Zurn Water Solutions Corp

NYSE:ZWS

Earnings Call Analysis

Zurn Elkay Raises Guidance Amid Strong Q3 Performance and Margin Expansion

In the third quarter, Zurn Elkay reported a 4% increase in sales, totaling $410 million, with adjusted EBITDA growing 9% to $105 million. The adjusted EBITDA margin expanded by 150 basis points year-over-year to 25.6%. Management raised full-year margin expansion guidance to 250-270 basis points and expects free cash flow to reach approximately $260 million. A notable improvement in margins was driven by enhanced productivity initiatives. Additionally, a new dividend of $0.09 per share represents a 12.5% increase. The company remains bullish about growth prospects, particularly in educational and healthcare sectors in 2025, driven by upcoming regulatory requirements in Michigan.

Strong Q3 Performance and Positive Outlook

In the third quarter, Zurn Elkay Water Solutions Corporation generated $410 million in sales, reflecting a 4% organic growth. This performance slightly exceeded the company's guidance. Importantly, adjusted EBITDA grew by 9%, pushing margins to a robust 25.6%, an impressive increase of 150 basis points year-over-year and the highest margin since the Elkay merger. The strong quarter allowed the company to raise its outlook not just for revenue but also for margins and free cash flow for the full year.

Robust Margin Expansion and Future Projections

Continuing on its positive trajectory, Zurn Elkay now expects an adjusted EBITDA margin expansion of 250 to 270 basis points for the year. This improvement is linked to ongoing productivity initiatives and synergies from the Elkay acquisition. As of now, free cash flow for the year is estimated at approximately $260 million, showcasing a strong financial foundation for future growth.

Shareholder Returns and Capital Allocation

Zurn Elkay is actively returning capital to shareholders, having repurchased $50 million worth of shares at an average price of under $31 during the quarter. This is part of a balanced capital allocation strategy that has seen the company reduce its net debt leverage to an all-time low of 0.8x. The company also announced a 12.5% increase in dividends, highlighting its commitment to rewarding shareholders while maintaining a strong balance sheet.

Market Resilience and Future Opportunities

Despite facing flat sales in certain residential end markets, Zurn Elkay's focus on nonresidential and institutional sectors remains strong. The company’s strategic initiatives are aimed at expanding its market presence, particularly within education and healthcare verticals, which are expected to be key growth drivers going into 2025. Legislative changes, such as Michigan’s new regulations for clean drinking water, are anticipated to create additional demand for products, including filtered bottle fillers.

Price Increases and Demand Projections

Further, the company plans to implement price increases between 1 to 2 percentage points in 2025 as demand improves, contributing to revenue growth. This is coupled with expectations of continued strong demand in their drinking water segment, which is forecasted to grow at double-digit rates following regulatory support.

Long-Term Growth Strategy and Market Conditions

Zurn Elkay's long-term growth strategy hinges on stable institutional demand, strong market fundamentals, and a favorable economic outlook. The company has managed to maintain positive core growth in 51 of the last 55 quarters, establishing a long-term CAGR of 6% to 7%. They expect these trends to persist, paving the way for solid performance in upcoming years.

Sustainability and Community Impact

On top of its financial performance, Zurn Elkay has made significant strides in sustainability. Their commitment to clean drinking water and environmental stewardship not only aligns with regulatory trends but also meets growing customer demands for responsible practices. Investments in community projects, particularly in areas affected by water supply issues, reinforce their brand image and open new markets.

Earnings Call Transcript 2024-Q3

[Operator]

Good morning, and welcome to the Zurn Elkay Water Solutions Corporation Third Quarter 2024 Earnings Results Conference Call with Todd Adams, Chairman and Chief Executive Officer; David Pauli, Chief Financial Officer; and Bryan Wendlandt, Director of FP&A for Zurn Elkay Water Solutions.

A replay of this conference call will be available as a webcast on the company's Investor Relations website.

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

[Bryan Wendlandt, executive]

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 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 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. We encourage you to review the GAAP information in our earnings release and in our SEC filings.

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

[Todd Adams, executive]

Thanks, Bryan, and good morning, everyone, and thanks for taking the time to call in this morning.

