Zurn Elkay Water Solutions Corporation (ZWS) Q2 2019 Earnings Report, Transcript and Summary

Welcome to the Rexnord Fiscal Year 2019 Q2 Earnings Conference Call. My name is John, and I'll be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] Please note that this conference is being recorded. And now I'll turn the call over to Todd Adams.

Good morning. This is Rob McCarthy, 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 the press release that we issued yesterday afternoon as well as in our filings with the SEC. In addition, some comparisons will refer to non-GAAP measures. Our earnings release and SEC filings contain additional information about these non-GAAP measures, why we use them and why we believe they're helpful to investors and contain reconciliations to the corresponding GAAP data. Consistent with prior quarters, we will speak to core growth, adjusted EBITDA, adjusted earnings per share and free cash flow as we feel these non-GAAP metrics provide a better understanding of our operating results. However, these measures are not a substitute for GAAP data, and we urge you to review the GAAP information in our earnings release and in our filings with the SEC. Please note that the presentation of our operating results is focused on our continuing operations as our VAG operations are reported as discontinued. Today's call will provide an update on our strategic execution, our overall performance for the second quarter of our fiscal 2019 and our outlook for fiscal year 2019. We'll cover some specifics on our two platforms followed by selected highlights from our financial statements. Afterwards, we'll open up the call for your questions. With that, I'm pleased to turn the call over to Todd Adams, President and CEO of Rexnord.

