Zurn Elkay Water Solutions Corporation (NYSE:ZWS) Q1 2024 Earnings Call Transcript

Zurn Elkay Water Solutions Corporation (NYSE:ZWS) Q1 2024 Earnings Call Transcript April 24, 2024

Zurn Elkay Water Solutions Corporation  isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good morning, and welcome to the Zurn Elkay Water Solutions Corporation First Quarter 2024 Earnings Results Conference Call with Todd Adams, Chairman and Chief Executive Officer; Mark Peterson, Senior Vice President and Chief Financial Officer; and Dave Pauli, Vice President of Investor Relations for Zurn Elkay Water Solutions. A replay of the 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 Dave Pauli.

David Pauli: Good morning, everyone. Thanks for joining us on the call today. Before we begin, I would like to remind everyone that this call contains certain forward-looking statements that are subject to the Safe Harbor language contained in the press release that we issued yesterday afternoon as well as in our filings with the SEC. In addition, some comparisons will refer to non-GAAP measures. Our earnings release and SEC filings contain additional information about these non-GAAP measures, why we use them, and why we believe they are helpful to investors, and contain reconciliations to the corresponding GAAP information. Consistent with the prior quarters, we will speak to certain non-GAAP metrics as we feel they provide a better understanding of our operating results.

These measures are not a substitute for GAAP and we encourage you to review the GAAP information in our earnings release and in our SEC filings. With that, I’ll turn the call over to Todd Adams, Chairman and CEO of Zurn Elkay Water Solutions.

Todd Adams: Thanks Dave and good morning, everyone and thanks for taking the time to listen this morning and hopefully everyone had a chance to go through the release last night. I’ll start on Page three. To cut right to the chase, we had a solid start to 2024 with Q1 sales, earnings and cash flow all ahead of our expectations heading into the quarter. From our perspective, the end market view that we’ve had for 2024 for the last six months or so, continues to look the same, with steady strength and institutional, some pockets of weakness and commercial and residential roughly flattish, with share gains, initiative growth and a little bit of price driving what we expect to be growth over the course of the coming year. Our margins and cash flow continue to expand as the compounding benefits of the early integration we did to bring Zurn Elkay together read through the results, with more room to go as we delivered the yield on the synergies throughout the balance of 2024.

The reality is we’ve totally integrated the businesses and truly operate as a single business. So all the productivity, supply chain benefits, pricing are all rolling in across the overall business as are the compounding benefits of all of our continuous improvement activities that happen day in, day out as part of the deployment of the Zurn Elkay business system. As you’ll hear a little later when Mark goes to the outlook, we have high confidence in the margin profile we’ve established and will continue to drive and as a result, we’re raising our outlook for the full-year margin expansion from 150 basis points to 150 basis points to 200 basis points with Q2 margins in the range of 24.5% to 25%. Our strong margins coupled with our flexible business model drive consistently high free cash flow and with the $50 million we generated in the first quarter, we use $19 million of that to repurchase about 600,000 of our shares with a plan to continue to do that over the course of the year.

Now I’ll turn it over to Mark.

Mark Peterson: Thanks Todd. Please turn to Slide number four. Our first quarter sales totalled $374 million and increased 400 basis points year-over-year on a pro-forma core basis. Mid-single-digit core sales growth in our non-residential end markets was partially offset by flattish year-over-year sales to our residential end markets. With respect to demand in the quarter, year-over-year order growth was in line with our sales growth as our book-to-bill ratio was one in the first quarter. As Todd mentioned earlier, end market trends in the quarter were consistent with our expectations and we did a bit better with our growth initiatives, which drove the sales performance slightly above our outlook 90 days ago. Turning to profitability, our first quarter adjusted EBITDA increased 24% from the prior year first quarter to $90 million and our adjusted EBITDA margin expanded 460 basis points year-over- year to 24.1% in the quarter.

The strong margin expansion was driven by the benefits of our productivity initiatives, inclusive of cost synergies, plus lower material and transportation costs compared to one year ago. For calendar year 2024, we believe our year-over-year margin expansion will be a bit better than we discussed 90 days ago and I’ll cover the more details of that later in the call. Please turn to Slide five and I’ll touch on some high-level balance sheet and leverage highlights. With respect to our net debt leverage, we further reduced our leverage from 1.1 times at December 31, 2023 to 0.9 times at the end of the first quarter, inclusive of the additional $19 million deployed to repurchase shares in the quarter. We continued that excellent capital allocation optionality and as we have discussed, we will remain focused on a balanced capital allocation strategy going forward.

I’ll turn the call back to Todd.