I'll start on Page 3. The third quarter, again, slightly exceeded our guidance across the board, and we are also raising our outlook again for the full year. We leveraged third quarter core growth of 4% into 9% adjusted EBITDA growth, which drove margins to 25.6%, equating to 150 basis points of margin expansion year-over-year.

Through 9 months, our consolidated EBITDA margins sit at 25%. And as you may have seen in the release, we raised our outlook for the year-over-year margin expansion to 250 to 270 basis points.

Free cash flow in the quarter was $87 million, and we deployed $50 million of that to repurchase 1.6 million shares during the quarter at an average price of under $31. Leverage falls to 0.8x. And as we mentioned in the release, we are raising our outlook for free cash flow and now see the full year around $260 million.

And finally, we again raised our dividend this year to $0.09 a quarter, which represents an increase of 12.5%.

Later in the call, I'll spend some time on the outlook for our end markets heading into 2025. But much like we've said throughout the year, the resilience of our end markets and perhaps our unique exposure to particular verticals give us confidence of an improving backdrop over the course of the next couple of years.

I'll hand it over to Dave to take you through some more color on the quarter. Dave?

[David Pauli, executive]

Thanks, Todd.

Please turn to Slide #4. Our third quarter sales totaled $410 million and grew 4% organically on a pro forma for basis. Mid-single-digit core sales growth in our nonresidential end markets was partially offset by flattish year-over-year sales to our residential end markets and pockets of the commercial segment within nonresidential. End market trends continue to align with our expectations, and our growth initiatives drove the sales performance to the higher end of the outlook we provided 90 days ago.

Turning to profitability. Our third quarter adjusted EBITDA was $105 million and our adjusted EBITDA margin expanded 150 basis points year-over-year to 25.6% in the quarter. At 25.6%, our third quarter adjusted EBITDA margin is the highest consolidated margin since the Elkay merger 2 years ago and up 30 basis points sequentially from the second quarter. The strong margin and year-over-year expansion was driven by the benefits of our productivity initiatives, leveraging our Zurn Elkay business system and continuous improvement activities across the organization as well as executing on the Elkay-related synergies.

For calendar year 2024, we believe our year-over-year margin expansion will be a bit better than we discussed 90 days ago, and we are again raising our expectation for full year EBITDA. We'll cover that in a little bit more detail later in the call.

Please turn to Slide 5, and I'll touch on some balance sheet and leverage highlights. With respect to our net debt leverage, we ended the quarter with $308 million of net debt and leverage continued below 1, at an all-time low of 0.8x. Our 0.8x leverage is inclusive of the $50 million we deployed to repurchase shares in the quarter. On a year-to-date basis, we have now deployed $130 million to share repurchases and $41 million to dividends.

We continue to have excellent capital allocation optionality, and as we have discussed, we will remain focused on our balanced capital allocation strategy going forward.

I'll turn the call back to Todd.

[Todd Adams, executive]

Thanks, Dave.

I'm back and on Page 6. Here, you can see our year-to-date sustainability impact and progress towards our targets. The beauty of our sustainability efforts and message and impact is that it compounds each and every day, and the benefit accrues not only to the environment but directly to our customers' benefit.

You've heard us talk about various states and legislation related to clean drinking water and filtration. The leading edge of that conversation has centered around the state of Michigan and its filter-first regulations, which are now being actively implemented. We're delighted to have worked with the state and its partners to develop the ways in which to implement solutions that will ensure that when a K through 12 student in the state of Michigan goes to school, they'll be drinking clean water.

The other element of our impact is in areas that have disruptions in their water supply, places like North Carolina with the recent hurricanes. We're helping communities and schools with filtration to ensure that PFAS and other contaminants that are in the water supply as a result of failed water treatment plants and a saturated watershed are filtered out and people are getting safe water in what is a very difficult situation.

I'm now on Page 7. Last quarter, we highlighted our long-term growth algorithm of market growth plus price plus breakthroughs, and over the last 15 years, that's resulted in a 6% to 7% compounded top line organic sales growth rate for us. This morning, we'll go a touch deeper on the market part of that equation as we head into 2025. And I'll share the headlines and the data that everyone reads about but also how to get underneath that to see how that impacts our business.