Thanks, Rob, and good morning, everyone. As you saw in our release last night, our second quarter results to continued to solid start to what we believe is shaping up to be both the strong and a record year for Rexnord. With core growth accelerating over the prior year, double-digit adjusted EBITDA growth and by the end of the year record free cash flow. We're seeing steady growth in most of our served end markets and more significantly, our strategic initiatives around innovation, cost reduction and commercial excellence are gaining momentum and we're seeing real benefits of all of those start to compound with a lot more to follow. We’ve updated outlook for fiscal year which includes an unchanged mid-single-digit for our core growth, but we’d steer everyone toward the higher end of that range and we've also raised our expectations for adjusted EBITDA, which we now project to be in the range of $433 million to $443 million. Looking more closely at our second quarter results, sales of $525 million included core growth of 9%, and we're up 16% on a reported basis. Core growth in our Water Management platform, which is currently comprised of our Zurn business increased 12% year-over-year. PMC core growth also accelerated as we expected coming in at 7% delivering mid-single-digit core growth for the first half. We're able to leverage a solid growth in both platforms and a 20% year-over-year growth in our overall adjusted EBITDA, which increased to $115 million with solid operating execution, delivering strong margins in both platforms. Adjusted EPS was $0.46 for the quarter and was up 44% over the comparable prior year figure. Mark will review both the consolidated results and the performance of each platform as part of his comments a little later in the call. Please turn to Slide 3. Looking at our operating platforms, in our PMC platform we recovered the few million dollars a delayed aerospace shipments in the first quarter and continue to benefit from the growing order activity across most of our served end markets. We're seeing good demand conditions from OEMs in end users as well as from our global industrial distribution channels and our sales funnels of digitally connected components is growing at a very strong clip. Both existing and new customers are rapidly migrating to our digital platforms to access design tools and print product configurators, secure price and delivery information and to place and track orders, which dramatically collapsing the buying cycle for our products and that's driving huge productivity for both our customers and for us. Let more to say about our recent progress when I update you on our digital DiRXN strategy in a couple minutes. PMC’s adjusted EBITDA margin improved 180 basis points year-over-year to 22.3%, reflecting the benefits of our prior structural cost reductions and our aggressive approach to managing input costs. PMC’s year-over-year incremental margins were 33% on an as reported basis, which includes Centa, but we're again above 50 on a core basis. Centa, which we acquired in February, continued to perform well in the second quarter. And we're beginning to see the impact of leveraging the Rexnord Business System to drive improvement in Centa’s performance and profitability. Water rates have been strong and our simplification initiatives are taking the unnecessary complexity and cost out of the business. The result is ongoing progress towards our objective of adding 1,000 basis points of margin improvement to Centa by fiscal 2021 with the reality of the fact that we are tracking to get there sometime in our fiscal 2020. Results in our Water Management platform strengthened in the second quarter as core growth accelerated to 12% and brought core growth in the first half of the year to the high single-digit level. In addition to the stable growth we are seeing in North America non-residential construction activity, our innovation pipeline continues to contribute to our above market growth as we ramp sales and market share from new product introductions over the last year. During the second quarter, we launched the first wave of new products to support our increased commercial focus on a North American fire protection market with 35 new SKUs added to our existing product offering. We have the dedicated commercial team in place and we intend to gain a larger share of just roughly $300 million adjacent market. We continue to monitor the tariff situation and the resulting uncertainty it creates for our customers, but our order growth to date has been healthy and stable in both platforms. We are confident that we have positioned ourselves to avoid any impact on our EBITDA margins and even more confident that we can continue to navigate it moving forward as a result of our proven capabilities and processes to manage the price cost equation in both the immediate term and over the long-term. Please turn to Slide 4. I am going to take a couple of minutes to bring you up to date on the developments around our digital DiRXN enterprise strategy. First, some background. We publicly launched our DiRXN strategy in May of 2017 with the plan of rapidly transitioning Rexnord to a digital operating model and provide a digital experience for customers that would bring the enhanced productivity of the B2C world into the B2B world. This concept is really about for both our customers and us, solving smarter by developing industry-leading digital tools, resources and products to substantially change the productivity of our customers and channel partners at each stage of their life cycle with our products. From search, design, select and procure to install, operate, maintain, and eventually replace. Embedded with that was the vision of enabling higher operating uptime and higher productivity for our customers by extending the edge of the customer's digital operating environment to include the engineered components that we provide and that will ultimately determine the performance of the customer's material handling and processing systems or a customers in building Water Management Systems. Solving smarter is a differentiated approach that makes our digitally connected products provide not just raw data, but also contextual information that leverages our institutional knowledge around specific product applications. This means that our products can explain. In real time how to interpret what their operating data means and correct and recommend a specific course of action directly through a customer's control system. Maintenance personnel don't need to visit the physical assets to assess their operating status, and they don't have to have experienced engineers to interpret the stream of operating data coming from those physical assets. They don't need to query the component; it will alert them and diagnose the issue for them, which means the immediate benefit to the customer. What this means is that we are creating the digital mechanical reality is absolutely the future of the continuous operating environments envisioned by industry 4.0. Since our solutions are compatible with any plant control system and require modest incremental investment by the customer, barriers to adoption are lowered and the payback period of the investment is shortened. The savings for the customer from avoiding a single unplanned system shut down would typically be many times the initial cost. We believe that bring the first-to-market to bring this differentiated capability can give us an important first mover advantage with customers that are focused on driving higher system reliability. Similarly, data from our connected water products cannot only help to conserve water, but can also help ensure a safe and reliable operation of the in building plumbing and Water Management Systems. Zurn’s ability to supply virtually all of the critical specification gate plumbing components, means greater ability to engineer a complete Water Management Solution that optimize the overall system performance and reliability. Unexpected failures can resolve. It can involve enormous costs to remediate. We've made good progress on several fronts during the first half of our year. At PMC, we are seeing a steady uptrend in customer activity and our digital platform as we set records monthly for overall online traffic and for use of our expanded offerings of digital tools and resources. Product configuration can now be done online for virtually all of PMC’s industrial products and our customers are increasingly going online for quotations and ordering. Going online activity also means increased digital lead generation. We recently introduced our first retrofit solution, responding to strong customer interest in accelerating the same productivity enhancing connectivity across our huge install base of equipment between new connected gear drives and the large retrofit opportunity, PMC’s funnel of connected product opportunities has grown rapidly and we expect to see an increasing contribution to our topline growth over the coming quarters. And our Water Management platform, we’ve experienced a highly positive reaction to the second quarter introduction of inSpec, Zurn’s new digital specification tool, used for adoption and feedback has been incredible. It's driving massive efficiency and productivity for engineers and architects as highlighted in the building engineers’ quote you will see on this slide. We're continuing to expand the capabilities and resources within inSpec and as the user base grows, it will only build upon our market leading spec share, which is a key growth enabler in every market environment. At the end of the quarter, we formally launched our initial range of connected backflow prevention valves. We believe Zurn can leverage its pipeline of digitally connected water quality and water conservation products with its competitive advantages into a leadership position in connectivity. Similar to how our commercialization strategy has developed within PMC, we will be introducing a backflow retrofit solution in the coming weeks because just as the field population of an industrial gear drives vastly outnumbers that annual shipments of new ones. The install base of backflow valves also divorced annual industry shipments of these devices. We're finding the owners of several types of facilities are keenly interested in substantial risk mitigation that are digitally connected backflow device can provide. Our work in other categories of specification grade valves is also well advanced and we expect to expand the available range of Zurn digitally connected product categories as we move to the second half of the year. The powerful value proposition that we're bringing to the market is one of those things that should perform well in every kind of economic environment and it's equally, if not more important in the retrofit markets than it is to the new construction markets. Before I hand it over to Mark, I want to leave you with just a couple of thoughts on our business, particularly given the amount of volatility we've seen in the equity markets, in the various headlines that seem to create confusion for people trying to assess how Rexnord will perform in this environment. First of all, over the last three years, we've made some significant changes to almost every facet of our business that should allow us to perform in any sort of economic environment and particularly one that has some inflationary conditions in it. Consider that we've made investments in growth and innovation that drives immediate payback for customers. Further enhanced our industry leading specifications share added strategic and key account management resources, invested in growing our share and more stable in markets that serve consumers as well as developing a game changing digital platform as well as a connected series of products. I'd also add that the distribution channel inventories have never been lower, so the risk of too much channel inventory is virtually zero, and we have divested every one of our large lumpy project based businesses. Beyond that, we substantially reduced our fixed cost structure through our scope for actions and in turn we've also increased our current and future cash flows. We're managing the price cost equation and extraordinarily well just as we had predicted, despite the impact of unprecedented tariffs that are impacting the global supply chain. Finally, we're attacking towards the lowest leverage we've ever had when at two times of net debt-to-EBITDA by the end of the year and our balance sheet, including the maturity profile and the interest rates on our debt has never been better. We expect fiscal 2019 will be a record year for us in terms of EBITDA and free cash flow and we've got more of everything I just talked about teed up for the second half of this year and into next year, which is our fiscal 2020. All of this strengthens our conviction that we can outperform our served markets and competition going forward. With that, I'll turn the call over to Mark.

