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spk07: Good morning, and welcome to the Zurn LK Water Solutions Corporation third quarter 2022 earnings results conference call with Todd Adams, Chairman and Chief Executive Officer, Mark Peterson, Senior Vice President and Chief Financial Officer, and Dave Pauley, Vice President of Investor Relations for Zurn LK 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 8K with the SEC yesterday, October 25th. At this time, for opening remarks and introduction, I'll turn the call over to Dave Pauley.
spk12: Good morning, everyone, and thanks for joining 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 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 LK Water Solutions.
spk04: Thanks, Dave, and good morning, everyone, and really appreciate everyone taking the time on the call this morning. The earnings release that we issued last night contains some perspective on the approach we're taking with respect to the fourth quarter outlook, and we'll go through that in some detail in just a bit. We'll also spend time taking everyone through the significant progress we've made on the integration of Elkay over the first 90 days, and finally provide some color on how we're thinking about 2023. There are obviously a number of moving parts as we bring Elkay into the fold, but in the end, the view and perspective we'll be sharing this morning is essentially aligned with the view that we had from the beginning, which was to bring these two amazing businesses together, then streamline and simplify the businesses into two significant product categories that from a performance perspective were very Zurn-like. We've done the work, and the path is now clear, and we'll share what that looks like this morning. As it relates to the third quarter, our results were very much in line with our expectations heading into the quarter. Solid core growth, the first quarter of LK on track, and solid margins and free cash flow. Our leverage ended the quarter at 1.5 times, and we expect further reduction in December and in the year between 1.2 and 1.3 times. You'll see a chart on the right stacking our core growth for the past three years, inclusive of our fourth quarter guidance. And for 2022, this equates to 12% core growth for the year, which is in line with our expectations for the double-digit core growth we communicated and have reiterated throughout the year. Mark will provide some additional color and unpack the growth for both the third quarter as well as the outlook in just a few minutes. If you could move on to page four. The reality is that it's not even four months since we closed the LK transaction, but the amount of progress our team has made is significant. And in doing so, it really sets us up to start 2023 as a single integrated business. We'll be wrapping up our first integrated strategic plan over the next several weeks, which will fully embed all of the growth and synergy expectations into our normal business cadence, as opposed to developing a plan for Zurn plus a plan for LK. We start 2023 as one business, and we have one plan that we're executing. In the first 90 days, we've completed all of our planned third-party rep changes, which is a huge undertaking because we're asking independent business organizations to change or change significant portions of their agencies from competitive lines to the new Zurn LK, while learning new or different products, transacting and quoting in different systems, while harmonizing around a set of common commercial practices. Having that behind us 90 days in with the quality of the third party representation we now have is a huge thing and will create a lot of leverage as we head into 2023. The other significant change we made is with the organization. We already have a single sales organization across the entire business, a single marketing organization across the entire business, as well as organizations around supply chain and distribution. We've established general manager roles over drinking water and sinks with engineering and product management aligned with these categories. essentially mirroring the Zurn model to organize, align, and focus the business on profitable growth. Without question, the single most impactful thing we've done in the first four months is a rigorous deployment of 80-20. The thing to remember is that as a privately owned business, LK had its own rationale for doing things the way they did. Whether it was serving certain channels or customers or being in certain product lines or SKUs, it made sense for them at a point in time. As we came together, we went through a very detailed and much-needed fact-based 80-20 review to put ourselves in a position to evaluate where we wanted to focus and deploy resources to drive profitable growth and where we needed to do something different or simply not to do it at all. I'll go on to say that the details I'll share didn't end up differing all that much from our initial tops-down assessment, but getting the teams to engage with the data and the details and And then framing it all to allow us to understand all the downstream implications of our simple communication work took a little bit of time. Whether it was customer, employee, or supply chain related, we needed to make sure that we got it right so that we could make decisions and move forward with the conviction and confidence it takes to do 80-20 the right way, which is a relentless prioritization around profitable growth. The punchline on the integration is that it's quickly becoming a single core business as we head into 2023. which bodes well in terms of realizing the expected synergies, and even more importantly, being in a spot to leverage our unrivaled product portfolio and solutions to drive better long-term growth and profitability by only focusing on what's core to us. Please turn to page five. To ground everyone on this page, when we closed the transaction and announced Q2 earnings, we talked about okay for the full year of 2022, and again, this is for the full year, not the half that we'll end up consolidating it, having about $600 million of revenues and EBITDA margins in the 14% to 15% range. In our detailed work over the past 90 days, we went through each of the primary categories, specifically drinking water, commercial sinks, and residential sinks and accessories, customer by customer and SKU by SKU. We then had the internal debates, conversations with customers, and evaluation of our competitive position and long-term strategy. along with the detailed understanding of any collateral impact from our conclusions. What this page highlights is that basically inside this $600 million revenue business is a growing and profitable $485 million base business with real sustainable competitive advantages, and that as we execute our simplification and rationalization initiatives, it's actually more profitable at $485 million than it is at $600 million. And then there are synergies on top of this run rate. The core ZERN LK will be drinking water and commercial sinks. In both cases, we're the clear market leader with above-market growth and terrific margins. We'll be selective in where and how we play in residential, but it'll be niche areas where it supports our overall strategy. I want to be clear