaping up to be both a strong and a record year for Rexnord, with core growth accelerating over the prior year; double-digit adjusted EBITDA growth; and by the end of the year, record free cash flow.

We're seeing steady growth in most of our served end markets, and more significantly, our strategic initiatives around innovation, cost reduction and commercial excellence are gaining momentum. And we're seeing real benefits of all those start to compound with a lot more to follow.

We've updated our outlook for the fiscal year, which includes an unchanged mid-single-digit range for our core growth, but we'd steer everyone toward the higher end of that range. And we've also raised our expectations for adjusted EBITDA, which we now project to be in the range of $433 million to $443 million.

Looking more closely at our second quarter results, sales of $525 million included core growth of 9% and were up 16% on a reported basis. Core growth in our Water Management platform, which is currently comprised of our Zurn business, increased 12% year-over-year. PMC core growth also accelerated, as we expected, coming in at 7%, delivering mid-single-digit core growth for the first half. We were able to leverage a solid growth in both platforms and had 20% year-over-year growth in our overall adjusted EBITDA which increased to $115 million, with solid operating execution delivering strong margins in both platforms.

Adjusted EPS was $0.46 for the quarter and was up 44% over the comparable prior year figure. Mark will review both the consolidated results and the performance of each platform as part of his comments a little bit later in the call.

Please turn to Slide 3. Looking at our operating platforms, in our PMC platform, we recovered the few million dollars of delayed aerospace shipments from the first quarter and continued to benefit from the growing order activity across most of our served end markets. We're seeing good demand conditions from OEMs and end users, as well as from our global industrial distribution channels, and our sales funnels of digitally connected components is growing at a very strong clip.

Both existing and new customers are rapidly migrating to our digital platforms to access design tools and product configurators, secure price and delivery information and to place and track orders, which are dramatically collapsing the buying cycle for our products. And that's driving huge productivity for both our customers and for us. I'll have more to say recent progress when I update you on our digital DiRXN strategy in a couple minutes.

PMC's adjusted EBITDA margin improved 180 basis points year-over-year to 22.3%, reflecting the benefits of our prior structural cost reductions and our aggressive approach to managing input cost. PMC's year-over-year incremental margins were 33% on an as-reported basis, which includes Centa, but were again above 50% on a core basis.

Centa, which we acquired in February, continued to perform well in the second quarter. And we're continuing to see -- and we're beginning to see the impact of leveraging the Rexnord Business System to drive improvement in Centa's performance and profitability.

Order rates have been strong, and our simplification initiatives are taking the unnecessary complexity and cost out of the business. The result is ongoing progress towards our objective of adding 1,000 basis points of margin improvement to Centa by fiscal '21, with the reality of the fact that we're tracking to get there some time in our fiscal 2020.

Results in our Water Management platform strengthened in the second quarter as core growth accelerated to 12% and brought core growth in the first half of the year to the high single-digit level. In addition to the stable growth we're seeing in North America nonresidential construction activity, our innovation pipeline continues to contribute to our above-market growth as we ramp sales and market share from new product introductions over the last year.

During the second quarter, we launched the first wave of new products to support our increased commercial focus on the North American fire protection market with 35 new SKUs added to our existing product offering. We have the dedicated commercial team in place and we intend to gain a larger share of this roughly $300 million adjacent market.

We continue to monitor the tariff situation and the resulting uncertainty it creates for our customers, but our order growth to date has been healthy and stable in both platforms. We're confident that we positioned ourselves to avoid any impact on our EBITDA margins and even more confident that we can continue to navigate it moving forward as a result of our proven capabilities and processes to manage the price/cost equation in both the immediate term and over the long term.

Please turn to Slide 4. I'm going to take a couple of minutes to bring you up to date and developments around our digital DiRXN enterprise strategy. First, some background. We publicly launched our DiRXN strategy in May of 2017 with the plan of rapidly transitioning Rexnord to a digital operating model and provide a digital experience for customers that would bring the enhanced productivity of the B2C world into the B2B world.

This concept is really about, for both our customers and us, solving smarter by developing industry-leading digital tools, resources and products to substantially change the productivity of our customers and channel partners at each stage of their life cycle with our products.

From search, design, select and procure; to install, operate, maintain and eventually replace; embedded with that was the vision of enabling higher operating up-time and higher productivity for our customers by extending the edge of the customers' digital operating environment to include the engineered components that we provide and then to ultimately determine the performance of a customers' material handling and processing systems or a customer's in-building Water Management systems.

Solving smarter is a differentiated approach that makes our digitally connected products provide not just raw data but also contextual information that leverages our institutional knowledge around specific product applications. This means that our products can explain in real-time how to interpret what their operating data means and recommend a specific course of action directly through a customer's control system.

Maintenance personnel don't need to visit the physical assets to assess their operating status and they don't have to have experienced engineers to interpret the stream of operating data coming from those physical assets. They don't need to query the component, it will alert them and diagnose the issue for them, which means the immediate benefit to the customer.

What this means is that we are creating the digital-mechanical reality that is absolutely the future of the continuous operating environments envisioned by Industry 4.0.