Thanks, Todd. Please turn to Slide number 5. Our second quarter of fiscal 2019 consolidated financial results were slightly ahead of our expectations. On a year-over-year basis, our total sales grew, 16% were sales increased 9%. Adjusted EBITDA increased by 20% to $150 million, and our adjusted earnings per share increased by 44% to $0.46. Please turn to Slide number 6. Our outlook for our fiscal 2019 core growth continues to incorporate mid-single-digit core sales growth, but as Todd discussed earlier, more toward the higher end of the range. Our increased outlook for adjusted EBITDA to be in a range from $433 million to $443 million, translates to a 12% to 15% year-over-year growth. As we continue to expect to deliver another year with free cash flow, I had a net income. Turning to Slide 7. We summarize our consolidated results for the quarter. Let's move onto Slide 8 and discuss the first of our two operating platforms, Process & Motion Control. Total sales increased 16% year-over-year in PMC with core sales growth of 7% then benefited from about $5 million of delayed shipments to our aerospace markets that we identified last quarter. Through the first half of the fiscal year, core growth in our PMC platform is a solid 5% and in line with our expectations heading into the year. Currency translation reduced our sales by 1% and the acquisition of Centa added 10% to our topline growth in the quarter. PMC experienced another quarter of solid growth in its process industry and consumer facing end markets and sell through rates in our North American industrial distribution channel. We're also consistent with last quarter. Our sales to aerospace customers were up by a high single-digit year-over-year for the reason I discussed earlier. In the top right corner of the slide, you can see the unchanged end market assumptions. I support the unchanged outlook for mid single-digit core sales growth at PMC that is incorporated into our fiscal 2019 guidance. Our fiscal 2019 outlook continues to assume positive growth across PMC’s primary end markets in the process, consumer discreet and aerospace sectors and in our distribution channels. PMC’s EBITDA and margins were inline with our expectations as adjusted EBITDA increased 26% year-over-year and margin improved year-over-year by 180 basis points to 22.3%. PMC benefited from strong operational execution, pricing was positive, and our strategy is to manage the impact of materials cost inflation continue to be successful. The structural benefits from the first wave of our supply chain optimization and footprint, repositioning initiatives that were completed in the last year second quarter. We're also fully reflected in PMC’s results. As the year-over-year incremental EBITDA margin, excluding the Centa acquisition again exceeded 50% in our second quarter. Having anniversary the year-over-year score for benefit, the PMC margin comparisons and recognizing that margins at Centa which we acquired in February are improving but are still below the PMC average. We expect PMC margin to be up modestly year-over-year for the second half of the fiscal year. In other words, we expect the margin benefits from core growth and from our strategies to more than offset input cost inflation will be partially offset by a margin impact of adding Centa and from our plan investment spending. Today, I'd also like to briefly highlight another recent new product introduction from PMC that is targeting our consumer facing end markets. Our new KleanTop modular conveying chain for the food processing industry. The family of products is targeted at baked goods applications like the tortillas seen in the picture on the slide in other food applications that require delicate handling like fruits and vegetables, poultry and seafood. We estimate for this new products family doubles PMC addressable rains of baked goods applications and includes specific design benefits around hygiene, maintenance and uptime. Please turn to Slide number 9, to discuss our Water Management platform. During our second quarter, our Water Management platform delivered 15% net sales increase that was a function of 12% year-over-year core sales growth and a 3% contribution from World Dryer. Top line results were slightly ahead of our expectations with good price realization, leveraging solid demand growth, and our new product pipeline. Today I'd like to highlight our recent asset purchase of the Froet of bi-functional roof drains that has disclosed in our 10-Q. This patented product offers major advantages to roof drain installations and contractor productivity. For many years, U.S. construction codes that required a second bypass drain to prevent standing water from accumulating. If the primary roof drain would it become clogged, which means that every roof drain location on a flat roof, typically as two drains installed in two separate holes in that section of the roof. Our bi-functional drain combines both drains into a single fixture and thereby eliminates half of the holes in the roof and half of the drain installations with significant savings measured in money and installation time and all while improving roof integrity. Our team is already actively working on accelerating the specification for this patented product. We are confident that this innovative solution can be another contributor to delivering above market growth at Zurn. As illustrated by our mostly unchanged underlying end market outlook that is summarized on the slide. Demand conditions in our core non-residential construction end markets remain favorable. We are moderating our outlook for the U.S. new residential construction market to reflect the recently weaker momentum in that market which only accounts for about 15% of Zurn sales. At the same time, we pent-up that growth in the value of U.S. non-residential building starts has strengthened in recent months net-net and recognizing that our year-over-year sales comparisons got a little tougher in our second half. Our outlook for Zurn’s full-year core growth has improved overall to high single-digit range. Forward indicators of non-residential construction activity like the Dodge Momentum and ABI Design Indexes continue to track favorably from a growth viewpoint. Water Management’s adjusted EBITDA increased by 10% year-over-year in the second quarter and we delivered a solid 27.1% margin as we continue to leverage our core growth and managed to a favorable price cost equation, while funding our market growth and cost reduction initiatives. Our margins expanded sequentially from our fourth quarter, but on a year-over-year basis declined from an exceptionally strong margin report in the year ago quarter when the platform benefited from the few favorable items in that quarter. We remain confident in Zurn’s ability to manage its material costs and tariff exposure, and we continue to expect our Water Management platform to deliver year-over-year margin expansion in our fiscal 2019, as we anticipate the incremental margin to be in the 27% to 30% range over the back half of the fiscal year. I would like to take the opportunity to add that there is no question that our early and aggressive actions to address the impacts of tariffs and overall input cost inflation has been critical and preserving our outlook for margin expansion for the full-year. As we have detailed previously and discussing some detail last quarter, we have used material costs, actions, robust supply chain management, and selective price increases to leverage our leading brands, the growing sales of innovative and cost savings, new products, and our distribution channel structure to manage our exposure and more than offset the impact of cost increases. We continue to work each of these strategies and we remain confident in our ability to deliver full-year adjusted EBITDA margin expansion, while continuing to fund our investments in innovation and growth. Moving on to Slide 10. You can see on the chart at the top left that our financial leverage as measured by our net debt leverage ratio declined to 2.5x at September 30. Our free cash flow has developed as expected across the first half of our fiscal year, and we remain on track to deliver at least $200 million of free cash flow for the full-year. Before we open the call for questions, I'd like to comment on accounting for our divestiture of VAG and then speak to restructuring expenses and our effective tax rate before we take your questions. First, we continue to account for VAG through discontinued operations. In early October, we signed the sale and purchase agreement and we anticipate closing the sale in our third quarter with the resulting cash proceeds held as cash in our balance sheet. Second, in terms of our cost reduction initiatives, we continue to project total restructuring expenses of $11 million to $13 million in our fiscal 2019. These costs are primarily made up of severance costs and are excluded from our adjusted operating results. Next, our effective tax rate will fluctuate by quarter given the varying levels of pretax income as well as the timing of other planning initiatives. We now project our fiscal 2019 adjusted net income to incorporate an effective tax rate of approximately 27% to 28%. For our third quarter, we anticipate a tax rate between 24% and 25%. Turning to slides in the appendix. First, we've included certain other assumptions incorporated into our guidance for fiscal 2019 on a separate slide. I need to remind you that our guidance covers our continuing operations only. In addition, our guidance excludes the impact of potential acquisitions, potential accounting gains or losses and future non-recurring items, such as restructuring costs. As has been our practice, the appendix to today's presentation also includes a reference table to help you determine the appropriate incremental quarterly share count to use for modeling our adjusted diluted earnings per share under the if-converted method if it is applicable. As illustrated on Slide 14, the if-converted method was dilutive to adjusted EPS in the second quarter, and therefore was applied. Lastly, we include a schedule with the pretax and after tax impacts of each adjustment in our calculation of adjusted net income plus the reconciliation tables related to adjusted EBITDA and adjusted earnings per share that are included in our earnings release each quarter. With that, we'll open the call up for your questions.