about the portions of the residential market that we are exiting and also what's left. The pieces we're exiting really have no strategic value in a ZERN LK context. None of it conveys anything or carries the LK brand or is sold through our current set of wholesalers and reps. It's made up of private label, white label, source sinks, and accessories of all different types of materials. And finally, products done for other OEMs sold through home centers. That makes no sense for us to continue to support. The slice of residential sinks we'll stay in, call it roughly 70 million, will be LK branded, sold through our existing channels, reps, and wholesalers, where we believe we do have strategic relationships and products. that when paired with our commercial lines make a ton of sense in the market. The other thing to highlight is this isn't going to all happen overnight. We've got some contractual obligations we have to fulfill. And we also want to maximize the value of the assets and inventory associated with the exit. But this is the core of what we're going to build around. And it's our best estimate that we can exit this level of business and start at this run rate sometime in the second quarter of 2023. It's also more clear that the drinking water and commercial sink product categories share the same characteristics and look like the core Zurn business from a growth, profitability, and returns point of view. If you turn to page six, I'll share a view of how we think the pro forma mix of the business looks after the rationalization. On the left, you'll see we're still aligned around the four highly profitable categories of specified water solutions that we have real competitive advantages and significant market shares in. On the right, we have a nice balance between new construction and retrofit replace with significant U.S. institutional and commercial construction exposure, with institutional and the sub-verticals of education and healthcare being our largest exposure. We have residential comprising only 15% of the pro forma revenues and leverage primarily to our PEX product offering, where we have a tightly focused strategy on our leverage to the material substitution trend in both residential and commercial. All in all, not wildly different than before, but we do think that by focusing 100% of our time on the strategic parts of our business will serve us well. When you look at this, over 95% of our revenues come from a number one or number two position. The reality is that being a number five or six in residential sinks, sold through home centers, or online isn't something that we built our business case around. I'll turn it over to Mark to walk through the third quarter and the fourth quarter outlook.
spk11: Thanks, Todd. Please turn to slide number seven. On a year-over-year basis, our third quarter sales increased 82% to $418 million. The recently completed merger with LK and the prior year wage-raised acquisition contributed 67% year-over-year growth, and the core business drove 16% growth, with price realization contributing high single-digit growth year-over-year and the balance of the core sales growth coming from our non-residential markets and our strategic share capture initiatives. This growth was partially offset by softening residential markets. Water safety and control, hygienic and environmental, and flow control product categories all contributed to the core sales growth. Foreign currency translation reduced sales by about 100 basis points. With respect to LK, I'll provide some color on the third quarter. Our non-residential business, which is comprised of drinking water and commercial sinks, grew low double digits on a year-over-year basis driven by solid market demand in both product categories and improving price utilization, as we've quickly implemented VEBS price realization standard work across all product categories within the LK product groups. The residential sink product group declined mid single digits in the quarter as the improved price realization was more than offset by the overall softening in the residential market, as well as the $5 million of product line exits as we started our 80-20 simplification actions in the quarter and began to exit certain residential commodity, private label, and OEM sink SKUs as Todd just discussed. Turning to profitability, our adjusted EBITDA, excluding corporate costs, totaled $91 million in the quarter, and our adjusted EBITDA margin was at the high end of our expectations for the quarter at 21.7%. As Todd discussed earlier in the call, we moved quickly to integrate these two businesses into one. That said, we can only provide directional color on margins between the legacy Zurn business and LK as the cost structures are quickly becoming one. Starting with the legacy Zurn business, margins did decline approximately 100 to 150 basis points year over year, as we anticipated, as the benefits of the sales growth, inclusive of price realization, our productivity actions, was partially offset by the increase in material and transportation costs, as well as our investments in our growth and supply chain initiatives. With respect to LK, margins saw a substantial improvement from low double digits in the prior year third quarter to mid-teens in the 2022 third quarter, driven by the accelerating price realization I discussed earlier, as well as some early benefits from our integration actions, partially offset by some investments needed in the business, as well as the adverse impact of material and transportation-related inflation. With respect to corporate costs, they totaled $7 million in the quarter, as we had expected. Please turn to slide 8, and I'll touch on some balance sheet and leverage highlights. Our net debt leveraged end of the quarter in line with our expectations at 1.5 times. pro forma for the adjusted annual expense run rate of approximately $27 million and the inclusion of cash utilization to pay off a legacy LK term loan at close, as well as transaction costs related to the combination. As a result of the leverage reduction, we did trigger a 25 basis point reduction in our base term loan rate that goes into effect during the fourth quarter. As we look to the end of the year, we continue to anticipate ending the year at 1.2 to 1.3 times net debt leverage. Please turn to slide nine, and I'll cover some of the highlights of our outlook for the fourth quarter. For the fourth quarter of 2022, we are projecting consolidated Zurn LK sales in the range of $350 to $365 million, and our consolidated adjusted EBITDA margin to be between 20% and 21% in the quarter, inclusive of our corporate costs, which we expect to be approximately $7 million in the quarter. I'll come back to some of the details on page nine, but let's move to page 10 and cover some of the items that on the walk of our third quarter sales to our fourth quarter outlook. As you know, our fourth quarter traditionally has fewer shipping days, as well as a seasonal slowdown in non-risk construction activity as we enter the fall and early winter season in certain regions of the country. This seasonality primarily impacts the legacy Zurn side of the business, given the product categories, and to a lesser degree, the healthcare product groups. Note that last year was an