Zurn Water Solutions Corp

NYSE:ZWS

Earnings Call Transcript 2022-Q2

[Operator]

Good morning, and welcome to the Zurn Elkay Water Solutions Corporation Second Quarter 2022 Earnings Results Conference Call with Todd Adams, Chairman and Chief Executive Officer; Mark Peterson, Senior Vice President and Chief Financial Officer; and Dave Pauli Vice President of Investor Relations for Zurn Elkay Water Solutions. This call is being recorded and will be available for one week. The phone numbers for the replay can be found in the earnings release the company filed in the 8-K with the SEC yesterday, July 26. At time for opening remarks and introductions, I will turn the call over to Dave Pauli.

[Dave Pauli, Vice President of Investor Relations]

Good morning, everyone and thanks for joining the call today. Before we begin, I'd like to remind everyone that this call contains certain forward-looking statements that are subject to the Safe Harbor language contained in the press release that we issued yesterday afternoon, as well as in our filings with the SEC. In addition, some comparisons will refer to non-GAAP measures. Our earnings release and SEC filings contain additional information about these non-GAAP measures, why we use them, and why we believe they are helpful to investors and contain reconciliations to the corresponding GAAP information.

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

One final reminder, we closed the Elkay transaction on July 1. So our second quarter results that we will be walking through today do not include the impact from Elkay. We will start reporting a combined Zurn Elkay with our third quarter results.

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

[Todd Adams, Chairman and Chief Executive Officer]

Thanks, Dave, and for everyone out there, just recognize Dave is a brand new dad three weeks ago. His wife Laura had a new son Nolan. So when you call him be sure to congratulate him, he's burning both ends of the candle here. So, thanks Dave for everything and congratulations.

So, well, good morning, everyone. And hopefully everyone had a chance to read through the earnings release last night. And we do certainly appreciate everyone taking the time to join the call this morning. As Dave said, the merger was completed on 7:1. And we've been working really, really closely together in the last few months in preparation of bringing these two businesses together. The strategic logic around the transaction continues to be exceptional. Complementary North American water quality, safety flow control, conservation and hydration products and solutions serving the same end markets and the same customers with both significant operational and commercial synergies.

I'm really pleased where we are with respect to the integration, probably three to six months ahead of where I thought we'd be at this point, because we've got a lot of important things already behind us in the few short weeks since we've closed. We’ve aligned the sales and marketing organizations into a single team just last week and we've already made or decided upon essentially all of the third-party rep changes that we want as a single business. In doing so we've established a single go to market and we'll be leveraging our proven demand creation capability which is super important and doing it right away will help us build the kind of momentum we want heading into fiscal year ’23, as opposed to dealing with that much change to start our full fiscal year as a combined business that maybe we contemplated originally.

We're also working through the change curve with the legacy Elkay team teaching and fostering a common language we're going to use to run our business, the Zurn Elkay Business System. In many, many ways this transaction reminds me of when the old Rexnord combined with the Zurn Business. We found a business with tremendous people, a great culture, fantastic products that could be better and go faster that even the Zurn team at that time thought. A really important difference is, we've got 15 more years of experience leveraging the Business System to develop and deploy a strategy, significantly more talent across the board to execute and an even clearer vision of what we can turn the combined business into. Because the only thing we're focused on is being the very best pure-play water solutions business in the market, and one that's a monster in both the marketplace and produces superior financial results.

In terms of the second quarter, which as Dave said, will be the last standalone quarter for the legacy Zurn Business in short, was really good. Sales growth of 17%, with 50% core growth and segment margins of 25.1%. Free cash flow was $41 million and leverage debt to $1.9 million. And when you look ahead to the end of ‘22 and to start fiscal year ‘23 leverage will be just above one times. We also announced an increase to the dividend last week to $0.07 a quarter, consistent with what we communicated back in February with the announcement of the Elkay transaction.

Before I turn it over to Mark, I want to touch on everyone's favorite topic of conversation in the last 24 months, supply chain. Taken as a whole, we've manage the unprecedented environment extraordinarily well, really for some time dating back to the onset of tariffs through the pandemic disruption and then the follow-on freight and logistics challenges that we've all dealt with. And doing all of that while growing at a double-digit topline rate. Consistent with what we said in the last three quarters, we're continuing to see our supply chain normalizing back to 2019 levels.