Thank you. Now I’ll begin the question-and-answer session. [Operator Instructions] And our first question is from Joe Ritchie from Goldman Sachs.

Hi. Good morning, guys.

Good morning.

So Todd, I wanted to touch on your comments regarding inventory never being lower. Can you maybe just walk through a little bit more color on that specifically as it relates to your end markets, what you're seeing across the channels?

Well, I mean if you look at it between Process & Motion Control and Water Management, I would say that that statement is true in both platforms. The inventory levels are at historic lows with respect to how we look at it. Inventories turning at a very high rate in the channel, and I think, obviously we have a belief that a little bit more inventory in both sides of the business would do us some good as well as our distributor partners. But at this point they're choosing to sort of run it pretty tight and we're obviously doing our very best to fulfill that demand and keeping time short, so that the end customers would be freight service. But I think that's really the only comments we’ll make on it Joe.

Obviously that's a pretty positive as it relates to the growth trajectory for your businesses going forward. But one other things that stood out again this quarter on the process side was really just around like the incrementals that you're putting up. I know that you referenced, Centa being a little bit of a drag moving forward. But the core incrementals 50% to 60% are quite strong. I'm just wondering like is that the expectation for the core business moving forward into the second half of the year?

Well, you may recall last year, we were still going through the final phases of our supply chain optimization program. So the first half we do get a greater benefit on the incremental side of things than we will in the second half. We've always steered people towards the 30% to 35% incremental in Process & Motion Control. I think you'll see that sort of normalized in the second half of our year. Obviously, we do believe that over time Centa, as we anniversary that the incrementals there will be in that 30% to 35% range. What you're seeing now is the initial mid- to high-teens EBITDA margin rolling through the results. But the way we think about Process & Motion Control is 30% to 35% core incrementals. We had a great obviously first half as a result of wrapping up a multi-year supply chain optimization program in the first half of last year. So that's the way I think you should think about it for the rest of the year.

