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Rexnord Corporation (NYSE:RXN)

F2Q13 Earnings Call

November 8, 2012 10:00 AM ET

Executives

Mark Peterson – SVP and CFO

Todd Adams – President and CEO

Analysts

Andrew Breichmanas – BMO Capital Markets

Charlie Boorady – Credit Suisse

Elana Wood – Deutsche Bank

Mig Dobre – Robert W. Baird

Operator

Good morning. My name is John, and I’ll be your operator for today’s call. At this time, I would like to welcome everyone to the Rexnord Second Quarter Fiscal 2013 Earnings Results Conference Call, with Todd Adams, President and Chief Executive Officer, and Mark Peterson, Senior Vice President and Chief Financial Officer of Rexnord.

This call is being recorded and will be available on replay for a period of two weeks. The phone numbers for the replay, can be found in the earnings release the company filed on an 8-K with the SEC yesterday, November 7th and are also posted on the company’s website, at www.rexnord.com.

At this time, for opening remarks and introduction, I’ll the call over to Mark Peterson, Senior Vice President and Chief Financial Officer of Rexnord.

Mark Peterson

Good morning. Before we get started, just a brief reminder that this call may contain certain forward-looking statements that are subject to the Safe Harbor language contained in the press release we issued yesterday, as well as in our SEC filings. In addition, some comparisons are for the non-GAAP measures.

Our earnings release in SEC filings contain additional information about this non-GAAP measures and why we use them.

Today’s call will provide an update on our overall performance for the second quarter, including details on our two platforms, followed by an overview of our financial statements and liquidity highlights

Afterwards, we’ll open up the call for your questions. With that, I’ll turn the call over to Todd Adams, President, and Chief Executive Officer of Rexnord.

Todd Adams

Thanks, Mark, and good morning everyone. I want to thank you for joining us for an overview of our fiscal 2013, second quarter financial results.

Turning to page 4, overall, we are pleased with our second quarter results which were slightly ahead of what we communicated in early August. Reported sales growth was 11%, core sales growth was 2%, our adjusted EBITDA was $101 million or 20.1% of sales, and our adjusted EPS was $0.24.

In the second quarter, we implemented the cost reductions we articulated, and continue to be vigilant on managing our cost while protecting long term growth initiatives.

In general, the market conditions we anticipated back in August for the balance of our fiscal year, have broadly been as we expected, with some puts and takes that I’ll discuss as we go through the platform results.

We are affirming our full year guidance of sales between $2,020 million to $2,060 million adjusted EBITDA between $412 million and $425 million and free cash flow greater than net income.

Moving to page 5, I’ll give a little color on each of the platforms starting within Process and Motion Control. Overall, the platform hosted 3% core growth and an adjusted EBITDA margin of 25.1%.

With strong execution, and enhanced growth initiatives offsetting what I’d characterize as incrementally slightly weaker industrial market trends which has broadly been discussed over the past several weeks.

We’re particularly pleased with the traction we’ve made on delivering gross profit improvements as our gross margins was 39% in the second quarter, up 210 basis points over the prior year which drove 140 basis point increase in our adjusted EBITDA margin and allowed us to deliver 4 million of incremental adjusted EBITDA year-over-year on reported sales that are effectively flat.

From a market perspective, our business through distribution continues to be solid with only a slight sequential moderation in the sell-through growth in the quarter, but still in the low to mid single digit range.

OEM and end user growth reflects the continued caution we discussed in August, which is a trend we don’t anticipate to change quickly, however, we are seeing some progression in a number of end markets.

We believe we’re beginning to see the order rates in our mining business stabilize, and our broad, industrial European demand recovered as we had expected in the quarter.

I think it’s very clear that within Process and Motion control, the overall OEM and end user sentiment is difficult with low visibility likely to continue for the next several quarter.

Our focus has been, and will continue to be, ensuring that our service levels are the very best, continuing to aggressively invest in new products and innovation to provide our customers with superior solutions that improve their overall reliability, productivity and ultimately make them more profitable while continuing to leverage RBS [ph] to eliminate waste to create the funding to allow us to invest back into our business, and extend our leadership positions.

Moving to our water management platform. As we had expected, and communicated, core growth improves sequentially to flat in the second quarter, compared to the prior year after having decline by 9% in our first fiscal quarter.

Reported growth was 38% reflecting the VAG acquisition, and our adjusted EBITDA margin was 16%.

If you look at the chart on the lower left part of the page, you’ll see the elements of our core growth broken down by platform, and ultimately by the two components of our water management platform.

As we had discussed, our Zurn business continues to truly outperform the underlying market and competition as we posted 5% core growth in the quarter driven by the traction of our growth initiatives.