Todd Adams: Thanks Mark and I’m back on Page six. Over the course of the last year, we’ve tried to communicate the significant opportunity and competitive advantage we have in the clean, safe drinking water category. As a quick Q1 update, we’re very much on track to grow the overall drinking water portion of our business at double digits from a topline perspective and continue to grow the number of filtered units installed, while capturing, recurring revenue from filters. Some of the questions we’ve got over the course of the year have been, so what else is happening besides drinking water? Well, here’s just one great example amongst the dozens and dozens of things that are moving the needle for us from a growth, market share, and profitability perspective.

Here’s the Hydro-X [ph] Sensor Flush Valve we’ve just recently launched within our hygienic and environmental category. We estimate that it’s a $450 million market category, including the retrofit replace market, where we have a decent number two share position. We’re the only one in the market with a unit that is hydro-powered with no solenoid because the two biggest pain points in the field are replacing batteries and solenoid failure. We’ve solved both with the Hydro-X. The diaphragm, gaskets, and seals are made of an elastomer that lasts eight to ten times longer than traditional rubber components and taken as a whole, we’re talking about approximately 10 years of maintenance reoperation as the unit is powered by Hydro-X technology, eliminates constant battering changes, which saves building owners both labor and battery cost.

The other key is that, it was designed with architects in mind. They want to spec something that looks stylish as well as functional, and it’s available with Bluetooth as a full connected solution, which helps in remote monitoring, troubleshooting, line flushing and predictive maintenance. We’re winning with this in large national accounts where reliability and sustainability are critical, and it’s just one more thing we have in our unrivalled portfolio and ability to deliver content to both new builds and the retrofit replace market. On Page seven, you can see our Q1 sustainability impact and progress toward our targets. We continue to elevate our sustainability efforts and are proud of the positive environmental impact our products deliver each state of building owners throughout the U.S. The vast majority of sales in the quarter came from products that deliver a sustainable attribute to our customers.

Products that reduce water consumption, protect the potable water supply in buildings, reduce energy or GHG consumption or are made with high levels of recycled content. Whether it’s reducing water usage, filtering out contaminants from water, or eliminating single use plastic bottles, we continue to innovate to address both water related challenges to public health and conservation. Water is so important and we continue to see growing and new challenges around this vital natural resource that we will continue to address as sustainability is essential to how we operate and drive our business. Last one for me is on Page eight and it’s really just more of a reminder. Over the past several years, we’ve been really intentional about defining our strategy and then going out and executing on it.

Here it is on a single page. Starting on the left, as a pure play North American water business, we’ve been laser-focused on the end markets, product categories, customers and geographies that we want to be in and then cultivated layers and layers of competitive advantages within our current business, with room to expand upon that, both organically and inorganically over the coming years. In the middle, the relentless deployment of the Zurn Elkay Business System provides us not only superior execution capabilities, but a common language and approach to running our business that drives above-market growth — above-market organic growth, exceptional incremental margins and substantial free cash flow. Since we’ve deployed ZEBS to Elkay, we’ve seen over a 1,000 point margin expansion in the first 18 months, with faster growth, better customer satisfaction and a highly engaged team that really has embraced ZEBS.

And finally on the right, we’re measuring outcomes and course correcting where necessary. This is something we talk about a lot internally to drive both simplicity and focus and to be able to communicate what’s truly a priority or in some cases, why we aren’t doing things. Hopefully this helps frame what to expect from us over the coming years. I’ll turn it back to Mark to hit the Q2 outlook.

Mark Peterson: Thanks, Todd. Please turn to Slide nine and I’ll cover our outlook for the second quarter of 2024 and an update on our high level guidepost for calendar 2024. For the second quarter of 2024, we are projecting year-over-year pro forma core sales growth to be in the low single digits and we anticipate our adjusted EBITDA margin to be in the range of 24.5%, 25% for the quarter, which is a 290 basis point to 340 basis point expansion over the prior year. For the full year, at this point, we see no changes to the sales assumptions we outlined 90 days ago. We still believe we will generate positive pro forma core sales growth year-over-year. With respect to our adjusted EBITDA margin, we now believe we will expand our margin between 150 basis points and approximately 200 basis points year-over-year.

Our free cash expectation for the year remains unchanged at approximately $250 million. Before we open the call for questions, just to remind you that we also included on Page nine our second quarter assumptions for interest expense, non-cash stock compensation expense, depreciation and amortization, our adjusted tax rate and diluted shares outstanding. In addition, we’ve included the prior year second quarter sales adjusted for the executed 80-20 product line exits to calculate pro forma core sales growth in 2024. Well, now I’ll open the call up for questions.

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Q&A Session

Operator: [Operator instructions] Your first question comes from the line of Bryan Blair with Oppenheimer. Please go ahead.