Got it. And then maybe one last question. As you think about the second half also, is there anything that we need to be aware of beyond your comments on incrementals that impacts the second half seasonally? I just take a look at it like your guidance for the year, the implied EBITDA is comparable to the first half usually the second half is a little stronger. Just any comments around that would be helpful?

I think you're spot on. I mean, our fourth quarter is obviously our strongest quarter for Process & Motion Control. You're also – the flipside of that is if you look at our Water Management platform seasonally, the December quarter and March quarter are weaker than the first half of the year just based on the construction season in North America. So the incrementals should still be fine year-over-year, but sequentially water slows a little bit just because of the nature of the products. And PMC is always just a little bit more than our fourth quarter than the other quarters.

Okay, great. Thank you.

Our next question is from Andrew Obin from Bank of America Merrill Lynch.

Yes, good morning. Can you hear me guys?

Yes. We can hear you.

Good morning, Andrew.

Just at PMC, you sort of highlighted improved sell-through through the distribution channel and for awhile, I think last year you were sort of questioning, why we're not seeing this acceleration? Could you just go by end markets and just tell us where are you seeing the increased demand and how much visibility you have in terms of the momentum and the channel?

Well, the momentum really started picking up probably about a year plus ago, Andrew. And we started off at sort of down just a touch and that migrated to flat to up a few percent and now obviously we're seeing it in that mid single-digit range. It's really – I wouldn't say that there's a lot of disparity. I don't think you have something growing, 15% or 20% and something declining. They're all in the low to high single-digit range. Obviously, process industries has been strong. Consumer industries have been steady. I don't think we're seeing a noticeable change in really any of the end markets at this point because you have to remember most of this is MRO activity. So we've reached a point where the inventory is in the channel are very stable. The same number of components failing every day, and so what you are seeing now is really the normalized end market demand with industrial production levels at a relatively stable rate. At any given part of the year, you're going to see certain end markets doing full maintenance as an example. You'll see food and beverage typically better in the second half of our year as they do maintenance over the winter to be ready for the warmer parts of the year. And the flip side is true on process industries, right, you'll see a little more activity over the summer months as they go through and run things at a peak. So I'm not demonstrably different across the end markets, but solidly in the growth category. And I would say very stable given where industrial production sets.

And so your view that this is not restocking, this is just steady state demand driven by MRO? Did I hear you correctly?

It’s not my view. It is the fact. There has been no restocking in our industrial distribution channels.

And just in terms of pricing, it's another concern on the channel. How does the dynamic control of price increases through the channel working for you guys?

Well, for us, we don't have any exclusivity with our distribution channels. So for us we have a relationship that allows us to push price through to the channel, smartly, selectively and in partnership with our distribution customers because we want to protect them as well as really cover the inflation input costs as well as, make the amount of money we need to reinvest to create innovative solutions. But the ability to get price through our channel is fairly understood, mature and has not been an issue whatsoever.

Terrific. Thanks a lot.

Our next question is from Joe O'Dea from Vertical Research Partners.

Good morning.

Good morning.

With respect to cash deployment when you look at leverage where you are now and the trajectory that you're on by the end of the year. And then you marry that with what we're seeing in the equity markets. I think that you've talked to maybe broadening out cash deployment as a next year opportunity or agenda item, but any consideration around accelerating that a little bit given what could be some opportunities there with these moves in the equity market?

Joe, I think our historical cash deployment has been really around debt reduction in M&A. I would say that for the remainder of the year, those are the two that we're going to remain focused on as you pointed out obviously when we get to the end of the year and we end it sort of two times that opens up some additional things for us to think about in terms of capital deployment. But we're not going to get ahead of ourselves. At this point, we want to make sure that we can march the leverage through an area that we think everybody is infinitely comfortable with as well as they very disciplined and do the M&A that we should be doing as we have been doing over the last five years to six years. The acquisitions that we've been able to do our performing extraordinarily well, but we've married that with a balanced approach to making sure that we're marching to leverage through a range that people are comfortable within. Over the rest of the year, I think that's what you're going to see us continue to do. But as we turn the page into the 2020, obviously we'll have some high class challenges to consider with respect to other uses of cash flow.

Got it. And then on digital product and talking a little bit about the retrofit being arguably the biggest near-term opportunity? Can you talk about just how you push that opportunity and is that something that you were collaborating with distributors who are serving some of those customers on the day-to-day basis? Just how you get in there and try to maximize that and accelerate the revenue recognition there on the retrofit opportunity?

