Q2 2023 Zurn Elkay Water Solutions Corporation Earnings Call
Speaker 1: Good morning and welcome to the Zurn LK Water Solutions Corporation second quarter 2023 earnings results conference call with Todd Adams, Chairman and Chief Executive Officer, Mark Peterson, Senior Vice President and Chief Financial Officer and Dave Pauley.
Speaker 1: Vice President of Investor Relations for ZERN LK Water Solutions. This call's being recorded and will be available for one week. The phone numbers for the replay can be found in the earnings release the company filed in an AK was SEC yesterday, July 24th. At this time, for opening remarks in introduction.
Speaker 1: I'll turn the call over to Dave Pauley.
Speaker 2: Good morning everyone and thanks for joining us on 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.
Speaker 2: In addition, some comparisons will refer to non-GAAP measures. Our earnings release and SEC filings contain additional information about these non-GAAP measures, why we use them, and why we believe they are helpful to investors, and contain reconciliations to the corresponding GAAP information.
Speaker 2: Consistent with prior quarters, we will speak to certain non-GAP metrics as we feel they provide a better understanding of our operating results. These measures are not a substitute for GAP, and we encourage you to review the GAP 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 Zernel K. Water Solution.
Speaker 3: the LK transaction and all the work we did to accelerate the integration and simplify the business is essentially behind us and we're now beginning to see the benefits both from a growth and profitability perspective with the initiatives we've been working on. You know sales in the quarter we're ahead of our guidance and order is even more so with high single digit.
Speaker 3: With our supply chain and service levels now back to pre-pandemic levels, and even better or shorter in many cases, our free cash flow was again very strong and it enabled us to repurchase 4 million shares in the quarter, bringing our year-to-date repurchases to 87 million dollars, as total leverage actually ticked down to 1.5.
Speaker 3: We also expect that to continue to decline over the second half based on a strong free cash flow expectation and end the year right around 1.2 times. With that, I'll turn it over to Mark and he'll take you through the quarter. Thanks, Todd. Please turn to slide number four.
Speaker 4: On a year-by-year basis, our second quarter sales increased 42% and were above the high end of our outlook for the quarter at $403 million.
Speaker 4: The LK merger contributed 47% year-over-year growth, and our core sales decreased 5% from the prior year. On a pro forma basis, including LK in the prior year's second quarter and reducing those sales for the $29 million impact from the product line exits that we have outlined, core sales decreased 1% year-over-year.
Speaker 4: As we discussed on our call last quarter, our year-over-year second quarter core sales growth was impacted by the timing of orders and shipments in the prior year as we began working down an elevated backlog in the second quarter of 2022.
Speaker 4: Breaking down this pro forma core sales, sales to our residential end markets decline in the mid teens year over year, as we've expected, which is substantially offset by a low single digit increase in core sales to our non-residential end markets.
Speaker 4: While prefrontal core cells modestly decline, prefrontal core orders increase the high-simil digit rate as we anticipated with drinking water growth outperforming the fleet average.
Speaker 4: Turning to profitability.
Speaker 4: Our adjusted EBITDA was 87 million in the second quarter, and our adjusted EBITDA margin was above the high end of our outlook for the quarter at 21.6%. This compares to 64 million and 22.6% in the prior year, first quarter, second quarter.
Speaker 4: The benefits of price realization and our productivity initiatives inclusive of the cost synergies that are a little over six million each quarter in calendar year 2023 was more than a step by the sell through a higher cost inventory purchase last year, which was complete during the second quarter. Investments in our growth and supply chain initiatives as well as the impact of the allocate merger.
Speaker 4: When looking at our margins sequentially, we stepped up 210 basis points from the first quarter of 2023, and we expect further margin expansion in the second half of the fiscal year.
Speaker 4: Please turn to slide five and I'll touch on some of the balance sheet and lever title lights.
Speaker 4: With respect to our net debt leverage, we ended the quarter with leverage at 1.5 times, inclusive of deploying $87 million of cash to repurchase common stock on the first half of 2023, and $112 million since we started repurchasing shares in the fourth quarter of 2022.
Speaker 4: At that leverage, we ended the quarter with leverage at 1.5 times, inclusive of deploying 87 million of cash to repurchase common stock on the first half of 2023, and 112 million since we started repurchasing shares in the fourth quarter of 2022. With that, I'll turn the call back to Todd.