Since our solutions are compatible with any plant control system and require modest incremental investment by the customer, barriers to adoption are lowered and the payback period of the investment in shortened. The savings for the customer from avoiding a single unplanned system shutdown would typically be many times the initial cost.

We believe that to bring the first market -- we believe that being the first market to bring this differentiated capability can give us an important first-mover advantage with customers that are focused on driving higher system reliability.

Similarly, data from our connected water products can not only help conserve water but can also help ensure a safe and reliable operation of the in-building plumbing and Water Management systems. Zurn's ability to supply virtually all of the critical specification plumbing components needs greater ability to engineer a complete water management solution that optimize overall system performance and reliability. Unexpected failures can resolve -- can involve enormous cost to remediate.

We've made good progress on several fronts during the first half of our year. At PMC, we're seeing a steady uptrend in customer activity in our digital platform as we set records monthly for overall online traffic and for our use of our expanded offerings of digital tools and resources. Product configuration can now be done online for virtually all of PMC's industrial products, and our customers are increasingly going online for quotations and ordering. Growing online activity also means increased digital lead generation.

We recently introduced our first retrofit solution, responding to strong customer interest by accelerating the same productivity-enhancing connectivity across our huge installed base of equipment. Between new connected gear drives and the large retrofit opportunity, PMC's funnel of connected product opportunities is growing rapidly, and we expect to see (sic) [it to be] an increasing contribution to our top line growth over the coming quarters.

In our Water Management platform, we've experienced a highly positive reaction to the second quarter introduction of inSpec, Zurn's new digital specification tool. User adoption and feedback has been incredible. It's driving massive efficiency and productivity for engineers and architects as highlighted in the building engineer's quote you see on the slide.

We're continuing to expand the capabilities and resources within inSpec, and as the user base grows, it'll only build upon our market-leading spec share, which is a key growth enabler in every market environment.

At the end of the quarter, we formally launched our initial range of connected backflow prevention valves. We believe Zurn that can -- we believe Zurn can leverage this pipeline of digitally connected water quality and water conservation products with its competitive advantages into a leadership position in connectivity.

Similar to how our commercialization strategy has developed within PMC, we will be introducing a backflow retrofit solution in the coming weeks. Because just as the field population of the industrial gear drives vastly outnumbers the annual shipments of new ones, the installed base of backflow valves also dwarfs annual industry shipments of these devices. We're finding that owners of several types of facilities are keenly interested in the substantial risk mitigation that our digitally connected backflow device can provide.

Our work in other categories of specification-grade valves is also well-advanced and we expect to expand the available range of Zurn digitally connected product categories as we move to the second half of the year. The powerful value proposition that we're bringing to the market is one of those things that should perform well in every kind of economic environment and is equally, if not more important, in the retrofit markets than it is to the new construction markets.

Before I hand it over to Mark, I want to leave you with just a couple of thoughts on our business, particularly given the amount of volatility we've seen in the equity markets and the various headlines that seem to create confusion for people trying to assess how Rexnord will perform in this environment.

First of all, over the last 3 years, we've made significant changes to almost every facet of our business that should allow us to perform in any sort of economic environment, and particularly one that has some inflationary conditions in it. Consider that we've made investments in growth and innovation that drives immediate payback for customers, further enhanced our industry-leading specification share, added strategic and key account management resources, invested in growing our share in more stable end markets that serve consumers as well as developing a game-changing digital platform as well as a connected series of products.

I'd also add that the distribution channel inventories have never been lower, so the risk of too much channel inventory is virtually 0. And we have divested every one of our large, lumpy project-based businesses. Beyond that, we've substantially reduced our fixed cost structure through our SCOFR actions. And in turn, we've also increased our current and future cash flows. We're managing the price/cost equation extraordinarily well, just as we had predicted, despite the impact of unprecedented tariffs that are impacting the global supply chain.

Finally, we're tacking towards the lowest leverage we've ever had, right at 2x of net debt-to-EBITDA by the end of the year. And our balance sheet, including the maturity profile and the interest rates on our debt, has never been better. We expect fiscal '19 will be a record year for us in terms of EBITDA and free cash flow, and we've got more of everything I just talked about teed up for the second half of this year and into next year, which is our fiscal 2020. All of this strengthens our conviction that we can outperform our served markets and our competition going forward.

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

[Mark Peterson, executive]

Thanks, Todd. Please turn to Slide #5.

Our second quarter of fiscal '19 consolidated financial results were slightly ahead of our expectations. On a year-over-year basis, our total sales grew 16%, core sales increased 9%, our adjusted EBITDA increased by 20% to $115 million and our adjusted earnings per share increased by 44% to $0.46.

Please turn to Slide #6. Our outlook for our fiscal '19 core growth continues to incorporate mid-single-digit core sales growth, but as Todd discussed earlier, more towards the higher end of the range. Our increased outlook for adjusted EBITDA to be in a range of $433 million to $443 million translates to a 12% to 15% year-over-year growth as we continue to expect to deliver another year with free cash flow ahead of net income.

Turning to Slide 7. We summarize our consolidated results for the quarter.

