Rexnord Corp. (NYSE:RXN)
Q3 2016 Results Earnings Conference Call
February 03 2016, 08:00 AM ET
Todd Adams - President and Chief Executive Officer
Mark Peterson - Senior Vice President and Chief Financial Officer
Rob McCarthy - Vice President-Investor Relations
Julian Mitchell - Credit Suisse
Joe O'Dea - Vertical Research Partners
Jim Giannakouros - Oppenheimer
Charley Brady - SunTrust Robinson
Mig Dobre - Baird
Andrew Obin - Bank of America
Jeff Hammond - KeyBanc Capital Markets
Kevin Bennett - Sterne Agee
David Rose - Wedbush Securities
Good morning and welcome to the Rexnord Third Quarter Fiscal 2016 Earnings Release Conference Call with Todd Adams, President and Chief Executive Officer, Mark Peterson, Senior Vice President and Chief Financial Officer, and Rob McCarthy, Vice President of Investor Relations for Rexnord. This call is being recorded and will be available on replay for 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, February 2, and are also posted on the company's website at investors.rexnord.com.
At this time, for opening remarks and introductions, I'll turn the call over to Rob McCarthy.
Thank you. Good morning and welcome everyone. Before we get started, I need to remind you that this call contains certain forward-looking statements that are subject to the Safe Harbor language contained in our 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 and why we use them.
Consistent with prior quarters, we will speak primarily to adjusted operating profit and EBITDA, adjusted net income, and adjusted earnings per share as we feel these non-GAAP metrics provide a better understanding of our operating results.
Today's call we'll provide an update on our overall performance for the third quarter and our outlook for the remainder of the fiscal year. We'll cover some specifics on our two platforms, followed by selected highlights from our financial statements, our liquidity, and our cash flow. Afterwards, we'll open up the call for your questions.
And with that, I'll turn the call over to Todd Adams, President and CEO of Rexnord.
Thanks, Rob, and good morning, everyone. Starting on slide four. Our third quarter results were consistent with our expectations for revenue, profitability and free cash flow. Our core sales declined moderated to 4% year-over-year, which is a function of 2% core growth in our Water Management platform, and a 9% core decline in our Process & Motion Control platform.
Acquisitions added 1% to sales, and adverse currency translation was a headwind that reduced our reported top line growth by approximately 400 basis points and reduced our revenue by a couple million dollars more than we had forecast.
Our adjusted earnings per share were $0.38 in the quarter, as our adjusted EBITDA margin was a bit better than projected and all non-operating items like our tax rate were consistent with our expectations.
Our strong free cash flow continues to benefit from solid operating execution and working capital management through the Rexnord business system and is now tracking to a higher target of $160 million for the full year, inclusive of about $30 million of cash spending on our supply chain optimization and footprint repositioning initiatives. We continue to be well positioned to execute and integrate bolt-on acquisitions.
Taking a closer look at how our platforms performed in the quarter. Water Management continues to demonstrate steady progress toward the 20% EBITDA margin level that we believe the platform can attain over the relatively near term.
Margins were up year-over-year by more than 3 percentage points to a new quarterly record of 19.5% and we continue to expect 18% or better for the full year. We continue to see attractive mid to high single digit growth in our North American non-res end markets in our third quarter, with a slowly improving balance between commercial and institutional activity as the year progressed.
The unusually wet fall played havoc with the activity in certain regional construction markets, but we probably got a little net benefit overall from the unusually warm weather across much of the US which allowed contractors in many markets to work deeper into the quarter.
Leading indicators continue to be supportive of continuing US construction market growth over the coming year and the level of – with the level of commercial building starts in the US still only reclaiming about one third of the peak-to-trough decline that occurred in wake of the Great Recession.
The very early stage institutional sector recovery has to date, been even more modest. On the infrastructure side of the platform we saw a significant amount of jockeying around with project schedules heading into year end and a handful expected third quarter shipments were deferred into the current quarter.
None were individually that large, but all together they cut off about two points of core growth for the platform in the quarter. Although those shipments are being made in the current quarter, we revisited our risk assessments regarding the likelihood for similar behavior in our fourth quarter, which I'll address in a couple of minutes.
Turing to our Process & Motion Control platform. We were pleased to see absolute daily sell-through rates in our North American distribution channel stabilize during the December quarter and into January.
Related to that, as we expected we saw only minor destocking early in our third quarter and we believe channel inventories are now generally well balanced versus current demand levels.
Assuming our channel partners absolute level of quarter rates remain mostly stable, our results should benefit from the removal of a major headwind due to destocking that will have knocked off about 200 basis points of very profitable revenue off of PMC's core growth in our current fiscal year.