Just to start with some basic information, starting on the left. Here's the Dodge Momentum Index, which measures the value in dollars of all nonresidential building projects in the planning process against the baseline year of 2000. The thought is that it's the leading indicator for all future nonresidential construction spending, and therefore, it's generally used to monitor the future direction of construction spending. Think of it as a 9- to 12-month preview of what's likely to start. But also realize that there's a lot in there: price, commercial, institution, governmental buildings. So it's a pretty broad view of what could happen.

In the middle, the next is ABI, which is a sentiment survey that tracks a cohort of partners of the AIA member-owned architectural firms and whether their billing activity for the previous month grew, declined or remained flat. To understand it just a little bit more, a score of 50 indicates a balance between positive and negative reports, while a score of 100 indicates that all firms reported improvements. A rise in the index above 50 means that more firms reported an increase in demand for design services than reported a decline in demand. It's important to note that a rise in the index above 50 is not a direct measure of rise in demand because the survey does not ask firms reporting stronger demand to quantify the level of increase in demand nor does it provide information on the size of those firms. That being said, higher readings in the ABI generally coincide with some form of growing demand.

And finally, on the far right, Construction Backlog is a measure of the amount of work surveyed contractors have in their current backlog. In some ways, it's their lead time to taking on new business. And as you might guess, it's their best estimate, assuming no delays and consistent levels of staffing. So when you look at and read the headlines of these, they all have a level of validity to them in how to think about the future, but it all varies by region, vertical and, other than backlog reporting, lack certainty as to what's really going on at the ground level, which you can begin to see in the starts data, which is on Page 8.

So here is the Dodge starts data on a square footage basis, actuals from 2021 through 2023, with an estimate through August for 2024 and a projection for 2025. Here, we've split the data between institutional and commercial and, again, measured in millions of square feet.

First, a couple of very simple observations. Square feet commercial is 2.5 to 3x the size of institutional largely as a function of the massive impact of warehouses which represent roughly 55% of the entire commercial starts data. Second, the institutional starts just doesn't bounce around all that much. And education, which would be everything from an elementary school to a new research building at a university, represents consistently 40%, plus or minus, of the entire institutional market.

Off to the right, you'll see the Dodge breakdown amongst the rest of the verticals between institutional and commercial. And for institutional, it's health care and recreation buildings, which includes things like stadiums, parks, public and private entertainment venues as well as churches, dorms, government and municipal buildings, the common thread being highly specified, dense, complex buildings built to last for decades and not particularly sensitive to interest rates and content-rich from Zurn perspective.

In commercial, the remainder of the verticals are parking garages, office, retail and hotel, with office, retail and hotel being the most relevant to our business, again, because of the incrementally complex nature of those types of buildings and environments relative to warehouses and parking garages.

If you move to Page 9, the only thing we've done here is further segment the data from Page 8 down to our key verticals. On the left, this graph is just the education and health care vertical starts information, again, actuals through 2023 and estimates and projections for 2024 and 2025. These 2 verticals represent 60% of the entire institutional index and 80% of our exposure to the institutional nonresidential construction market. Simply said, we're materially over-indexed to the strong, stable parts of institutional within nonresidential construction.

On the bottom left, this is the graph, again, just for office, retail and hospitality verticals, the same period as before, with the conclusion being those verticals represent only 30% of the overall commercial starts information, yet represents 75% of our exposure to commercial. So when you look at this and break it all down, it's certainly one reason why our business has been so resilient over the past 20 years.

The other thing is that when you look at the projection for starts in 2025 within our most critical verticals, it's better than at any point in time over the last number of years. So certainly a good signal for us, but we're not popping champagne yet because those starts, number one, actually has to happen. And two, we'll see it when we start to see the bid quotes turn into buy quotes, which brings me to the last one for me, which is on Page 10.

I'll start by saying nonresidential construction and all that goes into it is a very complex industry. If you visited a job site or even built a home, this will resonate with you. When you think about all the coordination amongst the trades, staffing levels, regional migration, supply chain challenges, permitting inspections and, on top of that, weather and just the reality of the different seasons in which work can be done in various parts of the country, it's complex.