Within the water infrastructure component of water management, VAG constitutes the majority of that group, and continues to perform very well.

In fact, we have essentially been integrating the legacy Rexnord, water infrastructure product lines into VAG over the past year.

When you break down our water management flat core growth in the quarter, it includes the legacy Rexnord water infrastructure product lines that were down 25% for the quarter, but the reality is, those product lines represent only a fraction of the water infrastructure business, and are not indicative of how we’re managing the business.

When you think about the water infrastructure business as a global business, consistent with how we’re managing it in pro forma, the VAG acquisition into the prior year, core growth in the water infrastructure and overall platform was in the mid single digit range for the quarter.

I point this out because this has been a reporting dynamic that’s been a bit difficult for people to understand, and fortunately is behind it, as VAG rolls into core sales growth in our fiscal third quarter.

From a market color perspective, non-residential construction is still bouncing along the bottom. That said, many of the induces are encouraging such as ABI and other projections around starts and spending, which for us will all be upside down the road.

Our results today are being driven by our actions to advance our product innovation and excellence initiatives, or driving increased specification of our products and broadening distribution.

Turning to the water infrastructure market, it’s clear that it’s a global game, and has to be played that way with a very broad product portfolio.

Fortunately, VAG gave us both, and we are really pleased with the acquisition, one year in. We are seeing the benefits manifest themselves at in-core [ph] volume, and anticipate the order rates and book to bill will continue to be strong over the second half of our year and into fiscal ‘14.

I’ll turn it over to Mark to walk through the numbers, and then come back to talk about our outlook in just a little more detail.

Mark Peterson

Thank you, Todd. Consistent with the prior quarters, we’ll speak primarily to adjusted operating profit, adjusted net income, and adjusted earnings per share as we feel these non-GAAP metrics provide a better understanding our operating results in the quarter.

Slide 6 of the presentation takes our reported results and reconcile to be just the result that exclude these items.

Turning to page 7, I’ll discuss our operating performance highlights for the second quarter. Second quarter sales increased 11% from the prior year to $500 million as core sales growth of 2% and a 12% increase in sales from the VAG acquisition were partially offset by foreign currency fluctuations in our fiscal 2012 second quarter divestiture that negatively impacted our sales by 3%.

Reported operating income for the quarter was $66 million which includes $2 million of our structuring cost. Excluding this item, our adjusted operating income grew 12% year-over-year, and as a percent of net sales, increased 10 basis points to 13.7%.

Second quarter adjusted EBITDA increased 11% to $101 million and our adjusted EBITDA margin was 20.1% of sales.

Second quarter adjusted net income from continuing operations increased 50% to $24 million in diluted adjusted earnings per share from continuing operations was $0.24 in the quarter.

Reported free cash flow was $28 million in the quarter which include a $7 million non-cash use related to the excess tax benefit recorded in connection with stock option exercises. Excluding this non-cash item, free cash flow was $35 million in the quarter.

Next, I’ll move to slide 8 and walk through the operating performance in our Process and Motion Control platform.

Sales in the quarter were $309 million compared to $310 million in the prior year period. Core sales was 3% in the quarter, driven by growth in aerospace, energy, and food and beverage end markets.

Foreign currency fluctuations in the fiscal 2010 (Later corrected by the company: fiscal 2012) second quarter divestiture negatively impacted sales by 3%.

Turning to profitability, reported operating income in the quarter was $57 million, and includes $2 million of restructuring spends in the quarter.

Excluding restructuring, adjusted operating income increased 10% from the prior year, as a percent of sales increased 180 basis points year-over-year to 19%.

Our adjusted EBITDA increased 6% year-over-year to $78 million and our adjusted EBITDA margin improved 140 basis points from the prior year to 25.1%.

The margin expansion in the quarter was driven by productivity gains and efficiencies as well as leverage on the year-over-year core growth.

Turning to page 9, I’ll make a few comments on our water management platform.

Water management sales in the second quarter increased 38% from the prior year to $190 million, due to the acquisition of VAG.

Core sales progressed sequentially to flat in the quarter as our growth and initiatives coupled with the VAG acquisition are delivering a traction we anticipated.

Second quarter reported operating income was $18 million, and includes a $200,000 restructuring charge excluding this charge, operating income was $19 million or 9.8% of sales, compared to $50 million or 106% of sales in the prior year second quarter.

Adjusted EBITDA was $31 million, or 16% of sales, and that compares to $22 million or 16.6% of sales in the prior year, second quarter.

