Zurn Elkay Water Solutions Corporation (NYSE:ZWS) Q3 2023 Earnings Call Transcript November 1, 2023
Operator: Good morning. And welcome to the Zurn Elkay Water Solutions Corporation Third Quarter 2023, Earnings Results Conference Call. 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. This call is 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 8-K with the SEC yesterday, October 31. At this time for opening remarks and introduction, I’ll turn it 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’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 and we encourage you to review the GAAP information in our earnings release in our SEC filings. With that I’ll turn the call over to Todd Adams, Chairman and CEO of Zurn Elkay.
Todd Adams: Thanks, Dave. And good morning, everyone. Thanks for taking the time to join us this morning. To jump right to it, we had a really strong Q3 operating performance, margins improved to 24.1%, up 410 basis points over the prior year. We also delivered record free cash flow in the quarter of almost $100 million, bought back another 445,000 shares and increased our dividend 14%. As we highlighted in our earnings release and one year into the Zurn Elkay combination, we’re really hitting our stride in terms of the benefits from the transaction, both from its energy savings as well as capturing the enormous secular growth opportunity we see in clean filtered drinking water. Over the next 12 months, we will be introducing more new products in the drinking water category than at any point since Elkay developed the category just over a decade ago.
This is both on the filter side as well as the filtration side. And all this is happening as we see continued positive momentum on the legislative front, as well as traction from the significant internal investments we’ve made to drive growth to grow the overall category. One year in we’ve accelerated the growth rate of drinking water, and now expect mid-teens organic growth for drinking water in 2023. In terms of the underlying market, while we grew in line with our Q3 guidance, we were expecting a little better internally after a pretty good start to July and August, which was offset by a so, so September, I’ll dive into what we’re seeing from a market perspective a little bit later. But as we look at how the years unfolded, it’s not hard to see from all the external data as well as our internal data that the market has more uncertainty in it than any point in over the last year.
What also covers we don’t believe that this is some sort of apocalyptic issue for ’24 and ’25. Now I’ll turn it over to Mark.
Mark Peterson : Thanks, Todd. Please turn to Slide number 4. Our third quarter sales were $398 million and on a proforma basis increased 100 basis points year-over-year. As we discussed during our last quarter, our year-over-year third quarter core sales growth was impacted by the timing of orders and shipments in the prior year because we were working on an elevated backlog in the third quarter of 2022. Breaking down our proforma core sales growth percentage a bit, our mid-single digit increase in core sales growth to a non-residential end markets was partially offset by a mid-teens decline in sales growth to a residential end market. With respect to orders, our proforma orders increased high single digits’ year-over-year, non-residential order growth was above the fleet average with balanced growth across drinking water, low control, water safety and control and hygienic environmental while year-over-year order growth in our residential end market was below the fleet average.
Turning to profitability. Our third quarter adjusted EBITDA increased 15% in the prior year third quarter to $96 million. And our adjusted EBITDA margin expanded 410 basis points year-over-year to 24.1% in the quarter. Looking at our margins sequentially, we set up 250 basis points from the second quarter of 2023. And as we had been discussing all year, the benefits of our price realization and our productivity initiatives inclusive of the cost synergies that are little over $6 million each quarter in calendar year 2023 fully read through in the third quarter with the impact of the sell through of higher cost inventory completely behind us. 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 leverage at 1.2 times, inclusive of deploying $100 million of cash to repurchase common stock during the first nine months of 2023.
In early October, we paid down $60 million of our term loan eliminating all future required principal payments, and generating approximately $4.5 million of annual interest expense savings going forward. Given the balance sheet position, and our strong free cash flow generation, we have good capital allocation optionality going forward. Turning the call back to Todd.
Todd Adams: Thanks Mark, and I’m on Page 6. Our ability to deliver tangible results that have an impact on the environment continues to compound as we execute our fundamental business strategy, which happens to have amazing symmetry with what our customer’s goals are to do the right thing for the environment, as well as human health and safety. Benefits like 14 billion single use plastic water bottles avoided through the use of our Elkay bottle fillers. Which is about 8% over the past year, and will easily be up double digits next year, as well as 23 billion gallons of water saved through our Zurn products like low flow faucets, fixtures, and sensors. The rating agencies around sustainability have also taken notice of the meaningful improvements, and it shows in their most recent ratings of our overall profile.
