Zurn Water Solutions Corp

NYSE:ZWS

Earnings Call Transcript 2021-Q3

[Operator]

Good morning, and welcome to the Rexnord December Quarter 2020 Earnings Results Conference Call with Todd Adams, Chairman 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 this morning, February 16.

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

[Rob McCarthy, executive]

Thank you. 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 earlier this morning 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'll speak to core growth, adjusted EBITDA, adjusted earnings per share, free cash flow and return on invested capital 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.

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

[Todd Adams, executive]

Well, thanks, Rob. We're a little bit later than normal. We had a -- I think a significant announcement this morning to merge our PMC business with Regal Beloit in a Reverse Morris Trust transaction that I'm sure we'll get to. But I want to start really talking about how our business performed over the course of the fourth quarter and 2020.

If you look at our fourth quarter, essentially flat year-over-year. Adjusted EBITDA of $96 million and absolutely terrific cash flow all year, establishing a record of $276 million. When you look at each of the platforms, we had an incredibly strong finish to 2020. Top line at Water Management up 15% year-over-year and core up by 10%. The momentum around our hygienic solutions continues to build, and really the power of what we put together is something that we'll get into a little bit later in the call.

In PMC, despite some pretty significant headwinds in aerospace, we were able to perform well. I think the trajectory coming out of Q4 into Q1 is really positive, and we're excited about the transaction and the combination, but PMC is performing at a very high level despite some pretty tough headwinds.

Finally, looking at 2020, taken as a whole, we did 2 acquisitions over the course of the year, Just earlier in the year and Hadrian, which we'll talk about in a moment. And we capped off the fourth quarter with $44 million of share repurchases to bring the full year to $140 million, and we exited the year 2.1x.

So taken as a whole, 2020 was a year that I think the business performed extraordinarily well. The things that we've done and our teams have done to make it more resilient through cycles has been demonstrated. And finally, the cash flow of $276 million was, I think, a testament to the power of all that coming together.

Turning to Page 4. This is essentially the outline of what we're doing. We're merging our PMC business into Regal Beloit in the form of a Reverse Morris Trust transaction, whereby it's not taxable for Rexnord shareholders. The headline value is $3.8 billion, which would represent a 14.2x adjusted EBITDA for 2020. And there's a lot of work between now and then, but we expect it to close towards the end of calendar year '21. And the synergies of the combined business, we believe, approach $120 million just on the cost side. So terrific industrial logic.

We had a high level of interest in doing this kind of transaction from not only Regal but others. And we're excited about the combination of creating a $2 billion PMC business or PT business inside of Regal with significant upside.

On the Zurn side, Rexnord shareholders will own 100% of Water Management and continue to do that. And I think as you'll see in the next few pages, we really think that it is a best-in-class, 100% pure-play water business with a terrific track record of success, a strong outlook and all the other things around sustainability and ESG that we think really allows us to focus on just that 1 business.

The balance sheet is going to be in a great spot, post-transaction leverage just about 2x. And for a long period of time, if you followed Rexnord, I think there was always the feeling that there was some significant value with our businesses, and this is a step in being able to crystallize that.

If you move to Page 5, this is essentially just a little bit of a snapshot over the last 6 years of what new Rexnord will look like, pure-play water, and almost a 6% compounded growth rate over the last 6 years and margin expansion of 360 basis points to just under 27% this past year. Underneath this, if you were to go back the last 10 years or 40 quarters, there's been exactly 2 quarters out of the last 40, where the core growth rate in Zurn was below 0.

So this is a business that's got terrific momentum. And I think when you look at the financial profile and the dynamics that we have been able to create and our teams have led, we're really excited about having the chance to spend 100% of our time focused on that.

On Page 6, the items on the left side of the page really are what creates the competitive advantage that we have. Spec driven, broad portfolio, lowest total cost of ownership and an increasingly strong presence in and around e-commerce. And what that does, it really creates this machine that we can continue to grow through cycles, take share. And I think if you look at us relative to some of our competitors, it's -- I think it's abundantly obvious that we are taking share.