The margin in our Zurn business remain very solid, and the cost reduction actions we took in the second half of fiscal 2012 and our legacy Rexnord water infrastructure business, are benefiting segment margins as core margin expansion in the quarter was offset by the mix impact of VAG acquisition.

Moving to slide 10, I’ll touch on a few cash flow and liquidity highlights.

During the quarter, our cash balance increased $47 million, to $440 million, primarily due to the free cash flow we generated in the quarter.

Total debt at the end of the second quarter was $2,111 million and net debt was $1,671 million resulting on a net debt leverage ratio of 4.2X compared to 4.3X at the end of our first quarter.

Looking forward, we anticipate our net debt leverage to continue to decline through a combination of improved adjusted EBITDA and free cash flow generation.

We will still have [ph] liquidity position with $759 million liquidity at the end of our second quarter, and as we highlighted in our last call, last quarter, we have no mean for debt maturities until 2018.

Before we move to our guidance for the balance of the year, I’ll provide a few of the financial metrics under our credit agreement and bottom venture [ph], and touch on a debt refinancing we completed in early October.

First, under the credit agreement, our senior secured leverage ratio was 1.3 times versus our covenant [ph] 5X, and accumulative credit basket was $522 million. Under the indenture, we finished the second quarter with a fixed charge coverage ratio of 2.5X, and the restrict to payment basket totaled $487 [ph] million inclusive of the $25 million general baskets.

Regarding the debt refinancing, in early October, we financed our existing credit facility and reduced the effective interest rate applicable to the term loan borrowing by 50 basis points resulting in annual interest savings of approximately $4.7 million. All other terms of the facility are unchanged.

With that, I’ll turn it back to Todd.

Todd Adams

Thanks, Mark. I’m on page 11 of the slide looking at our fiscal 2013 outlook. As I indicated in my opening comments, we are affirming our fiscal 2013 sales, adjusted EBITDA and free cash flow guidance as outlined on the page.

With respect to our third quarter, at a high level, we anticipate our third quarter to look a lot like our second quarter.

Consolidated sales dollars will generally be in line with our second quarter with Process and Motion controls, Process and Motion control sales increasing sequentially, offset by lower water management sales when compared to our second quarter, due to the seasonal slowdown in construction which also results in a lower margin sequentially in the water management platform.

Overall, this would equate to low to mid single digit consolidate core growth versus the prior year.

We anticipate consolidated adjusted EBITDA dollars and margin to again, generally be line with our second quarter with consolidates adjusted EBITDA margin expanding over 100 basis points compared to the prior year.

At this point, I’ll turn the call back to the operator and take your questions.

Question-and-Answer Session

Operator

(Operator instructions) And our first question comes from Charlie Brady from BMO Capital Markets. Please go ahead.

Andrew Breichmanas – BMO Capital Markets

Hi good morning. This is Andrew on for Charlie Brady.

Todd Adams

Good morning, Andrew.

Mark Peterson

Good morning, Andrew.

Andrew Breichmanas – BMO Capital Markets

Yes, I just have a question about the divestiture of the business, I was just wondering, you guys mentioned you’re in negotiations, does that mean that you guys have found a buyer or are you still shopping around?

Todd Adams

It means that we’ve identified a couple of buyers that we’re negotiating with, and we anticipate concluding the transaction sometime in the next three to six months.

Andrew Breichmanas – BMO Capital Markets

Next question I guess is, do you know how that might, will that affect kind of the EBIT margins for PMC going forward or how it might affect it?

Todd Adams

Well given the fact that it’s included in discontinued operations, it’s already included in the margins that we’re reporting. So on a net basis, is you were to look backwards, it would clearly be accretive to margins. It’s not frankly that big, but it is accretive.

Andrew Breichmanas – BMO Capital Markets

Okay. And I may have missed it, but have you seen any further deterioration in Europe at all?

Todd Adams

We have not.

Andrew Breichmanas – BMO Capital Markets

Okay. All right. Thank you guys.

Todd Adams

Thanks.

Operator

Our next question comes from Julian Mitchell from Credit Suisse. Please go ahead.

Charlie Boorady – Credit Suisse

Hi guys, it’s Charlie for Julian. How are you?

Todd Adams

Good morning, Charlie.

Charlie Boorady – Credit Suisse

I had a question. You guys made some good progress on the cost [ph] PMC, just wondering if you have any sense in terms of ending you might be in, and whether or not we should expect some further gains on the cost there?

Todd Adams

I think we clearly outlined the fact that we were going to reduce our cost over the back nine months, we took a step towards that in our second quarter, we continue to take steps each and every day through productivity and efficiencies, along with eliminating sort of the structural product cost.

