Zurn Elkay Seems To Be Drifting Despite Solid Execution

Between a more general derating of previously high-multiple industrials and perhaps some rotation out of the once-hot water theme, Zurn Elkay (NYSE:ZWS) has remained weak since my last update on the company in February. Down about 10% since my last update, the stock has underperformed Watts (WTS) and Mueller (MWA), but the year-to-date comparison is a bit more favorable to Zurn Elkay.

I really don’t see much to fret about here. I’ve been impressed with not only how Zurn Elkay has leveraged strong availability to gain share (as well as leveraging hygiene retrofit trends), but also how well margins have held up in a challenging cost environment. The outlook has faded some since my last update, but I’m still bullish on Zurn Elkay based on mid-single-digit long-term organic revenue growth and mid-to-high single-digit FCF growth.

Non-Resi Momentum Is Slowing A Bit, But The Outlook Is Still Positive

As I expected, non-residential activity is picking up in the wake of the pandemic, with categories like offices and retail still soft relative to torrid growth in industrial. Zurn Elkay has stayed busy with ongoing retrofit business, particularly with touchless hygiene retrofits for bathrooms. There’s been a little turbulence in recent leading indicators, but I’d call the outlook still directionally positive.

The July ABI came in at 51.0, a deceleration from 53.2 in June and 53.6 over the past twelve months, but still in the expansion zone. The Dodge Momentum Index accelerated, though, with a July reading of 178.7 (versus June in 173.6 and 165.2 for the trailing twelve months). Project inquires have likewise slipped a bit (56.1 in July versus 58.2 in July and a 10-year average of 59), but are still in a healthy place.

I do expect some deceleration in commercial construction next year, as well as further erosion in residential, but I think growth will still stay above 4%. At the same time, institutional construction (by far Zurn Elkay’s largest category) should accelerate to over 5%, with both health and education ahead of institutional sector averages.

Can Claims Inflation Push Higher-Value Retrofits?

Zurn Elkay isn’t really a play on water infrastructure, but there are still some environmental angles here in the company’s leak detection/prevention products. I’ve talked about this before, but the simple takeaway here is that Zurn Elkay offers products that can help detect leaks or other plumbing issues and shut off the water (and alert owners/operators) before any meaningful damage occurs.

Avoiding water damage with automated sensors that don’t really cost all that much relative to potential damage (or as a percentage of new installation or full renovation costs) is a strong enough argument on its own, but I think insurance companies could provide a kicker here. One of the notable trends now in insurance is the impact of inflation on rising claims severity – with labor and parts significantly more expensive than they were a year or two ago, insurance companies are looking at larger payouts for property damage claims. With that, there’s even more incentive to encourage retrofits of leak detection equipment, and while I don’t recall Zurn Elkay talking about this as a significant driver, I think it could make an incremental difference.

Leveraging Clean Water Opportunities

I’m also bullish on the post-Elkay deal opportunities from Zurn Elkay’s move into drinking water. Elkay was a well-run company on its own, and the deal makes sense as a logical extension of Zurn’s addressed markets/portfolio. Zurn already had a large presence in commercial and institutional markets, and the opportunity to benefit from drinking water retrofits (like bottle-filling stations) is not trivial.

I also see a residential growth angle here. Home water treatment is a growth market, and one that Franklin Electric (FELE) and Pentair (PNR) have been investing in, and I believe there are transferable technologies and competencies at Elkay that could make the company a more significant player here in the coming years.

Strong Results In Challenging Times

I can’t find much to fault in Zurn Elkay’s recent earnings. The second quarter saw 15% organic growth, suggesting a little bit of share growth on top of high single-digit pricing. Zurn Elkay has been leveraging a healthy market for hygienic retrofits (sensor-driven touchless fixtures for restrooms) but has also been benefiting from strong availability – in an environment where some companies are struggling to ship to demand due to component shortages, Zurn is leveraging its balance sheet to ensure product availability and reasonable order-to-delivery turnaround times.

Gross margin declined 260bp (to 40%) on those input and distribution cost challenges, but exceptional discipline on SG&A spending supported 28% growth in adjusted EBIT and 14% growth in adjusted EBITDA.

The Outlook

Zurn Elkay’s decision to leverage its balance sheet to gain share will have a negative impact on FY’22 free cash flow, but that doesn’t bother me, and it doesn’t have a meaningful impact on long-term value, as this will reverse over time. I’m slightly more concerned about management’s commentary that Elkay’s recent performance hasn’t been quite up to expectation (the deal closed on July 1), but I also think Zurn management is underselling the longer-term synergy opportunities (building in some “under-promise and over-deliver” breathing room).

Relative to my FY’23 assumptions (which will include a full year of Elkay), I’m expecting long-term core revenue growth of around 5% and mid-to-high single-digit FCF growth. I also use a 15x forward EBITDA multiple based on the company’s strong margin and ROIC profile.

The Bottom Line

Zurn Elkay doesn’t look hugely cheap on discounted cash flow, but I wouldn’t really expect to see a screaming bargain at a well-run, well-regarded company, and I think a high single-digit annualized long-term return is still respectable. Likewise, I see fair value in the mid-$30s based on my 2024 EBITDA estimate discounted back (I’m using ’24 to give some benefit to post-deal synergies and post-pandemic normalization).

I was worried when I last wrote about Zurn Elkay that there could be a “catch a falling knife” risk with the stock as the entire water sector, once a darling on the Street, was seeing investors rotate away. I still have some risk there, but I think Zurn Elkay is one of those below-the-radar names that will continue to outperform its core underlying markets and build value for investors. It won’t be flashy, and there will be periodic economic cycle risk, but it’s still a good name to consider.