Yes. It's a great question. Obviously we're working closely with our distribution partners. We've actually stood up a separate sort of retrofit organization internally, as well as working with key and strategic accounts. Right, I think the greatest benefit that we see is to go to our existing customers who have a large installed base and offer them the opportunity to retrofit their existing fleet and provide enormous productivity for a very, very low initial price point. So that's a three pronged approach where we're leveraging in our key and strategic account resources to go and talk to the people that have those large installed bases or leveraging our distribution partners to do the same for us. And then obviously the organization is going to go out and try to define maybe competitive situations where there's a competitor in there and that competitor is doesn't have a connected capability, and we can come in and really sell the value proposition because those products are remanned and reserviced all the time. And so there's always opportunities to sort of come in and offer a better solution. So it's really a three pronged approach for us. We're seeing the funnels build really across all three of those channels. And as I said in my comments, I expect that you'll see some impact in the topline growth as we move through the balance of this year, but more pronounced when we get to fiscal 2020, but we're really excited about it and so our customers, and I think our distributors are as well because this is a value proposition that is an easy sell for a very low five digit or five figure sort of number. You can take an existing product and connect it to your control system. And the cost of an hour of downtime is a six figure number, right. So it's a no-brainer when you can get to the right people at the right time and we're having great success with it and we're excited about where it puts us.

Thanks very much.

Our next question is from Jeff Hammond from KeyBanc Capital Markets.

Hey. Good morning, guys.

Good morning, Jeff.

Good morning, Jeff.

Just want to go back to the macro commentary on water. Maybe just talk about, you moved the color of the dot next to res, and just where are you seeing specifically some slow in there? And then just on non-res, I mean it sounds like its building momentum, but we had a peer yesterday kind of talk about September seeing some slowing in, in project activity, and just want to see if there's any signs, just given some of the volatility if you've seen any of that? Thanks.

Sure. Just for context, res is 10% to maybe 15% of our water business and it's primarily PEX and PEX-related products. So if think about what we're doing there is we're really highlighting the fact that if you look at housing starts, if you look at interest rates, I think we're just sort of taking a little bit more of a cautious approach on residential. It's the very smallest part of our business. It's the least impact to us in terms of our margin capability. So we're really just sort of flagging it as say the reality is the residential is likely going to slow. Offsetting that really is what we think a very good set of circumstances and background in non-resident. If you think about the cycle, we moved into that institutional part of the cycle where healthcare, education, municipal is all very strong. That's where we're at and we've talked about for years. That's where we're extraordinarily well positioned and that's sort of what you're seeing. So we're not seeing, I would say, the slowing that maybe you referenced. We see really strong backlogs and we feel good about the second half and certainly at this point into fiscal 2020. All things could change, but I think at this point, the cycle is progressing as we expected. I mean it's still very early in the recovery on that institutional side as we've talked about. But that's the context around a little bit of res exposure and why we changed it and how we feel about the rest of the business over the next period of time.

Okay, great. And then Todd maybe just update us on how you feel the execution is going on SCOFR 2. And then just any early thoughts on as you kind of build the thought process and plans around SCOFR 3, where are you going to be focusing et cetera? Thanks.

Sure. SCOFR 2 is a much simpler move, a series of moves. And I think where we are today I think we'll start to accrue the benefits of that really starting in our fourth quarter. Most of the work is wrapped up and we're pretty pleased with what the benefit will be. I mean, it's sort of right in line with what we had communicated. Obviously, we've signaled or flashed SCOFR 3. I think it's probably a little bit early to talk about it. Publicly other than to say, it looks like something probably in between one and two with some length of execution is probably in the one- to two-year timeframe. So I think when we get to, perhaps, we’ll have a little more color when we get to our Q3 call, but for sure by the time we get to our Q4 call, we'll lay out sort of what that looks like. But it's not crazy to think about it as a $20 million save. We will work to see if we can't maximize that into something a little bit more over time.

Okay, thanks a lot.

Our next question is from Mircea Dobre from Baird.

Yes, thank you. Good morning, guys. And I just want to pickup where Jeff left here with this SCOFR discussion. So maybe as the reminder on SCOFR 1, kind of what the incremental benefit was in 2019 and if it is all kind of focused on the first half of the year? And then SCOFR 2, you're still essentially on track and targeting $15 million of benefit, right? So those are still…

All correct, yes.

Okay, good. And then also on Centa, you sound from an execution standpoint, you sound incrementally positive here on a quarter in terms of what you can do in driving the margins. As I remember, you were initially targeting a three year window for improving margins by a 1,000 basis points. I heard you say that you could do that exiting fiscal 2020, and just to be clear here as to what the magnitude of that would mean, that would be – roughly call it a $12 million, $13 million of incremental, EBITDA dollars based on that businesses revenue base. Am I correct?

At a full-year run rate, correct.

At a full-year run rate?

Yes.

So in fiscal 2020…

Yes, so think about it, just to be clear, when we acquired the business, it was in that sort of 12% to 13% range. We felt that we had 1,000 points in margin. What I'm referring to is that, we won't get a full-year of that 1,000 point benefit in 2020, but we'll get there at some point during the year. The first full-year of that would probably be in our fiscal 2021, but I know where you're going in costs?

But yes…

And then lastly, as we're talking about the core PMC business, you’re essentially kind of sticking with that longer-term view of 35% incremental margins excluding the items from sculpture and excluding sentence, correct?

That is correct.