On Page 7, it's really just a 1 review of 2020, where we actually grew 8%, touchless doubled in the year or more. We're growing in adjacent markets like fire protection and site works.

The MRO penetration and the amount of aftermarket that is actually now part of our revenue base has never been higher. And we got 2 deals done in Just and Hadrian that continues to position us to take share going forward. And if you look at the little chart up to the right, you can see that relative to any end market forecast, we've outperformed consistently for a long period of time, and we'll talk a little bit how we're planning to do that on a go-forward basis.

Page 8 is the -- what we do, right? It's water conservation, safety and control, primarily for commercial buildings as well as in residential systems. So we've got the broadest portfolio under 1 brand with 1 rep network and the highest amount of specification. And I think what's equally important is all these products are designed to work efficiently together. And with our connected solution, we're becoming increasingly important to building owners to monitor the water conservation and safety and control inside their buildings.

Page 9 is a page that maybe not excite some people, but the ability to provide almost every component into a commercial restroom in a package, again, that all works together is what we've been trying to build for a long time, and we continue to make some pretty significant success, create some significant wins over the last year by adding content to our portfolio.

Hadrian is a business that we've coveted for a long time, sort of a 1x relative market share business and an over $500 million market that's half MRO with a terrific e-commerce presence. We have the ability now to really create a turnkey solution for any building really in the country. So we're excited about that start.

Page 10, I think, gives you a glimpse of really what we have created over time, and that's our water business on the left, 26.8% margins. And when you look at other water businesses, I think it's clear that, number one, they command a premium valuation. And number two, our performance is substantially above that peer set.

So before I turn it over to Mark, I just want to say that we think it's a great day for shareholders. We're excited about the opportunity to partner with Regal on that RMT transaction, and then the unveiling of our water business on a stand-alone basis is something that I think shareholders and customers are going to love.

So with that, I'll turn it over to Mark.

[Mark Peterson, executive]

Great. Thanks, Todd. On Slide #11, as you can see here on a year-over-year basis, our consolidated sales were flat and core sales were down just 2%, and a roughly 70 basis point impact from our product line simplification actions.

Positive contributions from currency translation added about 1 point. Just Manufacturing and Hadrian acquisitions in our Water Management platform added 2 points to our reported sales growth, which was partially offset by a small divestiture on our PMC platform that reduced our total sales by approximately 1 point.

With respect to profitability, our adjusted EBITDA was $96 million in the quarter, and our adjusted EBITDA margin was 19.6%. As you recall, we recorded a catch-up on merit and incentive compensation expenses during the quarter that we detailed in our last call.

In addition, during the quarter, we elected to add some investment spending in our Water Management platform as well as paying incremental and widely distributed bonus to our associates that demonstrated outstanding dedication to the pandemic in both platforms, which together resulted in approximately $4 million of additional expense in the quarter. Adjusting for that $4 million of additional expense, our margin would have been 20.4%.

Let's turn to Slide 12, and we'll review our 2 platforms. So the platform level, the sales in PMC moderated sequentially with 8% decline and core sales were down 8% as well on a year-over-year basis. We had an approximate 100 basis point headwind from our 80/20 simplification actions. A small divestiture in one of our China businesses also reduced PMC sales growth by just over 1 point, and was offset by about 1 point of positive currency translation.

Breaking that down further, the year-over-year sales decreased in our aerospace operations, which accounted for approximately 15% of our PMC sales in calendar '19, was consistent with the 36% decrease we experienced in our September quarter. When you exclude the aerospace operations, the core sales and the balance of the PMC platform in our December quarter were down only 3% on a year-over-year basis. That's inclusive of 100 basis points of headwind from 80/20 actions, and this compares with a comparable 9% decline in our September quarter.