So I wouldn’t want to put it in an inning [ph] other than to say that it’s a continual effort for us. I don’t think that there’s a disruptive cost expectation you should model in, but you should expect continued rigor around that, just like we do each and every day.

Charlie Boorady – Credit Suisse

Okay, great. And then on the water management side, you mentioned that VAG rules into the core number next quarter. You mentioned that VAG had been in your core numbers. This quarter you would have been kind of mid single digit range. Just wondering if you might be willing to kind of give just a couple of numbers back, just off kind so we can see how the entire business maybe trending on a core basis.

Todd Adams

You mean pro forma VAG –

Charlie Boorady – Credit Suisse

Yes, pro forma, yes.

Todd Adams

I think, Charlie, we’re going to try to stay away from that only because it sort of dilutes the way we record it. We’ve reported core growth, suffice to say, it has a very positive impact on what we had been reporting on a core basis if we were to do that.

Charlie Boorady – Credit Suisse

Okay, great. Thanks, guys.

Todd Adams

Thank you.

Operator

Our next question comes from John Inch from Deutsche Bank. Please go ahead.

Elana Wood – Deutsche Bank

Hi, good morning, it’s Elana Wood.

Todd Adams

Good morning, Elana.

Mark Peterson

Hi, Elana.

Elana Wood – Deutsche Bank

Just some questions on the water management side of the business. Can you give us a sense of how much VAG pressured margins for this segment, or maybe what the underlying margin of expansion would have been without VAG?

Todd Adams

Yes, if we were to look at solely on a core basis, I think that the incremental year-over-year margin improvement would have been in excess of 100 basis points on the core water management businesses.

Elana Wood – Deutsche Bank

Okay, great. And then I wanted to just circle back to the North American infrastructure piece of the water, from I know, it’s a small piece of the business, but with sales down so dramatically, I’m assuming that margins are pretty low. I’m just trying to get a sense of one, I mean do you think we’re at a bottom here for that business? And secondly, to what degree has that business been pressuring your margin?

I mean I would assume that margins in that business could be in the low single digit range. So I’m just trying to get a sense of when that business comes back, what kind of margin benefit, or once that business gets to have a normal level, what kind of margin tailwinds we may have?

Todd Adams

So what’s pressuring the top line today, Elana, has been the auto rates that we experienced sort of 12 to 18 months ago. So what was booked 12 to 18 months ago, is what’s delivering. So the fact that sales were down in the mid 20% range, really is a reflection of what are rates a long time ago.

If we look at the book to bills the last two quarters in that North American piece, there were 1.8 in June, and 1.2, high 1.2s in the September quarter. So we clearly feel as though we have seen the bottom.

As it relates to margins, when we looked at this year in what was going to be rolling out of the backlog, we took the initiative to reduce our facility in that part of our business. And so we’re getting the benefits of that, but clearly, the margins are very low.

And so with the positive book to bill, the restructuring actions we’ve taken, plus introducing those product lines through the VAG worldwide network, we feel very comfortable that the past is not reflective of what the potential is going into the future and we see really positive things over the next 18 months for that business.

Elana Wood – Deutsche Bank

Okay. That’s very helpful. And then just last, I just want to circle back to the 30 million of annual cost take out that you referenced where I was just wondering if 30 million is still the right number and maybe you could just give us an update as to sort of where you are at the end of the second quarter in terms achieving those cost take outs?

Todd Adams

Yes. We implemented all the cost productions that we had communicated. Incrementally, we’re always looking at areas to improve efficiencies. And we’ll tweak that as we go, but 30 million was clearly implemented and I think we’ll be in a spot by the time we get through the end of the year that it’ll be an excess of 30 million. So it’s one of those things that’s ongoing.

We took the initiative early based on what we saw, and as we move forward as things change, we’re trying to stay a couple of steps ahead. And so there was some more that we’ve implemented, but the 30 million is a sort of not less than sort of a number.

Elana Wood – Deutsche Bank

Okay. I have one more question, Todd, currency. So I remember last quarter, you had a base case range of 115 to 120. Have you modified that?

Todd Adams

To be perfectly honest, I think the currency assumptions that we had, we’re at a point in time, I don’t think we’re going to continually modify the currency rates as it reflects into our guidance. It’s a little bit better today. But the range of sales and profit, is inclusive of sort of where currency is today.

Elana Wood – Deutsche Bank

Okay. Perfect. Thank you so much.

Operator

(Operator Instructions) And our next question comes from Mig Dobre from Robert W. Baird. Please go ahead.

Mig Dobre – Robert W. Baird

Good morning. This is Mig Dobre with Baird. How are you guys?

Todd Adams

Hey, good morning, Mig.

