Robert McCarthy - Vice President-Investor Relations Todd Alan Adams - President, Chief Executive Officer & Director Mark W. Peterson - Senior Vice President and Chief Financial Officer.

Charles D. Brady - SunTrust Robinson Humphrey Julian Mitchell - Credit Suisse Securities (USA) LLC (Broker) Jeffrey D. Hammond - KeyBanc Capital Markets, Inc. Mig Dobre - Robert W. Baird & Co., Inc. (Broker) Kevin Bennett - Sterne Agee Joe J. O'Dea - Vertical Research Partners LLC David L. Rose - Wedbush Securities, Inc..

Welcome to the FY 2016 Q2 Earnings Release Call. My name is John, and I will be your operator for today's call. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. Please note the conference is being recorded. And now I'm going to turn the call over to Rob McCarthy..

Thank you, John. 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 second quarter and our outlook for 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.

With that, I'll turn the call over to Todd Adams, President and CEO of Rexnord..

Thanks, Rob, and good morning, everyone. I'll start on slide four. Our second quarter results were in line with our expectations for core growth, profitability and free cash flow.

Our core sales declined 6% year-over-year, which is a function of a 1% core growth in our Water Management platform, and a 11% core decline in our Process & Motion Control platform, which I'll cover in more detail in just a few minutes.

Acquisitions added 3% to sales, and average currency translation was a headwind that reduced our reported top line growth by approximately 500 basis points. Adjusted earnings per share was $0.34 in the second quarter, as our adjusted EBITDA margin was slightly better than projected and accounted for a modest upside to our EPS guidance.

Free cash flow was robust and consistent with our expectations and moreover we continue to be well positioned to execute perspective bolt-on acquisition activity. In terms of color on the quarter, I want to start with Water Management.

The conviction we've had, and the progress we've made and the margin opportunities continue to track well, as we posted record margins in the quarter, and overall are now running around 18% for the first half of the year.

In the quarter we advanced a number of critical milestones in our overall supply chain and footprint optimization plan, enough to pull into this year, two actions both in water that were originally planned for next year.

The incremental cost to implement the plan, will hit over the back half of this year, but more importantly we get the benefits and the run rate beginning less than five months from now.

Over the second half, we expect Water Management to continue to be a source of solid core growth and margin expansion, with the actions we've accelerated, adding to the margin trajectory we're currently on, which is in the higher teens to 20% range over the next several quarters.

Turning to demand, the Water Management platform continues to perform well, as core growth was in line with our expectations and what we outlined heading into the quarter and reflects the comparability impact of large projects shipments in last year's second quarter. The U.S.

non-residential construction market continues to be a key positive as growth continues to be solid despite some lengthenings in projects schedules due to the weather issues experienced earlier in the year, and the ongoing tight supply of available construction labor.

Our outlook for the balance of the fiscal year and next year as well, is that we'll continue to benefit from robust fundamentals in the non-residential construction market. U.S.

spending growth continues to run at elevated levels and leading indicators like the ABI and the Dodge Momentum Index, continue to support our expectations for robust activity levels, headed into next year and beyond.

In our water and water infrastructure end markets we're continuing to see some solid order growth, as our first half book-to-bill totaled 1.18 times and first half core sales growth was 6%, which is a combination of up double-digits in Q1 and down single digits in Q2.

As we've discussed, quarterly sales comparability year-to-year is often impacted by project shipment timing, which is what happened in Q1 and Q2 and is simply inherent in the business and the end markets we serve.

Looking forward, with a solid backlog in water infrastructure, we expect to see stronger reported core growth and margins for that part of the platform in the second half.

Water Management in total is and should continue to be a real positive for us moving forward, in terms of core and in particular profitability, as it will now account for about 40% of Rexnord consolidated earnings, as we exit this year. Moving to Process & Motion Control.

I'll spend just a minute, providing a little detail on several key end markets as well as our industrial distribution channel. Like for most industrial companies, I think it's fair to say that it's not a rosy picture out there in many end markets.

However, there certainly are some bright spots that are worth talking about, and in our case, both Aerospace and food and beverage continue to perform well. These end markets comprise about a third of the overall platform revenues and more than that, when you look at it from an earnings perspective.

