Zurn Elkay Water Solutions Q2 2024 Earnings Call Transcript

Quartr
Provided by Quartr
July 31, 2024

There are 11 speakers on the call.

Operator

Good morning, and welcome to the Zurn LK Water Solutions Corporation's 2nd Quarter 2024 Earnings Results Conference Call with Todd Adams, Chairman and Chief Executive Officer David Polly, Chief Financial Officer and Brian Wendland, Director of FP and A for Zurn LK Water Solutions. A replay of the conference call will be available as a web cast on the company's Investor Relations website. At this time, for opening remarks and introduction, I'll turn the call over to Brian Wendland.

Speaker 1

Good morning, everyone, and thanks for joining the call today. Before we begin, I'd like to remind everyone 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 are helpful to investors and contain reconciliations to the corresponding GAAP information. Consistent with prior quarters, we will speak to certain non GAAP metrics

Speaker 2

as we feel they provide

Speaker 1

a better understanding of our operating results. These measures are not a substitute for GAAP. We encourage you to review the GAAP information in our earnings release and in our SEC filings. With that, I'll turn the call over to Todd Adams, Chairman and CEO of Zurn LK Water Solutions.

Speaker 3

Thanks, Brian, and good morning, everyone, and thank you for taking the time to call in this morning. So I'll start on Page 3. We turned in what we believe is a pretty solid quarter and are again raising our outlook for the year. We leveraged core growth of 3% into 20% adjusted EBITDA growth, which drove margins to 25.3%, equating to 370 basis points of margin expansion year over year. Free cash flow in the quarter was $80,000,000 and we deployed $60,001 to repurchase almost 2,000,000 shares in the quarter.

Speaker 3

For the first half of the year, in dollar terms, EBITDA is up $35,000,000 and free cash flow is up $50,000,000 over last year's first half, and we continue to expect a nice second half from a cash flow perspective. Qualitatively, our underlying markets continue to match our views coming into the year and we're making steady progress on our growth initiatives and breakthroughs. Hopefully, our results over the last 12 months have answered the question on whether or not we'd achieve the $50,000,000 plus in synergies from the LK transaction given where our consolidated EBITDA margins now sit. Our story at this point is really quite simple. We have what we believe is the premier water solutions business in North America with best in class financial performance and a business system and culture that underpins our confidence in being able to perform at a very high level regardless of the macro environment.

Speaker 3

We have a balance sheet and cash flow profile that puts us in a position to reliably and increasingly return capital to shareholders while executing on proprietary M and A opportunities moving forward. I now have the privilege of turning the call over to our newly minted CFO, Mr. Dave Polly. At the same time, I'd like to say good morning to our former CFO and now Chief Administrative Officer, Mark Peterson, who's listening in as he's driving to work and certainly not missing having to get here early for this call. Dave?

Speaker 2

Thanks, Todd. Please turn to Slide number 4. Our 2nd quarter sales totaled $412,000,000 and increased 300 basis points year over year on a pro form a core basis. Midsingledigitcore sales growth in our nonresidential end markets and initiatives was partially offset by flattish year over year sales to our residential end markets and pockets of the commercial segment within non residential. With respect to demand in the quarter, year over year order growth was in line with our sales growth as our book to bill ratio was just above 1 in the quarter.

Speaker 2

End market trends continue to align with our expectations and our growth initiatives drove the sales performance to the higher end of the outlook we provided 90 days ago. Turning to profitability. Our Q2 adjusted EBITDA increased 20% from the prior year Q2 to $104,000,000 and our adjusted EBITDA margin expanded 370 basis points year over year to 25.3% in the quarter. At 25.3 percent, our 2nd quarter adjusted EBITDA margin is the highest consolidated margin since the LK merger 2 years ago. The strong margin and year over year expansion was driven by the benefits of our productivity initiatives inclusive of cost synergies plus the lower material and transportation costs compared to 1 year ago.

Speaker 2

For calendar year 2024, we believe our year over year margin expansion will be a bit better than what we discussed 90 days ago, and we are again raising our expectation for full year EBITDA margin. We will cover that in more detail later in the call. Please turn to Slide 5, and I'll touch on some of the balance sheet and leverage highlights. With respect to our net debt leverage, we ended the quarter with $333,000,000 of net debt and leverage continued below 1 at 0.9 times. Our 0.9 times leverage is inclusive of the $61,000,000 we deployed to repurchase shares in the quarter.

Speaker 2

On a year to date basis, we have now deployed $80,000,000 to share repurchases and 28,000,000 to dividends. We continue to have excellent capital allocation optionality. And as we have discussed, we will remain focused on a balanced capital allocation strategy going forward. I'll turn the call back to Todd.

Speaker 3

Thanks, Dave. I'm on Page 6. Here you can see our year to date sustainability impact and progress towards our targets. We continue to see sustainability as both a core part of and natural byproduct of our business. The vast majority of our sales in the quarter came from products that deliver sustainable attributes to our customers, products that reduce water consumption, protect the potable water supply in buildings, reduce energy or GHG consumption or are made of high levels of recycled content.

Speaker 3

Whether it's reducing water usage, filtering out contaminants from water or eliminating single use plastic bottles, we continue to innovate to address water related challenges to public health and conservation. We'd run our business the same way even if there wasn't anyone looking because the essence of what we do is to help our customers with their water challenges. But since people do keep score, I think it's important to note that across the main agencies that rate us on our own sustainability efforts, we are either in the top 3%, top 8% or top 10% rated across the broad university of companies rated by these agencies. We approach sustainability with the power of the and, delivering great results and helping our customers meet their challenges and doing the right thing for the environment, our associates and shareholders. I'll leave everyone with just a few thoughts on Page 7.