In general, the way to think about our business is that the average length of time to construct the nonresidential building is approximately 18 months, some shorter, some longer. With our portfolio, which is by far the broadest and most expansive in the industry, we participate across the entirety of those approximately 18 months with flow systems early in the process, water safety and control in the middle and towards the end of the process with hygienic and environmental and drinking water.

This is the chart on the left. To think about how that manifests itself within our business, you need to understand the lag effect. Simply said, in any given year, only about 20% of our new construction sales will come from starts activity within that calendar year, and roughly 80% will come from the start activity of prior years. To the right, we've tried to illustrate that over a given year by quarter. Think about it this way, in Q1 of 2025, virtually all of our new construction sales will come from starts in 2024. And by the time we get to Q4, current year 2025 starts will have about [ 40% ] contribution to our sales.

I think the way to conclude all of this is to say on top of all the market data we just run through, we've got our own more detailed views of specific regions, channels and customers and is ultimately how we manage the business. We also have things like drinking water and filtration, which can drive outsized growth that isn't really dependent on anything we've looked at this morning. The net of all of that is that it gives us high confidence in our core growth outlook and will continue to improve over the next couple of years.

And with that, I'll turn it over to Dave on Slide 11.

[David Pauli, executive]

Thanks, Todd.

While the market has had its ups and downs over a longer period of time, we have demonstrated an ability to deliver core growth through a number of different market dynamics. Over the last 55 quarters, we have had positive core growth 51x, and our long-term core sales CAGR back 10 years is 6%. We are focused on a single geography in North America that is highly leveraged to the stable education and health care end markets within institutional. Our retrofit exposure has increased over the years to 45%, and we are deploying resources at the local regional levels where we win every day. There is not a single contiguous nonres market here in the U.S. This is a hyper-local, hyper-regional business.

Our track record of sales growth has allowed us to deliver excellent profitability and cash flow. Year-to-date, our consolidated EBITDA margins are 25%, and our expectation is 30% to 35% incremental margins as we move forward. Our margin strength has come from leveraging our variable cost model and relentless continuous improvement through the deployment of the Zurn Elkay business system. The CapEx-light model, coupled with our disciplined working capital management has led to robust cash flow.

And finally, on capital allocation. The balance sheet has never been in a better spot. We currently have the lowest leverage we have had as a public company with a flexible balance sheet, allowing us to increase our return of capital to shareholders via dividend and share repurchases while in the background cultivating M&A.

Please turn to Slide 12, and I'll cover our outlook for the fourth quarter and for calendar year 2024. For the fourth quarter of 2024, we are projecting year-over-year core sales growth to be in the low single digits and are anticipating our adjusted EBITDA to be between $88 million and $90 million for the quarter. For the full year, we expect to see low single-digit pro forma core sales growth year-over-year.

With respect to our adjusted EBITDA margin, we are again raising our outlook and now expect adjusted EBITDA margin expansion to be between 250 and approximately 270 basis points year-over-year. Our free cash flow expectation has also improved as we are now expecting cash flow to be approximately $260 million.

Before we open the call for questions, just a reminder that we've included on Page 12 our fourth quarter assumptions for interest expense, noncash stock compensation expense, depreciation and amortization, adjusted tax rate and diluted shares outstanding. As a reminder, the year-over-year sales comparison in the fourth quarter is completely comparable as the last impact from product line exits occurred in last year's third quarter.

We will now open up the call for questions. Thank you.

[Operator]

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

[Bryan Blair, analyst]

Another solid quarter. You noted growth in all product categories for Q3. I guess to level set, was there a meaningful delta in growth rates in the quarter? And then for Q4, what are you contemplating by major product category in the low single-digit guide that you've offered?

[David Pauli, executive]

Yes, Bryan, this is Dave. Nothing different between the different product categories. Obviously, drinking water continues to perform very well. We saw double-digit growth in the installed base of filtered bottle fillers in the quarter. We continue to focus on just expanding the installed base of filtered bottle fillers as well as the attachment rate of those filters.

Todd talked about some of the events in Michigan this quarter, and I think that will help both of those factors that our team are focused on. So we'll now have a nice installed base of filtered bottle fillers in Michigan with a pretty high attachment rate on a go-forward basis as the state looks to comply with that legislation and then I would say very similar for the fourth quarter in terms of breaking down between the 4 product categories, how the sales looked in the third quarter. I'd expect something similar in the fourth quarter.