unusual year in Zurn, as approximately $10 million in scheduled third quarter shipments shifted to the fourth quarter due to certain container delays, but if you adjust the prior year third quarter and fourth quarter for that timing issue, the usual Q3 to Q4 decline did take place. As both Todd and I have discussed earlier in the call, we've accelerated our 80-20 simplification actions. Over the past 90 days, we've been able to thoroughly review the LKCL's volume at its SKU level and customer level, and have finalized a plan to simplify the business to focus on better growth, better margins, and better returns on invested capital. In late July, we aligned the site to at least 10 million to 20 million of exits in the second half of 2022. And with the completion of our analysis, we'll be exiting 25 million in the second half of 2022, with 5 million already taking place in the third quarter and 20 million occurring in the fourth quarter for an incremental 15 million of exits on a sequential basis from Q3 to Q4. Lastly, the residential market has softened from where we were 90 days ago. In the third quarter, we experienced a low double-digit decline in our served residential market. As we look ahead to the fourth quarter, we anticipate further declines in the residential market, and I've built that into our outlook for the year-over-year contraction of approximately 20% in the fourth quarter. It's important to note that our products that serve the residential market tend to be more of a stocked product, so the decline we experienced in the third quarter and our assumptions for the fourth quarter include market decline as well as destocking. The items I just covered walk our third quarter sales to the high end of our fourth quarter outlook. And given the fact that we are entering into the end of the calendar year and the macro environment appears to be deteriorating, we believe customer sentiment and market behavior could be more volatile. And as a result, we are adding some additional conservatism into our outlook, as highlighted on the right side of the slide. Turning to profitability in the third quarter, at the midpoint of our guidance range for adjusted EBITDA margin and the midpoint of our sales range, The sequential decriminal margin from the third quarter to the fourth quarter is less than 20%. Exits of lower margin SKUs, improving price realization in the LK product groups, cost controls, and our continued actions to integrate into one business are all contributing to improved margins despite the lower sales. Before I turn the call over to Todd for some closing comments, I'll touch on a few additional outlook items that were on page nine. We anticipate our interest expense to be approximately $9 million. Our non-cash stock comp expense should be about $8 million. Depreciation and amortization will come in at around $22 million. Our tax rate on adjusted pre-tax earnings will be about 27% to 28%. And diluted shares outstanding will be approximately $179.5 to $180.5 million in the quarter. With that, I'll turn the call back to Todd on page 11.
spk04: Thanks, Mark. Before we turn it over to your questions, I just wanted to cover a little bit about 2023 in some perspective. Hopefully everyone appreciates the level of transparency we went through this morning. In an ideal scenario, we would have been able to lay off this entire simplification story last quarter or perhaps even before, but the reality is the amount of work and decisions and conversations that needed to be had just took a little bit of time. You know, we pride ourselves on simplification, and I think as we reflect on, and I reflect on how the last quarter went, you know, we're not happy with it. And so hopefully we're providing the amount of clarity with purpose this morning that you can appreciate. Obviously, the changes will have a huge impact on not only the dollars of profit, but a dramatic impact on the margins on a pro forma basis as we exit 23 and look, exit 22 and look to 23. We believe we're taking an appropriately cautious view on the fourth quarter, but I wanted to spend some time on 2023. From an end market perspective, we see record levels of non-residential construction backlog and strong confidence indicators in the contractor community. The momentum around institutional construction continues to be very strong. Commercial construction, as always, will be more mixed and super hyper-leveled. In aggregate, we think the market will still be up next year, probably more so in the first half, or at least more confidently in the first half than the second. So we'll continue to watch on how that develops. Our quotation volume, however, continues to be strong, and we're not seeing any material slowdown in demand whatsoever. Residential, as Mark highlighted, will without question be impacted. Near term, we're seeing a near-jerk reaction across the board. The lagging impact from where mortgage rates have gotten to and are going is having an adverse impact on the residential side of things. But as you saw earlier, it's not only 15% of our business and inside of that multifamily should continue to see growth. And we have a highly variable model inside our residential serve product lines. So the impact on profitability is relatively muted relative to the other markets and product lines we have. After three years of challenge, I think we start 2023 with the supply chain dynamics that are a lot more stable. Lead times are back to normal. Container costs are down dramatically. Understanding on how all that changes order behavior is something to watch, that we don't have all that much inventory at all sitting on shelves in wholesale or retail distribution. We're generally seeing live demand in our order rates, and we'll end the year with a smaller backlog than we started. But I think the net impact of all of that heading into next year is a positive, particularly when we monetize some of the higher cost inventory we have throughout Q4 and Q1, which means cash flows should be very strong. In our design-procure-assemble test model, we'll benefit from lower input costs and a strong U.S. dollars as we procure through our supply chain, and we're quite confident the combination of lower input prices, lower freight, and the inventory reductions will end up being a positive for the year. In a scenario when market's slow, we really don't have much in the way of fixed costs to absorb, and the vast majority of our selling expense is tied to variable rep commissions. And finally, we've got the benefit of $50 million of synergies flowing through the next two years. with a great balance sheet and our ESG profile continues to improve as we focus our business on the four key pillars of water. We're gonna continue to monitor all this over the coming months, but our takeaway is that as we look at next year, we think that the overall setup for our business is a lot more half full than half empty than a lot of other years at this point in time. Couple that with our resilient business model, the Zurn LK business system and a great team. We sit here and believe we can deliver a ton of value both in the marketplace and the shareholders over the coming years. With that, we appreciate everyone's time on the call this morning, and we'll open it up to your questions.
