Zurn Water Solutions Corp

NYSE:ZWS

Earnings Call Transcript 2019-Q3

[Operator]

Good morning, and welcome to the Rexnord Third Quarter Fiscal 2019 Earnings Results Conference Call with Todd Adams, President and Chief Executive Officer; Mark Peterson, Senior Vice President and Chief Financial Officer; and Rob McCarthy, Vice President of Investor Relations for Rexnord.

This call is being recorded and will be available on replay for a period of 2 weeks. The phone numbers for the replay can be found in the earnings release the company filed in an 8-K with the SEC yesterday, January 30.

At this time, for opening remarks and introductions, I'll turn the call over to Rob McCarthy.

[Rob McCarthy, executive]

Thanks, Paulette. Good morning, and welcome everyone.

Before we get started, I need to remind you that this call contains certain forward-looking statements that are subject to the safe harbor language contained in the press release that we issued yesterday afternoon as well as in our filings with the SEC. In addition, some comparisons will refer to non-GAAP measures. Our earnings release and SEC filings contain additional information about these non-GAAP measures, why we use them and why we believe they're helpful to investors and contain reconciliations to the corresponding GAAP data.

Consistent with prior quarters, we will speak to core growth, adjusted EBITDA, adjusted earnings per share and free cash flow as we feel these non-GAAP metrics provide a better understanding of our operating results. However, these measures are not a substitute for GAAP data, and we urge you to review the GAAP information in our earnings release and in our filings with the SEC.

Please note that the presentation of our operating results is focused on our continuing operations as our VAG operations, the sale of which was completed during the quarter, are reported as discontinued operations. Today's call will provide an update on our strategic execution, our overall performance for the third quarter of our fiscal 2019 and our outlook for fiscal year 2019. We'll cover some specifics on our 2 platforms followed by selected highlights from our financial statements, and then 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 hopefully saw in our release last night, our third quarter results were generally right down the middle. We continue to be pleased with the progress we've made in building upon the competitive advantages we enjoy in both platforms while leveraging RBS to drive consistent execution. We're also well on our way to delivering a record year for free cash flow. And coupled with delivering adjusted EBITDA towards the higher end of our original forecast, we expect to end March of '19 with our leverage ratio right around 2x and heading lower into fiscal 2020.

Fundamental market demand continues to support growth and margin expansion in both of our platforms, and as I'll speak to in a moment, we are seeing the benefits read out from our strategic initiatives around innovation, cost reduction and commercial excellence, which positions us really well across a wide range of potential macro and end-market scenarios in our upcoming fiscal 2020.

With just a quarter to go, we're going to continue to maintain our cautious approach to forecasting, which, as a consequence, results in us slightly raising our adjusted EBITDA outlook for the year, which we now project to be in the range $437 million to $443 million while affirming our core growth outlook.

Looking more closely at our third quarter results. Sales of $485 million included core growth of 6% and were up 11% on a reported basis. Core growth in our Water Management platform was 10% year-over-year even as the year-over-year comparison became more difficult. PMC delivered 4% core growth with balanced growth across our aerospace, process and consumer-facing end markets. We delivered another double-digit growth EBITDA -- quarter of EBITDA, which resulted in $103 million, with solid operating execution and margins in both platforms. Adjusted EPS was $0.47 for the quarter and was up 21% over the comparable year-ago figure. Mark will review both the consolidated results and the performance of each platform as part of his comments a little later in the call.

Please turn to Slide 3. Looking at our operating platforms. Core growth in our PMC platform normalized in the third quarter as growth in shipments to our aerospace end markets returned to the average level that we saw over the first half of our fiscal year and demand trends were stable across PMC's consumer-facing and process industry end markets. PMC's adjusted EBITDA margin was 22.3% as we continue to offset the impact of tariffs and overall cost inflation on our margins and delivered a core incremental margin above 30%.

Centa, which we acquired almost a year ago now, continued to perform really well in our third quarter and is turning out to be a terrific acquisition for us. We've leveraged our RBS integration process to drive improvements across the business in the areas of safety, quality, delivery and cost, which have, in turn, significantly improved our ability to win new business. We're well ahead of the original milestone we set to deliver, the 1,000 basis points of margin improvement at Centa by our fiscal 2021. Post the end of the quarter, we acquired the remainder of Centa China, of which we previously owned 47.5%.