Let's move on to Slide 8 and discuss the first of our 2 operating platforms, Process & Motion Control. Total sales increased 16% year-over-year in PMC with core sales growth of 7% that benefited from about $5 million of delayed shipments to our aerospace markets that we identified last quarter. Through the first half of the fiscal year, core growth in our PMC platform was a solid 5% and in line with our expectations heading into the year. Currency translation reduced our sales by 1%, and the acquisition of Centa added 10% to our top line growth in the quarter.

PMC experienced another quarter of solid growth in its process, industry and consumer-facing end markets. And sell-through rates in our North American industrial distribution channel were also consistent with last quarter. Our sales to aerospace customers were up by a high single-digit year-over-year for the reason I discussed earlier.

In the top right corner of the slide, you can see the unchanged end market assumptions that support the unchanged outlook for mid-single-digit core sales growth of PMC that is incorporated into our fiscal '19 guidance. Our fiscal '19 outlook continues to assume positive growth across PMC's primary end markets in the process, consumer discrete and aerospace sectors and in our distribution channels.

PMC's EBITDA and margins were in line with our expectations as adjusted EBITDA increased 26% year-over-year and margin improved year-over-year by 180 basis points to 22.3%. PMC benefited from strong operational execution, pricing was positive, and our strategies to manage the impact of materials cost inflation continue to be successful. The structural benefits from the first wave of our Supply Chain Optimization and Footprint Repositioning initiatives that were completed in last year's second quarter were also fully reflected in PMC's results as the year-over-year incremental EBITDA margin, excluding the Centa acquisition, again exceeded 50% in our second quarter.

Having anniversaried the year-over-year SCOFR benefit to PMC margin comparisons and recognizing that margins at Centa, which we acquired in February, are improving but are still below the PMC average, we expect PMC margin to be up modestly year-over-year for the second half of the fiscal year. In other words, we expect the margin benefits from core growth and from our strategies to more than offset input cost inflation, will be partially offset by the margin impact of adding Centa and from our planned investment spending.

Today, I'd also like to briefly highlight another recent new product introduction from PMC that is targeting our consumer-facing end markets: Our new KleanTop plastic modular conveying chain for the food processing industry. This family of products is targeted at baked goods applications, like the tortillas seen in the picture on the slide, and other food applications that require delicate handling, like fruits and vegetables, poultry and seafood. We estimate that this new products family doubles PMC's addressable range of baked goods applications and includes specific design benefits around hygiene, maintenance and up-time.

Please turn to Slide #9 to discuss our Water Management platform. During our second quarter, our Water Management platform delivered a 15% net sales increase that was a function of 12% year-over-year core sales growth and a 3% contribution from World Dryer. Top line results were slightly ahead of our expectations, with good price realization leveraging solid demand growth and our new product pipeline.

Today, I'd like to highlight our recent asset purchase of the Froet line of bifunctional roof drains that is disclosed in our 10-Q. This patented product offers major advantages to roof drain installations and contractor productivity. For many years, U.S. construction codes have required a second bypass drain to prevent standing water from accumulating if the primary roof drain were to become clogged, which means that every roof drain location on a flat roof typically has 2 drains installed and 2 separate holes in that section of the roof.

Our bifunctional drain combines both drains into a single fixture and thereby eliminates half of the holes in the roof and half of the drain installations with significant savings measured in money and installation time, and all the while, improving roof integrity. Our team is already actively working on accelerating the specification for this patented product, and we are confident that this innovative solution can be another contributor to delivering above-market growth at Zurn.

As illustrated by our mostly unchanged underlying end-market outlook that is summarized on this slide, demand conditions in our core nonresidential construction end markets remain favorable. We are moderating our outlook for the U.S. new residential construction market to reflect the recently weakened momentum in that market, which only accounts for about 15% of Zurn's sales. At the same time, we point out that growth in the value of U.S. nonresidential building starts has strengthened in recent months.

Net-net, and recognizing that our year-over-year sales comparisons get a little tough in our second half, our outlook for Zurn's full year core growth has improved overall to a high single-digit range. Forward indicators of nonresidential construction activity, like the Dodge Momentum and ABI design indexes, continue to track favorably from a growth viewpoint.

Water Management's adjusted EBITDA increased by 10% year-over-year in the second quarter, and we delivered a solid 27.1% margin as we continue to leverage our core growth and manage to a favorable price/cost equation while funding our market growth and cost-reduction initiatives. Our margin expanded sequentially from our fourth quarter, but on a year-over-year basis, declined from exceptionally strong margin reported in the year-ago quarter when the platform benefited from a few favorable items in that quarter.

We remain confident in Zurn's ability to manage its material cost and tariff exposure, and we continue to expect our Water Management platform to deliver year-over-year margin expansion in our fiscal '19. And we anticipate the incremental margin to be in the 27% to 30% range over the back half of the fiscal year.

I'd like to take the opportunity to add that there's no question that our early and aggressive actions to address the impacts of tariffs and overall input cost inflation has been critical in preserving our outlook for margin expansion for the full year. As we have detailed previously and discussed in some detail last quarter, we have used material cost actions, robust supply chain management and selected price increases to leverage our leading brands, the growing sales of our innovative and cost-savings new products and our distribution channel structure to manage our exposure and more than offset the impact of cost increases. We continue to work each of these strategies and we remain confident in our ability to deliver full year adjusted EBITDA margin expansion while continuing to fund our investments in innovation and growth.