[Bryan Blair, analyst]

Okay. Understood. And you kind of offered a segue there. With drinking water still growing double digits, looking to 2025, is there any reason to expect that growth rate to moderate? And to what extent, if you can quantify? Could Michigan filter-first implementation or other states following suit benefit your team over time?

[David Pauli, executive]

Yes. So I think in terms of next year, nothing would suggest that it would slow down. Just in terms of trying to size Michigan, if you look at the state, the legislation that was passed requires 1 bottle filler, 1 filtered bottle filler per 100 students in the state. And so if you look at the state of Michigan, there's just about 1.5 million occupants within K through 12 schools. And so you can do the math on how many bottle fillers would be required in the state. Just as a proxy, an average bottle filler might sell for $1,200 to $1,300. And then there's also regulation around just faucets within classrooms and things like that. So there's a number of filtered faucets that we'll also sell into the state of Michigan.

The other thing to keep in mind, though, with the legislation in Michigan is that it's a 2-year adoption. So the law was passed in October of last year. The state just put out applications for schools within the last month, 1.5 months. Schools will start to get approval for spending, and then they'll likely spend in '25 and '26. So a lot of the legislation stuff that is either in play or passed, like in the State of Michigan, tends to have a fairly long period of adoption.

[Bryan Blair, analyst]

Understood. Appreciate that detail. One more quick one, if I may. You mentioned the normalized 30% to 35% incrementals you expect to drive going forward. I believe you're also underway with some supply chain repositioning that should benefit EBITDA growth next year. Can you remind us of the benefit that should drop through and perhaps the phasing or the timing of that?

[Todd Adams, executive]

Yes, Bryan, it's Todd. We've sized that somewhere in the neighborhood of $5 million to $10 million at full run rate. I think we'll be in a position to articulate that perfectly when we get to February. But I think you can, for sure, count on 5 next year. And then it's just a matter of how fast does it all ramp and can we get all the benefit in the year just based on current inventory levels and sell-through and all that kind of stuff. But it's something we've been working on for a number of years. I think it's a particularly helpful hedge against the backdrop of a potential tariff environment. But we've been working at it for a number of years, and so it will begin to read through next year and then full run rate into 2026.

[Operator]

Our next question comes from the line of Andrew Buscaglia with BNP Paribas.

[Andrew Buscaglia, analyst]

So the story all year has been really strong margins. And this quarter, in fact, gross margins, I thought were exceptional. I wonder if you could talk a little bit more about gross margins, what's driving that? How sustainable are the current levels? And then what's the long-term goal from here in gross margins? Is there really a ceiling? Or can that just keep going higher?

[Todd Adams, executive]

Well, I think it's a testament to a number of things, one, the foundational Zurn Elkay business system work that happens day in and day out that winds its way into gross margin through productivity, waste elimination, improvements in quality, waste elimination around freight and things like that. So the short answer is it's incredibly sustainable.

And then I think the other thing to point out is our fastest-growing product category is mix favorable. And so I think it's our view that it's very sustainable at the levels it's at, subject to the usual seasonality that we see. But in general, we think it can continue to march higher. I don't know that there is a number that I'm going to give you, but from where we are, I think targeting over time, a 50% gross margin is realistic for our product portfolio as it sits today.

[Andrew Buscaglia, analyst]

Yes, that's helpful. Another question I had along the margin line is, on Slide 10, you talk about how you work through that process. Is there a margin differential as you work through the months 1 through 18?

[Todd Adams, executive]

Not particularly. I think when you get to the end, our drinking water margins are better than our hygienic, but when you aggregate the 3 across, they're pretty similar at the end of the day.

[David Pauli, executive]

Yes. And that slide, obviously, Andrew, assumes that all jobs start at the same time and end at the same time, which isn't necessarily the case. So you've got jobs in process, in different stages of the process, at any given point in the quarter.

[Operator]

Next question comes from the line of Andrew Krill with Deutsche Bank.

[Andrew Krill, analyst]

The slides were helpful. So on those and all that information on Dodge starts where you mentioned more encouraging projections looking into next year but that you need to see that naturally happen. So just wondering, have you seen kind of any increase in like pauses or hesitancy with customers to like actually push projects through the finish line right now?