spk07: At this time, I would like to inform everyone, if you would like to ask a question, please press star, then the number one on your telephone keypad. Your first question comes from the line of Brian Blair with Oppenheimer.
spk09: Thank you. Good morning, guys.
spk07: Morning, Brian.
spk09: I appreciate the perspectives on 2023 set up. And I guess if we can maybe offer a little more detail on how your team's thinking about the setup for growth on the non-residential side. We're, of course, interested in your core verticals of education and health care and how those projects are progressing as we approach the new year. And then on the resi side, I guess the key question is just how much pain is ahead after the channel reset of Q3, Q4? Yeah.
spk04: Look, I think as we look at non-residential taken as a whole, institutional is approaching 50% of our overall business. And when you look at backlogs across the country, they're at near record levels. And when you think about the amount of time that it's going to take for that to roll through the build cycle, it's really all of 23 and probably part of 24. Our quotation levels are continuing to be really good. And so, you know, we believe that the market is going to be up next year in aggregate. I think commercial construction will continue to be more mixed. Obviously, the office segment of that is, you know, muted. But we're seeing growth in retail for the first time in 25 years. So I think that that's a really a very hyper local game. So you might see a lot of activity in Florida and Texas and Southern California and maybe not as much in the upper Midwest to the Northeast. So, you know, taken as a whole, we think the market is up next year, you know, one to three points. I think we're going to monitor it over the course of, you know, the next four months and into next year. But I do think that the market growth, you know, in non-residential is going to be there as well as in waterworks. As far as it relates to residential, look, we took some of the pain in the third quarter. We're going to take some more. and the fourth quarter, as Mark highlighted. But when you take a giant step back, you know, housing is still underbuilt. There is going to be some level of new construction. Perhaps it's not at the same level as everyone thought six months ago. But, you know, the trend around multifamily, which, frankly, is sort of critical in the product lines that we have, you know, should continue to be strong as people need places to live. And so I would say that for the next... you know, quarter or two. I think residential is going to be a little dodgy. But hopefully by the time we get to the second half next year, we're sort of on plane and it's not as big of a headwind as it was in the third quarter and the fourth quarter and likely will be, you know, as we start 2023.
spk08: I appreciate that, Keller.
spk09: And with regard to LK, maybe offer a little more detail on how we should think about the cadence of Continued 80-20 rationalization seems extremely first-half weighted in terms of 2023 impact. On a net basis, how should we think about base earnings, growth outlook, cross-selling synergies, and netting against the planned rationalization going forward?
spk04: I think what we recognize, Brian, is that it's it's going to be something that we have to over communicate i think what we tried to do this morning was basically give you a pro forma look at uh 2022 if we were to have accomplished this all from there what we'll do prospectively is take that 485 and that 92 to 95 million of ebitda and articulate our results around that as we as we go through the quarter, we'll obviously have some revenue related to the stuff we're exiting, but we'll try to isolate that and articulate how much is left to go. What did we exit in the quarter? And what you'll see, I think, is the margin profile for that core LK business continuing to grow. And so, you know, you'll see the growth in the core, core LK, you know, happening real time, quarter by quarter. So it won't be, you know, we'll try to be transparent around of the 485, what's growing from a market standpoint, what's growing from a pricing input, what's growing from a strategic initiatives and cross-selling opportunity that may show up either on the Zearn side or the LK side. I mean, I think the big takeaway starting in 23 is it really is just one business with two additional really, really dynamite product lines that are now structured and being run like we're running the Zearn business. We're going to do our very best to communicate and articulate around that kind of framework as we get into 2023.