We continue to see positive trends in year-over-year sales comparisons in nearly all of our vertical markets and geographies with positive core growth continuing in Asia and in our renewable energy end market, which helps drive growth in our overall power generation sales. Our global industrial MRO business, again, excluding aerospace end markets, also contributed to a sequentially stronger industrial sector comparison.

North American distribution channel sell-through, although still somewhat choppy on a month-to-month basis, continued its pattern of stabilization during the quarter and has improved from the September quarter. Overall, and given support from backlog, year-over-year change in our shipments to OEMs and end users continue to outperform global MRO during the quarter.

Operating execution was again solid in the quarter as we benefited from our SCOFR, structural cost reduction initiatives, executed in recent years, plus a small portion of the cost actions we initiated earlier this year in response to the ongoing pandemic, which primarily benefited our June and September quarters. Combined with some adverse mix through the relative weakness in our aerospace business, our final quarter transition costs related to our SCOFR 3.0 actions and the incremental elective spending I detailed earlier, PMC's adjusted EBITDA margin was 20.1%.

Water Management sales were up a solid 10% on a core basis and up 15% after adding the contributions from Just Manufacturing, which we acquired at the end of January 2020, and Hadrian, which we acquired in December. Rapidly growing sales from our touchless sensor products was again the primary driver, but the year-over-year change on the top line across our other water management product lines improved sequentially from our September quarter, and we're down by only a low single-digit percentage on a core basis outside of touchless.

Zurn delivered an 8% increase in adjusted EBITDA and the margin was 24.5%, which reflects the incremental investment spending and the compensation expense outstanding issues I discussed earlier, as well as the minor impact from Hadrian's relatively lower margin profile that we will improve from here as we integrate the business.

Let's move to Slide 13. As Todd discussed earlier, we finished with a record year of free cash flow, which increased 13% from calendar year '19 million to $276 million in calendar year 2020. We deployed roughly $340 million in share repurchases, the acquisition of Just and Hadrian and our common stock dividend, while maintaining our net debt leverage ratio at 2.1x and near the low end of our overall targeted range.

Let's turn to Slide 14. With visibility still challenging, we will again limit our forward commentary to the upcoming quarter and continue to incorporate somewhat wider than typical ranges around our assumptions for revenue growth and margins. We continue to provide relatively precise guidance for elements where we can exercise potential control of the result and incorporating some downside risk for those elements where we have, frankly, less control.

So with that said and taking into consideration demand trends of January, our backlog positions and elevated uncertainty given the persistent strength of the pandemic, we're projecting total revenue in our Water Management platform to increase by a high single-digit percentage year-over-year, as we expect Water Management growth to moderate slightly from the December quarter when our growth benefited from some backlog conversion as well as a somewhat easier year-over-year comparison.

For our PMC platform, we're projecting that year-over-year revenue growth will weaken somewhat sequentially to a low double-digit decline, as we expect aerospace sales growth to have its toughest year-over-year sales comparison as it bottoms out in the quarter. Looking ahead to the June quarter, as you might expect, we anticipate year-over-year growth rates to accelerate substantially in both platforms and turn positive in PMC, as we anniversary the most -- the quarter that had the most significant impact from COVID during 2020.

Based on our platform sales expectations, we'd expect our adjusted EBITDA margin in our Water Management platform to be between 25% and 26%, and for our adjusted EBITDA margin in our PMC platform to be between 22.5% and 23.5%. We expect our corporate expense to be about $10 million in the quarter.

Before I turn the call back to Todd, just a few comments on our tax rate, interest expense, stock comp expense and our depreciation and amortization. We anticipate our tax rate on adjusted pretax earnings in the March quarter to be approximately 28%. Our interest expense for the March quarter is expected to be approximately $12 million, noncash stock comp expense should be about $15 million, and our depreciation and amortization will come in around $24 million.

So please turn to Slide 15, and I'll turn the call back to Todd for some concluding remarks.