[Todd Adams, executive]

Not at any pronounced way, Andrew. I think you said the magic statement, which is they actually have to happen. And so when you look at the '24 information, that's actuals and projections through August. We're not seeing on the ground anything moving around over the last quarter. And then obviously, as they get into 2025, there's usually some wiggle in the beginning of the year based on the weather patterns in the U.S. But taken as a whole, the Dodge starts information usually is pretty reliable and gets, I would say, retroactively updated every time it's issued each month. And the bias is usually, again, to increase it. So we've got to see it happen but nothing pronounced or anything of any significance on delays or pushouts from our vantage point.

[Andrew Krill, analyst]

Okay. Great. And on net pricing, just I think my understanding is this year, net price has been a bit below the long-term algorithm, maybe in like 50 bps or so range. Just can you talk us through like your confidence that I think maybe like 1 to 2 points in 2025 as demand comes back a bit?

[Todd Adams, executive]

Yes. I think that's a very, very good assumption. We're seeing the market put in price increases beginning in 2025. We've done our preliminary communication around that. And everything that we see and I see leads me to believe that that's a really good assumption heading into 2025 as we sit here today, right? I mean I think to the degree there are tariff implications or other things that happen between now and points in time in 2025, that could differ. But I think as a baseline, that a couple of points of price is probably a really good assumption heading into 2025.

[Operator]

Next question comes from the line of Nathan Jones with Stifel.

[Nathan Jones, analyst]

As a follow-on to Bryan's earlier question on the incrementals and supply chain savings, you've got 30% to 35% normalized incrementals. Should we think of the supply chain savings over the next year or 2 as contributing to that 30% to 35% incremental or as additional to that 30% to 35% incremental?

[David Pauli, executive]

Yes, Nathan, it's Dave. I would think about it as additional. So 30% to 35% normalized incremental margins, and then we'll have a step-up benefit from that supply chain action.

[Nathan Jones, analyst]

Awesome. Back when you guys acquired Elkay, you gave some data around the number of water fountains in the U.S. It was like 8 million, and the penetration of bottle fillers on those was I think it was 1.6 million. Is there an update you have to that? I'm just interested to see kind of how the penetration of those has evolved over the last couple of years to get kind of a better idea of how long the runway is for our penetration of bottle fillers.

[David Pauli, executive]

Yes. So if you look at the, call it, 1.5 million, 1.6 million 2 years ago, Nathan, I'd say there's an incremental 200,000 to 300,000 bottle fillers, I guess, since July of 2022. Yes, so there's still a fairly massive installed base of non-bottle fillers and non-filtered bottle fillers here in the U.S.

[Nathan Jones, analyst]

What's your opinion on what the saturation of that is? Like if there's 8 million water fountains out there. They're not all going to have bottle fillers eventually. There's going to be a top number to that. I imagine it's still far, far above where it is today. But do you have any kind of guesstimation of what max penetration might be?

[Todd Adams, executive]

Nathan, I don't know that we do. But I think you can reliably think about that installed base growing in the couple of hundred thousand to potentially 300,000 over the coming years. So I think check back with us when we feel like it's more appropriate. But at the present, I think it's very, very early days. I mean the category is, I think, 11 years old, right? And so it took our entire lifetimes and multiple lifetimes to get to the 8 million of installed drinking fountains.

I think with legislation mandating particular number of units per student and then the retrofit replaced, right, because the life cycle of a bottle filler is somewhere in the neighborhood of 10 years, so we're in the very early innings of capturing a little bit of that very initial replacement cycle. But I think you can think about it as reliably growing the installed base by a couple of hundred thousand, probably moving to 300,000 over the next 5 years or so.

[Operator]

Next question comes from the line of Mike Halloran with Baird.

[Michael Halloran, analyst]

Good slides. And I'm just trying to triangulate the Dodge starts and the subsegment information with the timing that you laid out on Slide 10. It seems to me what you're saying is there's relative stability in your markets as we sit here today, tailwinds from a potential spike in the education and health care side of things. I mean that would be more in the second half of next year. So the idea from your perspective, if I'm triangulating this, is pretty stable going into the front half of next year and then back part of next year in '26 is where the tailwind from that would come in. Or is it just a little early to make that assumption?