Results in our Water Management platform continue to be strong in the third quarter, with our core growth driven by strong demand across both commercial and institutional verticals. In addition to the stable growth we're seeing in North America nonresidential building construction activity, we're gaining increasing traction with our market expansion initiatives in the fire protection and site works adjacencies, and our innovation pipeline remains strong. We're excited about the prospects for our expanding offering of smart, digitally connected product solutions, and we expect to see a growing incremental revenue contribution from these beginning in our fiscal 2020.

Like everyone else, we continue to monitor the tariff situation and the resulting uncertainty it creates for our customers. But our order growth to date has continued at healthy levels in both platforms. We're confident that we positioned ourselves to mitigate any negative impact on our EBITDA margins, whether the tariffs stay at current levels or they increase, and that we can continue to manage the price/cost equation in both the intermediate term and over the long term.

To wrap up, the way to think about our third quarter and outlook for our fiscal '19 is that we're very much on track despite a fair amount of macro challenges that we've been able to successfully navigate. Even more important is the fact that we're on the trajectory we're on as a result of the compounding effects of the strategic initiatives we've deployed over the last several years.

If you turn to Slide 4, I'll spend just a little time on how that all translates into how we're set up to perform heading into our fiscal 2020 and beyond. As we interact with investors during the course of the quarter and as equity market volatility spiked, everyone's attention turned to growing concerns about potential changes in the global economic environment. This slide provides a snapshot of the objectives we've been laser-focused on for the past 3 years that we believe provides some visibility of our ability to perform in both well in the coming year and across a wide range of economic scenarios.

As we discussed in virtually every interaction with investors as well as with the sell side, we've spent the last couple of years preparing for the business eventuality -- preparing the business for the eventuality of a weaker macro environment and, more importantly, getting the work done to make our business more resilient in tougher economic periods. While we don't have a crystal ball, we thought it would be helpful to put into context some of the things we've done and are doing to provide some perspective as we wrap up the last quarter of our fiscal '19, which will include new records for annual free cash flow and adjusted EBITDA.

First, we've been working to drive sustainably higher free cash flow and strong cash conversion ratios by optimizing our physical footprint, improving our asset utilization and reducing our maintenance CapEx requirements. We're confident that we can deliver at least $200 million of free cash flow in our fiscal '19 that ends on March 31, and we expect to deliver significantly higher free cash flow in our upcoming fiscal 2020.

As a result, our financial leverage continues to decline from 2.3x at the end of the quarter and on a path of 2.1x 2 months from now and well below 2x next year. We also intend to periodically pay down debt from surplus cash balances. In fact, in January, we paid down $75 million of our outstanding term loan, which reduces our cash interest run rate heading into 2020. We believe our improving balance sheet and consistent high levels of free cash flow will enable us to continue to balance our acquisition strategy with our objective to reduce our financial leverage.

Second, we're wrapping up the second wave of our Supply Chain Optimization and Footprint Repositioning initiatives and are tracking to deliver $15 million of annual savings from SCOFR 2.0 in our fiscal 2020. We've also begun to deploy resources for a third wave of SCOFR initiatives that we plan to outline when we report our Q4 results in May. In broad strokes, we expect the total annualized savings of SCOFR 3.0 to be in the $20 million zip code and achieved over 18 to 24 months from the time we start.

There will be some modest upfront spending requirements associated with SCOFR 3.0, and they are factored into our expectations for additional free cash flow growth in our upcoming fiscal 2020. The strategic objective of our SCOFR initiatives has been to reduce fixed cost and complexity, transitioning to a less capital-intensive and more variable cost model that can perform well across a wider range of operating environments. Beyond driving further improvements in our returns on capital, the enhanced operational flexibility provides for more effective control over our cost structure in periods of rapid change.

Third, we're demonstrating our long-standing ability to manage the price/cost dynamic in an inflationary environment and mitigate the impact of tariffs on our margins. With the planning and execution discipline provided by the Rexnord Business System, our teams have deployed a range of agile countermeasures that include aggressive alternative supply chain management and selective pricing actions, along with material substitution and product line simplification, to proactively and effectively deal with this complicated and changing cost dynamic. Our solid execution is supported by the strength of our brands in both platforms, the structure of our distribution channels and our key channel partner relationships.