[Todd Adams, executive]

Thanks, Mark. We'll obviously take any questions you had. But it's going to be a busy year as we go through the process of both working through the regulatory items to get the transaction to the finish line with Regal and then also doing the work to stand up water as a stand-alone public company. But we are excited about it.

I think the transaction is truly transformative in a lot of different ways, both for the markets we serve and then, obviously, for shareholders. The best-in-class water business that we've been working at and now have everyone's attention on, we think, is going to be exciting. The growth -- the opportunities to grow organically as well as to continue to do M&A is something that I think is going to create a lot of value over time.

So it's going to be a busy year. We'll keep you as informed as we can about the transaction and all the things that I'm sure you're going to ask, but we'll turn it over to your questions and answer what we can.

[Operator]

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

[Bryan Blair, analyst]

So great top line performance in Water Management and, obviously, touchless. The trajectory there is quite exciting. Where did the touchless portfolio finish as a percentage of segment mix for 2020?

[Mark Peterson, executive]

Touchless for us was roughly about $95 million to $100 million in sales in the year. So up over 100% from where it was in '19.

[Bryan Blair, analyst]

Got it. And last quarter, you had cited order rates that supported $140 million, $150 million for 2021. Is the -- are run rate orders still supportive of that range? Or has there been further acceleration?

[Mark Peterson, executive]

No, I'd say that's still in the ZIP code, right? If you look at next year, the order rates and trends right now are supportive of what we had talked about last quarter as the target for next year's sales.

[Bryan Blair, analyst]

Got it. Okay. And then given the touchless and hygienic momentum and then current visibility across the remainder of the platform. I know there are puts and takes there. But I believe you cited a low single-digit order decline in the fourth quarter outside of touchless, which is a bit better than expected. Is the expectation that Water Management core sales will grow in 2021 or is it still early to make that call?

[Mark Peterson, executive]

Well, you know it's February 16, so it's probably -- take it with a grain of salt, but I think we're pretty confident that we're going to grow on a core basis this year. And I think the first 45 days of the quarter would absolutely support that for the first quarter. And with the vaccine coming, construction season starting again, we feel like that's clearly something that we're going to be able to do.

[Bryan Blair, analyst]

That's great to hear. And then a quick one on Hadrian. You mentioned that profitability is lower currently. What are run rate margins? And where do you expect them to go as you scale that business?

[Todd Adams, executive]

That's in the lower teens. And I would suspect that we'll be able to march them up north of 20% in a reasonably short period of time.

[Operator]

Your next question comes from the line of Mig Dobre from Baird.

[Mircea Dobre, analyst]

Congratulations on today's announcement. Seems like a very good way to unlock shareholder value. I guess my first question is, maybe Todd, perhaps you can comment on how this transaction, in your view, changes the focus of the organization, your approach, your ability to deploy capital.

And I'm curious if -- on the flip side, given the amount of work that you guys are going to have to do over the next 11, 12 months, if this perhaps precludes you from doing additional deals or capital deployment here in the mid term.

[Todd Adams, executive]

Mig, I think I got it, you're awfully hard to hear. But look, I think -- I don't think much is going to change. I think we are very focused on each of our platforms and the end markets we serve. Our strategy and our deployment of that strategy is going to remain exactly as it's been. We've got some work to do to untangle some things that may have gotten tangled over time, but it doesn't preclude us from doing anything from an M&A standpoint if we think it's the right thing to do.

And so it doesn't change any of the focus. I think it's essentially business as usual. And I think we have 2 terrific teams that are both locked in and are going to have a great year.

[Mircea Dobre, analyst]

Okay. I see. Hopefully, you can hear me. I'm trying to speak up a bit here. Then maybe a question on RBS and SCOFR. As we're thinking about Water Management at pure-play, looking back, it seems like a lot of your SCOFR benefits were derived from PMC. I'm wondering how your business system really applies to Water Management? And what investors should expect from a margin standpoint going forward out of this segment?