[Todd Adams, executive]

No. I think in general, if the starts turn out to occur as projected in the verticals, particularly on the institutional side, the vast majority of that benefit accrues to 2026. And just as maybe a point to make, this represents just our new construction sales, right, and so with 40% to 45% of the remainder of the business as retrofit, replace, break, fix, which occurs in a relatively orderly 2% to 3% growth per annum. And then it doesn't include our residential exposure. So this is just new construction in institutional and commercial. But your thesis around when does it show up yes, it will show up a little bit towards the end of 2025 but in a more pronounced way throughout '26, provided these things happen as they're projected today.

[Michael Halloran, analyst]

Makes sense. I was going to ask about the other piece, but you got to it. So how do you think about the balance sheet usage from here, you raised the dividend, balance sheet is in great shape, obviously. How does that funnel from an M&A perspective look at this point? And how do you think about actionability?

[Todd Adams, executive]

I think Dave covered a lot of that in his comments. And obviously, we think we can continue to grow the dividend at a double-digit rate for the foreseeable future. We're going to continue to invest in ourselves by buying back stock below what we see the intrinsic value being based on our view of the outlook.

And to get to the root of your question, the cultivation activity is picking up. And so I think we're going to have opportunities to convert things that we've cultivated on a proprietary basis sometime in '25. I think that the nature of the conversations gives me some element of confidence that there will be some things that are actionable and we'll be able to convert. But in the meantime, I think we're going to reliably invest in what we believe is a great investment ourselves and continue to watch and be in a position to execute on some M&A sometime in '25.

[Operator]

Next question comes from the line of Joe Ritchie Goldman Sachs.

[Joseph Ritchie, analyst]

So I want to follow up on that question. It was really helpful to get some of this macro data and the kind of like the initial framework for next year. I just want to maybe understand that education and health care piece a little bit better because, for the last few years, we've seen a bunch of ESSER funding come through on the education side. And so I don't know, is there maybe a little bit more color on what's driving that expected increase in 2025 on the starts data?

[Todd Adams, executive]

Dave can probably quote the ESSER numbers more efficiently than I can. But when you look at the vast majority of that funding, virtually none of it went to building any form of new schools. It was all everything from salaries to safety to technology. And so the demand for new schools, and frankly, the age of schools, did not benefit in any way from that ESSER funding. And so I think when you look around the country and you see population migration, you see the age of those K through 12 schools throughout the country and the requirements today to make them safe buildings, sustainable buildings, I think that's simply what's driving the expected outlook.

But Dave can probably quote the ESSER numbers more efficiently than I can.

[David Pauli, executive]

Yes. I think, Joe, when you look at it, I think Todd hit it, the ESSER numbers were massive in terms of the amount of money that was provided to K through 12 schools in the U.S. I think the unfortunate thing is, what this graph is illustrating is that it wasn't spent on new construction. I think that's the point. There were certainly some upgrades that were made but not even in a material way. And so in terms of our numbers, we haven't seen a massive influx or a significant influx from ESSER funds going towards drinking water updates. And so I think as the U.S. school infrastructure continues to age, you start to see new construction come out here in 2025.

[Joseph Ritchie, analyst]

Got it. Okay. Understood. That's a really good distinction. I appreciate that. And then I guess my follow-on question, look, it's great to see the balance sheet position where it is today, sitting at sub-1x leverage at this point. Just give us an update, if you can, on your M&A pipeline priorities for the excess liquidity that you have today, and any thoughts around that would be helpful.

[Todd Adams, executive]

Yes. I mean much like we said just a question ago, the idea would be to continue to stick to what it is we do. I would not see us doing anything outside the U.S. I think it would be a combination of things within categories as well as some adjacencies that fit nicely between some of our existing product lines. So very much sticking to our knitting in our core market that give us incremental content per square foot that we can leverage through the way we go to market today and obviously migrate to the model that we've leveraged, as Dave pointed out, CapEx-light, highly specified, those types of things. So that's the pattern of things that we're shooting at and cultivating. So I think it will look a lot like things we do today in our core market here in North America.