PMC also benefited from ongoing positive core growth in our global aerospace and food and beverage end markets, which account for more than one third of PMCs revenue and a larger share of its earnings. The outlook for both remains positive as we head into the end of this year and as we look forward into next year.
As we anticipated, we saw increased volatility in December industrial activity, as the macro environment weakened further in certain process industry verticals and many of our direct OE and end user customers manage their inventory levels and cash flow carefully heading into year end. That said, the overall impact was mostly consistent with our outlook and overall PMC core growth end margins were inline with our expectations for the quarter.
Given the incremental volatility we've all seen since November, and the increasing pressure on developing economies, we think an incremental dose of caution around expected order rates and shipments schedules is probably appropriate heading into the final quarter of our fiscal year.
We also need to address the incremental drag from currency translation related to the strengthening of the dollar since mid November. Considering these factors and given our intent to provide a reliable short term outlook in a volatile environment, we are trimming our outlook for adjusted earnings per share in fiscal 2016 to range of a $1.37 to $1.41.
With almost half of the revision due to more adverse currency translation and inclusive of $13 million or $0.08 of non-recurring expenses associated with our supply chain optimization and footprint repositioning initiatives that are not being excluded from our guidance.
As of late, there seems to be a broader appreciation of the magnitude of the weakness across the industrial sector. In our case, our power transmission group within our PMC platform has been experiencing a demand recession for the past two years and longer in some end markets.
While there is always some downside risk in any market, we believe that our industrial platform is past the steep part of the curve and its exposure at this point is primarily aftermarket.
As we close out our fiscal year '16 over the next couple months and you begin to think about next year, we think its important to highlight that our revised outlook incorporates a roughly flat year-over-year comparison for consolidate adjusted EBITDA in our fourth quarter and fourth quarter core improves to flattish heading into next year.
And again, our fourth quarter outlook includes absorbing a portion of the growing period cost to implement our supply chain optimization and footprint repositioning initiatives, which we continue to believe are on track to deliver initial net benefits by the fourth quarter of our upcoming fiscal year and a $30 million annualized savings run rate by the end of that same quarter.
To quickly update everyone on this. Our new facility in Mexico has been built. We are in the process of outfitting it and we expect to begin low volume production by early spring. The other initiatives underway in both platforms are progressing as expected and are on track to deliver the plan savings.
In addition to the line of sight we have with our structural cost reduction initiatives, simply normalizing demand levels in our industrial aftermarket distribution channel would provide significant upside to our current levels of profitability, measured in the tens of millions of EBITDA dollars. We believe that effectively capturing these two opportunities should deliver around $60 million of organic EBITDA over the coming three years.
We also believe there is another $40 million of EBITDA and potentially more, through a combination of sustained growth and margin expansion in our Water Management platform, innovation driven opportunities across our aerospace and food and beverage end markets and the expanding benefits from our RBS-led commercial excellence initiatives within our power transmission group, that despite a very challenging fiscal 2016 continues to generate best-in-class profitability and strong free cash flow.
As always, we overlay our top line initiatives with RBS-led strategies to continuously improve our processes and productivity, reduce our asset intensity, eliminate waste and enhance our ability to respond rapidly to changing market conditions.
With the improved balance in our overall portfolio, we expect to generate a combined total of more than 60% of this years earnings in our water, food and beverage and aerospace end markets where we are generating positive organic growth and have a favorable preliminary outlook for the upcoming fiscal year.
We feel increasingly optimistic about the intermediate term opportunities in our core industrial operations, where we expect to leverage the early signs of market stability with our directed share gains initiatives.
Our supply chain optimization and footprint repositioning initiatives will enhance our cost competitiveness and provide incremental growth opportunities beyond the ones I've just reviewed, while at the same time cutting our global footprint by more than 20%, structurally reducing our fix cost and CapEx requirements and enhancing our return on invested capital.
We also believe that deploying our annual free cash flow for strategic bolt-on acquisitions, with our strong discipline around valuation could add another $60 million to annualized EBITDA over the same year – over the same three year period.
To recap, we believe we have an excellent opportunity to capture a $100 million or more of organic EBITDA over the next three years. And that we can augment our internal initiatives with another $60 million or more of acquired EBITDA over the same time, while steadily delevering our balance sheet.
So now let's move to slide five. Consistent with what we've shown you for the past several quarters, this slide outlines our market growth assumptions for our 10 largest served markets that account for about 85% of our annual revenue.
We've made no changes to the estimated ranges for market growth across any of these verticals, although our overall bias is towards more conservatism and we are narrowing our weighted average end market assumption to the lower half of our previous range.