We're also expecting some additional tailwind as our work at Centra delivers the margin expansion in fiscal '20 and '21 as we drive towards delivering 1,000 basis points of margin opportunity that we identified when we acquired Centa last February. We're continuing to track towards delivering the objective on a run-rate basis before the end of our fiscal '20 and on a full year basis in our fiscal '21.

In addition, as we've also highlighted on our last earnings call, we've made significant positive changes to almost every facet of our business over the last 3 years. While the areas I just talked about are all cost and cash flow related and obviously critically important, what's also exciting is the number of seeds we planted over the past few years that are starting to flower in terms of incremental growth opportunities they present. The investments in direction and our smart conditioning monitoring system across both platforms and for both new and retrofit applications grow our addressable end markets by several hundreds of millions of dollars, and next year, we think that they could deliver at least 1 point of above market -- underlying growth above market.

The work we've done to establish ourselves in adjacencies like food, fire protection and site works, coupled with the divesting of all of our large lumpy project-based businesses, gives us a far more stable revenue base than we've ever had. We expect fiscal '19 will be a record year for us in terms of EBITDA and free cash flow. With the foundation we've been building the past several years, we've never been as well prepared as we are today to handle whatever challenges our fiscal '20 or '21 might bring. All of this strengthens our conviction that we can outperform our served markets and competition moving forward.

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

[Mark Peterson, executive]

Thanks, Todd. Please turn to Slide #5. Our consolidated financial results for the third quarter of fiscal '19 were in line with our expectations. On a year-over-year basis, our total sales grew 11%, our core sales increased 6%, our adjusted EBITDA increased by 11% to $103 million and our adjusted earnings per share increased by 21% to $0.47.

Please turn to Slide 6. Our outlook for our fiscal '19 core growth continues to incorporate core sales growth in the upper half of the mid-single digit range. Our increased outlook for adjusted EBITDA to be in a range of $437 million to $443 million translates to a 13% to 15% year-over-year growth. And we expect to deliver a year with record free cash flow. On Slide 7, we summarize our consolidated results for the quarter.

Let's turn to Slide 8 and discuss the first of our 2 operating platforms, Process & Motion Control. Total sales increased 12% year-over-year in PMC, with core sales growth of 4%. Through the first 9 months of the fiscal year, core growth in our PMC platform is running between 4% and 5% and right in line with our expectations heading into the year. Currency translation reduced our sales growth by 2 points, and the acquisition of Centa added 10% to our top line growth in the quarter.

PMC continued to see growth across a wide range of its aerospace, consumer-facing and process industry end markets, and growth is generally stable in our domestic distribution channels. We saw somewhat weaker trends in our European distribution channels late in the quarter and reflected that in our set of end-market assumptions that support our unchanged outlook for mid-single-digit core sales growth at PMC in our fiscal '19.

PMC's EBITDA and margins were in line with our expectations, as we outlined last quarter. Adjusted EBITDA increased 12% year-over-year, and margin was sustained at 22.3%. PMC benefited from strong operational execution to the restaurant business system. Pricing was positive, and our strategies to neutralize the impact of tariffs and broader cost inflation on our adjusted EBITDA margin continued to be successful while we continue to invest in our growth initiatives. Excluding the margin impact of Centa, which we acquired last February, and currency translation, PMC's incremental margin on its core growth was in the mid-30s percent range and in line with our expectations for PMC's core operating drop-through in our third quarter and on average over time. We continue to project year-over-year margin expansion from PMC for the full fiscal 2019.

To briefly highlight on our smart solution for PMC, we have formally launched our smart conditioning monitoring system as a retrofit solution for the global installed base of gear drives. The image in the slide is from an updated sales tool. As we've highlighted before, our key differentiation in IIoT digitally enabled components is the condition monitoring unit in the center of the diagram, providing not just raw data but onboard data analysis that can speak directly to existing customer plant control systems, provide actionable recommendations in real time and drive improved productivity by enabling true condition-based maintenance and improved system uptime.