Mark Peterson

Good morning, Mig.

Mig Dobre – Robert W. Baird

So I sort of want to focus on one of the bright spots in the quarter which was Zurn where you guys clearly outgrew the market and you’ve done that for a little while. And you’ve been mentioned that commercial construction hasn’t really been there to provide a tailwind for you and from what I can see here, this is roughly a $450 million business or there about, annual run rate.

I’m wondering, if indeed we’re starting to see this market pick up, what sort of opportunity do you guys think you have on a top line here? And as a follow up to that would be, what would be the incremental margins on those additional revenues?

Todd Adams

Sure. Obviously we’ve talked about I think the progress the Zurn business has made over a number of years around specification and new products as well as improving our service levels. And so all that is sort of manifesting itself and I’ll call it well above market in competition growth today.

I think that’s in a market with starts square footage and everything else that’s still negative.

I think as we’ve articulated over time, that as the market turns positive, Zurn will grow at a multiple of what the market is growing. And so we’re clearly optimistic that we’ve seen the worst of it, we’re one year closer to any recovery obviously, but as that turns positive, you’ll see Zurn grow at a multiple of the market.

And what that means for margins is that, you’ll see high 20s to potentially low 30s on incremental margins. And the thing to remember about Zurn is that it is sort of an asset like model around the manufacturing. It’s not vertically integrated, so we don’t get the same sort of leverage that you’d get if you were manufacturing everything, but you do have that protection on the down side which we’ve enjoyed and allowed us to retain margins at a very high level to what’s arguably the worst environment in commercial construction ever over the past five years.

So we’re really happy about the progress, we think that the business is extremely well positioned to deliver excellent growth and profitability as the market recovers over the next several years.

Mig Dobre – Robert W. Baird

Excellent. That’s helpful. And then sort of sticking with the water theme here. You mentioned the improved book to bill in North America water.

Can you comment at all on pricing of some of these orders and the potential impact that that will have on margins going forward to 12 to 18 months from now?

Todd Adams

I don’t know that we have any specific sort of pricing dialogue we want to get into around some of the backlogs. Suffice to say that as the market recovers, clearly the backlog pricing improves over time.

And so as you go through a weak demand period, obviously pricing erodes a little bit as that demand picks, up the pricing environment gets a little better, we clearly feel like we’re on that side of the curve in North America, municipal, and so I think that’ll play itself out.

Again, the order that we’re booking today, deliver six to 18 months out. So you’ll see that manifest itself in improved margins moving forward, along with the benefit of the cost reductions, and the integration of that business into the VAG global network that we’ve undertaken.

Mig Dobre – Robert W. Baird

Great. And my last question, looking at PMC. We know that mining remains a headwind, but you highlighted a number of other end markets that are driving some growth, and I guess I’m wondering, is it your view that these end markets can continue growing at a pace where they can offset some of the softness in places like mining? And can you give us some color about the driver here? Is it improved penetration, or some of the new product introduction or what’s driving that growth?

Todd Adams

I think it’s a combination of things, Mig. It’s not one single thing. It’s obviously new products. It’s a deeper focus on customers and key vertical markets. And it’s also enhancing our position in relationships and within distribution. So it’s really all the above.

Obviously, mining are both material handling end market, for us is large, so to out run that headwind takes a lot of effort obviously. You can speculate, can we continue to do it going forward? I think the next six months are going to be key, looking at order rates, in that segment, because I do think that while there’s a headwind in the market, it’s an awfully large market.

And we’ve got a lot of growth initiatives and new customers that we’re pursuing. So I think that we’re going to remain vigilant because we think long term, that’s a great market to be in. And we’re going to stay focused on trying to grow in other areas.

So we’ve got all of our commercial teams out, being aggressive, staying true to the investments, we’re making new products in vertical markets.

And I think that when you step back of the investments that we’re making now in a tough time, we’re going to pay off big time down the road. But I don’t want to speculate that we can continue to outrun the headwind in mining, other than to say that we are, and we’re going to keep doing the same things that allowed us to outperform this quarter.

Mig Dobre – Robert W. Baird

Very well, best of luck to you guys.

Todd Adams

Thanks, Mig.

Mark Peterson

Thanks, Mig.

Operator

We have no further questions at this time. So I’ll now turn the call back over to Mark Peterson for closing remarks.

Todd Adams

Thank you, everyone for joining us on the call this morning. We appreciate your interest in Rexnord. And look forward to updating everyone on our third quarter results in early February. Have a good day.

Operator

Thank you. Ladies and gentlemen, this concludes today’s conference. Thank you for participating. You may now disconnect.

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