Moving on to Slide 10, you can see on the chart at the top left that our financial leverage, as measured by our net debt leverage ratio, declined to 2.5x at September 30. Our free cash flow has developed as expected across the first half of our fiscal year, and we remain on track to deliver at least $200 million of free cash flow for the full year.

Before we open the call for questions, I'd like to comment on accounting for our divestiture of VAG and then speak to restructuring expenses and our effective tax rate before we take your questions.

First, we continue to account for VAG through discontinued operations. In early October, we signed a sale and purchase agreement and we anticipate closing the sale in our third quarter with the resulting cash proceeds held as cash in our balance sheet. Second and in terms of our cost-reduction initiatives, we continue to project total restructuring expenses of $11 million to $13 million in our fiscal '19. These costs are primarily made up of severance costs and are excluded from our adjusted operating results.

Next, our effective tax rate will fluctuate by quarter, given varying levels of pretax income as well as the timing of other planning initiatives. We now project our fiscal '19 adjusted net income to incorporate an effective tax rate of approximately 27% to 28%. For our third quarter, we anticipate a tax rate between 24% and 25%.

Turning to the slide 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 covers our continuing operations only. In addition, our guidance excludes the impact of potential acquisitions, potential accounting gains or losses and future nonrecurring items, such as restructuring costs.

As has been our practice, the appendix to today's presentation also includes a reference table to help you determine the appropriate incremental quarterly share count to use for modeling our adjusted diluted earnings per share under the if-converted method if it is applicable. As illustrated on Slide 14, the if-converted method was dilutive to adjusted EPS in the second quarter, and therefore, was applied.

Lastly, we include a schedule with the pretax and after-tax impacts of each 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 your questions.

[Operator]

[Operator Instructions] And our first question is from Joe Ritchie from Goldman Sachs.

[Joseph Ritchie, analyst]

So Todd, I wanted to touch on your comments regarding inventory never being lower. Can you maybe just walk through a little bit more color on that specifically as it relates to your end markets, what you're seeing across the channels?

[Todd Adams, executive]

Well, I mean, if you look at it between Process & Motion Control and Water Management, I would say that, that statement is true in both platforms. The inventory levels are at historic lows with respect to how we look at it. Inventory's turning at a very high rate in the channel. And I think, obviously, we have a belief that a little bit more inventory in both sides of the business would do us some good, as well as our distributor partners. But at this point, they're choosing to sort of run it pretty tight. And we're obviously doing our very best to fulfill that demand and keep lead time short so that the end customers get great service. But I think that's really the only comments we'll make on it, Joe.

[Joseph Ritchie, analyst]

Now obviously, that's pretty positive as it relates to the growth trajectory of your businesses going forward. But one of the things that stood out again this quarter on the process side are -- was really just around, like, the incrementals that you're putting up. I know that you referenced Centa being a little bit of a drag moving forward, but the core incrementals of 50% to 60% are quite strong. I'm just wondering, like, is that the expectation for the core business moving forward into the second half of the year?

[Todd Adams, executive]

Well, you may recall last year, we were still going through the final phases of our supply chain optimization program. So the first half, we do get a greater benefit on the incremental side of things than we will in the second half. We've always steered people towards the 30% to 35% incremental in Process & Motion Control. I think you'll see that sort of normalize in the second half of our year. Obviously, we do believe that over time, Centa, as we anniversary that, the incrementals there will be in that 30% to 35% range. What you're seeing now is that initial mid- to high teens EBITDA margin rolling through the results. But the way to think about Process & Motion Control is 30% to 35% core incrementals. We had a great, obviously, first half as a result of wrapping up the multi-year supply chain optimization program in the first half of last year. So that's the way I think you should think about it for the best -- the rest of the year.

[Joseph Ritchie, analyst]

Got it. And then maybe one last question. As you think about the second half also, is there anything that we need to be aware of beyond your comments on incrementals that impacts the second half seasonally? If I just take a look at, like, your guidance for the year, the implied EBITDA is comparable to the first half. Usually, the second half is a little stronger. Just any comments around that would be helpful.

[Todd Adams, executive]

I think you're spot on. I mean, our fourth quarter is obviously our strongest quarter for Process & Motion Control. You're also -- the flip side of that is if you look at our Water Management platform, seasonally, the December quarter and March quarter are weaker than the first half of the year, just based on the construction season in North America. So the incrementals should still be fine year-over-year. But sequentially, water slows a little bit just because of the nature of the products, and PMC is always just a little bit more on our fourth quarter than the other quarters.

[Operator]

Our next question is from Andrew Obin from Bank of America Merrill Lynch.

[Andrew Obin, analyst]

Can you hear me, guys?

[Todd Adams, executive]

Yes, we can hear you.

[Andrew Obin, analyst]

Just at PMC, you sort of highlighted improved sell-through through the distribution channel. And for a while, I think last year, you were sort of questioning why we were not seeing this acceleration. Could you just go by end markets and just tell us where are you seeing the increased demand, and how much visibility you have in terms of the momentum in the channel?

