Description

Executive Summary

Zurn Elkay Water Solutions (Zurn) has the characteristics of high-quality industrial compounders given its less cyclical than expected profile, a high amount of aftermarket content, strong market share in niche product areas where the price to impact ratio is low, fragmented competition where few offer scale giving the company the ability to gain organic share, low capital intensity and excellent free cash flow conversion, and ample capital deployment opportunities.

Background

Zurn is a high-quality asset that has only recently been available for purchase on a standalone basis. Previously it was a part of Rexnord. In early October Rexnord spun its non-water business into a RMT with Regal Beloit and began trading as Zurn. The process and motion control business trades as Regal Rexnord under the ticker RRX. In anticipation of the spin Zurn was written up on VIC by cnm3d (in March ’21) under the old ticker RXN. We believe the attractiveness of Zurn is still underappreciated by the market.

Zurn produces plumbing products mostly for commercial and institutional applications (70% of the business). It makes both “behind the wall” items like drains, backflow preventers, and valves as well as “front of wall” items like sinks, faucets, and flush valves. It is #1 or #2 in most product categories with market shares from the teens to 40%, and its position both behind and in front of the wall is unique in the US (and most closely resembles the publicly traded Geberit in Europe, which has similar margins and a much larger sales base and market cap). In February Zurn announced the acquisition of the privately held Elkay for equity, which will increase revenue by 70%. Elkay is a highly complementary asset both in terms of product mix and culture. It will provide Zurn with Elkay’s #1 water dispensary business (> 50% of revenue and a bit over 20% of the combined entity) as well as a #1 sinks franchise while building out faucets. The deal closed on July 1, 2022.

Pro-forma for Elkay the business mix will be as follows:

Zurn is one of the few assets directly tied to water management, which has desirable ESG characteristics. The company’s products address water scarcity, climate change, waste, and hygiene.

Thesis

Zurn operates in an attractive industry where its business model allows it to gain share over time

Zurn has an attractive business model that was obscured under Rexnord. Organic growth has been mid to high single digits and is not very cyclical. Organic growth for Zurn has been positive for 42 of the past 44 quarters. Typically, the industry grows volume at 2-4% and Zurn manages another two points of pricing. Zurn has been a market share gainer through its history. They drive share by highlighting the premium quality and cost savings of their products. Install times for their products are often less than 20% of competitors, and the labor cost savings can be more than the price of the product while being highly reliable. As a result, architects often “spec” Zurn into a project, and Zurn is obsessive about gaining spec share through its differentiated representative network. At the same time Zurn also expands into adjacencies in a still fragmented market. On average it has been able to gain two points of share per year. This puts typical organic growth at 6-8%. Elkay has had a similar growth profile showing double digit growth for the past five+ years. In the past ten years their clean drinking business has grown 12% annually.

Zurn operates a very cash generative business that can be deployed towards attractive M&A

Zurn runs a very asset light model it calls “design, procure, test”. It outsources the most capital-intensive elements to a wide range of third parties. It has long had a presence throughout Asia and more recently has expanded its sourcing network to Latin America. Even during this moment of severe supply chain disruption Zurn has managed to deliver mid-teens organic growth. Zurn’s production and the high value to cost ratio of its products has allowed it to generate EBITDA margins sustainably above 20%. Recent quarters have shown EBITDA margins around 25% ex-corporate costs and 22-23% including them, which were elevated post the RMT transaction that the company has been working down.

Zurn’s capex runs at < 1.5% of revenue. This together with margins results in a high FCF conversion at around 65% of EBITDA. Under Rexnord Zurn pursued less M&A than we anticipate in the coming years. Previous to Elkay, the company had closed on five acquisitions at an average EBITDA multiple < 10x, versus the company’s multiple of 15-20x. Its largest deal was for Hadrian at an EV of $101m. They are acquiring Elkay (at the announcement date’s stock price $29.79) for $1.56b, which is 14.2x Elkay’s ’22 EBITDA and 9.8x post $50m in synergies that look achievable based on the company’s past M&A experience and overlaps in salesforce and marketing and the supply chain. The Elkay transaction deleverages the balance sheet from just over 2.0x net debt to EBITDA on a trailing basis to 1.0x on a trailing pro-forma basis at year end.