Even with a slightly more cautious view of our fourth quarter to a roughly flat year-over-year comparison for EBITDA, flat EBITDA and positive free cash flow means declining financial leverage. We believe the improved balance of our portfolio as we exit this fiscal year improves our opportunities to sustain and grow our EBITDA organically in the near term, while providing the foundation to achieve the three year opportunity outlined.
With that, I'll turn it over to Mark to review the numbers.
Thank you, Todd. Slide six of the presentation, takes our reported results and reconciles the adjusted results. Recall at the beginning in our quarter, and as reflected in this reconciliation, we revised our definitions of adjusted net income and adjusted earnings per share to exclude non-cash amortization of intangibles and to include stock option and LIFO expenses.
Turning to slide seven, I'll just comment on a few key metrics from our consolidated results in the quarter. First, and as Todd has covered, our revenue was consistent with our expectations for the quarter with additional dollar strength since November creating about half of the gap at the mid point of our guidance range and shifting water infrastructure project schedules accounting for the balance.
Nevertheless, our Water Management platform delivered exceptional margin expansion that more offset the minor top line drag. As a result, our overall decremental margin improved sequentially to 34% and our adjusted EPS was inline with our expectations.
Positively the structural destocking phase in our North American distribution channel appears to have concluded in our third quarter and our cost savings initiatives continue to be on track to deliver our targeted savings for the year. So we continue to expect our decremental margin for all of fiscal 2016 to be consistent with the 30% level that we historically expect.
Turning to cash flow, our free cash flow is down only slightly year-over-year in our third quarter, as continuing strong working capital management offset about half of the year-over-year earnings decline and puts us on a path to run $110 million of free cash flow in our second half and $160 million for the fiscal year.
Next, as we look at the operating performance in our Process & Motion Control platform on slide eight, you can see the margin pressure created by the strong year-over-year impact on our margins from the combination of the 11% revenue decline and the adverse mix affect created by lower distributor sell-through rates.
But margin improved sequentially to reflect the moderating destocking activity in our distribution channels and the beginning of the seasonal pick up in our food and beverage end markets.
As we look at our fourth quarter, and as we indicated last quarter, we expect adverse year-over-year mix from the weaker distribution sales levels and higher investment spending associated with our footprint actions to constrain PMC's fourth quarter EBITDA margin on a year-over-year basis.
That said, we do expect further sequential improvement in PMC's margin in our fourth quarter as we benefit from stronger contributions from our operations serving aerospace and food and beverage end markets. For the full year, we have not changed our expectations that PMC's EBITDA margin will be in a 21% to 22% range.
Turning to slide nine, I'll make a few comments on our Water Management platform, where we continue to generate positive core growth and strong year-over-year margin expansion.
Our adjusted EBITDA margin expanded by 320 basis points in the third quarter, as ongoing RBS-led productivity improvements in our valve and gate group and solid sales growth in our US non-residential construction end markets was levered – leveraged by favorable overall project mix.
As we look ahead for Water Management, and I'd like to remind everyone that the timing of project shipments increased significant variability in quarterly core sales growth comparisons in the platform.
Having said that, we continue to expect platform core growth to accelerate through the end of our fiscal year, supported by favorable non-residential construction demand, the phasing of product shipments in our current backlog and the sequential moderation of project shipment levels in last year's second half.
With respect to Water Management margins, we expect to deliver additional year-over-year margin expansion in our fourth quarter. As we take a more conservative posture towards schedule and shipment timing risks for certain water infrastructure projects, we continue to expect that Water Management's adjusted EBITDA margin should exceed 18% in fiscal 2016.
Moving on to slide 10. You'll see our strong cash enable us to further strengthen our cash position and liquidity as we continue our disciplined approach to capital allocation and seek to reduce our leverage ratio over the coming quarters.
Growing stabilizing annual EBITDA, our strong free cash flow and accelerating rate of cost savings as we move through fiscal 2017 would appear to position us to reduce our leverage ration to below four times by the end of March 2016 and puts us on track towards 3.5 times by the end of our fiscal 2017.
Our liquidity position remains strong. We have a patient capital structure, given our maturity profile. Going forward, we will continue to evaluate our capital allocation opportunities in the context of our overall capital structure, the liquidity requirements and our longer term objective to reduce our financial leverage.
Before turning the call back to the operator to take any questions you may have, I'll make a few final comments on our outlook. In addition to the outlook highlights Todd covered earlier in the call, slide 11 in the presentation also highlights our assumptions for interest expense, depreciation and amortization, our effective tax rate, capital expenditures and fully diluted shares outstanding for fiscal '16.
In addition, our guidance assumes we do not incur any non-operating other income or expense, we do not forecast realized and unrealized gains or losses from foreign currency fluctuations, gains or losses on disposal of assets or other items that are recorded in this P&L line item.