Bryan Blair: I noted continued double-digit growth in drinking water and further rollout of filtration. You want to offer any finer points on the growth rates you’re seeing both with the platform overall and in filtration and as there’s intense line focus for the public and now with some government action federally and at a state level and led [ph] to key thoughts, other issues, how your team is thinking about the multi-year opportunity.

Todd Adams: Yeah. It’s very much the same, Bryan, that we’ve communicated in the past. I would say that when you look at the filtered units growth, that is going to move around a little bit quarter-to-quarter, but over the course of the year, that should absolutely be in the double-digit range. I think the algorithm really requires it to be in the high single-digit growth in terms of filtered units growth over a long period of time and then obviously filtration is growing significantly faster than that and that’s what happened in the first quarter and what we see is the right algorithm for us. As you point out, I think that the drumbeat around legislation and filtration and everything else continues to ramp. I’m not sure that we’re seeing much of any benefit of that at this point.

It really is just that core strategy that we’ve had and I think over the balance of the year and into next year and probably the year after, that’s when we’ll start to see the benefit. I think that while some of these things have passed, the implementation path is awfully challenging. I think not to say that we were all concerned that it’s going to happen. It’s just the rollout takes time and so what we’re seeing today is really just the core business and the core strategy that we’ve had continuing to have success and we expect that I think it amplified a little bit as this thing ultimately gets implemented.

Bryan Blair: That makes sense. Appreciate the color there. A very strong margin performance in Q1, pretty robust guide for Q2. So on an LTM basis, through Q2 implied a little over 24% margin, nothing to push back on there. It does imply when your current guide for fully your ’24, there’s some moderation in back-half margin. Can you walk us through what your team is contemplating on the progression for Q3, Q4, what may drive that moderation or it’s more so just conservatism baked into guide one quarter.

Todd Adams: Yeah, I think it’s certainly the latter. I think the approach that we’ve taken for the second quarter guidance is really just to tell you what we’re seeing over the next 90 days. I don’t think that there’s anything that I can communicate that would sort of give you less comfort about the back-half. I think that we’re just trying to be a little bit conservative to start the year. Obviously, where the sales come in in the second half will be important, but I think from a cost structure and a gross margin, which is what you’re seeing flow through this year, it’s all gross margin improvement. That kind of improvement is going to sustain through the balance of the year and so I don’t think there’s anything that we’re going to point to from inflation or things that we see on the horizon are going to give us less confident about that sustainability of the margin in the second half.

I think it’s just more just a function of we’re only 90 days in. I think we’re really happy with what we’re seeing. It’s all permanent stuff. We’re giving you a look at what Q2 looks like and then, we’re visiting the second half, but nothing discrete from that perspective.

Bryan Blair: Understood. Again, excellent start to the year. Thanks guys.

Operator: Your next question comes from the line of Andrew Buscaglia with BMP Paribas. Please go ahead.

Edward Magi: Good morning, everyone. This is Ed Magi on for Andrew. I wanted to ask, so the outlook for interest rates has begun to change in recent weeks. I was wondering if you could help us square some of the tone of recent Federal Reserve commentary with the outlook and the non-residual construction not changing. Thanks.

Todd Adams: Yeah, I think Ed, it helps to understand that when you look at our overall mix, roughly half is institutional and then beyond that, roughly half of the total is retrofit replace and so while I think on the margin, a lower interest rate environment helps the commercial aspect of our business as part of the residential. I think that, I don’t think that the catalyst that we thought in the second half of having a couple of interest rate cuts was going to ignite any sort of significant growth and so the fact that it’s not likely to happen or happen to the same level, I don’t think really changes our view on that. I think the thing to think about is it’s a very hyperlocal market and so what’s happening in one part of the country and the commercial or residential space, could be the exact opposite in another part of the country and I think, as you go through the year, we’ve been absorbing some of this commercial bad news for the better part of 18 months, quarter-by-quarter-by-quarter.

I don’t think there’s a cliff in commercial coming. I think we’re just absorbing that bad news. Obviously, we’re seeing continued strength in institutional and then as we talked about share gains and some initiative growth, particularly around drinking water and things like the Hydro-X, are what we see in what we’re doing to combat what I think everyone thinks is sort of a lousy commercial market. But I think, that’s how we see the interest rate environment. It’s obviously somewhat sensitive and if it was lower, it would probably be better, but I don’t think we’re talking about material changes to that in our second half outlook.

Edward Magi: Very helpful. Thanks. And then, leverage is sticking below one, the cash flow engine is I think, I was just wondering if you could update us on, what you’re looking at with the pipeline and the outlook for M&A as it goes to the second half or the rest of 2024. Thanks.