[Todd Adams, executive]

Well, the momentum really started picking up probably about a year-plus ago, Andrew. And we started off at sort of down just a touch and that migrated to flat to up a few percent, and now obviously, we're seeing it in that mid-single-digit range. It's really -- I wouldn't say that there's a lot of disparity. I don't think you have something growing 15% or 20% and something declining. They're all in the low to high single-digit range. Obviously, process industries has been strong, consumer industries have been steady. I don't think we're seeing a noticeable change in really any of the end markets at this point because you have to remember, most of this is MRO activity. So we've reached the point where the inventories in the channel are very stable. There is a -- the same number of components failing every day. And so what you're seeing now is really the normalized end-market demand with industrial production levels at a relatively stable rate. In any given part of the year, you're going to see certain end markets doing full maintenance. As an example, you'll see food and beverage typically better in the second half of our year as they do maintenance over the winter to be ready for the warmer parts of the year. And the flip side is true on process industries, right? You'll see a little more activity over the summer months as they go through and run things at a peak. So not demonstrably different across the end markets, but solidly in the growth category. And I would say very stable, given where industrial production sits.

[Andrew Obin, analyst]

And so your view that this is not restocking, this is just steady-state demand driven by MRO. Did I hear you correctly?

[Todd Adams, executive]

It's not my view. It's a fact. There has been no restocking in our industrial distribution channels.

[Andrew Obin, analyst]

And just in terms of pricing, it's another concern in the channel. How is the dynamic in terms of price increases through the channel working for you guys?

[Todd Adams, executive]

Well, for us, we are -- we don't have any exclusivity with our distribution channel. So for us, we have a relationship that allows us to push price through to the channel smartly, selectively and in partnership with our distribution customers. Because we want to protect them as well as really cover the inflation in input cost as well as make the amount of money we need to reinvest and to create innovative solutions. But the ability to get price through our channel is fairly understood, mature and has not been an issue whatsoever.

[Operator]

Our next question is from Joe O'Dea from Vertical Research Partners.

[Joseph O'Dea, analyst]

With respect to cash deployment, when you look at leverage where you are now and the trajectory that you're on by the end of the year and then you marry that with what we're seeing in the equity markets, I think that you've talked to maybe broadening out cash deployment as a next-year opportunity or agenda item. But any consideration around accelerating that a little bit, given what could be some opportunities there with these moves in the equity market?

[Todd Adams, executive]

Joe, I think our historical cash deployment has been really around debt reduction and M&A. I would say that for the remainder of the year, those are the 2 that we're going to remain focused on. As you pointed out, obviously, when we get to the end of the year and we end it sort of 2x, that opens up some additional things for us to think about in terms of capital deployment. But we're not going to get ahead of ourselves. At this point, we want to make sure that we can march the leverage to an area that we think everybody is infinitely comfortable with as well as stay very disciplined and do the M&A that we should be doing, as we have been doing over the last 5 or 6 years. The acquisitions that we've been able to do are performing extraordinarily well. But we've married that with a balanced approach to making sure that we're marching the leverage to a range that people are comfortable with. And over the rest of the year, I think that's what you're going to see us continue to do. But as we turn the page into 2020, obviously, we'll have some high-class challenges to consider with respect to other uses of cash flow.

[Joseph O'Dea, analyst]

Got it. And then on digital product and talking a little bit about the retrofit being arguably the biggest near-term opportunity, can you talk about just how you push that opportunity? Is that something that you're collaborating with distributors who are serving some of those customers on a day-to-day basis? Just how you get in there and try to maximize that and accelerate the revenue recognition there on the retrofit opportunity.

[Todd Adams, executive]

Yes, it's a great question. Obviously, we're working closely with our distribution partners. We've actually stood up a separate sort of retrofit organization internally as well as working with key and strategic accounts, right? I think the greatest benefit that we see is to go to our existing customers who have a large installed base and offer them the opportunity to retrofit their existing fleet and provide enormous productivity for a very, very low initial price point. So that's a 3-pronged approach, where we're leveraging our key and strategic account resources to go and talk to the people that have those large installed bases; we're leveraging our distribution partners to do the same for us; and then obviously, the organization that's going to go out and try to find maybe competitive situations, where there's a competitor in there and that competitor is -- doesn't have a connected capability and we can come in and really sell the value proposition. Because those products are remanned and reserviced all the time, and so there's always opportunities to sort of come in and offer a better solution. So it's really a 3-pronged approach for us. We're seeing the funnels build, really, across all 3 of those channels. And as I said in my comments, I expect that you'll see some impact in the top line growth as we move through the balance of this year, but more pronounced when we get to fiscal '20. But we're really excited about it, and so are our customers. And I think our distributors are as well because this is a value proposition that is an easy sell. For a very low, 5-digit or 5-figure sort of number, you can take an existing product and connect it to your control system. And the cost of an hour of downtime is a 6-figure number, right? So it's a no-brainer when you can get to the right people at the right time. And we're having great success with it and we're excited about where it puts us.