Our guidance also excludes the impact of potential acquisitions and divestitures, and future non-recurring items such as restructuring costs.
With respect to restructuring, I'll take a few minutes to provide you with an update. First, the supply chain optimization and footprint repositioning program is expected to impact our fiscal '16 results as follows.
Unchanged from our update last quarter, we expect to incur approximately $30 million in costs that run through our adjusted operating result. Also unchanged in our forecast restructuring expenses of $14 million $16 million, which are primarily made up of severance costs and are excluded from our adjusted operating results.
Also excludes from our guidance for adjusted EPS of approximately $3 million of accelerated depreciation. Our forecast for capital expenditures in fiscal '16 related to this project is unchanged and is included in our CapEx outlook for approximately 3% of sales.
Second, and in addition to this project, we continue to anticipate incurring restructuring cost of approximately $5 million to $6 million related to other cost reduction initiatives during the year.
Before we open the call for questions, I would like to make one final comment on our effective tax rate. Our effective tax rate will fluctuate by quarter, given varying levels of the pre-tax income, as well as the timing of other planning initiatives. We currently anticipate that our fourth half tax rate will be approximately 35% and yield an approximate 30% rate for the full year.
With that, we'll open the call for your questions.
Thank you. We will now begin the question-and-answer session. [Operator Instructions] Our first question is from Julian Mitchell with Credit Suisse.
Hi, thank you. Just one question firstly on the margins in PMC. The decremental margin year-to-date's been around 50%. If we do see some kind of a smaller sales decline in the next fiscal year, do you think those decremental margins would be considerably smaller or that's a reasonable run rate? And then if you could just clarify if you've seen any change in pricing conditions in PMC.
Hi, Julian, it’s Todd.
I would expect as we move into next year, if we do see a sales decline, which I am not sure we'd be prepared to project at this point. I think you'd see the decremental margins improve pretty significantly from there, based on the overall mix between OEM user and aftermarket.
I am quite confident that, the aftermarket will constitute a bigger percentage of revenue next year than it did this year. And also you're beginning to see the early benefits from some of the supply chain and footprint things we've been talking about. So, I think what you are seeing this year is sort of max pain relative to the margins, and as we move forward, I think you'll see that it’s substantially better.
Second question was pricing. At this point we haven’t seen much of any pricing pressure. I think we're preparing for that and driving productivity and doing things to eliminate waste in our products and our processes, but at this point the pricing environment is been relatively stable.
I think customers are always going to look for a better value over time, but at this point we're starting to see some stability there and we're not projecting much of any price moving forward, because I think we're trying to be conservative, but we're always going to try to go for it.
Thanks. And then my second question would be on Water Management. Clearly the outlook for institutional construction in the US is a little bit better than say 12 months ago.
I just wondered if you'd seen any or you're concerned about any kind of slowdown on the private sector, non-res construction market in the US?
I think that’s something we watch pretty carefully and I think when you look at all that non-res and commercial construction, I think you have to take a step back and look at the length of the recovery and the relative starts when you compare it to sort of circa 2008, 2009 and we're still substantially below that.
The issue we've – I think everyone is seeing is the length of the recovery here is been so long. There is been pockets of weakness in the economy over time, whether it be lending or other and as a result you're getting an uneven sort of view on a recovery.
When we think about other thing – when we look at, you know, I'd say the best indicator for us is that momentum index and that still continues to be positive and grow, you know, quarter-to-quarter or half-to-half, it could be a little bit choppy when it translates to what got put in place and what sales would be. But overall we think that the trend is still positive for sure throughout the next year.
Great. Thank you.
Our next question is from Joe O'Dea with Vertical Research Partners.
Hi, good morning. Could you just talk about trends since early November? You've talked about some stabilization in the aftermarket, but also now a little bit more cautious posture, just given kind of developments from the beginning of the year.
So maybe what you're seeing, whether you're seeing some of that incremental weakness in January or if it's too early and confidence around and end of destock or whether you now expect a little bit more of that in 4Q?
Joe, are you primarily talking about recent developments with respective industrial and the channels and direct and OE kind of thing?
Entirely that, yes.
I think the industrial distribution channel sort of projection that we provided in November was a little bit of destock early in the quarter, sell-through rates stabilizing in November and December and into January and to date that’s sort of exactly what we've seen.
I think we've got a lot of analytics behind what gets sold in, what's get sold out and then we were pretty confident that December would be the end of any significant destocking.
As we look forward, I think what we put into our outlook is the potential for a little bit of deterioration, nothing structural or not another step down, but just sort of chop and really grinding along as people figure out what the next year looks like. We've incorporated that, but to date I think we've seen the stability in the aftermarket part of the business that we expected.