Speaker 3: Thanks Mark. We continue to prioritize drinking water and filtration growth based on the massive opportunity we see in the K through 12 and higher ed end markets. We've been investing in an awareness campaign adding commercial resources, top grading our product offering for simpler installation and maintenance.
Speaker 3: and also advancing the filtration aspect of drinking water with the addition of a PFAS filter that we expect to begin selling sometime in the fourth quarter.
Speaker 3: In the last 90 days, we spent time doing three blitzes across states that have advanced legislation that will require more access, reporting on water quality, as well as mandating filtration.
Speaker 3: K through 12 is a school by school or district by district game where we're engaging with administrators, faculty teams, educators and parents, and we'll continue to do that as Jefferson County & More
Speaker 3: Hello? We'll continue to do that as we continue to work at that.
Speaker 3: At the higher ed level, we're seeing tremendous traction as both public and private universities prioritize sustainability in their master plans.
Speaker 3: We saw our funnel for higher ed grow by over $20 million in higher ed alone. And we hope we continue to see that that be, will be a significant growth opportunity for us, not only this year, but for several years to come. As we continue to keep sustainability in front and center in front of all of our
Speaker 3: in the top 2% within our end markets.
Speaker 3: As I've said before, this isn't born out of any target to go through the motions. It's fundamental to our business, is integrated into every asset or every facet of our business and our business system, and we truly believe it's adding a competitive advantage to us in the marketplace. With that, I'll turn it back over to Mark, who will take you through our outlook.
Speaker 4: Thanks, Todd. Please turn to slide 8, and I'll cover the highlights of your outlook for the third quarter.
Speaker 4: For the third quarter of 2023, we are projecting sales in the range of $390 million to $400 million and our adjusted EBITDA margin to be in the range of 23.5% to 24%.
Speaker 4: Like last quarter, to help better understand the growth trends in the business in 2023, on the right side of the chart, we have presented ZERN, LK, a pro forma sales for the third quarter of last year, which takes on reported sales for the third quarter of 2022. Less the year-by-year impact of the 80-20-partitline exits we've executed.
Speaker 4: With respect to the sales outlook, you can see on the page our assumptions for year-to-year performance growth and our non-residential and residential end markets, which has impacted by the timing of orders and shipments last year as we continue to work down and elevate the backlog in the third quarter of 2022.
Speaker 4: We anticipate pro-formal orders in the third quarter to expand in the mid to high single digit range every year with non-residential and market growth above the average and residential and market growth below the average for the quarter.
Speaker 4: Turning to profitability. Our third quarter margin is expected to expand 350 to 400 basis points year over year, and 190 to 240 basis points sequentially from the second quarter of 2023. So we'll begin to fully benefit from the lower commodity and transportation costs we've been experiencing.
Speaker 4: Turning the page nine. With half of a calendar year behind us, we have adjusted our full year outlook and now expect sales for calendar year 2023 to be in the range of 1.525 billion to 1.55 billion and are consolidated in just the EBITDA to be in the range of 335 million.
Speaker 4: to 345 million, resulting in year-over-year margin expansion of at least 140 basis points up to 170 basis points.
Speaker 4: So more to the third quarter outlook, we have provided our expected full year of performance sales growth for our non-residential and residential end markets, which has calculated off the prior year reported sales, plus LK sales for the first half of 2022, less the impact of the 80-20 product line exits we have executed.
Speaker 4: In addition, we have increased our free cash flow outlook for the calendar year from approximately $200 million to approximately $215 million.
Speaker 4: Before we open the call for questions.
Speaker 4: Just a reminder that we have included on page 8 and 9 our third quarter and full year outlook assumptions respectively for interest expense, non-cash stock-comp expense, and non-cash expense.
Speaker 4: depreciation and amortization, our adjusted tax rate, and deluge shares outstanding. We'll now open the call up for questions.
Speaker 1: The floor is now open for your questions. To ask a question this time, please press star one in your telephone keypad. If at any point you'd like to withdraw from the queue, please press star one again.
Speaker 1: The floor is now open for your questions. To ask a question this time, please press star one in your telephone keypad. If at any point you'd like to withdraw from the queue, please press star one again. We'll now take a moment to compile our roster.