Just for some context, from the time we order things to the time we receive, convert and ship them, it used to take about 70 to 80 days. Obviously, just a proxy for the total, but think of it as our end-to-end supply chain loop. Then you have to back that into best-in-class availability and lead times with share gain driven double-digit growth and some seasonality. Our supply chain ballooned to about 160 days to 170 days over the last 12 months to 18 months. But through a bunch of effort and strategic changes to our supply chain sourcing and [indiscernible] processes along with some 80:20 work we've been doing, what we're seeing today is that, that's back into 80 day to 90 day range with further improvements through the fourth quarter and into fiscal year ’23. The punch line is that, you should expect to see a sizable inventory reduction for us over the second half of the year. And also what looks like a more favorable and freight -- favorable commodity and freight cost environment as we start fiscal year ‘23.

With that, Mark is going to take you through some financial details and I'll come back and cover a few details on the integration.

[Mark Peterson]

Thanks, Todd. Let's turn to slide number four. On a year-over-year basis our second quarter sales increased 17% to $284 million. On November '21, Wade Drains acquisition accounted for 2% of the year-over-year growth and the core business drove 15% of growth with generally balanced core sales growth across our water safety and control, hygienic and environmental and flow control product categories. With respect to profitability, our adjusted EBITDA, excluding corporate costs totaled $71 million in the quarter and our adjusted EBITDA margin was just over the high end of our expectations for the quarter at 25.1% and improved 60 basis points sequentially from our first quarter of 2022. On a year-over-year basis, about the benefits of the sales growth, inclusive of price realization and our productivity actions was partially offset by the increase in material and transportation costs as well as our investments in our growth and supply chain initiatives.

With respect to our corporate costs, it totaled $7 million in the quarter as we had expected and it should remain at that approximate level per quarter for the balance of the year. Please turn to slide number five, and I'll touch on some of the balance sheet and leverage highlights. With respect to our net debt leverage, we ended the quarter in line with our expectations at 1.9 times pro forma for the adjusted annual corporate expense run rate I just discussed. When it includes Elkay, our leverage will continue to decline, and by the end of the third quarter will be at a level that will trigger a 25 basis point reduction in our base term loan rates. As we look to the end of the year, we continue to anticipate and in the year in the low 1 times range.

With that, I'll turn the call back the Todd to cover some highlights from the Zurn Elkay combination.

[Todd Adams, Chairman and Chief Executive Officer]

Thanks, Mark. I think I'm on slide six. So on this page, this is what constitutes Zurn Elkay in terms of the sectors of the water solutions market we serve. In drinking water, the legacy Elkay brand is the gold standard for providing clean drinking water in public and private spaces. In terms of relative market share and specification rates, nobody comes close. The fundamental growth drivers in drinking water is really twofold, access to clean filter drinking water coupled with the sustainability aspect of eliminating plastic bottles into landfills, where we see billions of water bottles annually. The second growth driver is the retrofit replace market of the traditional drinking fountain. With over 8 million of these installed and only about 1.4 million bottle fillers installed, we see significant runway as we drive conversion in key institutional end markets, while building an even larger installed base. We also see path to add-on and build the filtration aspect of the product and category, leveraging our connected capabilities for seamless monitoring and also signaling the replacement of that.

In water and safety control, where we've seen significant share gains in the last several years, we provide back flow prevention, pressure relief valves, irrigation valves, as well as all the valves required in a quench fire protection system. Superior flow curves, ease of installation and by far the lowest total cost of ownership, puts us in the driver seat from an industry perspective trend. As labor savings and availability become huge factors in decisions the customers make. The amount of patented third-party approved innovation in this category is critical and we believe that we have the number one single brand in the back flow.

The hygienic and environmental sector is essentially everything required to create a safe hygienic space inside of a commercial restroom, along with the connected capabilities to improve maintenance effectiveness, eliminate outages and damage to building during flood or leak events. Touch sensor product, sinks for restrooms, labs, health care facilities and food processing along with partitions and hand dryers. In this category we're leveraging our unparalleled solution set under the bright shield umbrella to provide real value to high traffic institutional and commercial customers who are migrating their environments to meet the well 2.0 standard.

And finally in flow systems, this is where we have the most comprehensive product portfolio in the industry. Essentially, providing a solution everywhere water needs to be controlled and moved efficiently and effectively throughout a building. Whether that's a rough floor, runway, highway or even internal to the building the Zurn spec rate is exceptional and we compounded that with also owning the weight brand of drainage products. At a high level, 55% of the business is new construction and 45% is combination of retrofit replace along with repair parts that happen as part of a regular MRO event. And this is true across essentially every core category with the exception of flow system, which is primarily new construction.

From an end market perspective, we're over 70% institutional and commercial. Within that 70% our largest single exposures are within the top end markets of healthcare and education. Two end markets that continue to perform nicely and where we continue to exert growth. Elkay only increases our exposure to these two end markets. The [Dodge] (ph) Momentum Index is an indicator of the strength of our end markets. As of June the Momentum Index was at a 14 year high, indicating that there are a lot of economic pressures and uncertainties right now, but the non-residential construction market continues to remain strong. Our residential exposure is primarily on the Elkay side and this is a category that we're still digging into and evaluating. And it's my sense that as we work through the integration you'll see us leverage our 80:20 methodology to do a little pairing or trimming in areas where we don't see the opportunity to create a competitive advantage.