With respect to OEs and end users, I think you saw sort of traditional behavior around calendar year end, where if you didn’t have to spend it, you can push it. We're not seeing cancellations. We're seeing a little bit slower decision making, but I wouldn’t say that we're seeing any massive declines relative to what we expected.
I think when you see some of the – some of the big OEs and end users talk about cutting CapEx and everything else, I think that’s mostly baked into what we've been talking about. And the other thing that so to highlight is that, at this point the majority of the revenues are aftermarket oriented, right. I mean, the OE and end user stuff is been down for a while.
And so the relative change there is pretty small. What we're seeing is stability in the aftermarket, majority of the platform in the aftermarket and that’s what gives us I think a little bit more confidence as we close out this year and head into next.
That's really helpful. Thank you. And then also on PMC, I think generally you see some increased seasonal activity around food and beverage and just whether or not that is progressing as anticipated as a lift in the quarter?
Yes. It’s really good question. We – it was warmer around the world through most of November and into early December. And so our seasonality usually picks up in November and December, particularly in Europe and what we saw is everything ran a little bit longer.
So a little bit more of that seasonal activity is going to take place in March quarter than it historically would. But we are seeing levels of activity pick up, consistent with what we'd expect.
So I think that is – it’s a great question. But not as much showed up in the third quarter, more we'll show up in the fourth quarter, but it is happening as planned.
Okay. Thanks a lot.
Our next question is from Jim Giannakouros with Oppenheimer.
Good morning, Todd, Mark, Rob.
Hey, good morning.
You guys highlighted Europe in your slides where you kind of trimmed expectations both in water infrastructure and general industrial. Could you give us a little more granular look there, either by geography or specific end markets? What drove that and, I guess, expectations of - is that temporary or should we extrapolate that into 2017?
Yes, I'll start with water infrastructure. I think what you're seeing is just a little bit lower level of activity and I would say its primarily Western Europe and I don’t think its going to extrap – its doesn’t extrapolate into next year.
I think we're just seeing a little bit of caution as governments and municipalities consider the impact of all the refugees coming into Western Europe. Everybody we've talked to would tell us that’s its sort of a temporary, let's figure it out versus, hey, there is going to be a step change there. So I would not extrapolate that into next year.
As it relates to general industrial, I think it’s just more moderating than it is negative. So I think we're just trying to take it down and just probably be a little bit more cautious, with the understanding that a lot of European industrial business gets exported to developing countries.
And we've seen a little bit of weakness really over the past three to six months in developing markets. And so we think that would probably bode well to be a little bit more cautious as we look at our European business that largely exports around the world.
That's helpful. Thank you. And one follow-up, if I may. On water infrastructure, Todd, you mentioned that you saw some jockeying around with timing that caught off, I think I caught you say 2% of core growth for the quarter. Was that a comment for VAG or was that a Water Management comment of the headwind that you saw there, that 2%?
Yes. But the two points would have been off the entire platform. And when I say jockeying around, just to sort of put in context, many of the things we do have to be inspected or certified by an agency of some sort and things that would have been schedule for December 27, you get the call saying, hey guess what, we're going to be there in January.
So its stuff like that, as opposed to hey, we're going to move this project from December to March. So its more of a function of I would say very tight stick handling of how things translated versus anything else.
And again, I even hesitate to call it out because that’s really sort of the nature of what this business is and I think if you look at over a longer period of time, you'd see the core growth and opportunities we see. But its stuff like that versus anything significant, Jim.
Understood. Thank you.
The next question is from Charley Brady with SunTrust Robinson.
Hi, thanks. Good morning, guys.
Hey, good morning, Charles.
Good morning, Charles.
I just want to quickly, just on aerospace part of PMC for a sec, and you know, you had - there's been some negative - a little bit of negative news, I guess, out of Boeing, maybe a little less negative news out of Airbus.
I am just wondering, some from a broad airframe perspective, are you guys seeing any near term impact on that? I know a lot of stuff gets a little bit further out. But from the aerospace platform, does that change your thinking as to how that business ought to look over the next 12 and then maybe even longer term on that, given what some of the - what Boeing and Airbus are saying?
I think its probably a little bit early Charley, to sort of call a big difference. I think when we look at backlog, and we look at the content and we look at where we're positioned, Boeing is talking about cutting the 747 to a half a plane a month. The reality is we don’t have a lot of content on that.
The 737 is moving into a next generation, but the current generation is slowing. All those things on a net basis are good for us over time. What it does in the next 12 to 24 months, I don’t think its going to change materially how we think about the business.
We've got a lot of content, our new and developing aircraft with big backlogs in order rates. And so it will be – I wouldn’t say that’s its going to be super robust, meaning double-digit growth, but expect growth in that business from us and we're well positioned and we have opportunities to take share.