Okay. Then lastly, in Water Management, your organic growth this quarter was – I thought pretty remarkable and I'm essentially trying to figure out what the moving pieces are because when I'm looking at just put in place construction through the quarter and I look at your key end markets. When things were fine but, but there were not as good as 12% organic growth would indicate. So how do we think about either idiosyncratic items that impacted the quarter or essentially the sustainability for lack of a better term of this kind of growth going forward?

Sure. Yes, I mean just to – first of all, there were no unusual items, projects, catch up, otherwise, no channel build or anything like that. If you look at the 12% organic growth, if it comes off of a relatively easy comp, if you remember last year in the second quarter we had the impact of the hurricane and core growth was only up just a touch. That being said, if you look at our second half, we expect very strong stacked core growth. All the absolute percentage in the quarter may not be as high as the 12% we just posted. If you look at the stacked growth over the course of the second half, it will actually probably look as good or perhaps even a little better than the 12% plus the one. So when you go back to – so why – just couple of things. Obviously, we're in a strong part of our end markets, where we have a very high relative share and we are going to outperform any market indices because of that. Second, we've been introducing new products at a great clip or really the past two to three years. We've been driving our specifications share up and we've got a connected strategy that will probably help us, not hurt us as we think about, the balance of this year into next year. And so from our standpoint, it really demonstrates the work that we've been doing, the transparency of the performance that you can see with VAG out of the picture and you know, as we think about Zurn and Water Management going forward and capital deployment, we've obviously would love to do more in and around some of the end markets that we serve here because as you can see, we've just got a terrific competitive advantage with the business and we're excited about where it's positioned going forward.

I see and last question, just picking on this last comment on capital deployment. How do you, how do you sort of think about the cyclicality of Water Management now and are there anything – is there anything that you can do either on capital deployment or maybe organically that way you build the business shifting more maybe towards the retrofit, I don't know, in order to essentially manage this dynamic?

Well, I think that you touched on it, right? Adjacent markets that continue to perform in whatever market, it would be adjacent to a non-res market would be areas that we focused on. Retrofit when we bought the business 10 years ago was virtually zero, it's somewhere between 30% and 35% today. This connected backflow and all these connected products offer us. We think a real opportunity as you go through any sort of non-res cycle to go in and retrofit existing products to the connected version, which is something we never have had before. So I wouldn't be surprised as you think forward, this business looks a lot more like PMC where it's half new, half retrofit. I think that everything we're doing with both organic and inorganic is sort of to get us to that mix and regardless of that we think are high relative share, really protects us as we go through a cycle at some point. We don't see that cycle in the next 12 months. But from a strategic standpoint, we're working to make sure that when it does come we're positioned to really outperform because of what we've done really since we bought the business 10 years ago.

Great. Thank you.

Our next question is from Charles Brady from SunTrust Robinson.

Yes. Thanks. Good morning, guys.

Good morning, Charles.

On the PMC slide, yellow box on Europe not surprising there at all obviously, but one of you just comment a little bit more on some of the geographies and the growth or lack thereof that you're seeing and particularly in the European markets.

Yes, Charlie. The yellow dot is not new. I think it's been there for a couple quarters. I think we're just, as we said, when we made the change, we're just taking a little more cautious outlook on Europe obviously, with some of the noise around things happening in Italy, the Brexit situation, we've just chosen to take a more prudent approach to way that we think about the market. I wouldn't say it's underperforming by any stretch of the imagination. I think it's just, it's certainly lower growth than in North America with some things to keep an eye on just given the political and macro concerns that exist in the continent and in the UK.

Okay. So you didn't down shift in the past three or four months or so. It's just kind of in for that.

No. I mean it's sort of think about it as relative to other regions. That's the one that is probably just from our standpoint as a little bit lower market growth profile, but nothing different in the quarter.

Okay, thanks. And then just on direction, I think at the Analyst Day, you talked about rolling out couplings after the gearboxes, as far as full monitoring ability? Can you just talk about, I guess you have more people signed on to that full monitoring ability on the gearboxes and what's going on in the couplings now rolled out to have that capability as well?

It varies by customer Charlie, but yes, I mean I think the product offering continues to advance. It also includes things like modular flattop belting, and many, many more of our products. So the adoption rate is high, customers are excited about it. I'm not sure I can add any incremental color other than to say, it's differentiated in the marketplace. People are talking about bringing to market connected products, but what they're bringing is products that provide information around heat vibration and temperature without any context. And so if you're a customer, that's great. I'm hot, I'm hot, I'm hot, I'm vibrating, vibrating, vibrating. But it doesn't tell you, why it doesn't tell you what to do and that's, that's a huge differentiation between what it is we have, where the data is provided in context to a control system that tells the customer exactly what the issue is and what to do about it. And so we think, the differentiation between what we've created and it's taken us a long time to do, but it embeds 127 years of application expertise behind it is a pretty big competitive mode. And to be able to do it across a broad series of power transmission components relative to other suppliers, you could do it, perhaps across one product category. It's a very differentiated approach. And so, obviously we're excited about what's been done, but we're getting into the phase where we’re more excited about what it does for growth and margin standpoint.

Yes. And just to that point, I mean, can you quantify what revenues are you getting from DiRXN and kind of where that's going to be over the next 12, 18 months?