[Operator]

Our next question is from Jeff Hammond from KeyBanc Capital Markets.

[Jeffrey Hammond, analyst]

Just want to go back to the macro commentary on water. Just maybe just talk about you moved the color of the dot next to res. And just where are you seeing specifically some slowing there? And then just on nonres, I mean, it sounds like it's building momentum, but we had a peer yesterday kind of talk about September seeing some slowing in project activity. And just wanted to see if there's any signs, just given some of the volatility, if you've seen any of that.

[Todd Adams, executive]

Sure. Just for context, res is 10% to maybe 15% of our water business, and it's primarily PEX and PEX-related products. So if you think about what we're doing there, is we're really highlighting the fact that if you look at housing starts, you look at interest rates, I think we're just sort of taking a bit more of a cautious approach on residential. It's the very smallest part of our business, it's the least impact to us in terms of our margin capability. So we're really just sort of flagging it, I'd say. The reality is the residential's likely going to slow. Offsetting that really is, what we think, a very good set of circumstances and background in nonres. If you think about the cycle, we've moved into that institutional part of the cycle, where health care, education, municipal is all very strong. That's where we're -- and we've talked about for years, that's where we're extraordinarily well-positioned. And that's sort of what you're seeing. So we're not seeing, I would say, the slowing that maybe you referenced. We see really strong backlogs and we feel good about the second half and certainly as we go into fiscal 2020. I mean, all things could change, but I think at this point, the cycle is progressing as we expected. I mean, it's still very early in the recovery on that institutional side, as we've talked about, but that's the context around just a little bit of res exposure and why we changed it and how we feel about the rest of the business over the next period of time.

[Jeffrey Hammond, analyst]

Okay, great. And then Todd, maybe just update us on how you feel the execution is going on SCOFR 2.0. And then just any early thoughts on -- as you kind of build the thought process and plans around SCOFR 3.0 scope, where you're going to be focusing, et cetera.

[Todd Adams, executive]

Sure. SCOFR 2.0 is a much simpler move, series of moves. And I think where we are today, I think we'll start to accrue the benefits of that really starting in our fourth quarter. Most of the work is wrapped up, and we're pretty pleased with what the benefit will be. I mean, it's sort of right in line with what we had communicated. Obviously, we've signaled or flashed a SCOFR 3.0. I think it's probably a little bit early to talk about publicly, other than to say it looks like something probably in between 1 and 2, with some length of execution that's probably in the 1- to 2-year time frame. So I think when we get to -- perhaps have a little more color when we get to our Q3 call. But for sure, by the time we get to our Q4 call, we'll lay out sort of what that looks like. But it's not crazy to think about it as a $20 million save. And we'll work to see if we can maximize that into something a little bit more over time.

[Operator]

Our next question is from Mig Dobre from Baird.

[Mircea Dobre, analyst]

I just want to pick up where Jeff left here with this SCOFR discussion. So maybe as a reminder, on SCOFR 1, kind of what the incremental benefit was in '19, and if it is all kind of focused on the first half of the year. And then SCOFR 2.0, you're still essentially on track and targeting $15 million of benefit, right? So those are still...

[Todd Adams, executive]

All correct, Mig, yes.

[Mircea Dobre, analyst]

Okay, good. Then also on Centa, you sound -- from an execution standpoint, you sound incrementally positive here on the quarter in terms of what you can do in driving the margins. As I remember, you were initially targeting a 3-year window for improving margin by 1,000 basis points. I heard you say that you could do that exiting fiscal '20. And just to be clear here as to what the magnitude of that would mean, that would mean -- that would be roughly, call it, $12 million, $13 million of incremental EBITDA dollars, based on that business' revenue base. Am I correct?

[Todd Adams, executive]

At a full year run rate, correct.

[Mircea Dobre, analyst]

At a full year run rate. So in fiscal '20...

[Todd Adams, executive]

Yes. So if you think about it, just to be clear, when we acquired the business, it was in that sort of 12% to 13% range. We felt that we could get 1,000 basis points of margin. What I'm referring to is that we won't get a full year of that 1,000 benefit -- 1,000-point benefit in 2020, but we'll be -- we'll get there at some point during the year. The first full year of that would probably be in our fiscal 2021. But I know where you're going and you're close. But yes.

[Mircea Dobre, analyst]

Okay. And then lastly, as we're talking about the core PMC business. You're essentially kind of sticking with that longer-term view of 35% incremental margins, excluding the items from SCOFR and excluding Centa, correct?

[Todd Adams, executive]

That is correct.

[Mircea Dobre, analyst]

Okay. And then lastly, in Water Management, your organic growth this quarter was, I thought, pretty remarkable. And I'm essentially trying to figure out what the moving pieces are because when I'm looking at just put in place construction through the quarter and I look at your key end markets, I mean, things are fine, but they were not as good as 12% organic growth would indicate. So how do we think about either idiosyncratic items that impacted the quarter? Or essentially the sustainability, for lack of a better term, of this kind of growth going forward?