So I think the headline news when you get down to where we play and participate, is actually, I don’t want to say we're insulated from it, but we've got a lot of good things going on that it should help us continue to grow really over the next 12 to 24 months in aerospace.
Right. That makes sense. Just as a follow-up, I guess, on the destocking of PMC, I think I heard you say you commented it knocked about 200 basis points off organic or core growth in '16?
Could you comment - and again, that's high margin stuff. Can you comment as to what the margin impact has been on '16? Just to give it a sense of when that destocking levels out or now it's leveled out, we start maybe in '17. We're not going to have that drag, just to frame in terms of what the margin impact has been for you guys?
Well, I think without giving away too much, I think it’s fair to say that it’s significant. And similar to how we started the call when the question was asked, the decrementals have been high this year, what happens next year, and I think its very fair to say that the revenues that we didn’t get because of the destocking, with the simply the lack of that results in a pretty substantial benefit to next year.
And so think about it as very high flow through on the incremental revenues and I don’t want to talk about the margin impact. We're going to end up at the platform level 23%, 24%, eating a ton bad news with the destocking in, next year the destocking subsides, and we've got this $30 million structural cost savings coming in.
So I think we feel really pretty fortunate to sort of end the year where we are having a lot of the bad news behind us, lot of the progress behind us necessary to get structural cost out of the way and that’s really I think what sets us up going forward.
Great. Thanks, Todd.
The next question is from Mig Dobre with Baird.
Hi. Good morning, guys.
Todd, maybe looking at PMC, sort of a few moving pieces here, you're highlighting that most of the business at this point is aftermarket and mentioning that things maybe are getting a little bit better in terms of destocking, yet customers potentially could have some hesitancy.
So I guess net-net, as you're looking forward, I'm wondering what your operating assumption is in terms of kind of how you're planning for the next year. I'm wondering if you're, at this point, still looking at potentially during my restructuring if things get worse, anything that you have in the pipeline looking 12-plus months out?
I think it’s a good question. First of all, I think our confidence on the aftermarket side is substantially higher than it was a year ago, nine months ago. At each interval it’s getting, I think we're getting increasing confidence is because of the level of detail understanding we have. So if it gets a little bit worse, I think we were well positioned for that.
I think the caution we're seeing is on the OEM and end user side where again, things that they are doing are sort of going to be impacted by the broader economic conditions. So I think its just prudent for us to assume that even though we've got sales funnels, that would support everything we're talking about in more, there could be some decisions of not to go forward with certain things.
So I think the aftermarket piece again, is much more dialed in than it’s been. The OEM I think it’s just the reality of where we are and more over of course there is more to do, right. I think when we've talked about the $30 million, there is another opportunity right behind it, probably not $30 million, but stuff that we've been working really on over the course in past year.
And so much like we worked on it for a period of time, we announced it, now we're implementing, we've been working on it. We're not ready to announce yet, but yes there is more to do, regardless frankly if there is an incremental downturn.
So I think when you step back from it, getting the work done to implement this $30 million, we did it in advance. We don’t have to go out create new ideas or anything else, all we have to do is implement. And that’s pretty comforting at a time when you realize hey, maybe there is some incremental uncertainty out there. So that’s going well for us.
The after market is sort of going well for us. The OE is going to be, I am sure its going to be a little bit choppy and little bit of a drag. But I think we're well positioned to ride through that. Not just absorb it, but then also what are we doing to take share in other industries where OEMs and end users are spending money.
So I think there is – on balance the PMC platform is set up reasonably well and don’t forget, a big piece of it is food and beverage and a big piece of it is aerospace.
Sure, sure. I appreciate that. And then maybe going back to some comments early in the call about the $60 million of organic EBITDA opportunity, can you maybe flush that out a little bit further?
Well, 30 you understand, right, 30 is the structural cost reductions that we've talked about, supply chain optimization, footprint rationalization that’s on track. And so we start getting that in the back half of '17 and by the end of '17 we get the full run rate, heading into our fiscal '18, which is essentially calendar '17. So I think that’s pretty clear.
The next 30 really identifies the rough order of magnitude of the impact that we've seen through the lack of sale to distribution because of the destocking and as things have weakened over time.
So that’s where we feel really good that we get a good portion of that next 30, despite the lack of destock and if we get just stability, and I am not talking about big growth, I am just talking stability, you could see the other. And so that’s where we see the next 30 coming from as we outlined in the prepared remarks.
I see. So you're not talking about a hockey stick in end markets or anything like that?
No, no, no. I mean, again, Julian's trying to flush it out. Charley's trying to flush it out, that next 30 I think its fair to say that probably half of that comes form just the lack of destock.
Thank you. I appreciate it.