spk08: That detail would be very helpful.
spk09: And I guess just to level set a bit more, by how much does your planned rationalization now exceed the initial deal plan? And where on the commercial side is there some 80-20 taking place? That seems mathematically implied.
spk04: Sure. When we made the announcement, we said approximately $700 million. LK had a budget of roughly $690 million. Obviously, the backlog reduction and all the noise that we talked about to get to the $600 million, that sort of happened before we owned the business and obviously was happening in real time. When we went to our board and we evaluated this we felt very confident that 60 million of revenue is stuff we were going to walk away from. And there was another call at 60 million under review. And I think that the details over the last three months have given us the conviction that, you know, that 60 that was under review was really something that we should walk away from. So when you look at the analysis and the business case and the approvals that we went through, When you look at year three and year four, our return on invested capital is within 50 basis points of what we had using the base LK numbers. And the difference really being nothing to do with the walkaway decisions, because we felt like we would be able to, through a combination of synergies and reducing fixed costs, make that a net positive. It really has to do with that maybe lower starting point than maybe the 690. So I think our business case is very, very much on track. The push is probably less than six months when you look at the timing of when we get on the return on invested capital run rates that we had anticipated initially relative to where we are today. And that's something we've looked very carefully at because The returns on invested capital for the deal and the industrial logic, the strategic logic, the financial logic is off the charts, and it probably just gets even incrementally better when you strip away some of the things we're walking away from. But I appreciate you asking the question because we continue to see the return targets very much in line with what we said when we did the deal.
spk06: Understood. Thanks again, I guess.
spk07: Your next question comes from the line of Mike Halloran with Baird.
spk02: Good morning, everyone. Just to follow up on one of the last couple questions there. So you're talking about $80 million or so of culled revenue having been executed on by the end of the year. And the incremental 35 million or so is what's going to be left to be executed on the front half of the next year as far as the runway goes. Is that a fair thought process?
spk04: No, it's a little bit different than that, Mike. So we think we will have gotten at 25 million by the end of 2022 with the remaining 90 to go in 2023.
spk02: Was the 25 an annualized number or a quarterly number? No.
spk04: It's in the quarter. In the quarter. In the quarter.
spk02: Okay. So I guess I'm confused then. Why wouldn't you be able to annualize that number to get to the $115 million? That's a great question. So you're saying in the fourth quarter you've culled $20 to $25 million of revenue, right? Yeah. So is that an annualized number that represents the annual number, or is that the revenue that is attached to that fourth quarter?
spk04: That is the revenue attached to the fourth quarter.
spk11: So, yeah, so $25 this year, right, $115 in total. So if you walked $22 to $23, there would be $90 more that would come out in $23 if you walked year over year.
spk02: Right, but I guess what I'm saying is if you've got a 20-year or so run rate from the fourth quarter, you've executed on the 80 or so because that's the run rate from a full-year perspective, and then what you're executing on from a remainder perspective is like 35?
spk04: I think the issue, Mike, is you've got to start at 600. When you look at the reported revenues for the year that we thought 90 days ago, it was roughly 600 million. From there, from there, we'll walk away from, out of that revenue run rate basis, we'll walk away from 125 or 150. So I think what Mark said is exactly right. The 25 is specific to the quarter. The 90 will come next year off of that $600 million run rate. So the numbers that we're going to be reporting will have the absolute impact of the walkaway that happens in the quarter. Had we done, we could have done it a different way, saying if you would have started 21, it would have looked, you know, maybe more in line with the run rate that you're talking about. But since we're doing it from a static starting point, that's the level of walkaway.
spk02: Yeah, I actually think we're saying the same thing, just different phrasing. I'll take it offline, though. It's not a big deal. So you talked about a balance sheet being in really good shape. The LK piece, you feel comfortable that you've made the right kind of strategic decisions to be able to execute on it. So what's the willingness to bring stuff in today? How does that pipeline look? And has the environment changed? What that pipeline looks like, multiples, anything like that?
spk04: I think it's probably very early to say. But I think, look, if we look at our pipeline of opportunities, it's pretty extensive and expansive. I think that, you know, we are going through an understanding of, okay, so how do these businesses and their outlooks get impacted by maybe what's in front of us? There are certain things that, you know, are going to convert, you know, over the next six to 12 months because they look exactly like what it is we do. We have confidence in understanding what the market outlooks like. So I think it's relatively unchanged. I think that the pace of the integration and the capacity and the team that we've built and have added to over the last six months gives us a lot of confidence that we can continue to do M&A. We think we can do it at the right levels to create great returns. And I think things that fit really, really well inside of our core. You know, I think there'll be a period of time where, you know, expectations need to get reset. We really have to understand in terms of value. But I think we're going to continue to do what we've been doing for a long time, which is cultivate things that fit inside of our core, transact at reasonable levels and integrate it well and grow from there.