Speaker 1: Our first question comes from the lineup.
Speaker 1: Brian Blair from Oppenheimer. Please go ahead. Thank you. Good morning, guys. It's all good. Good morning, Brian .
Speaker 5: With your right to your Q3 revenue guide, does somebody get to parse that out a little bit more? I know there's a lot of year on year noise.
Speaker 5: But it seems like there's a fair amount of conservatism and it seems like there's a fair amount of conservatism.
Speaker 5: year on year, but perhaps walk us through how you're thinking about the sequential revenue program.
Speaker 4: Yeah, look, right. I think, you know, as we've kind of been all year long, you know, we've been a little more conservative of looking going into the next 90 days across the board. So I think I mean, you said it's accurate. You look back historically. Yes, our third quarter tends to be similar.
to the second quarter from a revenue standpoint could be a little bit up, could be a little bit down, could be on par. So I think that you've seen the guide, there's a bit of conservators and that's been our practice this year. So nothing different there. I think you're right on the order trends. We expect those to continue like we saw in the second quarter. The third quarter, the revenue growth, as you pointed out, clearly is impacted.
by the backlog, you know, work down that we had last year. So I think the orders are a better proxy of what we're seeing from a demand standpoint.
but yeah, I think the sequential trend that you've laid out of what you historically see and
I mean, that's imminent that we see that would change that, but you know, we've just taken more of a cautious approach to the to our outlook this year. lessons are
Okay, understood. And perhaps provide a little more color in what your team's seeing in your key institutional verticals and your current pace of activity, how the project pipeline has developed your date and specific to...
how your commercial drinking water platform has influenced the pipeline and your forward opportunity.
Yeah Brian , so institutional is you know notionally half of our total revenues but primarily between education and health care. So I think you know from a from a current state perspective backlogs really across the country in those two verticals continue to be very high and if you follow some of the leading indicators in that
in the institutional end market, they've been quite positive. So obviously, we continue to think that the diversity of the business, adding drinking water, specifically adding filtration into the educational vertical provides us.
I think a lot of comfort that this is something that we can grow sustainably for a pretty long time. There's pockets of strength when you go throughout the country obviously. And then there's pockets of where there's just less activity, but it's nothing unusual.
in that institutional end market really since the beginning of the year. So very much on track, drinking water is certainly helping our value proposition when we're talking to K through 12 schools and colleges and universities because as I said in my comments, sustainability.
at the university level is increasingly important. K through 12, we're getting solid traction with a combination of legislation and then really just going out school by school and district by district and communicating what we're doing, which is essentially we can provide clean drinking water to students for one dollar per student per year.
which is an amazing value prop that we think is gonna resonate for a really long time.
Absolutely. One last one. I know you're not providing 2024 guidance, but you had put out the 25 million in incremental synergy guide before. Is there any shift to that at this point?
No, I think it's very much on track. I think the majority of the work is behind us. There's some things that we're wrapping up over the course of the next two to three months. We obviously announce the closure of one of our facilities and consolidation of that into.
two different LK facilities that's primarily around sync manufacturing. So that work is underway. And so, you know, we'll hit the ground running on 1124 with another 25 million into our earnings run rate.
Understood.
Our next question comes from a line of Jeff Hammond from Keybank. Please go ahead.
Hey, good morning guys.
Morning, Jeff. Hey, so it sounds like the order rates were maybe a little bit better than you expected. Can you just speak to what's coming in better, and then just within the different product categories, is it pretty broad-based, are there outliers, good or bad?
I think that the two sort of outperformance areas for us were a combination of residential improving, you know, we started to see Resi deteriorate a little bit in the third quarter and more into the fourth quarter. We've seen that begin to snap back, you know, I think as housing starts begin to stabilize.
improve, we're seeing a little bit of traction there and then obviously drinking water.
You know, the comparable is easy given the backlog reduction, but you know, we're seeing significant order growth in both you know, the bottle filling units as well as filtration. So those are the two outliers. Everything else is sort of around, you know, sort of the fleet average. You know, we saw some strength in our...
in our flow systems business, which is very encouraging. And then we continue to do just a great job in water safety and control. So it was relatively broad base, but combination of residential and then drinking water were the two areas of sort of outperformance.
Okay.