We're seeing solid orders and continue to have decent visibility to what looks like low to mid single digit growth, over the second half of the year. This is after a decent first half. When you look at the remainder of Process & Motion Control, there is a big piece of the aftermarket that we serve to the industrial distribution channel.

This is the part of our business where we're seeing the channel inventory reduction significantly impact our growth rates over the first half, which again were pretty much in line with what we had expected heading into the second quarter.

To dimension of the impact of the destocking, that alone has impacted Process & Motion Control growth in the first half by 4 to 5 percentage points and overall Rexnord core growth by about 2%. The next piece of the equation is what happens with the ID sell-through and direct OEM and end-user shipments.

And here's where we've seen some end market demand weaken slightly in September and October. The thing to point out here is that while sales were a bit less than we had been expecting and down year-over-year, it was relatively stable sequentially from the first quarter.

As we think about this part of our business over the second half and in particular the December quarter, we believe that we could see some volatility of uneven demand over the next couple of months as many industrial companies that need and use our products, temporarily defer spending heading into the end of the calendar year.

But balancing that is the fact that, this is the part of the business, where we do carry some backlog. For Process & Motion Control in totality, all of this can be summed up in the following way. A third of the platform is aerospace and food and beverage, growing nicely with a reasonable outlook.

Next, the first half was largely impacted by de-stocking which we believe is mostly behind us at this point and impacted first half growth between – by between 4 and 5 percentage points.

And finally, direct sales and sell-through weakened somewhat in the quarter and a little in October and we're assuming there is likelihood that could continue to slip as we head into the end of the calendar year.

As it relates to our outlook, the net result of all the end markets updates is that with six months left to go on our fiscal year, we're electing to become even more realistically cautious with respect to short cycle industrial demand.

We're also incorporating an incremental $0.04 of expense from the acceleration in our strategic footprint initiatives into the P&L. The net impact of these two assumptions results in an adjusted EPS range for the year of $1.43 to $1.48.

While we're not exactly happy with the absolute result, we are pleased with the way the overall Rexnord portfolio is setting up to perform over the coming quarters and into next year. Water, aerospace and food and beverage exposed end markets now comprise over 60% of revenues and earnings for the company.

In the remaining end markets, we've absorbed the brunt of a channel de-stocking over the course of the first half and this had a significant impact not only on growth, but overall margins.

On the self-help side of life, we've made substantial progress on the initiatives embedded in the $30 million of annual savings that we planned for during last year and began implementing just in the past six months.

I'll remind everyone that we'll begin to see some of the benefits beginning in early fiscal 2017, which at this point is only five months away.

In the meantime, we're leveraging the Rexnord business system to drive efficiencies and reduce cost to mitigate the impact of a lower top line, while continuing to protect investment scenarios that will enable us to drive above market core growth going forward.

As an example, in our PT end markets, we're on track to deliver $30 million of first fit order opportunities to new customers by the end of fiscal 2016. We've been investing in tools, adding talent and implementing new processes and are seeing the measurable impact that will accelerate and amplify our growth moving forward.

Now let's move on to slide five. Consistent with what we've shown you for the past couple of quarters, this slide outlines our growth assumptions for our largest 10 served end markets that account for about 85% of our annual revenue.

As I already highlighted, the most impactful change to our market view is a more realistically cautious outlook for sell-through in our U.S. industrial distribution end markets where we're revising our forecast by two to three points – or from a mid-single digit decline to a high single digit decline – which reflects weaker sell-through in the U.S.

plus a couple of million more dollars for potential corresponding related – corresponding channel inventory reductions. We've also tweaked our market forecast slightly lower for our direct sales into a couple of our process end market verticals, but these minor changes were mostly accommodated within the existing forecast ranges from a quarter ago.

This lowers our overall end market growth forecast to between down 2% and down 4%. For reference, our first half core growth was minus 3% and was impacted by 2 percentage points related to the channel inventory de-stocking, and over the second half we expect our core growth to improve modestly.