We're delighted to have roughly 98% of our revenues in North America. A large mobile population, highly specified with code variations across every city, town and municipality and over 95% of our revenues come from either a number one or number two market share position. What I hope you take away from this is, we’ve built a significant sustainable competitive advantage in a served market that's over $9 billion today, and we see opportunities for growth within both our served market, as well as room to continue to grow our served market as we enter into new categories.

If you could move ahead just one page to slide seven. Given the highly complementary nature of the combination, products also sold to the same customer, same end markets with the same go-to-market approach, we thought there to be a significant opportunity over time to leverage the Zurn Elkay Business System to drive a broad amount of synergies initially targeted at $50 million across SG&A, manufacturing and supply chain and finally 80:20. As we've developed our integration plans and phasing we placed a high priority on aligning the sales and marketing organization, so that we can quickly present ourselves as one place to the marketplace and to our customers. We'll also look to combine our functional areas where it makes sense, leveraging one corporate structure and team and then begin to work on our purchasing, logistics, distribution and supply chain work streams to capture the synergies of nearly $1.7 billion business today with growth into the future.

I talked earlier about 80:20, but the opportunity here is significant. The discipline of segmenting products and customers, simplifying the business is something that is new to the legacy Elkay business. As we found in Zurn, this takes a little time, but once completed and executed the benefits will be dramatic and will allow us to focus on the critical few things and eliminate all the waste and the complexity that can build up over decades. I think the way to think about the synergy, the combination at this point is that we're highly confident in the $50 million we've outlined, and we've got a growing funnel of opportunities that will identify, develop, communicate and execute over time.

If you can move to page eight. Having a well-established approach to how we run our business has been a true game changer for us. For us, it's a common language and approach to the key pillars of people, plant, process and performance, that engages prioritize and aligns everyone around the most important things with clearly defined resources and accountability at the point of impact. Our strategy deployment process deploys our long long-term strategy into action plans, KPIs and work that happens every day with complete transparency and we reinforce that by paying for performance. As we become a pure play water business and now an even larger pure play water business, we recognized and embraced our role in water stewardship sustainability and helping the environment. We believe in it strongly enough and actually included purpose as one of the core principles of ZBS.

ESG isn’t something we just talk about or report on once a year, it's integrated into the way we think about and develop our long-term strategies. How we engage our associates and understanding what we do matters, to save water, provides clean drinking water and we realized that we have an obligation to play a role in tackling some of the world's most pressing water challenges. What’s also important is that, purpose really matters to our people. It aligns everyone around the same goals, everyone in Zurn Elkay is on an annual incentive plan. Everyone at Zurn Elkay has equity in the company. Everyone gets 20 hours of paid volunteers that helps us attract, retain, develop and promote highly -- highly engaged workforce and that's really what makes the difference. Our associates have access to our wave social impact fund where we cultivate fund and deploy solutions that advance our efforts around the environment. And we're also having a meaningful positive impact in the areas we live and work.

The last one for me is on page nine. We strongly believe that part of creating a high performing business and culture is clarity. This page takes what we try to -- what we're trying to accomplish, really down just a one-page. First is focus, pure play water and categories where we can build a sustainable competitive advantage and we work every day to build a bigger and bigger moat around our business. Next is the how and what. Leveraging ZBS to drive growth, margins and cash flow, both within our core business as well as with smart acquisitions. And finally, driving measured performance for our customers, shareholders, associates and the environment.

With that, I'll turn it over to Mark for the outlook.

[Mark Peterson]

Thanks, Todd. Please turn to slide 10 and I'll cover some of the highlights of our outlook for the third quarter. For the third quarter of 2022, we are projecting Zurn sales to increase year-over-year by a high-teens percentage and we anticipate Elkay related sales to be between $145 million and $155 million. With respect to margins, we expect our Zurn Elkay adjusted EBITDA margin, excluding corporate costs to be between 21% and 22% in the quarter, which result in 100 basis point to 200 basis point expansion year-over-year when you pro forma the third quarter of 2021 for Elkay. We anticipate corporate costs in terms of adjusted EBITDA to be approximately $7 million in the quarter.