Just on the clean water kind of initiative, can you just talk about, you know, momentum versus expectation and just what you typically see from a sales cycle given, you know, it seems very, you know, kind of local, you know, local regional.
It is, particularly on the K-12 side of life. Obviously our specification share across the country is significant. And so as schools get built or retrofit, we start the game in a really good place. I think what we're trying to do is drive...
you know, more access points inside of these particular schools, obviously getting them to understand the benefits of locking in a filtration solution over a period of time, but you are correct. I mean it is a school by school, district by district. There's not a overarching, you know, sort of mandate.
of when to do it and how to do it. And so that's where partnering with the commercial resources we've added internally along with our third party reps. We're able to go out and really understand where are the big school districts, what are the influencers, what's our competitive position, and then how do we sort of...
get that work done for them over the time period that works for them. I think that is the one thing in K through 12, that's a little bit unique relative to higher ed, which is students are not there in the summer. So the vast majority of the work gets planned, I would say late winter into spring so that it's done.
over the summer and then it gets a little bit quiet as kids are back in school. I think universities, you know, that's obviously sort of a living breathing thing almost every day of the year. So that work gets done, you know, over time. So I think from a school perspective, particularly on K through 12, you know, I think the momentum that we're building this year.
will benefit us even greater into next year, right? As they begin to do some more long range planning on what they're doing. I'd also say Jeff that, you know, in a case where a school district may have, you know, 500 units.
They're not going to replace or upgrade these all at one time. They're going to do school A, B, and C, and then they're going to do the remainder over time. So it's really one of those things where
you know, the business and the opportunity given the 131,000 schools is just, it's just huge. And, and, and when you get to the end, you know, we'll be ready to retrofit and replace the others. So it's a longer, it's a longer process, but one that I think has, you know, far more durability over, over a really, really long period of time. Okay, great. Last one on buyback.
You guys seem to be running ahead, kind of the pace for the 100 million. Just wondering if you're thinking same or different around buyback, just given the stock move. I'm just wondering if you're thinking the same or different around buyback, just given
for us, and the time was really.
really positive for us with the first that opportunity to buy the stock of the prices that we did. We'll continue to keep about capital allocation strategy in place over on not this year, but going next year as well.
positive for us with the first half and the opportunity to buy the stock at the prices that we did. We'll continue to keep a balance capital allocation strategy in place over not just this year but next year as well.
Thanks, good morning everyone. One of the apps got in free cash flow. I think it was nicely above what we were expecting this quarter. I wanted to see, you know, I guess any of like the big drivers of that strong free cash flow seems like inventories help and maybe just how you're thinking about that for the rest of the year.
Yeah, I think for us free casinos, you know, got a positive this year, and the team did a really nice job with managing the trade-working capital in the business this year working down the inventories from the elevated levels last year.
So, as we look at the balance of the year, and from a timing standpoint, we'll probably reduce a bit in the third quarter, and then up, check again, in the fourth quarter from a state in standpoint, it's a timing of some payments. But at the end of the day,
You know, we took her out, look up, we took her out into $215 million. So good momentum. I'll be a strong leader of cash when we see a lot of good momentum going on next year as well.
Andrew, I think the one point to make is our overall lead times in our supply chain are roughly half of what they were a year ago. So obviously we've had a view on demand and a view on that we were going to be able to get back to that and obviously
Function of that is then selling through that high cost inventory that you saw us do in the first half. So it all sort of works together in terms of the demand that we're seeing sort of broadly in line with what we're expecting, maybe a little bit better. Our supply chain is back to pre-pandemic levels, notionally half of what it was 12 months ago.
And then, you know, our service levels are high. So the net effect of that is, you know, the margin progression that we communicated.
you know, tracks very nicely with the cash flow. So from an accounting basis, you know, our margins were, I would say, understated relative to the current purchases that we were making. So you'll see that, as Mark pointed out in the outlook, that drives the vast majority of that margin step up in the second half.
Okay, great, all makes sense. And from a follow up just on the guidance, maybe more for the 2023 guide. Just, what's one of the major puts and takes that would push you to like the low versus higher end of the range? Thank you.
Well, I mean, I'll let Mark comment as well, but I think it's really five months left in the year. There is always going to be a range of outcomes. I don't think there's anything specific that would push us one way or another. I think the order trends that we've seen through