By introducing a retrofit solution, we can accelerate the customer payback by lowering the required upfront investment and enabling broader adoption faster. Our development journey with this new technology is being supported by our voice of customer work. We are engaged with customers that operate large populations of gear drives and are enthusiastic about a solution that can accelerate the improvements when you deliver uptime, safety and productivity. As we look forward, we see our retrofit strategy as an incremental growth opportunity that can be independent of a new equipment sale and relatively less sensitive to potential macro-driven changes in our customers' capital spending budgets.

Please turn to Slide 9 to discuss our Water Management platform. During our third quarter, our Water Management platform delivered a 10% net sales increase on both a core and as-reported basis. Top line results were in line with our expectations and continue to be a function of solid demand growth, our innovation pipeline and good price realization.

As illustrated by the end market outlook that is summarized on the slide, demand conditions in our core nonresidential construction end market remain favorable. With 1 quarter to go in our fiscal year, we have upgraded our outlook for the commercial sector of the U.S. nonres construction market to reflect the reality of what we're seeing on the ground and our expectations for a solid start to the 2019 construction season in our nonres construction end markets.

Although we have only seen U.S. construction spending data through October, during the federal shutdown, reported U.S. spending growth and commercial verticals was up by more than 7% year-over-year in October and 8% for the trailing 3-month period. The Dodge Momentum Index, which measures nonresidential construction projects that are actually moving forward and is a leading indicator for construction starts and spending, flowed into the year-end with an average 25% year-over-year growth from July through November. Contractors continue to have significant backlogs, and we continue to have a favorable outlook for our U.S. nonres construction markets in our fourth quarter as we look into the first early innings of fiscal 2020.

And just briefly highlighting the Zurn launch of retrofit solution for the backflow prevention valve market during the quarter, which adds another growth vector that is independent of new building construction activity. We see good opportunities to generate incremental growth by delivering real-time visibility and control of this critical element in every building's water system.

Water Management's adjusted EBITDA increased by 10% year-over-year in the third quarter, and we delivered a solid 25.6% margin as we continued to leverage our core growth and manage to a favorable price/cost equation while funding our market expansion and cost-reduction initiatives.

In both of our operating platforms, we've been able to manage our exposure to tariffs and overall cost inflation and neutralize the impact of these headwinds on our adjusted EBITDA margins through a combination of materials cost actions, robust supply chain management, influx of price increases given our leading brands, the growing sales of our innovative and cost-saving new products and our distribution channel structure. 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 2.3x at December 31. Our free cash flow has developed as expected across the first 9 months of our fiscal year, and we remain on track to deliver at least $200 million of free cash flow for the full year. As Todd mentioned earlier, we paid down $75 million of our term loan in January, which equates to about $3 million of annualized interest expense savings.

Before we open the call up for questions, I'd like to comment on our restructuring expenses and our effective tax rate before we take your questions. 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 the varying levels of pretax income as well as the timing of our planning initiatives. In the third quarter, our adjusted EPS benefited by about $0.04 from a lower-than-projected tax rate at 16% that reflects the clarification of certain tax exposures under the 2018 U.S. tax reform that will also positively impact our tax rate going forward. As a result, we now project our fiscal '19 adjusted net income will incorporate an effective tax rate of approximately 25% to 26%. For the fourth quarter, we anticipate a rate between 29% and 30%.

Turning to the slides in the appendix. First, we've included certain other assumptions incorporated into our guidance for fiscal '19 on a separate slide. I'll remind you that our guidance covers our continuing operations. In addition, our guidance excludes the impact of potential acquisitions, potential accounting gains or losses and any 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 the modeling of 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 third 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 also included in our earnings release each quarter.

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

[Operator]

[Operator Instructions] And our first question comes from Joe O'Dea from Vertical Research.

[Joseph O'Dea, analyst]

First question on the Water Management side. When we look at 10% organic in the quarter and 12% organic last quarter, any perspective on how that compares to what you're seeing in the end markets? Just to try to appreciate what you're posting from an outgrowth perspective and then how you look at that opportunity set to continue outgrowing over the next 12 months or so.