Before we open the call for questions a few comments on our interest expense, stock comp expense, depreciation and amortization, tax rate and diluted shares outstanding for the September quarter that will include the preliminary estimated impact of purchase accounting, as well as the new shares issued with the merger. Please note, the depreciation and amortization will most likely change as we finalize the purchase accounting over the coming quarters. But as of now, these are our best estimates. We do not expect a material deviation. We anticipate interest expense to be approximately $8 million, our non-cash stock comp expense to be about $8 million, depreciation and amortization will come in around $22 million, which consist of approximately $8 million of depreciation and approximately, $14 million in amortization. Our tax rate and adjusted pre-tax earnings to be between 27% and 28%, and diluted shares outstanding will be approximately $179.5 million to $180.5 million in the quarter.

So, before we turn it over to questions, I'll just make a few final comments. Number one, I'm sure there are a lot of questions with respect to what's Elkay, what’s Zurn. I'll tell you, the businesses are coming together incredibly fast. And so, I think we're going to stick with our convention of guiding one quarter forward with one segment, but I'll try to give you a little color in terms of how to think about both the third quarter and the full year.

With respect to the third quarter, and specifically around the Elkay numbers. Number one, I think we're trying to be a bit conservative. This is a new acquisition, it’s significant, there is a lot of change and moving parts, as I talked about in my earlier comments with respect to both the sales organization, as well as all of our third-party reps. Some color there really would be, we had roughly 40 reps between the two of us, we've migrated that down to about 30. Half of those there was really no change, where we actually shared third-party representation. The remaining half, three quarters of that were Elkay reps that are now becoming Zurn Elkay reps and the remaining quarter, a combination of Zurn reps or Elkay reps that are taking on the Zurn line and some changes, so a lot of moving parts.

The other thing to contemplating and consider is, we're also getting after 80:20 right away. This number, obviously, assume some level of [indiscernible] revenue in it. And so I think it's probably a little bit inaccurate to think about this as the true underlying run rate. But nonetheless, we think if we can make the changes we've made around the sales and marketing organization to get that moving at a nice clip, make the rep changes, as well as get some of the 80:20 done. We think the third quarter is in a great spot and puts us on the right trajectory heading into '23.

With respect to the full year for Elkay, which we'll never report when we report at second half, but fundamentally the way to think about the first half of the year was that, it was a little bit behind maybe what we would have hoped for. I think there is a handful of reasons. Number one, I think the legacy Elkay business was probably just a little bit behind implement and holding the pricing that was necessary in the market, given the inflationary environment. Number two, I think the team, both internally and along with all the third-party reps that we're going through a bit of uncertainty were just a touch distracted. And finally, as we dig into it post pandemic and throughout '21 they saw a combination of demand spikes and some capacity constraints, lead times extended, the backlog grew, when the backlog grows people placed more orders. The team did everything they could to bring that backlog down and in-line to where it has been historically and sits today.

As a function of that, the order rates really towards the end of '21 and first half of '22 were just a touch behind. All that being said, the Elkay business is growing, when you adjust the backlog reduction last year relative to second half, we are seeing the double-digit growth that we thought. And from an EBITDA perspective, the run rate in the second half looks to be in the range of 85 to 90.

And I'll also remind everyone that, as we think about the synergies in '23 and '24, we've got a growing funnel of opportunity there. And so, before we turn it over to your questions, I wanted to provide that kind of color. And with that we will take your questions.

[Operator]

Thank you. [Operator Instructions[. Your first question comes from Bryan Blair from Oppenheimer. Please go ahead.

[Bryan Blair, Oppenheimer]

Thank you, Good morning guys.

[Todd Adams, Chairman and Chief Executive Officer]

Good morning, Brian.

[Mark Peterson]

Good morning, Brian.

[Bryan Blair, Oppenheimer]

So I would start with your core growth and dig in a little bit there. Came in ahead of our expectations in the second quarter is, obviously, strong momentum into Q3. Are there any end-markets or product lines that are really outperforming the rest of the portfolio or exposures now? And how should we think about volume versus price in your high teens guide for Q3?

[Todd Adams, Chairman and Chief Executive Officer]

Yeah. I’ll let Mark touch on the numbers, but fundamentally it’s very consistent across really all the sectors that we serve, right? I wouldn't call one and outline. I mean, we talked about really, really strong order rates in hygienic and environmental. Last quarter that continues, flow systems is very good as is water safety and control. So I wouldn't say anything as an outlier relative to the 15% core sort of growth. And Mark, you can cover --

[Mark Peterson]

Yeah. Bryan, on the price element, I think we've been consistent in saying we're going to be delivering a high single-digit price in the year and in the back half of the year and that has not changed. That's consistent with what we've expected. I think some of the incremental growth we just -- we've done some things strategically [indiscernible] saw some of our initiative. I think we just feel like we're doing a little bit better on some of that share capture then we are anticipating the first half, and I’d say in the back half of -- the market probably is a touch on back half as well and the combination was driving on some better projected topline growth in third quarter and what we have talked about in the first half of the year.