Sustainalytics ranks Zurn Elkay sustainability program in the top 3% of our industry and the top 7% of the more than 15,000 companies they rank each year. With MSCI we have a AA rating, which puts us in the top 10% of our industry. And lastly, S&P Global has rated us in the top 8% of our industry. When you step back from it the one thing to take away from all of this, is that our core or in this case 84% of our total revenues is that we really attack the climate risk of water scarcity, whether that’s low water consumption valves, or providing point of views filtered drinking water, our products, protect, conserve and manage the water we all depend on. The world faces an array of climate and water related crises, including flooding and drought events driven and exasperated by climate change water pollution, and its impact on biodiversity and human health and aging infrastructure that can contaminate water supplies.
Our continued investment in engineering and R&D allows us to focus on addressing these crises, which are essential to sustainability and an essential part of how we drive our business forward. I’ll move to Page 7. We’re seeing serious momentum on the filtration side of our business. As our installed base of filtered enabled drinking water dispensers continues to grow as customers shift more and more to filtered solutions. Combined with an increase in filter replacement rates as awareness around the dangers of lead and other harmful contaminants in drinking water continues to build. Coupled with legislation and regulatory requirements that are beginning to be implemented. Not only are we seeing legislation passed in Michigan related to filter first, we’re launching new products that continue to increase the contaminants our filters are certified to reduce, ultimately protecting students, patients, and the overall public against ingesting more potentially harmful contaminants by providing continuous safe clean drinking water with our filtration solutions.
Today we’re announcing the launch of our very first PFAS filter on the market, that’s integrated into bottle fillers and drinking water dispensers. This filter will continue to do what our filters do today in filtering outlet and other contaminants. That now adds the two most prevalent PFAS contaminants to what it effectively filters. PFAS consumption has been linked to a number of serious health concerns, which makes effective filtration from drinking water a big deal and something we’re excited about to be the first to market in offering our customers and users. Our solution utilizes highly engineered activated carbon which absorbs these contaminants. This technology is the most water efficient solution in effectively filtering PFAS, and is done in our case proprietary filler footprint which is a smallest footprint on the market.
To give you some sense of how difficult it is to launch a filter like this, these filters have to reduce the PFAS chemicals down to a concentration that is 250 times less than with lead. We expect regulations will continue to evolve as the public learns more about PFAS, but by being first in providing effective and certified filtration against these two most prevalent PFAS chemicals. We believe we provided a great upgrade to schools, universities, and even homes in our never ending pursuit to provide the safest and cleanest drinking water for everyone. The Elkay filtration line of products is truly market leading, with the longest lasting lead filter on the market certified to 6000 gallons, along with the most comprehensive contaminants claims on the market.
The beauty of our filtration business is that it will continue to compound well into the future as we continue to build the installed base while capturing an increasing level of replacement. I’ll move on to Page 8. There’s been a lot of discussion throughout the year related to the non-residential construction market and its imminent demise. I’m joking a bit. But I think it’s important to understand a little bit of how we look at — look at it in total beyond the headline numbers. On this chart, on the upper left, is actual and projected institutional starts, on a square footage basis. Below is the same for commercial starts. A couple of things to point out, roughly 50% of our total business is leveraged to the institutional end markets and verticals, specifically education and healthcare.
Generally, institutional starts average somewhere in the neighborhood of 80 to 90 million square feet per quarter over the past five years. Another thing to point out is that generally speaking, this segment hasn’t been particularly interest rate sensitive, at least historically. What’s been grabbing a lot of the headlines in the commercial part of non-residential construction, which by order of magnitude from a square footage perspective is three to four times bigger than institutional, that represents only about 30% of our business. What’s happening here is the massive build out of warehouse space and some automotive expansions is creating large downdraft in the overall actual and projected starts on a square footage basis throughout 2023 and into 2024.