[Todd Adams, executive]

Yes. Joe, I mean, I'm not sure we're perfectly equipped to tell you exactly what the market grew in the quarter, but our view is that it's sort of growing in 3%, 4%, 5% range. We're getting a little price on top of that. And the balance really coming from a combination of both our connected initiatives, our adjacencies that we talked about in both fire protection and site works and then also the fact that, as the institutional markets recover, we have a higher relative share there. And so you're seeing that sort of translate into above-market growth. I think the 12% we posted last quarter was off of essentially a flat number the year before. The 10% growth we're posting this quarter is off about a 7% growth a year ago -- I'm sorry, 5%. And so we expect good growth again in our fourth quarter. And as we start our fiscal 2020, I think we feel really good about where the end markets sit. Obviously, pricing is sticking. And then more importantly is the fact the initiative-driven growth is building momentum. And so I think we feel pretty good about where we positioned the business. And obviously, we're watching the latest data like everybody else, but I think that'd be our best shot at this point.

[Joseph O'Dea, analyst]

And then one on free cash flow. You talked about a position for a step-up in fiscal '20. Can you put any context around that on pace to hit the $200 million or better target for fiscal '19? And I think some moving parts in terms of savings that you should have from SCOFR 2.0, cash taxes, but even -- if you just take it off of the fiscal '19 base, what would that be rolling into '20 when some of these kind of contained cash outflows go away?

[Todd Adams, executive]

Yes. Mark is shaking his head a little bit, doesn't want to get too far in front of providing -- we still have a quarter to go. But again, it's tens of millions more, right, I think, is the way to think about it. We'll get a little sharper as we close out the quarter and provide a little guidance. But you're right, there are a lot of digital benefits on the tax side as well as the benefits we're getting from a variety of things that we've already done that should benefit next year nicely. So I would think about it in the range of tens of millions of dollars, and we'll refine that and get back to you when we announce in May. But it's comfortably above $200 million.

[Joseph O'Dea, analyst]

And then just thinking about kind of the out-years from a tax rate perspective and now at 25% to 26% for the year. Is that a better longer-term tax rate to use? Or should we still be thinking kind of 27% to 28%?

[Mark Peterson, executive]

Yes. I think, Joe, for now, you look -- the rate within the year, we thought was in that 29% to 30% range. I think, next year, it's safe to use the 27%, 28%. We're still working some things strategically, but we've made some progress in some of the things related to GILTI that we've talked about over the past several quarters. Looking into next year, I think 27% to 28% rate in the P&L on an adjusted basis is reasonable.

[Operator]

Our next question comes from Mig Dobre from Baird.

[Mircea Dobre, analyst]

I want to go back to Joe's question on Water Management. And the way I understood what you said, you're essentially generating outgrowth, effectively as high as 500 basis points versus the market. There are a number of things that you're doing here that you cited. The question is, as you look going forward, do you believe that this level of outgrowth is sustainable? I mean, we can make our own assumptions as to kind of what we think about the construction environment overall, but would your own initiatives still allow you to be able to post this kind of performance in the next 12 months or 18 months?

[Todd Adams, executive]

Well, Mig, I think if you were to go back and look at the business really since we've owned it, beginning in 2007, I think you could make a very strong case that we've had market outgrowth every single year. And I think if we look at the things that we've done over the course of the last couple of years around, again, adjacencies, around connected products and where we are with our spec share and a variety of other things that really drive long-term growth, and we've only done things to enhance that, and so without question, we will outgrow the market. Whether it's 500 basis points or 200 basis points, I couldn't tell you exactly. But without question, we're confident in our ability to outgrow our served markets, our competitors. And I think it's not just a 1 or 2 quarter phenomenon. It's really a decade of doing so. And so we feel really good about being able to make that statement heading into our fiscal 2020.

[Mircea Dobre, analyst]

All right. And then, I guess, we spent quite a bit of time talking about your institutional business in the past, but maybe we can focus a little bit on commercial. You upgraded your outlook here. So I'd love a little more color or your thoughts around that. But what sort of exposure do you really have here in commercial? How do you define that market as far as Zurn is concerned?

[Todd Adams, executive]

Yes. I'll give you sort of qualitatively how we're thinking about commercial. And obviously, I think it's attracted a little bit of attention on that little chart that changed from yellow to green. And just for context, this is set up to sort of provide our best view on how we think our business is going to perform really over the next quarter or so. And based on backlogs, based on what we're seeing in the marketplace, based on business that's been won, that's our best view of where we're going to see commercial over the next 2 to 3 quarters. In terms of our business there, it would be anything that is noninstitutional. So think about the office, think about manufacturing, think about retail and things like that, those are the areas that we would group into the commercial bucket. And so it's not meant to be sort of a contrarian call and say that it's growing again. But -- and our view is, without question, the next quarter or 2, it's still going to be very good for us. There is no question that the growth is slowing overall. But in general, we feel really good about not just institutional but commercial over the sort of near to intermediate term.