[Todd Adams, executive]

Well, the Rexnord Business System has been deployed at Zurn since we acquired the business in 2007. And it's at that point in time when margins I think were about 19%. And now they're 27%. So the business system definitely applies. And I think perhaps the best example of the results of the business system lie inside of Zurn. It's extraordinarily lean. It's got terrific supply chain capabilities. And manifests itself in growth and margins and cash flow that I think are superior to essentially anybody we compete with. And so we think the business system will continue to create opportunities for growth and future margin expansion just as it has for the last 13 years.

[Mircea Dobre, analyst]

And maybe 1 last follow-up from me. To your point on free cash flow, can you give us a sense for what free cash flow looks like for Water Management as a stand-alone business, either as a percentage of sales or however you want to frame it going forward?

[Mark Peterson, executive]

Yes. Mig, I think the way to think about it is you got to look at the '22 as sort of the first full year, and it's probably right around $150 million, plus or minus.

[Operator]

Your next question comes from the line of Brett Linzey from Vertical Research Partners.

[Brett Linzey, analyst]

First question is just on stranded costs. I'm wondering how you're thinking about -- as you separate PMC, have you sized those? And just given the time to close, you obviously have a running start here to eliminate any of those redundancies, but just trying to get a sense as to the size of potential stranded costs?

[Todd Adams, executive]

Well, the corporate number is right around $40 million. From a cost standpoint, I think we believe that water or RemainCo will end up in the $15 million to $20 million of corporate costs. So a combination of us just being smaller, maybe not needing some functions related to international operations and things of the like. And then also, Regal will likely end up absorbing some of those costs as they add PMC to the mix. So there's going to be some additional support. Now whether it's the exact same resources or it's different resources, that's how we're thinking about getting from 40% down to that 15% to 20%.

[Brett Linzey, analyst]

Okay. Great. And then just thinking about the post-transaction leverage about 2x, water obviously generates a lot of cash. What is the right leverage level? And how are you thinking about your total capacity post transaction for water to grow that business inorganically?

[Todd Adams, executive]

Well, I think we view water as a growth business. And so from a cash flow standpoint, we clearly have the ability to move leverage up 2 to 3x. I think it's where we're going to start and stay comfortable. And then obviously, the cash flow generation year in, year out is -- creates more flexibility.

So I don't think leverage is going to be the problem. I think it's just a function of continuing to invest organically, find the right M&A. And then obviously, there are bigger, more transformative things out there that we can do with water. And that wouldn't create a problem with leverage.

So from our standpoint, we think we've got great flexibility on the other side of this, which will be basically 2022.

[Operator]

Your next question comes from the line of Jeff Hammond from KeyBanc.

[Jeffrey Hammond, analyst]

Congrats on the deal. Just on Hadrian, can you give us what the revenue is for that business? Or I guess, within 1Q, what's the core growth and what is the revenue from Hadrian?

[Mark Peterson, executive]

So revenue from Hadrian, it's about $60 million annually, Jeff. And obviously, maybe a little bit lower in Q1 just given the construction season.

But we think the core growth we'd be pegging in Zurn would be in that low single-digit range for Q1 at this point.

[Jeffrey Hammond, analyst]

Okay. And then just on, I guess, on the capital allocation, another kind of follow-on, you guys had laid out fairly recently a balanced structure of dividend, buyback and M&A. And I'm just wondering if any of that changes as you think about scaling up water as a stand-alone more rapidly from an inorganic versus kind of returning cash to shareholders?

[Todd Adams, executive]

Yes. Jeff, it's something that we'll obviously spend a lot more time on, but it would be my suspicion that the capital allocation strategy for water will be modestly different in and around perhaps things like buybacks and the dividend. But we haven't made a final determination on that. But obviously, we believe that it's much more of a growth-oriented business, so retaining the flexibility to be able to do that, I think, will be at a premium.