[Joseph Ritchie, analyst]

Yes. And I should have probably clarified the question a little bit. Maybe just on the adjacencies, Todd, can you elaborate on that? Like, what are the types of different opportunities that are out there that could fit with the portfolio today?

[Todd Adams, executive]

Well, I mean, when you go inside each of our 4 significant categories, there's a bunch. And so I'm not going to get into each and every detail of the pockets of opportunity that we see, but suffice it to say, they will all fit really nicely within 1 of the 4 product segments that we talk about today.

[Operator]

And our last question comes from the line of Brett Linzey with Mizuho.

[Brett Linzey, analyst]

Just wanted to come back to the construction cycle illustration, very helpful. I was wondering if you might be able to drill down on the groupings in a little more detail. So if you look at the flow systems, which does lead, are you seeing any early signs of improvement on the rate of change that might inform that things are getting better there? Any granular color on some of those rates of change.

[Todd Adams, executive]

Yes. I mean, qualitatively, I would say if you had to force rank what's growing the fastest, that might be our fastest growing at the present, again, excluding drinking water. And so what we're seeing is we're seeing flow systems activity at a pretty decent clip. If we weren't seeing that as a backdrop to some of the stability and maybe early innings of growth in the Dodge Starts, it would be a little bit worrisome. But we are seeing flow systems grow in line with what we would expect and sort of at the trajectory that I think the starts data would indicate. That's just qualitatively.

Obviously, that has some level of seasonality to it because of the number of starts, obviously, beginning in the late fall and through winter and certain parts of the country decline. So we've seen that throughout the year. So I think it's a good sign. We're not trying to declare victory in 2025 yet because a lot can happen between now and then, but they're performing in line with the trajectory that the starts data would indicate.

[Brett Linzey, analyst]

Okay. Great. And then just to follow up on some of the growth. So you noted the high end of the growth achievement and was driven by growth initiatives, but you didn't go as far as saying anything was related to share gain. Do you think you picked up a little bit of share in the quarter? And I guess is there any way to parse out what growth initiatives bridged you to the upper end versus more market-related activity.

[Todd Adams, executive]

Yes. I think measuring share in a quarter is extraordinarily difficult. I think the way to think about it is, are we growing our specification share reliably over time? And I think the answer to that question is unquestionably yes. And so rather than try to measure a discrete set of opportunities that may have started as long as 18 months ago and say did you capture share, the north star for us is did we grew our specification of share throughout the year and specifically in the quarter, and the answer to that is absolutely. And so that will manifest itself in long-term share gains versus trying to measure it in any specific quarter with a unique set of opportunities against the competitive set.

[Brett Linzey, analyst]

Okay. Great. Maybe just one last one because I'm last. But back to the EBITDA margin progression. So it's just been really, really strong. You noted the ongoing productivity. When you think about the efforts in terms of structural versus discretionary, is there any variable discretionary costs that would maybe need to come back next year? And then thinking about the mix complexion institutional versus commercial, if commercial does get better next year and maybe there's some moderation in some of the pockets of institutional, is there any mix dynamics to think about?

[Todd Adams, executive]

I'll try to remember the whole question. But I think that I don't see anything from a variable basis that needs to come back beyond the stuff that you would ordinarily think of like rep commissions and freight and things of that matter, but all at a ratable level, so inside that 30% to 35% incremental envelope.

And then as it relates to the categories, institutional, I would say it's not a secret, it's our most profitable vertical; commercial next; followed by residential. And so as we see institutional chug along and as we see commercial begin to recover, commercial is probably much more in line with the fleet average. So I would say it's good but nothing outside of that. So again, I think when you look back over time, those incrementals are pretty reliable. Institutional is clearly our most profitable vertical and residential is our least profitable. So I think taken as a whole, we're pretty comfortable with that 30% to 35% incremental going forward.

[Brett Linzey, analyst]

Appreciate the extra insight, best of luck.

[Todd Adams, executive]

You bet.

[Operator]

That concludes the question-and-answer session. Mr. Bryan Wendlandt, I turn the call back over to you.

[Bryan Wendlandt, executive]

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 fourth quarter results in early February. Have a good day.

[Operator]

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.