Well, last year, the first year of launch or first partial year of launch, we did about $20 million in fiscal 2019, which we're in right now. It will probably be closer to $50 million and it'll grow from there.

Great. Thanks. Appreciate it.

And our next question is from Bryan Blair from Oppenheimer.

Good morning, guys. Thanks for taking my question and nice quarter.

Thanks.

Hoping to circle back quickly on Centa, the original EBITDA guidance that you put out contemplated, I think it was $13 million in incremental M&A contribution, $0.11 to World Dryer. With Centa strong year-to-date performance, where is that number shifted in terms of the current guide?

Well, it's probably a little bit better than that. I don't know that we're going to get into specific contributions to EBITDA. We can tell you from a growth standpoint, it's growing nicely as you can see in the reported versus corn numbers. And from an M&A standpoint, it’s probably a little bit ahead of what we had included in our initial guidance.

Okay, fair enough. And then on the Zurn side, you highlighted at the Investor Day the expansion into adjacent fire and site works markets seems like a very interesting longer term opportunity. Can you provide a quick updates on those initiatives? Maybe size, run rate exposure and where those revenue streams may scale over the next couple of years?

Sure. I think the – starting with fire protection, we've identified about a $300 million segment of the market that we think we can really exploit by leveraging the Zurn brand as well as essentially all the components that a contractor needs to provide a quench fire protection system. Whereas today they have to go to a number of providers, and as a result of that, the general contractor has a very limited ability to value engineer solution for a building owner. The lead product, if you will, but the most important product in that is the backflow prevention device. And so what we've done over the course of the last, call it nine to 12 months, is build out the family of SKUs that allow us to go to a general contractor, and help them value engineer solution for a customer, so that they can provide the entire system to the end user with sort of the one invoice, one Zurn benefits and everybody makes a little bit more money. And it's so much easier to do. And so we're having great success there. But we started with having the Trojan horse of the product into that end market and the very best brand in that part of the market which is Zurn backflow. Site works, we got into site works a little bit through an acquisition. We made a Green Turtle four or five years ago. Aside from that, as we look through these growth adjacencies, the Water Management in and around commercial buildings as well as on highways, airports is a terrific sort of growth market for us. We're thinking about that, it’s about $150 million to $200 million market and we've been aggressively pursuing building a rep channel to get to that. So what these are? These are products that are replacing poured-in concrete, right, which is expensive, difficult to manage, and these are drop-in solutions. And so in both cases, we're starting with great products, a differentiated go-to-market because we have a broadest portfolio with one brand and now attacking these two markets. And I would say, it's still early, but if you look at our relative share in any other market we serve, it's 25 at the low end, 50 plus at the high. We're coming into these markets with very low share. So we would expect the trajectory on that share game over a number of years to sort of track to that 25% plus range. So you can sort of see the magnitude of the opportunity that was probably $100 million opportunity over the next three to five years.

Okay, very helpful color. Thank you.

[Operator Instructions] Next question is from Julian Mitchell from Barclays.

Hi, good morning.

Good morning, Julian.

Good morning. Just one question from me, I think just circling back to the EBITDA, guidance for the second half, relative to the first half, understood that water seasonally is a bit of a dampener in the second half. So maybe just trying to understand within PMC, would it be the case that some terrific impact and higher investment spend? That's what is maybe weighing on the increase in EBITDA in the second half? And maybe just help us understand, what you think the gross tariffs impact will be over the next sort of 12 months. I'm assuming list three, a fully gets enacted early next year?

Well, I'll try to unpack what you asked. And so the tariff situation for us with a fully implemented lists three and the fiscal year would be about $20 million of which through material substitution, alternate supply chain, selective price increases, we think results in absolutely no impact to our earnings and in fact results in a margin that's probably in the 20% to 30% range in EBITDA. So that's step number one. We don't have a tariff concern. We will worry about what it does to long-term demand, but in terms of a headwind to our business at anyway shape of form we just, that's not in our second half and we don't see that being the case even if there is a fully implemented lists three. With respect to seasonality, obviously we're expecting a better second half of earnings in our PMC business than our first. As I said, we don't see any headwinds from tariffs. And obviously we see earnings in the second half, a little bit less and our Water Management platform as a result of the normal seasonality. And so again, Juliana knows that answering your question as fully as you may like, but the tariffs are not the issue. And if you're poking around that, hey, maybe the run rate could be a little bit greater. Again we're sort of balancing that with, hey, we've got six months to go in our fiscal year. We've had a really nice first half. The trajectory of the business is strong. All the things that we've done internally are bearing fruit. And we'll just watch how the year plays out. But at this point, we felt comfortable taking it up to where we did. And, you know with any luck, we'll be back here and a little bit – and give you the real fourth quarter number at that point because we'll have nine months behind us. But at this point we feel good about, the year and where we're positioned heading into our fiscal 2020.

That's very clear. Thank you. End of Q&A

At this time, we have no further questions.

Thanks everybody for joining us on the call today. We appreciate your interest in Rexnord and we look forward to providing our next update when we announce our fiscal year 2019s third quarter result in early February. Have a great day.

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating, and you may now disconnect.