As an aside, our best estimate is that warehouse represents less than 5% of our overall sales, meaning we’ve not really benefited much from that massive build up, nor will it be devastating if it’s down a bunch, again, not the greatest of news, but the downside is capped and we have plenty of areas to find growth. On the upper right is the average non-residential backlog — non-residential construction backlog, for only the commercial and institutional end markets, which excludes infrastructure, which can skew the backlog significantly. And as you see, the backlog for commercial and institutional has been relatively steady in terms of months at about nine and below is the Dodge Momentum Index, which is a monthly measure in dollars of the initial report of non-residential building projects and planning, and is a leading indicator for construction spending approximately one year out.
The reason to take everyone through this is to highlight there are a ton of facets to understand the underlying non-residential construction market in the U.S. On top of this, we also have access to and leverage internal bid and by code information across our own portfolio, as well as some of our large wholesale partners. Finally, I think it’s incredibly important understand how hyper-local it is. What’s happening or not happening in the bay area, can be totally different than what’s happening in the Carolinas, particularly when the build cycle typically spreads over the course of 12 to 18 months. Lastly, it’s important to recognize that new construction represents about 55% of our overall business, with 35% happening outside of what we see on this page in a somewhat orderly retrofit replacement, and break fix market.
The vast majority of questions we’ve got over the course of the year have been about the market, our exposures and what it means to growth going forward. We’re not trying to guide for 2024 at this point. But we wanted to provide a little bit more context as we all sort through how to think about the economy and where it’s headed. Before I turn it over to Mark, I’ll make just a few quick points on Page 9. Taking into account everything I just talked about, here’s a look at our 10-year core growth profile at 6% compounded. I’ll also point out that over the course of the last 51 quarters, that’s 12 years and three quarters, we’ve only had four negative core growth quarters, with the largest coming in June of 2020, which was down 5%. With all the bumps in the road and challenges over the past 10 years, hopefully you can see how the mosaic of the realities of the end market dynamics I went through on the prior slide, coupled with our historical growth algorithm of market plus price, plus share translate into a more resilient scenario than meets the eye.
And it’s back tested against our results that you see here. That doesn’t mean a scenario we face today with interest rates and the types of uncertainties that are out there are exactly the same as any point in the last 10 years. But what also is different, is that our growth algorithm now includes market price share and category growth in drinking water and filtration, which is something we saw in Elkay and it’s why we’ve attacked the opportunity show aggressively over the past year. Last couple of points for me are on ZEBS and our fundamental business model. From a business perspective what a terrific place. We see a clear path to profit and margin expansion in an uncertain environment with the incremental $25 million of synergies we’ll be delivering throughout 2024.
The momentum around filtered drinking water breakthroughs will only gain momentum over the next 12 months. And it provides an idiosyncratic growth driver that is new to us and still very early in its runway. Our business system and relentless focus on simplification and continuous improvement give us a ton of confidence that we can continue to create margins and cash flow to invest back into growth. And finally, we’ve cultivated and created a business model built to be agile with a highly variable cost structure, low CapEx that generates consistently high free cash flow year in and year out. That coupled with a great balance sheet gives us considerable optionality to drive shareholder value over the coming years. And with that, I’ll turn it back to Mark.
Mark Peterson: Thanks, Todd. Please turn to Slide number 10, I’ll cover the highlights of our outlook for the fourth quarter. The fourth quarter of 2023, we were projecting sales to be around $351 million, which gets you to the endpoint of our initial outlook for the year at $1.5 to $5 billion. We anticipate our adjusted EBITDA margin to be in the range of 23% to 23.5% for the quarter, which translates to approximately $336 million to $338 million for the year. For the effective free cash flow, we’re increasing our full-year outlook to approximately $230 million and the $250 million we highlighted 90 days ago. A few highlights led to our outlook. First, our fourth quarter outlook reflects our best cut of the market based on what we saw later in the third quarter and into October, as well as the traditional seasonal decline in sales in the fourth quarter and if you are shipping days in the fourth quarter compared to the third quarter.