[Mircea Dobre, analyst]

Okay. So that's more specific to what you're seeing in your business rather than a broader market call? Just to be clear.

[Todd Adams, executive]

Yes, that's correct. That's correct.

[Mircea Dobre, analyst]

All right. And then lastly for me, just kind of housekeeping items into fiscal '20. Just want to confirm that you're still expecting $10 million of incremental SCOFR savings in fiscal '20 and your margin exit rate on Centa would be that 1,000 basis points that you talked about previously. And that's it for me.

[Todd Adams, executive]

Close. I think in -- as it relates to the SCOFR benefit from SCOFR 2.0 in our fiscal '20, the comments we've made on the call were actually $15 million of savings, probably a little bit more in the back half than the front. And then the Centa exit rate of '20 will include that 1,000 basis points of margin. We'll get the full run rate benefit of that 1,000 basis points from acquisition in our fiscal '21. But the exit rate will definitely be at that level.

[Mircea Dobre, analyst]

But Todd, on SCOFR, you had some savings -- SCOFR 2.0, you had some savings in '19, too, right? So the incremental -- the true incremental '20 versus '19 is not $15 million, it's less. Or do I have that wrong?

[Todd Adams, executive]

No, no, that's not what happened. I mean -- so the $15 million SCOFR 2.0 will all be incremental in '20.

[Operator]

Our next question comes from Julian Mitchell from Barclays.

[Takeheiko Makishi, analyst]

This is Jason on for Julian. Maybe just starting on the free cash flow. You had commented in previous quarters how both businesses might have seen a little bit of lean inventory in the channel. Is that still the case? And if so, is that something to consider? I know you're not giving specific guidance on free cash flow, but just heading into 2020, is that something to consider there? Or has that kind of been resolved and we should sort of more be thinking about restructuring savings, et cetera?

[Mark Peterson, executive]

Yes, Jason, this is Mark. I think, we'll -- I think the question you're referring to is inventory in our channel, those are distribution partners, if I'm understanding that right. We've kind of got a long channel inventory, so our products at distributors before selling to the customer has been relatively consistent. Our opinion has been it's been on the lower end of where we think it should be. But that's been very steady for several quarters. And it didn't really change a lot as last quarter. So channel inventories have remained stable. Our opinion has been it's a little on the low side, but stable is the answer to the question.

[Takeheiko Makishi, analyst]

Understood. There was no -- sorry.

[Todd Adams, executive]

No impact on our free cash flow as a result, right, one way or the other because that's sold inventory, which is relatively flat from where it's been. And so the only comment was there's no change to our resulting free cash flow no matter what happens with that channel inventory.

[Takeheiko Makishi, analyst]

Got it. And then moving on to demand a little bit. You've mentioned a weakening of European industrial distribution just certainly in the quarter. And the -- just referencing that red/green chart earlier, it sort of remained yellow. Was European distribution trending more towards green throughout the first maybe 2/3 of the quarter and then it sort of turned for the worse and that's why you kept it in yellow? Or was it always sort of trending there and then had a little bit more incremental weakness late in the quarter? Just any more color you could give there would be helpful.

[Todd Adams, executive]

I mean, I wouldn't -- I don't think any of it's particularly pronounced, right? I think we saw a general weakening over the course of the quarter, and our view is that, that's not going to change as we round out our fourth quarter here. And that's sort of why we chose to shade it a little bit of a different color heading into our March quarter. Obviously, I think when you read and see all the news coming out of primarily Western Europe, it is slowing a little bit. And so we chose to just sort of update the outlook for people, and it's obviously reflected in our fourth quarter outlook and what we just did in the third quarter. So nothing pronounced, but I think it's generally a bit slower than it was in the first half of the year.

[Operator]

Our next question comes from Jeff Hammond from KeyBanc.

[Jeffrey Hammond, analyst]

So maybe just speak to what you're seeing in the North America industrial distribution channel. And certainly, you've improved the mix within PMC, but any particular end markets where you're seeing yellow or red lights flashing?