[Bryan Blair, Oppenheimer]

Okay. I appreciate the detail there. And Todd, you mentioned that Elkay growth has been a little behind what the team has had hoped coming into the close of the deal. Can you parse out growth on the drinking water side versus sinks and faucets?

[Todd Adams, Chairman and Chief Executive Officer]

Well, I think the way to think about it is, the elements of maybe some of the -- not the same level of growth, it’s really split between both. I think the price and holding the price in an inflationary environment, that really apply to both categories. The distraction risk really with both the internal team, as well as some of the third-party reps, that applies to both. And then, obviously, the lead time is probably a little bit more weighted towards the drinking water side of things. So I would call it a meaningful difference, Bryan. But I would say the lead time and then the slight air pocket from an orders perspective was really more on the drinking water side.

[Bryan Blair, Oppenheimer]

Okay, understood. And I understand that 2023 guidance is not out there yet, but 2023 recession fears have gripped the market for most of this year. Given current visibility Zurn Elkay’s end-market profile and product mix, are you seeing anything specific to your business right now that concerns you of a meaningful pullback going into next year?

[Todd Adams, Chairman and Chief Executive Officer]

No. Obviously, we're not guiding for '23 and we're really not even guiding for the fourth quarter at this point. So we've got some road to travel before we get there. But I do think, number one, I think our proven demand creation opportunities in all sorts of markets, I think gives us a ton of confidence. And I don't know what the number of quarters is at this point, Dave, 47 or –

[Dave Pauli, Vice President of Investor Relations]

48.

[Todd Adams, Chairman and Chief Executive Officer]

In the last 48 quarters Zurn has had one quarter, so we were down year-over-year. So I think that gives us some confidence that we're going to continue to grow. We think adding Elkay into our demand creation process and system creates a ton of upside and leverage heading into '23. And I would just say, you can find your way to a double-digit growth rate without much market growth. We've got some carryover price. We've got some share gain initiatives. And if the market and the forward look is just a touch positive, I think we've got the opportunity to do another double-digit year. And then we've got several sales synergies to really work through as we head into '23. And so, we're obviously cautious in watching it and monitoring it. But in my opening comments we talked about the forward look, and I think people are still very busy. I think there's a lot of work that's going to get done into '23. And so, still early, but I think that's the way we're thinking about it.

[Bryan Blair, Oppenheimer]

All helpful color. Thanks again, guys.

[Operator]

Your next question comes from Nathan Jones from Stifel. Please go ahead.

[Nathan Jones, Stifel]

Good morning, everyone.

[Todd Adams, Chairman and Chief Executive Officer]

Good morning.

[Mark Peterson]

Good morning.

[Nathan Jones, Stifel]

I'm going to start off with some questions on Elkay. Can I just get a clarification that, Todd, did you say the EBITDA run rate in the second half looks to be in the $80 million to $90 million range?

[Todd Adams, Chairman and Chief Executive Officer]

No, I said $85 million to $90 million.

[Nathan Jones, Stifel]

85 to 90. Okay. So you talked about -- so Elkay here when they deal we've been [indiscernible], and so we're a little bit behind that. Do you feel like these are air pockets where we can -- where you're going to catch up back towards that run rate? Is $85 million to $90 million on $600 million of revenue or something like that the right base for us to look at from 2022 to forecast Elkay going into 2023?

[Todd Adams, Chairman and Chief Executive Officer]

Yeah. I think that's entirely reasonable, Nathan. I'll just say, when we announced the deal, we probably sort of rounded the number to $700 million, some people have took the $700 million and moved it to $750 million. By the time we actually aligned around a forecast that was probably still early in the year, we were at $665 million. But I think if you were to use that kind of range, I think you're -- I think you're in a decent jumping-off point to think about '23.And the only unknown at this point would be, what do we see a synergy upside from the $50 million that we've sort of pencil in today. And we'll think through what that might look like over the next several months, but that's probably a good place to start.

[Nathan Jones, Stifel]

Probably a bit unfair to ask about synergies above the $50 million, but I did want to ask about just philosophically your thoughts on revenue synergies here? I would say that having more products to market to the same customers as ones Zurn Elkay would give you an advantage and there should be revenue synergies for the business here, can you just talk about what kind of synergy opportunities on the revenue side you think there will be? How long those things kind of take to kick-in?