Before I turn it over to Mark to provide a little more detail on the financials, I hope you take away the following this morning. Overall, we believe our second quarter results reflect another decent quarter of solid execution in a highly volatile and challenging market environment.

We reviewed and revised our assumptions to reflect an incrementally more cautious view of likely direct sales and sell-through rates in our U.S. industrial distribution channel, taking a prudent view that we believe limits further downside.

We will continue to be aggressive and nimble in the markets and as market conditions evolve and we're leveraging the business system to eliminate waste, improved productivity and keep ourselves ahead.

Finally, we have also accelerated certain elements of our significant and structural self-help initiatives, while capturing additional productivity gains and margin expansion in our operation serving global water markets.

The net result of that means that earnings over the next six months will end up being a little bit lower than we thought, which is something we're not pleased about and will continue to work to improve upon.

Secondly, as you think about Rexnord's portfolio and future performance, it's essential to understand that the shift in our overall earnings mix is accelerating in a significant way this year and will position us very differently as we enter the coming fiscal year.

And with the expected benefits from just the first stage of our supply chain and footprint optimization coming into our numbers as we move to next year, we're increasingly upbeat about our relative financial prospects in our fiscal 2017.

And last, but certainly not least, our business model generates significant free cash flow in good times and in not so good times.

This year will be no different, as we expect to generate approximately $100 million in the second half of our year to either de-lever or to execute upon smart M&A that will add growth, future earnings and cash flow to our core businesses. With that, I'll turn it over to Mark to review some of the numbers..

Thanks, Todd. I'm on slide six of the presentation, which 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 in line with our expectations for the quarter and adjusted EPS was slightly better. With respect to profitability, your increase drag from our U.S.

distribution channel pushed our overall decremental margin to 45%, which is actually a bit better than forecast. Given our reduced outlook for U.S. distribution, our decremental margin will remain above normalized levels in our third quarter, but we continue to see the full-year coming in around the 30% level, we historically expect.

Furthermore, we continue to expect that destocking will be essentially complete in the current quarter and our cost reduction initiatives are on track to deliver our targeted savings for this year. Turning to cash flow, our free cash flow declined year-over-year, but was in line with the expectations.

The year-over-year change reflected a decline in our net income, partially offset by improved working capital management, as well the expected increase from cash tax payments in this fiscal year.

Next, as we look at the operating performance in our Process & Motion Control platform on slide eight, you can see the strong year-over-year impact on our margins from the combination of the 12% revenue decline and the adverse mix affect created by weaker distributor sell-through and the constant de-stocking in the quarter.

While we experienced last quarter, food and beverage and aerospace revenues were again up on a year-over-year basis.

As we look at our third quarter, we expect adverse year-over-year mix from weaker distribution sales levels and higher investment spending associated with our footprint actions to hold PMC's third quarter EBITDA margin to around the second quarter level. For the full year, and incorporating our incrementally more cautious outlook for the U.S.

general industrial demand, we now project 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 strong year-over-year margin expansion as our adjusted EBITDA margin expanded by 90 basis points to reflect ongoing RBS-led process improvements, productivity initiatives in our valve and gate group and leverage on the sales growth in our non-residential construction end markets.

As we look ahead for Water Management, I'd like to remind everyone that the timing of product shipments can create significant variability in quarterly core sales growth comparisons in Water Management.

Having said that, we continue to expect platform core growth to accelerate at 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 product shipment levels in last year's second half.

With respect to Water Management margins, we expect to deliver ongoing year-over-year margin expansion through year-end and particularly in our fourth quarter. Overall, our confidence in Water Management's full year outlook remains high and we now expect Water Management adjusted EBITDA margin to exceed 18% in fiscal 2016.

Moving to slide 10, you'll see our strong free cash will enable us to rebuild our cash position after allocating $40 million for cash repurchases in the first quarter. Our liquidity position remains strong and 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, our liquidity requirements and our longer term objective to reduce our financial leverage. Before we turn 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 representation also highlights our assumptions for interest expense, depreciation and amortization, our effective tax rate, capital expenditures and fully diluted shares outstanding for fiscal 2016.