spk02: Appreciate that. Last one, just on the destocking side, based on the positive commentary in the non-residential businesses, sounds like there's no destocking needs there, if anything, maybe the opposite. Confirm that one way or another. And then also, how long do you think the destocking is going to take to get to the right normalized level of inventory in the channel perspective on the residential side?
spk04: So you're correct. I mean, from a From a non-residential side, there's really not that much inventory at all throughout all the various channels. And so what we're seeing now is probably a little bit of lead times coming in, people being more cautious with order patterns, and a little bit of backlog reduction. We think the vast majority of that is behind us in the fourth quarter on the non-res side. I think that when you look at residential, I think we're taking a big whack out of it in the third and fourth quarter. There may be a little bit in the first quarter, but I don't think it's material in the grand scheme of things. So I think we get, you know, clean sell through the demand numbers, you know, late Q1 and into Q2. So I think, you know, our business is not a push model where we have a lot of stuff on the shelf. It's really a spec pull through. So nobody's really procuring this before they need it, and there's really not much in the way of shelf inventory. So I think, you know, we'll see this channel dynamic change dramatically. The impact of lead times coming in, people being more cautious, you know, I think that's going to be a case-by-case basis. But all that being said, as long as we're driving specification and preference, and we see this backlog continuing to be strong in the non-residential side, I think you know, the growth rates that we'll deliver are, you know, broadly speaking, you know, real-time demand.
spk13: Great. Really appreciate the call, guys. Thanks.
spk04: Thanks, Mike. Thanks, Mike.
spk07: Your next question comes from the line of Jeff Hammond with KeyBank Capital Markets.
spk13: Hey, good morning, guys. Hey, Jeff. Morning, Jeff. Hey, just as we go back to kind of the 23 look, just Can you give us a sense of how you're thinking about carryover price as well as kind of outgrowth momentum in the core?
spk11: Yeah, Jeff, from a carryover standpoint, if you think about next year, on the Zurn side, we obviously got ahead of the pricing game faster. We've done LK. We've made a lot of progress in LK and the back half. So if you think about pricing, I'd say on the Zurn-type product categories, you're probably think about as a low single digit type number um in the next year given the comps on the lk side given the fact that our back half is a little bit stronger in the first half they can think about that as more of a mid single digit on the lp says we're going to blend it together it's that low to mid single digit range from a price realization going into next year jeff okay and then at this point at this point jeff we don't really
spk04: we really don't have a view on pushing a lot more price heading into 23. We'll obviously continue to evaluate it, but as the world sits today, you know, with input costs coming down and everything else, we've got, I would say, a sizable tailwind of lower input costs. And so, you know, we want to leave ourselves the room, you know, if we need to get a little bit sharper on pricing areas, we certainly have the carryover and we certainly have the tailwind. So if you think about Mark's number in aggregate of, call it low to mid single digit carryover, we think that the market on the non-res side is clearly up. We think res, you know, call it down a touch and then, you know, some outgrowth. And so you can find your way to, you know, I think pretty reasonable growth over the course of 23, how it shakes out by quarter will be impacted by some of the dynamics that we've talked about. But it's more, as I said in my comments, a little more half-full than it is half-empty when you look at the really concentrated, simplified business post some of these rationalizations.
spk11: Yeah, and Jeff, I missed your question on market output. If you think of what we're doing strategically, we feel any given year we're trying to get two to three points right on the share capture side. But we wouldn't feel any different about that vision than we have in the prior years in our ability to execute on strategic growth initiatives.
spk13: Okay, great. And then it looks like the water fountain in the commercial sink business grew pretty well. I think you said low double digits. Just talk about kind of the order and quoting activity. Does that align with kind of the legacy during commercial, or just how's that trending?
spk11: Commercial things, yes. I think it looks very similar to that element within our CERN business, very similar product categories. We've seen already the power of having both brands in our portfolio. So I think from a growth standpoint, that category, both brands, saw low double-digit growth in the quarter for sure. We expect that to be very similar in the fourth quarter.
spk13: Okay, and then just last one, I mean the Certainly with some of the LK resets, the stock's been under, you know, some considerable pressure here. Just how are you thinking, or have you revisited, you know, share buybacks as a use of kind of cash for, you know, free cash flow generation?
spk04: We have. You know, we have, what's the number left? Roughly 200 million. Yeah, we've got 168. 168, 170 million left on our repurchase plan. We also have... you know, a year of very, very strong free cash flow ahead of us. And so the combination of all that, you know, you can work your way to a leveraged number of, you know, a half a turn by the end of next year without doing anything. And so as we talked a little bit earlier, we've got some other day that we want to do. We want to keep the balance sheet, you know, pretty conservative as we go through this period of uncertainty. But share buybacks, should we feel it appropriate, are definitely on the table. We're confident in our ability to execute in 23 and 24. And if we see a situation that is a dislocation, at least in the near term, I think there's a chance that we may do something. I think the other part of it is, I think as we scale the business, we'll probably revert to a more balanced return of capital to shareholders through M&A, dividend, and stock buyback, just like we did prior to the RMT. And so I think we're probably a quarter away from that in the moment, but I think that that's definitely on the table, and we do have the capacity to do that with the kind of cash flow and balance sheet profile we have.