[Todd Adams, Chairman and Chief Executive Officer]

Well, we don't -- we haven't baked [indiscernible]. I would encourage you maybe not to make them in yet, but I do think the overall pull through bundle opportunity, but there is only upside. When you think about the prior way, we went to market and they went to market, you could have a scenario where a third-party reps in a relationship with an end-user or a contractor or an engineer would have had Elkay and then another brand and another brand. And now we have the opportunity to pull through really all of the other product categories pending where we have stronger relationships. So we think the alignment gives us a real leg up with building owners, engineers, architects, mechanical contractors, as well as with the third-party reps that we leverage and wholesalers. So I think that those are going to be pretty evident and they will happen. And I think we’ll have a view on how to dimensionalize that a little bit. But suffice it to say, there is only upside from a revenue synergies as we head into ‘23 and ‘24.

[Nathan Jones, Stifel]

And just one more on inventory and cash flow. Mark, any color on kind of where you think inventory or how much inventory is likely to come down? And what that contribution to cash flow is going to be in the second half of the year?

[Mark Peterson]

Yeah. Nathan, I think when you look at the back half of the year, as we've talked about, we put a conscious effort in place to build our inventories up in the first half to assure availability, and that has worked well for us. But now we are in a great spot, and I think the back we're looking at, I call it, ballpark $40 million plus or minus by the inventory reduction within our core business to drive the cash that we expected for the balance of the year.

[Nathan Jones, Stifel]

Great. Thanks for taking my questions.

[Todd Adams, Chairman and Chief Executive Officer]

Thanks, Nathan.

[Operator]

Your next question comes from Jeff Hammond from KeyBanc. Please go ahead.

[Jeff Hammond, Keybanc Capital Markets]

Hey, good morning guys.

[Todd Adams, Chairman and Chief Executive Officer]

Good morning, Jeff.

[Mark Peterson]

Good morning, Jeff.

[Jeff Hammond, Keybanc Capital Markets]

So just back, finally, on the kind of the reset on Elkay from the $665 million to $600 million kind of annual run rate. Is that -- I mean, should we think about that as largely this water fountain air pocket, because I'm just trying to get a better sense of how much is that issue versus real demand weakness versus 80:20, some of the distractions?

[Todd Adams, Chairman and Chief Executive Officer]

Well, I mean, Jeff, maybe the way to think about it is the following. If you think about $665 million to, call it, $600 million, a good portion of that variance is really first half related. The difference would be really some of the 80:20 actions that we've got dialed in in the second half that would not have been the $665 million. And so, you asked about the fundamental growth, if we adjust the second half last year for some of the backlog reduction, particularly in drinking water, we're seeing clear double-digit growth in drinking water in the second half. If you look at the core Zurn business, which are similar product, same customer, same end markets, we're growing in high-teens. So from our standpoint, this is really a dynamic that happens because we were a little bit line on price in the first half. There's a whole bunch of moving parts with respect to the sales and Rep Organization. We’ve got this backlog draw down in the second half of last year, and lead times are back to where they need to be.

And so, from my standpoint, yes, we would have liked it to run rate in a little bit higher, but the second half is sort of, I would say, very consistent with what we would have expected and will look a lot more Zurn like in terms of its growth performance going forward after we adjust for the sort of correction that happened really before we own the business.

[Jeff Hammond, Keybanc Capital Markets]

Okay. And then just -- you talked about kind of them being behind on price, kind of what -- what's the process around pricing and had they announce kind of additional pricing or you guys announce additional pricing actions here to kind of get some of that up?

[Todd Adams, Chairman and Chief Executive Officer]

Yeah. I mean, the dynamic of extending lead times and a big backlog doesn't put you in the greatest position to implement significant price. And so I think that Elkay was a little bit more conservative, making sure that they were reducing backlog, holding lead times and maybe a little less focused on capturing all of the price that they probably deserved. And so, as that backlog has come down and lead times are back to best-in-class levels, we feel the timing is right for price, and we've got that in and that's in the second half. And then from a process standpoint, we've got price and price management aligned around really one team in that sales and marketing organization that we've snapped together. So I don't think we'll have any disparities or differences in the way we go to market and how we price things really effective today. So I think that's sort of a behind us sort of issue.

[Jeff Hammond, Keybanc Capital Markets]

Okay, great. And then just last one. A lot of good color on kind of supply chain. I'm just wondering kind of if you see any temporary risk around kind of China restart, kind of supply chain getting locked up at all around that. And just on the core, how you think about the margin trajectory in the second half versus kind of how you're thinking about it 90 days ago?

[Todd Adams, Chairman and Chief Executive Officer]

I think from a supply chain standpoint, there is always the potential for things to happen. But from what's in our control, I think my comments would support our belief that we are in a really, really good shape. I mean, if I look at what we've got sort of in flight or in process for the fourth quarter, I don't think we've ever had more visibility to how we deliver the second half with the supply chain we have. So, that feels really good.