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 and potential and tangible asset impairment charges we may incur as we assess certain branding strategies in our water and wastewater infrastructure end-markets.

With respect to restructuring, I want to take a minute to provide you with an update. First, the supply chain optimization and footprint repositioning program is expected to impact our fiscal 2016 results as follows.

We've increased our forecast for costs that will run through our operating results from approximately $7 million to approximately $13 million in the fiscal year. This change reflects the acceleration of certain elements of the plan into our fiscal 2016 and fiscal 2017.

The incremental impact is about $0.04, and is included in our advised outlook for adjusted EPS. We now project $14 million to $16 million of restructuring expense, primarily made up of severance costs, up about $1 million from last quarter.

Unchanged in our forecast is approximately $5 million of accelerated depreciation in the year, which is also excluded from adjusted EPS. As a result of the accelerated actions Todd discussed, we'll incur approximately $3 million of fixed asset impairment charge in our third quarter.

Our forecast for CapEx in fiscal 2016 related to this project is unchanged and is included in our CapEx outlook of approximately 3% of sales.

Second, and in addition to this project, we now anticipate incurring restructuring cost of approximately $5 million to $6 million related to other cost reduction initiatives during the year, up about $1 million from our last quarter. And before we open the call for questions, I want 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 our tax planning initiatives. We currently anticipate that our second half tax rate will be between 25% and 27% with third quarter tax rate that will be between 10% and 12%. With that, we'll open the call up for your questions..

Thank you. We'll now begin the question-and-answer session. And our first question is from Charley Brady from SunTrust Robinson..

Thanks. Good morning guys..

Good morning, Charley..

Good morning, Charley..

I just want to see on the destocking, just so I understand the outlook.

The tender as you went through the second quarter, did it – you were seeing it decelerating or was it steady? And then as you come into October, have you seen a change that gives the confidence that we go through the third quarter and we're kind of done with it?.

That's absolutely correct. When you look at the year, I think it sort of unfolded, a significant destocking really over the first half. And what we're seeing in September is majority of that destock frankly abate.

What we've got in our outlook is maybe absorbing a little bit more, if in fact we do see a weakening in sell through rates within distribution. So I think we feel good, Charley, about the balance of the destocking really being behind us. Obviously, there is a risk that if demand takes a big step down, that could create further destocking.

But at this point we don't see it happening in October and we don't think we see it going forward..

Okay. And just one more, a clarification on the restructuring commentary.

Does the pull forward into 2016 from 2017, is that largely in the water platform or is any of it going to PMC?.

The two actions are primarily in the water platform. So these are two things that we had been planning for. But as we started the year, we looked ahead and said where can we pull activity forward to gain and benefit to sort of get into the run rate by 2017.

These were two areas where we had made substantial progress, we had the chance to do so and so, we did it. And so, you'll see those unfold really over the back half of the year and we'll begin to get that run rate as we start 2017.

So, I think what underpins our conviction around the margins is not only the current quarter performance, but what we have behind that and so, yes, those are both water related..

Great. Thanks..

We have a question from Julian Mitchell from Credit Suisse..

Hi, thank you..

Hi, Julian..

Good morning Julian..

Hi. Just wanted to follow up on the restructuring comments, as you said there's a bunch of different initiatives going on, supply chain and severance and so forth.

I just wondered if you could roll it all up together, and maybe help us understand what kind of incremental savings you expect this year versus last year and then in – and then what's incremental in fiscal 2017 taking all the measures sort of combined?.

I think – maybe I'll start at the end – and what we are trying to accomplish from an outcome standpoint, and then Mark can sort of feather in what's in 2016, what's in 2017.

And what we have on the table and announced – and this is only the stuff we've announced to date – there's more that is sort of in the pipeline for finalization and development really over the course of the next six months. But we see $30 million to $35 million of savings, as we exit our fiscal 2017.

Let's say, okay, so that's, that's sort of the ultimate sort of goal. And as we look at all the projects, I think at this point everyone of those is underway. So it's not something that needs to be developed; it's not something that needs to be started.