[Todd Adams, executive]

No. I think, in general, the distribution business for us is pretty stable, right? I think it just doesn't fluctuate a whole lot. Channel inventories have remained relatively flattish really from the last 2 years. So we're not seeing anything to us that is a flashing red. In any given quarter, you'll see things that are maybe a little bit better, maybe a little bit worse than what you would have expected, but overall, I would characterize it as very much stable and consistent with what we usually see. We've had a couple of distributor partners announce earnings, and I think that their industrial distribution side of things was pretty much in line with what we see. And so the fundamental pull-through in end market demand just doesn't vary that much as you look at the MRO market, which is primarily what we're talking about here. And so I wouldn't call it anything flashing red. I would say that there's some things that are green, there's some things that are yellow, but overall, generally pretty consistent and stable with what we usually see.

[Jeffrey Hammond, analyst]

Okay. And then just talking about direction and the Smart Condition Monitoring System. As you kind of push into '20, how are you thinking about kind of incremental revenue contribution? And how is that kind of run rating as you went through the third quarter?

[Todd Adams, executive]

Yes. I mean, it's pretty exciting. I think when we look at it, the things that we've done over the course of the year to put ourselves in a position to launch, I would say, even a more fulsome suite of solutions as well as now the opportunity to address the retrofit market put us in a spot where we should see tens of millions of growth from direction, heading into our fiscal 2020. We're not going to sort of get into the quarter-over-quarter growth, but I would tell you that, in the quarter, we won a number of larger new projects that will ship in 2020. That -- we won it solely as a result of having a Smart Condition Monitoring System offering. And the funnel around retrofit opportunities is growing by the day. And so in both cases, we're pretty excited. And I -- it's not just PMC. It also is on the Zurn side. So we're optimistic that this is sort of a growth opportunity in any environment, but more and more, we're seeing that this is really a differentiator in the marketplace. Customers are choosing us as a result. And the retrofit opportunity, we're just scratching the surface on that. But that is an installed base that's massive that we can exploit, and you'll see the benefits of that really for the first time in our fiscal 2020.

[Jeffrey Hammond, analyst]

Okay. And then the last one. It seems like, this year, you stayed ahead, managed the inflation pretty well. Have you -- are you contemplating or have you announced any pricing for, I guess, calendar '19 in either business?

[Todd Adams, executive]

Well, we've made a number of pricing adjustments really over the second half of the calendar year. We have some normal price increases that go into place January 1, and we're just sort of contemplating our next move. I would tell you that we don't have a long lead time to implement, and so we're pretty comfortable that if the macro cost environment requires it, we can act very quickly. But as of right now, we're in a pretty good place with our price increases, but obviously, if things change, we'll revisit that. And just like this year, we anticipate a very smooth and effective implementation, and we'll see where we go. But other than that, no, nothing pronounced.

[Operator]

Our next question comes from Charley Brady from SunTrust Robinson.

[Charles Brady, analyst]

Just wondering if we can get a little more granularity for PMC on the 3 sort of buckets there, aerospace, food and the broad-based distribution and kind of what the growth you're seeing among those 3 buckets.

[Mark Peterson, executive]

Charley, it's Mark. Yes, on the distribution side, as Todd said and kind of in the comments we made, distribution across North America has remained generally stable, so we've been growing in that low to mid-single digit in distribution for the better part of this past fiscal year. We did see a little incremental weakness at the end of the year in Europe and a little bit in rest of the world, to be expected, but nothing that was totally a surprise as we finished out the calendar year. Within aerospace, the demand in aerospace has been strong. We've seen nice backlog build in aerospace, nice book-to-bill rates in the aerospace business. Consumer, I'd characterize as generally stable. That's been a low single-digit grower for us for this fiscal year, and I think we look for that to continue. And then our process side, as Todd mentioned, look, in any given quarter, some can be up, some can be down. But in general, our overall process industry end markets, again, grew for us in that low to mid-single-digit range in the quarter. And there is where we won some of these larger projects Todd talked about in the direction initiative, a couple on the new gearbox side, a couple on the retrofit side. That will benefit 2020. So overall, we kind of characterize the balance of the end markets as generally stable in the quarter.