spk13: Okay, great. Thanks, guys.
spk01: Your next question comes from the line of Nathan Jones with CIFL.
spk06: Morning, everyone.
spk14: Morning, Nathan. I wanted to ask a question around the stickiness of pricing. You obviously had a lot of inflation flowing through this year. You talked about monetizing some higher-priced inventory late this year, early next year, which I guess implies that you'll have some lower-priced inventory. coming along. How sticky do you think pricing is likely to be from the price increases that you've already put through now in a deflationary environment? And how accretive could that be to margins in 2023?
spk04: Yeah, it's very sticky. I think, you know, when you look at specified plumbing products, the pricing is And I don't recall a scenario in 15 years where I've been around the business where it has not been. That being said, project by project, opportunity by opportunity, you have to be aware of what's happening amongst the competitive set. And we've seen a very early market to date. We would expect that to continue. And so if it plays out where the prices continue to be sticky and we're selective where we choose not to be, there is a sizable tailwind coming through with lower input costs. And so we've left ourselves the room in the way we've thought about 2023 to see a position to do that, but it's our position that the pricing is sticky. And if you look at the inflation that we've passed through relative to other products that go into non-residential construction, If anything, we've fallen down the Pareto because we haven't seen the doubling of prices in some categories. And our price increases have been really to offset some of the input costs that we've managed really well. But based on our model, we don't have the fixed costs. We're not buying spot commodities. We're well positioned to capture that tailwind. And when you think about what that could mean to margins, it's significant. Even without all of that and some of it, we see pretty strong margin accretion into next year on maybe not even a double-digit growth sort of level. So I think our business model is built for this kind of environment.
spk14: Thanks. A couple questions around LK. So I would assume that the revenue that you're exiting would have been lower growth than the revenue that you're maintaining. I think you'd already targeted LK over the long term to be a double-digit growth kind of business. Does this increase the expectation over the long term outside of any 2023 market disruption for the growth profile of LK?
spk04: I don't know that we would sign up to increasing that, but I think when you look at the categories that really now make up and constitute the core LK, we absolutely think drinking water has a longer-term secular growth trend above what we have. And as Mark pointed out, with the relative market share we have in commercial sinks, we have a terrific opportunity to outgrow the overall market just because of the size, scale, presence, and spec nature of that category. And so I think maybe the way to think about it is a much, much higher degree of confidence around that kind of outgrowth as opposed to increasing the absolute outgrowth.
spk14: And then just last one. The exit of the residential sinks business, I would assume, comes with a fair amount of inventory liquidation. Can you talk about the cash generation that you should see from the exit of that business?
spk04: Yeah, it'll be sizable. And obviously the inventory investment to support that portion of the business was not generating much of any profit. It was outsized relative to the inventory positions in what is core. And so I think it's, you know, at least $25 million as we liquidate those inventories and likely more.
spk14: Great. Thanks for taking my questions. Thank you.
spk01: Your next question comes from the line of Joe Ricci with Goldman Sachs.
spk00: Hi, good morning. This is Vivek Srivastav on for Joe Ricci. Thank you for the question. You bet. Absolutely. Not to beat a dead horse here, but the $90 million that you exit next year on LK, assuming most of it is first half, Is that the right way to think, that $20 million goes away in fourth quarter of 2022, and then $45 million each goes in first and second quarter of 2022? So, sequentially, basically, like $25 million higher exit in 1Q23 versus fourth quarter of 2022.
spk11: I think the way Mike was talking about it is, I think, more accurate, right? You've got 20, in this quarter, it's a $20 million impact. We had five last quarter, so $20 million in the back half. Those actions, they do annualize, right? So as you think about the walk, yes, as I said in the walk, you've got a $91 impact year-over-year, but a big chunk of the actions that have taken place as you start annualizing those numbers, I think the way Mike was describing it is accurate. So the annual walk, as we've laid out, is intact, but a lot of the actions are taking place right now that will drive the incremental impact next year. Really more so in the first half than actually how it laid out.
spk04: I think maybe to make it very simple, before any market price or strategic growth initiatives, run rating Q1 at $120 million and Q2 at $120 million and Q3, that's the base before we do anything. Correct. As we walk away from this. That's the That's the part I talked about. We're going to try to isolate that and communicate around what is that $120 million growing year over year? What are the margins related to that? And then we'll give you what we walked away from and the impact of that. But that's really the way to think about it.
spk00: Thanks. That's helpful. And I have a question on free cash flow. I think the color you provided on inventory liquidation That is helpful. Anything else from the skew rationalization which will impact your FCF conversion? And how should we think about your free cash flow conversion longer term?