[Todd Adams, executive]

Sure. Yes, I mean, just first of all, there were no unusual items, projects, catch-up, otherwise, no channel build or anything like that. If you look at the 12% organic growth, it comes off of a relatively easy comp. If you remember last year, in the second quarter, we had the impact of the hurricane and core growth was only up just a touch. That being said, that being said, if you look at our second half, we expect very strong stacked core growth. While the absolute percentage of the quarter may not be as high as the 12% we just posted, if you look at the stacked growth over the course of the second half, it'll actually probably look as good or perhaps even a little better than the 12% plus the 1%. So when you go back to why, just a couple of things. Obviously, we're in the strong part of our end markets where we have a very high relative share and we are going to outperform any market indices because of that. Second, we've been introducing new products at a great clip over, really, the past 2 to 3 years. We've been driving our specification share up. And we've got a connected strategy that will probably help us, not hurt us, as we think about the balance of this year into next year. And so from our standpoint, it really demonstrates the work that we've been doing. The transparency of the performance that you can see with VAG out of the picture. And as we think about Zurn and Water Management going forward and capital deployment, we obviously would love to do more in and around some of the end markets that we serve here because, as you can see, we just got a terrific competitive advantage with the business. And we've -- we're excited about where it's positioned going forward.

[Mircea Dobre, analyst]

I see. And last question, just sticking on this last comment on capital deployment, how do you sort of think about the cyclicality of Water Management now? And are there anything -- is there anything that you can do, either on capital deployment or maybe organically the way you build the business, shifting more maybe towards retrofit, I don't know, in order to essentially manage this dynamic?

[Todd Adams, executive]

Well, I think that you've touched on it, right? Adjacent markets that continue to perform in whatever market that would be adjacent to a nonres market would be areas that we'd focus on. Retrofit, when we bought the business 10 years ago, was virtually 0. It's somewhere between 30% and 35% today. This connected backflow and all these connected products offer us, we think, a real opportunity as you go through any sort of nonres cycle to go in and retrofit existing products to the connected version, which is something we never have had before. So I wouldn't be surprised, as you think forward, this business looks a lot more like PMC, where it's half new, half retrofit. I think that everything we're doing with both organic and inorganic just sort get us to that mix. And regardless of that, we think our high relative share really protects us as we go through a cycle at some point. We don't see that cycle in the next 12 months, but from a strategic standpoint, we're working to make sure that when it does come, we're positioned to really outperform because of what we've done really since we bought the business 10 years ago.

[Operator]

Our next question is from Charley Brady from SunTrust Robinson.

[Charles Brady, analyst]

On the PMC slide, yellow box on Europe, not surprising there at all, obviously. But wondered if you'd just comment a little bit more on some of the geographies and the growth or lack thereof that you're seeing? And particularly in the European markets.

[Todd Adams, executive]

Yes, Charley, the yellow dot is not new. I think it's been there for a couple of quarters. I think we're just -- as we said when we made the change, we're just taking a little more cautious outlook on Europe, obviously, with some of the noise around things happening in Italy, the Brexit situation. We've just chosen to take a more prudent approach to the way that we think about the market. I wouldn't say it's underperforming by any stretch of the imagination. I think it's just certainly lower growth than in North America with some things to keep an eye on, just given the political and macro concerns that exist in the continent and in the U.K.

[Charles Brady, analyst]

Okay. So you didn't downshift in the past 3 or 4 months or so, it's just kind of been where it's at.

[Todd Adams, executive]

No, no. I mean, it sort of -- think about it as relative to other regions, that's the one that is probably just, from our standpoint, has a little bit lower market growth profile. But nothing different in the quarter.

[Charles Brady, analyst]

Okay. And then just on DiRXN, I think at the Analyst Day, you talked about rolling out couplings after the gearboxes just as far as full monitoring ability. Can you just talk about, I guess, have more deals signed on to that full monitoring ability on the gearboxes? And what's going on? Are the couplings now rolled out to have that capability as well?

[Todd Adams, executive]

It varies by customer, Charley, but yes. I mean, I think the product offering continues to advance. It also includes things like modular flattop belting and many, many more of our products. So the adoption rate is high. Customers are excited about it. I'm not sure I can add any incremental color, other than to say it's differentiated in the marketplace. People are talking about bringing to market connected products. But what they're bringing is products that provide information around heat, vibration and temperature without any context. And so if you're a customer, that's great. I'm hot, I'm hot, I'm hot, I'm vibrating, I'm vibrating, I'm vibrating, but it doesn't tell you why and it doesn't tell you what to do. And that's a huge differentiation between what it is we have, where the data is provided in context to a control system that tells the customer exactly what the issue is and what to do about it. And so we think the differentiation between what we've created, and it's taken us a long time to do, but it embeds 127 years of application expertise behind it, is a pretty big competitive moat. And to be able to do it across a broad series of power transition components, relative to other suppliers who could do it perhaps across one product category, it's a very differentiated approach. And so obviously, we're excited about what's been done, but we're getting to the phase where we're more excited about what it does for us from a growth and margin standpoint.

[Charles Brady, analyst]

Yes, and just to that point, I mean, can you quantify what revenues you're getting from DiRXN and kind of where that's going to be over the next 12, 18 months?