[Jeffrey Hammond, analyst]

Okay. And then just last one. PMC, I think you're calling for low double-digit declines in 1Q. Just wondering what you're seeing from an order trend standpoint, Regal, I think talked about, on their call, some 30% growth in January and some restocking activity, and it does seem like the industrial side is turning the corner. So just what kind of underpins that decline in 1Q?

[Todd Adams, executive]

Well, I think, we're seeing similar trajectory. I think we're just trying to be a little bit conservative here. And obviously, we still have the headwind from aerospace, and the other thing not to forget is that if you go back to March of last year, we were actually flat in the March quarter.

So we were performing -- we performed extraordinarily well at the onset of COVID and so it's a modestly tougher comp for us in PMC. But I think the trajectory that we've seen through 45 days is supportive of something that's probably a little bit than that. But for the time being, we're trying to keep everybody focused on just executing as well as we can.

[Mark Peterson, executive]

Yes. And just to add to that point. As Todd said, the comp is more of the issue in aerospace. If you look at where the order rates are, order rates in the business are supportive of returning to growth in our second quarter as we highlighted. So that's -- piggybacking on that, the demand trends are different than what the sales headlines in our read in the quarter.

[Operator]

[Operator Instructions] Your next question comes from the line of Matthew Fields from Bank of America.

[Matthew Fields, analyst]

Just want to ask about the kind of the capital structure and leverage commentary. I'm definitely missing something because I know you guys are saying pro forma leverage after this transaction is expected to be down at 2x by the end of the year. Obviously, that's a year-end 21 number. But if I just strip out the $268 million of PMC EBITDA based on your current kind of net debt numbers, I get more like 5.5x leverage. Is there something I'm missing? Is there a step in between here and there? Is there a pro forma EBITDA that you're going to be including? Or is it just growth throughout 2021 that gets you to 2x? Can you just help me bridge that gap, please?

[Todd Adams, executive]

Sure, not to turn this into a modeling call, but you're missing a dividend that's going to come from Regal to RemainCo.

[Matthew Fields, analyst]

Okay. Not just RXN shareholders, but RXN the credit group will be receiving proceeds from the dividend, too?

[Todd Adams, executive]

That's correct.

[Matthew Fields, analyst]

Okay and then just...

[Todd Adams, executive]

Rob is happy to walk you through the transaction off-line in any details if you want to know.

[Matthew Fields, analyst]

Yes, that would be helpful. And then I know that your bond debenture obviously has limitations on restricted payments. This is a $3.7 billion spin. So is this predicated on the fact that you can do this because pro forma for that dividend and everything, you'll still be below that 3x net leverage test in the RP covenant?

[Todd Adams, executive]

Again, I think some of these details are better off-line. I can assure you that with the advisors we've had and the advice we have, whatever indenture concern you have doesn't exist. So I'd recommend you take it up with Mark and/or Rob in a separate call.

[Matthew Fields, analyst]

All right. That's fair enough. And then lastly, given that the sort of new business is going to look vastly different than before, does it make sense to have the current bonds in here? I mean they are only a -- they're 2025 maturity, they're callable now with a step down in December kind of coinciding. Do you envision kind of terming out this debt with sort of newer, longer-term bonds upon closing?

[Mark Peterson, executive]

Yes. This is Mark. The way it works is the bond will go away, the term loan goes away, and you replace with a new term loan B size just for the water business. Look, it has a very similar covenant structure, covenant light. We'll downsize the revolver a bit. But that's the way the capital structure will shift.

[Matthew Fields, analyst]

Okay. So you envision going to a new loan-only structure after this?

[Mark Peterson, executive]

Correct. Term Loan B only. Yes, a lot of term loan B only.

[Operator]

There are no further questions...

[Todd Adams, executive]

So thanks to everybody that could join us on the call today. We appreciate your interest in Rexnord, and we look forward to providing the next update when we announce our March quarter results in April. So have a great day, and please continue to stay safe.

[Operator]

Thank you for joining today's conference call. You may now disconnect.