I think in terms of the margin progression. I think it's very much on track with what we talked about 90 days ago. Obviously, as we merge these businesses together and blend everything from corporate functions to sales and marketing, to reps and rebates and everything else, we're already seeing a 100 basis point to 200 basis point pro forma expansion in the third quarter. And I would say that, that really wouldn't have much if any synergy in it. And so, as we think about the second half, beginning with the third quarter into the fourth quarter and then the trajectory into

‘23, I think we're very much -- I think we're confident that prices holding, there is a likelihood to commodities and freight costs are lower into next year. So I think from a margin perspective, it's shaping up, I would say, on track to maybe a little bit better than maybe what we would have thought [Multiple Speakers] 90 days ago.

[Mark Peterson]

Yeah. Second half and really strong ‘23. Yeah.

[Jeff Hammond, Keybanc Capital Markets]

Okay. Thanks guys.

[Todd Adams, Chairman and Chief Executive Officer]

Thanks.

[Mark Peterson]

Thanks Jeff.

[Operator]

Your next question comes from Mike Halloran from Baird. Please go ahead.

[Mike Halloran, Baird]

Good morning, everyone.

[Todd Adams, Chairman and Chief Executive Officer]

Hi, Mike.

[Mike Halloran, Baird]

First on the balance sheet side, just, obviously, Elkay now closed, you guys got a lot of heavy lifting there, any restrictions from your perspective on going out and seeing what that pipeline can bring in and maybe some thoughts on how that pipeline looks right now?

[Todd Adams, Chairman and Chief Executive Officer]

Mike, we do have a terrific balance sheet and we know we continually cultivate things that fit into the pure play water solutions sort of mode. There aren't any restrictions on really what we can or can't do. I think our view has always been invest the time, stay away from auction processes and cultivate really good ideas that we can leverage. And so, none of that's changed. I think the pipeline is, I would say, very active. But I also think we have the opportunity to be patient. So our priorities are deliver a terrific second half, generate a ton of cash flow, position ourselves to capture the synergy savings into '23 and beyond, and hopefully, that's a little bit more. And also we do have to management the capacity to do more. So I think from our standpoint nothing has changed. And I would say, if anything the richness of the conversations really over the past year plus is far better than it had been, so we're still in the game.

[Mike Halloran, Baird]

Makes sense. And then on the synergy side there, obviously, in your prepared remarks you talked about where the focus has been, sales and marketing, rep network, things like that. And when you think about the core synergies, the sourcing and the other three pieces you kind of laid out in that $50 million. Have you started work on that or is that something that's still on the come? And how are you managing kind of that cumulative process from a cadence and perspective?

[Todd Adams, Chairman and Chief Executive Officer]

Yeah. We've absolutely started -- we've mapped what we're planning to do, how we're going to do it, when we're going to do it? And some of those work streams are already in play. So it's not a -- we're going to pick it up on 1-1-23, I would say, I'm optimistic that now that we've got a lot of the sales and marketing and corporate stuff behind us, there is an opportunity to perhaps accelerate some of that in the back -- and get more done in the back half than maybe we would have contemplated. So it's not like we're three to six ahead and we're going to take a break. There's a reasonable chance that we continue to pull stuff forward.

[Mike Halloran, Baird]

Thanks for that. Appreciate it.

[Todd Adams, Chairman and Chief Executive Officer]

Thanks, Mike.

[Mark Peterson]

Thanks, Mike.

[Operator]

Your next question comes from Joe Ritchie from Goldman Sachs. Please go ahead.

[Vivek Srivastava, Goldman Sachs]

Thanks. This is Vivek Srivastava on for Joe Ritchie. My first question is on the education vertical, it’s a pretty big end market for you guys. Can you provide an update on the conversations you're having within this vertical, with your customer? And especially for the Elkay business, are you seeing some faster sales conversion, especially given like this conversion going on from fountains to bottle filling stations, and schools have a pretty significant stimulus funding right now?

[Mark Peterson]

Well, I think on [indiscernible] vertical is a big vertical for us, and I think the combination of this business -- these businesses, that was one of the pluses for us. When you think about the bottle filling stations, combined with what we built out on bright shield, a big opportunity going forward. I would say, to the first part of your question, the richness of the conversations are only getting stronger. And that's one of the reasons why we've, as Todd mentioned earlier, we really pushed hard to get the commercial front-end integrated as soon as possible to get alignment, because one of our key growth initiatives and have a team built collectively across the organizations around education vertical to drive that opportunity. So I think, for us we feel really good about it, bullish on it. We haven't changed our stance. And I think over time when we think about the sales synergies of the organization, that’s a huge piece of the puzzle for us. And having that team aligned early, having the reps aligned early, getting people marching towards that strategic initiative sooner rather than later only benefits us as we go into '23 and into ‘24.