Each of these are absolutely underway and we are currently absolutely on track to that $30 million to $35 million of savings as we exit our fiscal 2017. So, you would see the run rate sort of beginning, call it April 1, 2017.

Mark can take you through some of the details of what we'll see in 2016, what we'll see in 2017, but that's sort of where we end up, Julian..

Yeah, so, Julian from a cost standpoint, we kind of laid out the pieces of the puzzle and what's going to hit this year. As you look into next year, we'll see approximately another, call it, $10 million to $13 million or so of operating expense that we'll be incurring, just looking at costs as we're ramping down, ramping up these initiatives.

But the thing that's different next year, it'll start getting savings, as Todd mentioned. We'll have savings that'll not entirely offset, but offset a meaningful portion of those costs. So, on a year-over-year basis, you'll see an improvement sequentially year-over-year in our overall EBITDA.

So, think about costs in the P&L, similar to this year but savings next year offsetting the majority of those costs, whereas this year you really aren't getting any savings, we're just incurring the duplicative costs this year..

Yeah. So, when you roll it forward, I mean, order of magnitude, it's in excess of 150 basis points of margin at the Rexnord level. And we've talked about where we are in water and obviously, some of the actions that we've talked about this morning get us rolling over that 20% EBITDA margin mark.

And what's even more exciting, we think, is that a lot of the savings come in our PMC platform, specifically on the industrial sort of end market side of things, where we're currently seeing relatively close to trough, if not trough conditions.

So, we're at near the bottom, we've got a whole bunch of self-help on the way and even a lack of any headwind, I think you're going to see us produce really nice margins as you head into the end of 2017 and into 2018. So, that's sort of the overall plan, Julian, and how it sort of bakes in the next couple of years..

Thank you for the thorough response. Just a quicker follow-up perhaps, capital deployment – things have been a little bit quiet there, I guess, for Rexnord the past few quarters.

Is that a function of a tougher organic top line environment? So you'd rather spend management time and attention on restructuring the existing business? Maybe just sort of talk through why things have gone quiet and maybe when they might liven up again?.

Well, it's not because we haven't chose to focus on it. I think we focused probably more on it over the last 12 months than we had in probably the prior couple of years. Our funnels are building, the proprietary funnels are building in a way that I think we're going to be, I think, very pleased with the outcome.

Whether it's the first half of next year, the second half of this year, it's a little bit challenging to predict, and we won't predict it. But I can tell you, the quality of the funnels, the level of effort and the focus is greater over the course of the last 12 months than it's been probably anytime in our history of being a public company.

So, I wouldn't get too focused on nothing's happened in the last nine or 10 months; just know that the quality of the funnel is building, the level of effort is – continues to be very high – and we view that as a super high priority for us moving forward.

As we talked, we've got substantial cash flow coming out of the business both this year and next. In the meantime, it allows us to continue to delever. But over time, what we want to do is leverage that free cash flow to buy better growth and increase the margins and cash flow of our core businesses.

So, we're not disappointed, we're investors and we're going to continue to be disciplined on that as we move forward..

Great. Thank you..

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

Hi, good morning guys..

Hi, Jeff..

Good morning, Jeff..

Hey. So, just back on the decremental margins in PMC and I think you mentioned they'll be above normal in this upcoming quarter and then should be better.

Can you just talk about what changes other than maybe the destocking to shift those decrementals to more normal or better than normal into the fourth quarter?.

Yeah, Jeff. This is Mark. As we talked about on our last call, a couple of things work to our favor. As you mentioned, clearly as the destocking decelerates half-over-half, what's been punishing our margin in the first half benefits our margin in the back half obviously that's a big piece.

And then, we've done a lot of things on the restructuring side and cost side in productivity that's driving – that's going to drive a big improvement in the back, so you saw us take restructuring actions in the first half of this year.

We've been working really hard at getting Rexnord material costs, you're going to see material costs benefit in the back half. So, we had to put it really into three buckets, the destocking piece that you talked about.

It's the restructuring actions that we've taken in our first half of the year benefiting the back half of the year and we've gotten pretty aggressive material costs. You're going to see a much improved – from our benefit an improved run rate on our material costs second half versus first half.