The next question is from Andrew Obin with Bank of America.
Hey, guys. Good morning.
Good morning, Andrew.
I guess I'll just keep going with the same topic. So, Emerson on their conference call yesterday indicated that they see a bottom in sight. And I guess what I'm picking up from you guys is something very similar from an operational standpoint, because with the destocking done, your destiny sort of becomes in your own hand and it could be that Q4 could be the operating bottom. Am I reading you right or am I just being too optimistic here?
Andrew, I think it could be, right. I don’t think we're not going to sit here and call a bottom. I can only tell you what we see and how we're positioned. And I think on a relative basis we feel good about where we're positioned relative to the level of industrial activity we're seeing day in and day out.
The percentage of the business that is truly aftermarket and then diversity of the overall industrial platform because it’s more then just sort of process industries. There is a big piece of aerospace and there is food and beverage.
So when you start to dissect it, I think it’s very fair to say that the outlook that we see over the next 90 days is clearly better than we saw the past 90 days for a lot of things that we've talked about.
Exposure to end market they are still going the right way, the destock being over and some of the things that we're doing internally to drive above market growth.
I appreciate that comment. Also can you guys just comment, we've been hearing commentary that private equity has exited the market for the deals and that the environment has gotten quite a bit better? What are you guys seeing in terms of opportunities?
Again, most of our opportunities are things that we're cultivating on a proprietary basis. We were close near the finish line with something that traded well into the double-digit and we backed away based on valuation. So I don’t know that that’s entirely true statement as it relates to us.
I mean, private equities around the hoop paying big multiples at least through December. We'll see what happens as people get I think more sanguine look at what the outlook is. But I wouldn’t say that we're really competing with private equity as much. I think we're competing with convincing families and businesses to sort of – to sort of this is the right time to sell and to sell to us.
But again, I think that’s probably more specific to us and you cover companies that are much, much longer and would probably have a better sort of sense to that.
I appreciate it. Thank you very much guys.
The next question is from Jeff Hammond with KeyBanc Capital Markets.
Hey, good morning, guys. Just to take another cut at PMC margins kind of into '17. Can you just frame or remind us what you think the year-on-year delta is on the restructuring cost versus benefit, and how that kind of plays into your incremental decrementals?
Yes. Jeff, its Mark. As we said, we got about $30 million of operating expense in all of Rexnord this year, that’s in our number. That number if you kind of split by platform, the low overweight PMC versus water, next year we expect that number on a net basis to decline $9 million plus or minus.
I think it would be fair to expect a little over half of that to benefiting PMC's margin into fiscal '17. So you can call it mid single digit.
Okay. What would be the roll-through benefit for water?
About – so if we have a $9 million just call it, it’s going to be roughly 5 or so in PMC, roughly $4 million in water.
On a year-over-year basis, net, cost net of savings.
Okay. Then great progress in water margins. And maybe just what's a reasonable time frame to hit the 20 and what kind of growth rates do you need to continue to see to get to that 20 over that time frame?
I think we've outlined Jeff, 12 to 24 months, is sort of where we think the 20 comes into – comes to fruition. I don’t think we're talking about growth rate that are much different than what we're seeing today.
I mean, a lot of this is predicated on structural cost reduction, and some improving mix as we get deeper into the institutional activity. But it doesn’t require double-digit growth, it doesn’t really require high single digit growth. I think mid single digit growth based on the businesses we have with things we're doing, gets you to that 20% mark in that timeframe.
Okay. Helpful. Thanks guys.
The next question is from Kevin Bennett with Sterne Agee.
Hey, there. Good morning, everybody.
Good morning, Kevin.
Todd, following up on Jeff's question on water, I'm curious as to - obviously a great margin this quarter. How much of that was mix related due to the infrastructure shipments being delayed in the fourth quarter? Is there any way you can touch on that?
It was probably a little bit Kevin, I don’t think its material, I mean, I think it was 30 bps or so.
It’s above 50, above 50 bps.
I think its more a function of again, just the continuation of everything we've been doing and there is going to be stuff even and within that, there is going to be certain infrastructure projects that are more profitable and others. And I think we're just sort of marching ourselves towards what we can do and the trajectory is clearly that’s one, and I think we control most of that.
Got you. That's great. Following up on, staying with water. A question on non-res. I know Julian asked this at the beginning. But I'm wondering if you could think about within Zurn, I guess your drain products typically go in early in a new building versus your more traditional plumbing products that go in later in a building.
I'm wondering if you could - obviously you won't tell me exactly what the growth rates were, but if we can parse it out that way to maybe get a view of the non-res market?