[Todd Adams, executive]

And Charley, it's Todd. Just one other thing. And we talked about it over the course of the call, but we've started the simplification journey about a year ago. So in addition to the growth we're seeing, we also are walking away from some revenue with respect to customer and product configurations as we try to segment our business and simplify it a little bit. So embedded in our growth numbers is some walk-away revenue, and that will continue. So the growth numbers we're posting and everything we're talking about is initiative-driven. But on the back side of that, you're going to see us sort of simplify our business, which is something that we think is a real opportunity, both on the cost and simplification side of things, to allow us to invest in better growth. So embedded in everything Mark just said is you got to include some walk-away revenue along the way.

[Charles Brady, analyst]

Great. That's really helpful. And just one more from me, probably a question you haven't had maybe ever. How low are you expecting leverage to go before you have to deploy capital on either more M&A or stock buyback or something, to where you're not building cash? Obviously, very strong cash flow this year, even better next year. You're going to be well below 2 if you don't do any M&A. I'm just wondering, what's the bottom end of your comfort level on net debt?

[Todd Adams, executive]

Well, Charley, you're right, that is a question we've never had before. We paid down $75 million of gross debt post the end of the quarter. We've got a very good outlook for free cash flow heading into next year. We think that we've got some decent earnings growth as well. So we end next year sort of in the 1.5-ish sort of range. I think we've said all along our view was to march the leverage down to something that was very comfortable not just for us but for the way investors thought about Rexnord. I think we're getting into that range. And once we get to that range, I think we'll sit back and make the right decisions for shareholders. And that could be a combination of a lot of things to return capital, and we're not going to run out and do a big deal to relever the balance sheet. We're going to stay very disciplined as we have been. But the story here is that returns on invested capital are extraordinarily high for our core business, and we're going to continue to make smart investment decisions and create shareholder returns. But the reality is Rexnord could be an investment-grade company. We generated a tremendous amount of free cash flow. We think that the combination of investment back into the core and doing smart acquisitions is best for shareholders, along with some sort of return of capital, either through a dividend or a buyback of some sort. But it's a little bit early to talk about that, but it is a reality that we are going to face, which is a great problem to have. And so heading into our fiscal 2020, we may talk a little bit more about that, but appreciate the question.

[Operator]

Our next question comes from Bryan Blair from Oppenheimer.

[Bryan Blair, analyst]

I don't think you specified -- I apologize if I missed it. Is there an update on expected PMC first that wins for fiscal '19?

[Todd Adams, executive]

I don't know that we have provided that, but it's going to be greater than $50 million. If you look at where we started this 3 years ago, I guess, it went from $15 million to $30 million, and this year, it'll probably be closer to $50 million. And so all that does is create a larger installed base. And I expect the number to frankly be a little bit bigger in 2020 as a result of the direction and Smart Conditioning Monitoring System that we're deploying. So again, thanks for reminding us to talk about it, but it's going to be north of $50 million this year.

[Bryan Blair, analyst]

Okay, very good. And then if you could provide a little color on your deal funnel. Obviously, you have increasing balance sheet flexibility as you're discussing, and M&A is certainly a big part of the long-term story. Any chance that we see you get more aggressive into your fiscal '20?

[Todd Adams, executive]

I don't think you're going to see us do anything crazy. I don't think you're going to wake up and go, "What did they just do?" I think the things that we're looking at in our funnel consist of things that look a lot like the World Dryers of the world, that look a lot like the Centas of the world, that make a lot of sense, that would fit very nicely into our core business. And we have the ability to extract both cost and revenue synergies in a relatively short period of time and create great returns. And so I think our funnel is a little bit bigger than it was a year ago this time, and I think the things in it look a lot like the things that we've just done and have done for a while. And I think we're optimistic that a couple of these things get to the finish line over the course of the next 6 to 9 months. But we're obviously not going to comment on anything specific. But I think we're optimistic that a couple of these things will convert and work out really well.

[Operator]

I will now turn the call back to Rob McCarthy.

[Rob McCarthy, executive]

Thank you, and thanks to everybody that could join us on the call today. We appreciate your interest in Rexnord, and we're looking forward to providing our next update when we announce our fiscal year 2019 fourth quarter results in mid-May. Have a great day.

[Operator]

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