Those are the three big buckets that I've put in that that drove the margin improvement. As you know, in our fourth quarter, it's always been traditionally higher volume quarter for us, there is definitely better leverage in the fourth quarter that you see every year..

Okay. And then on water, it seems like you're very happy with order, orders in backlog in water and the trend is still favorable, but some timing issues.

What's the risk that as we get into the second half ramp, you continue to see lumpiness or choppiness or some of these issues that maybe holding things back near-term?.

Just to be clear, we don't see anything being held back. I think, if you look at our non-res piece of Water Management, it's growing in the mid-high-single-digit area, right, over the first half.

If you look at our water infrastructure side, you saw a double-digit growth in the first quarter and you saw single-digit declines in the second quarter, has nothing to do with the level of activity. It has everything to do with the timing. And so we don't see good to be perfectly honest here. We don't see anything sort of holding up being abnormal.

It's just really a function of year-over-year comps in particular in that water infrastructure piece. And then in this case in particular, large shipments in Q2 last year. Oddly enough no one asked us about the up double-digits in Q1, but you hit the point. I mean, the book-to-bill is 1.18 through the first half.

It gives you a sense that we feel pretty good about the second half as it relates to the growth in water infrastructure side. And I think, you put our comments on non-res and where we think that – where that trend line looks and in both cases they're positive.

So, we don't see any, I would say significant hurdles to delivering what Mark talked about as a pretty, pretty solid growth in the second half for water in total..

Great. Thanks, guys..

Our next question is from Mig Dobre from Baird..

Just a clarification maybe on the restructuring to make sure that I understand this. Mark, you mentioned $10 million to $13 million in expenses potentially for next year.

As I understand that, those would be excluded from adjusted EBITDA, but there is an associated benefit with the actions that you have undertaken this year, that will be flowing through and most of that would be in PMC.

Am I thinking about this correctly?.

Yeah, it's a good question to clarify. No, what I was talking about – this year – so in our operating results, in our EBITDA, we had about $13 million of expenses that are rolling through them. We said we're going to have severance and retention cost, there'll will be restructuring of $14 million to $16 million.

If you look at next year, we'll have in that $10 million to $13 million range of costs running through EBITDA again, as we're accelerating – as we're moving through other pieces and phases of the project, but we're going to start generating savings next year. That will offset a meaningful portion of those costs.

So, year-on-year we'll get an EBITDA benefit, okay just from where we are in the phase of this project. In addition to that, we will be incurring additional restructuring next year and we'll probably be in a similar range, $13 million to $15 million or $16 million range of restructuring cost that will not be in the EPS number..

Yep. Just for clarity, the $1.43 to $1.48 has $13 million of expense in it..

Correct..

And this is short of transitory cost related to duplicate production facilities, outsourcing and things like that. So the $1.43 to $1.48 has $13 million of expense in it this year, and no benefit, next year we begin to get the benefit into the run rate and probably has some approximate number like $13 million in it next year as well..

Got it. Okay, that's helpful. And then, can we get a little bit of color on pricing. I mean, there are a lot of moving parts here and price cost, that's really what I'm getting at.

Obviously, material costs are probably coming down across the board, how much of that can you keep, how much of that do you have to give back to the customer and maybe some color on both segments if you would?.

Yeah, I'll start with – I'll start with water. We see pricing – in holding, we think price cost is favorable in the second half relative to where it ran in the first half in PMC. Remember, a good piece of this goes to industrial distribution, where we see the ability to increase prices, albeit modestly, every year.

So, we don't see that abating on the OEM and user side. It's very difficult to ascertain, how much is price. But, again we're not seeing significant price pressures at this point anywhere and that's not really something that, we've historically ever bumped into, to be perfectly honest not even in the great recession.

So, what we see now is sort of a balanced view that we're going to be smart on price, not leaving it on the table, but not get too aggressive.

And we're going to be super aggressive on the commodity side of things and you'll see that roll through our second half and that's – I think, that's how we see the end markets shaping up from that perspective..

Do you feel comfortable providing some sort of a price cost gap that we should keep in mind?.