[Todd Adams, executive]

Well, last year, the first year of launch -- or first partial year of launch, we did about $20 million. In fiscal '19, which we're in right now, it'll probably be closer to $50 million, and it'll grow from there.

[Operator]

And our next question is from Bryan Blair from Oppenheimer.

[Bryan Blair, analyst]

I was hoping to circle back quickly on Centa. The original EBITDA guidance that you put out contemplated, I think, it was $13 million in incremental M&A contribution: $11 million, Centa; $2 million, World Dryer. With Centa's strong year-to-date performance, where has that number shifted in terms of the current guide?

[Todd Adams, executive]

Well, it's probably a little bit better than that. I don't know that we're going to get into specific contributions to EBITDA. We can tell you, from a growth standpoint, it's growing nicely as you can see in the reported versus core numbers. And from an M&A standpoint, it's probably a little bit ahead of what we had included in our initial guidance.

[Bryan Blair, analyst]

Okay, fair enough. And then on the Zurn side, you highlighted at Investor Day the expansion into adjacent fire and site works markets, seems like a very interesting longer-term opportunity. Can you provide a quick updates on those initiatives? Maybe size, run rate exposure and where those revenue streams may scale over the next couple of years?

[Todd Adams, executive]

Sure. I think the -- starting with fire protection, we've identified the -- about a $300 million segment of the market that we think we can really exploit by leveraging the Zurn brand as well as essentially all the components that a contractor needs to provide a quench fire protection system. Whereas today, they have to go to a number of providers. And as a result of that, the general contractor has very limited ability to value-engineer a solution for a building owner. The lead product, if you will, but the most important product in that, is the backflow prevention device. And so what we've done over the course of the last, call it, 9 to 12 months is build out the family of SKUs that allow us to go to a general contractor and help them value-engineer a solution for a customer so that they can provide the entire system to the end user with sort of the 1 invoice, 1 Zurn benefits. And everybody makes a little bit more money and it's so much easier to do. And so we're having great success there. But it started with having the Trojan horse of the product into that end market and the very best brand in that part of the market, which is Zurn backflow. Site works, we got into site works a little bit through an acquisition we made of Green Turtle 4 or 5 years ago. Aside from that, as we look to these growth adjacencies, the Water Management in and around commercial buildings as well as on highways, airports is a terrific sort of growth market for us. And we're thinking about that as about $150 million to $200 million market. And we've been aggressively pursuing building a rep channel to get to that. So what these are, these are products that are replacing poured-in concrete, right, which is expensive, difficult to manage, and these are drop-in solutions. And so in both cases, we're starting with great products, a differentiated go-to-market because we have the broadest portfolio with one brand and now attacking these 2 markets. And I would say it's still early. But if you look at our relative share in any other market we serve, it's 25% at the low end, a 50-plus at the high. We're coming into these markets with very low share. So we would expect the trajectory on that share gain over a number of years to sort of track to that 25-plus percent range. So you can sort of see the magnitude of the opportunity is probably $100 million opportunity over the next 3 to 5 years.

[Operator]

[Operator Instructions] Our next question is from Julian Mitchell from Barclays.

[Julian Mitchell, analyst]

Maybe just one question for me, I think. Just circling back to the EBITDA guidance for the second half relative to the first half, understood that water seasonally has a bit of a dampener in the second half. So maybe just trying to understand within PMC, would it be the case that some tariff impact and higher investment spend, that's what is maybe weighing on the increase in EBITDA in the second half? And maybe just help us understand what you think the gross tariffs impact will be over the next sort of 12 months, assuming List 3 fully gets enacted early next year.

[Todd Adams, executive]

Well, I'll try to unpack what you asked, sort of the tariff situation for us with a fully implemented List 3 in the fiscal year would be about $20 million, of which, through material substitution, alternate supply chain, selective price increases, we think results in absolutely no impact to our earnings, and in fact, results in a margin that's probably in the 20% to 30% range in EBITDA. So that's step number one. We don't have a tariff concern. We worry about what it does to long-term demand, but in terms of a headwind to our business in any way, shape or form, we just -- that's not in our second half. And we don't see that being the case, even if there is a fully implemented List 3. With respect to seasonality, obviously, we're expecting a better second half of earnings in our PMC business than our first. As I said, that we don't see any headwinds from tariffs. And obviously, we see earnings in the second half a little bit less in our Water Management platform as a result of the normal seasonality. So again, Julian, I don't know that we're answering your question as fully as you may like, but the tariffs are not the issue. If you're poking around that, hey, maybe the run rate could be a little bit greater; again, we're sort of balancing that with, hey, we've got 6 months to go in our fiscal year. We've had a really nice first half. The trajectory of the business is strong. All the things that we've done internally are bearing fruit. And we'll just watch how the year plays out. But at this point, we felt comfortable taking it up to where we did. And with any luck, we'll be back here in a little bit, and we'll have to give you the real fourth quarter number at that point because we'll have 9 months behind us. But at this point, we feel good about the year and where we're positioned heading into our fiscal 2020.

[Operator]

At this time, we have no further questions.

[Rob McCarthy, executive]

Thanks, 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 year 2019 third quarter results in early February. Have a great day.

[Operator]

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