[Vivek Srivastava, Goldman Sachs]

Thanks, that's helpful. And just one more on free cash flow. On the Elkay free cash flow side, as we have had more time to spend with the Elkay team. Can you share some of the opportunities which are there within the Elkay business in terms of free cash flow improvement? And any color you can provide on the timeline of driving those improvements?

[Mark Peterson]

Yeah, couple of things from a cash flow standpoint. I think we will -- over time we will manage I think the working capital a bit tighter and then how the business manage it. So I think there is definitely going to be working capital opportunity in more later part of this year and into '23, it takes a little bit of time, but that’s an opportunities. And the other piece of the puzzle is CapEx. They are more vertically integrated than us, and obviously, their CapEx is going to be a bit higher, but as I think through, some of the things that we're going to do are [indiscernible] simplification and just bit of a different mindset around capital. We think there is an opportunity to reduce the capital intensity of the business going forward. Those were the two areas as we looked at '23 and beyond where we see the opportunity to improve cash flow run rate and the business [indiscernible] for the past several years.

[Vivek Srivastava, Goldman Sachs]

Great, thank you.

[Operator]

[Operator Instructions] And your next question comes from Brett Linzey from Mizuho. Please go ahead.

[Brett Linzey, Mizuho]

Hey, Good morning everybody.

[Todd Adams, Chairman and Chief Executive Officer]

Good Morning, Brett.

[Brett Linzey, Mizuho]

Hey just wanted to come back to couple of your comments, Todd, on the more favorable freight and cost environment. Let's just assume that these supply chain issues and inflation issues begin to resolve in some of the areas you talked about. How are you thinking about those tailwinds into '23? I think you mentioned 100 basis points to 200 basis points in the second half, is it fair to think about a similar magnitude of tailwind as we're looking into '23 here too?

[Todd Adams, Chairman and Chief Executive Officer]

Well, we're not -- I wouldn't spend them yet, but yeah, I think that's totally reasonable. I mean if you look at -- if you look at the cost of a container, if you look at some of the input commodities that are significant portions of our products. They're all down considerably over the last six months, we'll see if that holds or not. But I think my view, our view would be, container costs are going to sort of moderate to the levels that are where they are today or perhaps a little bit lower. I think commodities for the most part have been really volatile, they stay where they are. There is a sizable upside. So I think don't spend it yet, but I think that there is a good chance that as we -- as we get through the fall here and into next year, I think it's highly likely that we're going to see a more favorable cost environment than what we've seen certainly in the last two years.

[Brett Linzey, Mizuho]

Okay. Great, thanks. And just a follow-up on that supply chain. I mean you guys have done a lot of work. Could you just level set us on some of your regional concentration, China versus Mexico, Indonesia? And with the Elkay close, I mean, are you thinking that might continue to evolve or how you run that playbook?

[Todd Adams, Chairman and Chief Executive Officer]

Yeah. I mean the supply chain will absolutely continue to evolve. I think we're going to end up -- when you look at it in aggregate, China will be less than 40%. And so, that was upwards of 75% five years ago. So I think the migration to regions and some of what you've talked about, some of which you didn't will continue really over the second half of this year as well as into '23. And so, our view is that, how do we create the less total cost supply chain with the most amount of flexibility. And I think the work that our teams have done and now that we're combined with Elkay will continue to evolve and really, really pleased with where we sit today and the work we've done to navigate through what's been a while, three or four years. But it feels like it's much more stable, resilient and derisked relative to where we were a while ago.

[Brett Linzey, Mizuho]

Yeah. That's great. And just one clarification on the synergies. I imagine there'll be cost to achieve. How are you thinking about the reporting mechanics of that? Are you going to spike those out as non-recurring and excluded them from results or are those going to be embedded? And then if you could just size them too that will be great?

[Mark Peterson]

Yeah. The cost to achieve -- well, primarily we spiked out. So a lot of it -- you can appreciate, one is tied to headcount changes or cost if you're moving facilities and whatnot. The majority of that will spiked out. There will be some that will just be inherent to the run rate, but I think -- I'd call that party material and the material component of it we will be calling out, so people have the visibility to the numbers without that baked into it.

[Brett Linzey, Mizuho]

Got it. All right, thanks for the color.

[Todd Adams, Chairman and Chief Executive Officer]

Thanks, Brett.

[Operator]

And there were no further question at this time. I will turn the call back over to the presenters for closing remarks.

[Dave Pauli, Vice President of Investor Relations]

Thanks everyone for joining us on the call today. We appreciate your interest in Zurn Elkay Water Solutions, and we look forward to providing our next update when we announce our September quarter results in late October. Have a good day everyone.

[Operator]

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