I don't think, it's – at the Rexnord level, I don't think it's something that's significant enough to worry about. Because I think, when you look at the diversity underneath and the variety of end markets and the brands, and how much is after market versus new, it really becomes a blended number.

I think, it's fair to say that it's positive, but I don't think, we're going to start to get guidance on that piece of the equation..

All right, appreciated. Thanks..

Our next question is from Kevin Bennett from Sterne Agee..

Hey, good morning everybody..

Good morning, Kevin..

Good morning, Kevin..

Todd, if I think about your end market outlook for the rest of this year.

If there was any – I guess kind of upside risk to one of the buckets, I mean what do you think that would be?.

I don't think, we're....

Where do you think that would be, I guess is a better question?.

I don't think, we're going to get into the habit of calling a bottom or sort of outlining upside at this point. I think what we're trying to do, Kevin, is give you a realistically cautious view, right, which is what we outlined of what we think we can do.

I think as you look through it, obviously water is going to be a source of very good growth over the second half. We have good visibility to we're going to get it done. The first half was impacted significantly by a destocking sort of period, that's behind us.

Offsetting that is you wake up every day, and you hear different sorts of bad news that doesn't really impact us too dramatically but it impacts behavior and sentiment, and I think how that translates through is tough. I think if there is anything that could be – maybe a modest opportunity is sell-through in Q4, right. We've gotten the inventory out.

We're planning for maybe a little bit of a chop in December just because if you're in for people, there could be some window dressing or deferrals but eventually that comes back because everything – everything we make in our Power Transmission business wears out, gets replaced like-for-like.

So I think we're in a reasonable spot, but the place that could surprise us, maybe to the upside. And I'm anxious even to say it, but we have to just watch sell-through in Q4 and we're a quarter away from that, so we'll keep you updated. Nothing would make us happier than to be able to take our guidance up.

But at this point, we've given you a view that we think is a realistically cautious and we're going to go out and execute that..

Fair enough and I appreciate that.

And then I guess a question for either you or Mark, given what is going on in the industrial economy and the uncertainty that's out there, I'm wondering if you guys are kind of rethinking your views on leverage and may shift some of this cash flow to actually paying down some debt or if – I know you guys are comfortable with leverage – but just wondering if your thinking has changed there?.

Look, Kevin, I don't think there is any doubt that the stock price has been hit really over the course of the quarter as we screen frankly just very high with respect to leverage.

The thing I'll comment on is, in a period of volatility, leverage is always going to be a negative; and if you think through the world in a trough mentality, leverage is going to be a problem. What we see is a good portion of our business – over 60% in water, aero and food and bev – growing nicely into next year.

We also see a set of industrial end markets that has a fair bit of aftermarket component to it that we've taken a brunt of the de-stocking. And we've got $30 million to $35 million of self-help not on the table, but in process. And so, when we think about leverage in the moment, leverage feels high.

If you talk about cash flow over the second half, we're going to generate over $100 million. That puts your leverage at 3.7 times, 3.8 times exiting next year with the end market backdrop and self-help that I talked about. So, the short answer is we can always pay down debt.

We know we screen high for that in the moment, but we're not looking at things in a trough mentality. We're thinking out one to two years and if we can use free cash flow, do smart M&A that ultimately puts core growth into our company and we can generate future earnings and cash flow with the acquisitions, we think that's a win for investors.

If something were to change in that equation, we can always pay down debt. But at this point, we think we're pretty well positioned from where we stood..

Okay. Fair enough. Thanks..

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

Hi, good morning. Over the course of the first half of the year, you had a more conservative outlook for sell-through versus what distributors were looking for.

I think that could have exacerbated some of the de-stock effect, but could you talk about into the back-half of the year now, do you find that your view is a little bit more aligned as distributors have come down and so that creates a little bit more stability around inventory changes moving forward?.

Hey, Joe. I think it's a great observation. If we – if you look back really over the course of the last three to four quarters – in each case our distributors that are either public or part of public companies have substantially reduced their growth outlooks and at each interval, we tried to get below them.

And I'll remind you that when we set our guidance, we set it below what our customers or channel partners were saying. And in each successive quarter, they've come down. The way we've positioned our outlook, it is again below what they've set.