We and industry experts see lots of additional M&A opportunity for the company given that there are still some reasonably scale private competitors with ownership structures like Elkay. There are also niche areas where Zurn has no exposure. At leverage of 1.0x versus the company’s target range of 2.0-2.5x there is a lot of room for more deals. In our numbers we anticipate additional M&A, some level of buybacks, and a growing dividend (the current yield is 44bp).

The commercial construction industry is far from peak with a robust retrofit opportunity available

The commercial construction industry is still depressed. Looking at the US Census Construction Put in Place data for non-residential construction, we are still not back to pre-pandemic peaks.

On this measure we have surpassed the 2007/2008 peak, albeit at levels well below volumes that would have been expected by GDP growth. But we see a subset of this series as far more relevant for Zurn. We look at this series ex-warehouse construction, which has been exceptionally strong since 2015 and has modest plumbing content. We also strip out Power & Gas construction, which is not very relevant for Zurn (though does not have a significant impact on the shape of the curve).

On this measure Zurn’s end markets are 7.4% below pre-pandemic highs versus the overall series down 5.6%.

Trends look even more depressed on a square footage basis with the market still well below 2016 peak levels of build based on Dodge commercial starts data. Another way to look at that is relative to GDP. Consider non-residential construction put in place ex-warehouse and oil and gas as a % of GDP.

Forward indicators also look positive. The Dodge Momentum index for commercial construction, which captures the dollar value of pipeline activity for commercial and institutional construction has inflected positively of late and is up double digits of late. This comports with the Architectural Billings Index still comfortably about 50.

In general, then, we feel good about where we are in the commercial construction cycle.

On top of the raw macro indicators there are two additional positive retrofit drivers that apply to Zurn. The first is the drinking water opportunity via Elkay. There is an eight million unit installed base of water fountains that are addressable with Elkay’s refillable water stations. These have done well during the pandemic, but we are in the early innings of the upgrade cycle given the 3-5 year life of units. The second is a specific opportunity in schools. We estimate education represented a mid-teens percentage of the standalone Zurn business and at least that if not higher combined with Elkay. Two different pieces of legislation recently added significant funds to education. The CARES act setup an Education Stabilization Fund (ESF), much of which is yet to be spent. The second set of covid relief provided additional funding for Elementary and Secondary School Emergency Relief (ESER) that is only now being distributed. Together we see mid-teens+ growth for education for the next several years.

Return Profile  

In our Base Case through 2027 we assume roughly 7% organic topline growth (12% in 2022 fading to 4% in the out years). We layer in the Elkay deal and then a HSD contribution from additional M&A after ’23. Elkay has an approximately 16% margin, but it is around 23% after synergies. Outside of that margin dynamic we assume a roughly 30% incremental margin. In addition to M&A we assume the company buys back around 2.5% of its shares a year and ramps the dividend ending the period above a 1.5% yield. With this evolution of the financials, we see a 22% IRR with the stock at 14.0x EBITDA. This corresponds to 19.1x P/E and 18.4x FCF. We believe these multiples to be reasonable to conservative. The aforementioned Geberit has roughly traded at a mid-20s EBITDA multiple and we see it as the best comp. The nearest US comp is Watts Water Technologies (WTS) trading just above 12.0x EBITDA. We see it as a less relevant comp given a very large resi DIY copper flow control business, but we use it to govern our downside case. Under more Bullish assumptions and a 17x EBITDA multiple the IRR could be in the mid to high 30’s%. In a Bearish Case with negative organic growth and a 11.0x EBITDA multiple there is 16% downside on ‘23.

Catalyst

• Strong organic growth as a result of a continued upswing in the cycle and market share gains
• Successful integration of Elkay
• Additional M&A