Yes, I think what we're seeing Kevin is, the water works piece of it, so the connections to the building, the protecting of the potable water supply in a building have been good. We're starting to see that move into the drain cycle that would actually start the building process and we haven’t seen it at all, to be honest with you and sort of the finished trim stuff.
So I think its sort of progressing as we'd anticipated, and so the water work is pretty good, drains getting better and we haven’t seen really much of anything on the finished plumbing side of things.
And so that’s what gives us the - I think reasonable view that really the next 12 months should be pretty good, backlogs are big, momentum index is up and we're just seeing that grind higher versus the explosive growth I think we had all hoped for.
But you know what, low to mid single digit growth, plus the opportunity to take share is a pretty good environment for us and you've seen us perform and we think we have another really good year next year.
Got you. That makes sense. And then one last quick question for Mark. On the corporate costs, it seems to really bounce around a lot. I'm wondering if you could help us out there, fourth quarter and then into '17?
Yes. A lot of its going to be – its timing of one of the biggest endurable [ph] products, some of the stuff we're spending on, and the work we're doing M&A opportunities, that always come to fruition. But that DOP [ph] costs and that has run through P&L now, so that can be another – that fluctuates quarter-to-quarter. So other than that, it’s not a lot of – not al of DOP activity that can go up and down by quarter.
For the full year though, we've got tell, we're going to be [indiscernible] We're still tracking to that. So if you model that, you look at your fourth quarter, model that 230 to the full year you will be in the right zip code.
Got you. Perfect. Well, thank you, guys.
The next question is from David Rose with Wedbush Securities.
Good morning. Thank you for taking my call.
You bet, David.
I was wondering if you can just highlight the free cash flow conversion expectations in Q4? And as we go into next year, can you keep it at the current levels in excess of 100% free cash flow conversion?
Yes, Dave. So if you look at our full year, we're projecting about $160 million, so obviously we're converting significantly above our reported net income and even above our investment our adjusted net income. One thing you've got to take into consideration, so is the timing of how restructuring dollar flow into cash flow versus in the P&L.
So if you look this year for example, we will have, that kind of all under P&L side of things and as Todd mentioned, we're about $30 million cash flow impact in the restructuring initiative, you put for next year that will be about $50 million or so next year. But even with that said, when you adjust to that, we're – obviously we're convert over 100% this year and we're highly confident that if you look at the next year the convert rate will be over 100% as well.
David, and maybe just to give you some perspective, we'll do 160 this year, and that includes about $30 million related to supply chain and footprint stuff, we'll do a little bit less next year because of what Mark talked about, more of the spending happens next year relative to the 30 that were spent this year.
But what I'll actually do this, then put yourself another year out, and even in a flat earnings environment, plus the benefits we're going to get from everything we've done, you're talking about 200 plus million a year and greater than a half of turn [ph] of leverage reduction just from cash flow.
And so I think that’s what we see and so I think that the hallmark and I think the thing that we got to keep pointing people to is the cash flow capability that we've got today, plus what we're doing to enhance it really becomes in the play and we're not talking about a long time away, I mean, we're in February 14 months from now we started getting another $30 million of free cash flow coming in everyday, maybe a little bit more with lower CapEx.
And so I think that’s the way to think about it and I think Mark's conversion comments are right on, but I think that’s where I think – I think that’s where you got to think about it is a couple hundred million dollars a year and growing even in a flat environment.
So as the M&A environment has been less opportunistic for you more recently, obviously improving the leverage ratios is a priority. You also have a share buyback, but there wasn't much activity recently. Maybe you can speak to that as well?
Well, I think on M&A, again, I think I comment it a little bit earlier that, we got close to something that would have been something we would have liked to buy. But again it traded well beyond valuation to that we felt we could provide a somewhat return to shareholders on.
That doesn’t mean that we don’t continue to sort of look at those processes, but again I think our focus is on cultivating proprietary deals and again, whether its this coming quarter or the first half of next year, you'll see something come out and its going to be likely proprietary.
On the share buyback, I think we've been pretty clear that we put in place the buyback and again we see obviously valuation opportunity, but spending or investing to buyback stock that doesn’t generate future earnings cash flow and there is already I would say a moderate concern about our level of leverage, we're sort of I think cautious.
And so where we sit today as we're going to keep generating high, high levels of free cash flow. We're going to likely convert some of these proprietary deals under relatively near term and then we've got a lot of good things going in our core businesses. So I wouldn’t look to share buyback as a primary vehicle, but if something changes, it’s always there.
Okay. Great. Thank you.
We have no further questions at this time. I'd like to turn the call back over to Rob McCarthy for closing remarks.
Thank you everyone for joining us on the call today. We appreciate your interest in Rexnord and look forward to providing further updates, when we announce our fiscal year 2016 fourth quarter results in May. Have a great day.
Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.
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