Next, we recently completed a product line review with a residential sync customer, after extensive negotiations, a level of profitability was not going to be acceptable to us. So we decided to phase out our supply ascertain whether it’s the things to this customer. As a result, our fourth quarter sales will be impacted by approximately $3 million to $4 million with really no impact on our earnings. Finally, given the momentum we have with our Filter drinking water growth initiative, coupled with the launch of our new PFOS filter and the recent passing of the Michigan filter first legislation, which requires all K-12 schools and childcare facilities in Michigan to provide filtered drinking water to students. We have accelerated a few million dollars of drinking water growth investments into our fourth quarter.
Before we open the call for questions, just a reminder that we have included on page 10, our fourth quarter outlook assumptions for sales growth for non-residential and residential product categories, interest expense, non-cash stock compensation expense, depreciation and amortization, adjusted tax rate and diluted shares outstanding. We’ll now open the call up for questions.
Operator: [Operator Instructions] Our first question comes from the line of Bryan Blair, with Oppenheimer. Your line is open.
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Q&A Session
Follow Zurn Elkay Water Solutions Corp (NYSE:ZWS)
Follow Zurn Elkay Water Solutions Corp (NYSE:ZWS)
Bryan Blair: Thank you. Good morning, guys. It’s encouraging to hear about the mid-teens core growth in drinking water for the year. As we look to ’24 the less certain market environment overall, is there anything you’re seeing that would prevent continued growth there? And given the growth that you have achieved this year, I assume momentum into next year, more favorable cost position? What is the run rate margin for drinking water? And as we look forward and include the ramp of filtration sales, which I assume will be marked and created in time, where should that margin profile be over the coming years?
Todd Adams: Yes, I mean, to, to sort of take it piece by piece. I don’t think that there is anything that we see that would rest or slowdown the growth in drinking water. In fact, you know, I think that, all the work we’ve done and the investments we’re making, give us I think high confidence that we can continue to grow at a very high clip in drinking water next year. Obviously, the algorithm around more units, higher attachment rate, that’s all beneficial and compounds over time, Bryan, so that, that is one that we feel really good about. As it relates to the margins, obviously above the fleet average, we’re not going to decipher exactly what that is, but above the fleet average. And I don’t think that, we see any challenge or risk to that either.
So I think we feel really good about, the last 12 months, as I mentioned, we’ve got a pipeline of new products over the next 12 months. That is going to dwarf, anything that we’ve ever done from an introduction standpoint. So that’s where we’ve spent the last year and I think it’s, it’s reading out in the first year nicely and I think that we have a strong momentum heading into ’24 and beyond.
Bryan Blair: That’s helpful. Thank you. I mean you walked through your portfolio exposures and the resilience you’ve had historically, confidence looking forward. I was hoping you could offer a little more detail some finer points on, how your team is thinking about the puts and takes of new institutional versus commercial non res exposures ready positioning price cost, follow-on synergies. As we think about 2024, in the prospects for earnings growth?
Todd Adams: Yes, I mean, we’ve highlighted, I think, a compelling case around the drinking water growth for next year at very high margins, we have 25 million of synergies that will read through. I think in terms of commercial, I think it’s clear to us that it’s going to be down a little bit, we don’t think that it’s huge, but it’ll be down. That’s on the new construction, side. Break fix, we think is sort of plus or minus a little bit, because a lot of that is actually planned retrofit, replace, and or just simply break fix. And then, I’m guessing, we probably thought that resi was going to inflect, a little bit earlier this year than it has, it’s not getting worse, but it hasn’t improved a whole lot. So I think we probably transition to flattish into next year.
And then we’ll see around waterworks, which is only 7% or 8%. But, I think there is a path to growth for sure, and a path for significant margin expansion, again, as we look at ’24. But, I think, as we look at the market, September, while still growing was less than what we thought, October, was probably a bit ahead of what we baked into our quarter. But I think there’s room for some uncertainty as you head into November, in December and in January. So I think we’re trying to be cautious with the way we’re providing the outlook. But I think the profitability, and the cash flows are going to be exceptional. And I think the resilience of the portfolio has proven itself over time. And we just have to continue to invest in our key breakthroughs.