So, that's why we sort of think that it's a prudent person's view to just continue to get below what they've said, but the positive is we think that the sell-through, as I said, is sort of stable, right.

And so, the comparables look difficult year-to-year, because when you look at sell-through, it's sort of peaked last year, September, October, November. And so you're coming off with a tough comp as it relates to year-over-year growth, but if you just look at what are we selling everyday and what gets sold through every day at our distributors.

That number is pretty stable, maybe down just a touch here or there, but pretty stable. And that's what gives us reasonable confidence in what we've provided for out..

Okay, and then just a follow-up, you had commented at the Investor Day about, kind of following some of the footprint and supply chain actions, identifying commercial opportunities.

And as you pull forward some of the footprint actions, does that – would it mean that you are pulling forward some of your kind of focus on the commercial opportunities and things that could actually materialize as we move into next year?.

Of course. I think when we highlighted it at Investor Day, the footprint and supply chain optimization plan, it was pretty comprehensive in nature. So it wasn't simply to reduce cost one-time. It was to create a more sustainable flexible model going forward.

And as part of that, there were some commercial activities that we felt lined up nicely with having a more variable model and a reduced price point and we are pulling those two forward concurrent with the actions we're talking about.

So we're on track with that and I think from our standpoint we're going to grind over the next quarter and the quarter after that and when you get to next year, you have a different trajectory in terms of opportunities for growth and cost structure is increasingly closer to $30 million better and so long way of saying, yes..

Great. Thanks very much..

Our next question is from David Rose from Wedbush Securities..

Good morning. Thank you for taking my call.

I was hoping maybe just briefly if you can touch upon the margins in Water Management, how much mix related and how much did you see in the benefits from VAG?.

So in the quarter, there was – the mix impact was marginal. It wasn't a big piece of it. But there was – to your viewpoint, there was some extent. But the majority of the margin improvement is coming from the work we've been doing at VAG over the past year, year and half and continuing to get the benefits of that.

And on the Zurn side, in non-res we grew up and we're getting very good leverage on that cost structure as we're growing. So, if I had to rank in our price statement, VAG biggest driver, leveraging growth in non-res number two, with a modest mix, that being number three..

I think, David, I think the thing we're trying to do really when you think through all of this is to create a more variable cost model, a more asset-light cost model. We're not as levered to the fixed cost and so the operating leverage that we're seeing in water today is good and will get better as we continue to do that.

And I think the thing that we probably haven't touched upon is that as we change some of the manufacturing strategy around a more asset-light or more supply chain oriented model, it reduces future CapEx and increases future cash flows.

So, I think the combination of everything we're doing, gives us better operating leverage today, when there is a downside and we don't know when that is going to be, it makes us even more variable. And long-term, it improves our free cash flow, because we're not investing in CapEx to the same degree we have to today.

So, a real positive and I think water is a demonstration of that going forward..

Okay. And then lastly on the water component, given what you saw in your ability to pull forward some of the cost takeout actions.

I'm assuming your sense of the cost takeout funnel is also growing on water, do you have an updated view on what your operating margin, I won't say potential but target is or maybe even you can call on a stretch goal, if you will?.

We've been saying for probably two years, that we had very good line of sight to high-teens. I think we're sort of at high-teens today.

I think as I've pointed out in my comments, it was clearly on track to maybe even higher teens to the 20% range, but with what've got in the hopper and maybe some of the things we've – we're sort of planning now, it's not unrealistic at all to see water in excess of 20% in the next couple of years.

And as I pointed out, it's a substantial part of the company at this company and couple of years ago, it was big but the margins were 13%, 14% at 18% on its way to 20% and growing that's where we sort of see it and that's what we've been working at.

So I wouldn't – I'm not going to give you our stretch goal, but it's safe to put it too in front of it..

Okay. Perfect. Thank you..

I have no further questions at this time..

Well then, I'll say 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 2016 third quarter results in early February. Everybody have a great day. Thanks..

Thank you, ladies and gentlemen. That concludes today's call. Thank you for participating. You may now disconnect..