spk04: Well, I think specifically as it relates to the fourth quarter, we're going to see free cash flow in the 90 to call it $100 million range. If we think about 2023, we think that the inventory reduction across the enterprise is going to be sizable. And so free cash flow next year should be, I would say, outsized relative to this year. And then you've obviously got that liquidation factor that is going to be permanent. And so I don't think there's anything unusual. We've obviously got to pay for some of the you know, the restructuring and things like that to get these $50 million of synergies that we've signed up for and see, but nothing outsized other than I think free cash flow next year should be very, very, very strong.
spk00: Thanks, sir. And then I have a last one on revenue synergies quickly. Are you already starting to get some traction here? And maybe just if you can provide some color on what are the opportunities on this front and any color and timing on this?
spk04: Yeah, I mean, we're in the throes of it right now. You know, when you think about some of the ESSER and HERF funding as it relates to secondary post, secondary education, you know, we're immediately having the conversations not only around drinking water, but also around our Bright Shield offering. And so we've targeted 25 school districts around the country where we're doing all the work to get at some of those funding. And we're seeing that convert real time. And so we're leading with drinking water. And then I think we're in a position to pull through some of the other more hygienic products, or vice versa, where we've had a good conversation, started with some school districts around creating more hygienic spaces. We're now pulling through the drinking water. The opportunity around filtration that we highlighted initially is significant. The filtration opportunity amongst the combined business over the next several years is $50 to $75 million of growth at very, very high margins. And so the commercial teams are already engaged in the field on some of these things. We're going through our strategic plan and how we deploy those, but I would say that the case of bringing these two businesses together and being able to provide even more specified content to customers is working.
spk06: Great, thanks.
spk05: Your next question comes from the line of Brett Lindsey with Mizuho.
spk03: Hi, good morning, all. Morning, Brett. Hey, I just want to come back to the 70 million of retained LK resi revenue that you're selling through the existing channels. Are these pieces closer to the corporate average or these revenue pools that are maybe still under earning or mixed negative that you think you can enhance the profitability over time and maybe review at a future date?
spk04: I think that they come in a little bit below the fleet average. But, you know, these are with our wholesale customers. They are LK branded. They do have, you know, an element of conveyance with other products. So these are in sort of professional grade plumbing showroom type of products. And so there's just without question, as we bring the two companies together, the opportunity to eliminate SKUs, work on continuous improvement to drive that up. I don't know that there's a meaningful price opportunity, but there certainly is cost opportunity as we bring the two companies together. And I think as you look at that, you know, consolidating manufacturing, simplifying the SKUs, combining the spend, and really focusing on manufacturing all these in, you know, in a more efficient way should drive the margins closer. if not two, the fleet average over time. That was the calculus in terms of why we decided to stay in it. I mean, it was branded products that have conveyance that we can improve the margins on and fit with our overall go-to-market through specification, third-party reps, wholesalers that we're strategic partners with and things of the like. The other stuff really was totally detached and and had a lot of resource and a lot of inventory tied up in it, and it was never going to be, you know, it was never going to be the kind of returns business that we wanted to create when we put these two together.
spk03: Yeah, no, it makes a ton of sense. And then just my follow-up, sounds like you're progressing well on the integration efforts. Just in terms of the phasing of some of those savings and how that might have, you know, now changed relative to earlier expectations, I mean, do you think those ramp a little bit quicker here in you know, Q4 in early 23. And just curious if there would be a change in any of the normal seasonal margin realization than you would typically see on a quarterly basis as you pull in these synergies, you know, maybe a little bit earlier next year in these rationalization efforts start to ramp up.
spk04: Yeah. No, I think we're going to hit the ground running in 2023 with the synergy realization as a result of, you know, I think the significant work we've done around creating these as product lines and moving on some of the, you know, costs that we had line of sight to. I'll leave it to Mark and Dave to communicate. I mean, obviously, you know, our seasonal patterns, you know, our first quarter is generally lower than our second and third, and our fourth is as well based on, you know, the weather patterns in non-residential construction. So, I think they'll all be amplified from a margin perspective relative to where they've been solely because of the synergies that we're going to generate. But I don't know that it's outsized at any one quarter relative to the next.
spk11: Yeah, that's fair. We'll obviously provide more color as we get closer, but right now we wouldn't say that it's overweight back half, overweight front half. As Todd said, a lot of the actions are occurring now where we feel pretty good about being at that run rate. going into next year. So there isn't really an outside overweight quarter.
spk04: It'll be incremental to each quarter, I think, is probably the way to think about it.
spk06: Yeah. Appreciate all the color. Best of luck. Thanks. Thanks.
spk05: And at this time, there are no further questions. Are there any closing remarks?
spk12: Yeah. Thanks, everyone, for joining us on the call today. We appreciate your interest in Zurn LK water solutions, and we look forward to providing our next update when we announce our December quarter results in early February. Have a good day.
spk01: This concludes today's conference. You may now disconnect.
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