Speaker 3

Halfway through 2024, we've raised our outlook for the year twice. If you look at a longer timeframe, we're growing at about only half of our 10 year CAGR. This is because of the highly publicized demise of the commercial end market in non residential construction. I'd say that a little sarcastically, but there have of course been and in the near term will continue to be some headwinds from the commercial end market and also a bit of a flattish residential market. Despite this, we are still growing and generating exceptional margins and free cash flow through a combination of our unique competitive advantages.

Speaker 3

To name a few, our end market exposures, specifications, portfolio breadth, new versus retrofit balance and differentiated secular growth opportunities like drinking water. And perhaps most importantly, the deployment of the Zurn LK Business System. Dave gave me the updated statistic yesterday about our core growth track record. Over the past 54 quarters, that's 13.5 years if you're playing along at home. We've had exactly 4 quarters we did not grow organically, which I think is a pretty decent sample size to evaluate our track record.

Speaker 3

Also of note, the largest decline in any one of those 4 quarters was down 5% in the pandemic quarter of June 2020. During this current period, I'll say of undergrowth we're in. To me, the silver lining is that our new baseline of margins and cash flow is materially higher than at any point over the past 10 plus years. We're returning more money to shareholders than ever and we continue to have ample capacity to do the right M and A while keeping the balance sheet in great shape, which brings me to the last point I'll make before turning it over to Dave. The thing that people either underestimate or don't understand about Zurn is the culture or really how foundational our business system is to our success.

Speaker 3

The pillars of people, plan, process, performance and purpose aren't just things we throw on a chart to talk about with people. It's deeply rooted in how we run our business and grounded in the spirit of relentless continuous improvement. Over the last few weeks, we've gotten some questions regarding Dave's promotion and Mark's new role, all within of what's the story behind the story. The answer lies in how we actually deploy and do the real work around the first pillar of the Zurn LK Business System, which is people. By truly recruiting, developing and retaining the best talent, it requires an intention, discipline and selfless perspective to do what's right for the business and the individuals to create long term sustainability.

Speaker 3

And when I say sustainability, I mean it in the context of the ability of continuing to perform at a high level without any decline in quality. And that's exactly the situation we have with Dave and Mark. We promoted an extraordinarily talented guided CFO who was ready, 42 years old, been here for 12 years, knows the business inside and out and has tremendous runway. And we get to leverage Mark's talent, experience and understanding of the business system into a bunch of new areas after having been here for 18 years, including 13 as CFO. We're in an enviable position to have affected this kind of organizational maneuver, but it wasn't on accident.

Speaker 3

It's just how we approach things. So Mark, I'll see you in about 15 minutes. Dave, congratulations and well earned. Go ahead and hit the outlook on Page 8.

Speaker 2

Thanks, Todd. Please turn to Slide 8 and I'll cover our outlook for the Q3 and update to our high level guidepost for calendar year 2024. For the Q3, we are projecting year over year pro form a core sales growth to be in the low single digits and we anticipate our adjusted EBITDA margin to be approximately 25% for the quarter, which represents an approximate 90 basis point margin expansion over the prior year. Taken as a whole, Q3 will look a lot like our 2nd quarter we just finished. For the full year, we are seeing no changes to the sales assumptions we outlined at the beginning of the year and still believe we will generate positive pro form a core sales growth year over year.

Speaker 2

With respect to our adjusted EBITDA margin, we are again raising our outlook and now expect adjusted EBITDA margin expansion to be between 200 and approximately 2 50 basis points year over year. Our free cash flow expectation has also improved as we are now expecting cash flow to exceed 250,000,000 dollars Before we open the call for questions, just a reminder that we have included on Page 8 our 3rd quarter assumptions for interest expense, non cash stock compensation expense, depreciation and amortization, adjusted tax rate and diluted shares outstanding. In addition, we have included the 3rd we have included the prior year Q3 sales adjusted for the executed eightytwenty product line exits to calculate pro form a core sales growth in 2024. The 3rd quarter is the last quarter that we will have an impact from the previously announced product line exits. We will now open the call up for questions.

Operator

Your first question comes from the line of Brian Blair with Oppenheimer. Please go ahead.

Speaker 3

Thank you.

Speaker 4

Good morning, guys.

Speaker 3

Good morning, Brian.

Speaker 4

Dave, congrats on the promotion.

Speaker 2

Thanks, Brian.

Speaker 4

Of course, and Mark drives safely.

Operator

Good morning.

Speaker 4

Hey, you guys mentioned end markets are generally tracking as expected. I was hoping you could offer some finer points on that front, perhaps drill down on what your team is seeing across institutional versus commercial non res verticals, the resi market and whether you anticipate any sequential change in underlying demands through the back half?

Speaker 3

Well, I think the perspective that I would give you Brian is we had a view that commercial was weak and I'll remind everyone that it has been weak really since 2020. So we've been absorbing the news, if you will, of this headwind quarter by quarter, year by year for a while. And so I think our ability to understand how that's going to roll through our results. I think we've baked that into our perspective that we don't expect, I think, any sort of significant change, if you will. To our view, it may be worse sequentially.

Speaker 3

But I think from an institutional standpoint, we continue to see strength. I also think it's important to understand that inside of the commercial vertical itself, about 40% to 45% of that is actually retrofit, replace, break fix. So while the headline on commercial construction is bad and I think there's a lot of reaction to that day by day, week by week. When you look at the pockets that we're in, we are not big in warehouses. So that news that's rolling through the top line number has really little impact on us because the content that we provide to a warehousing building is relatively low.

Speaker 3

So you got to look beneath the headline number and into the pockets and we do that and we do that by region. I think we've done a pretty good job of trying to assess how that may impact our growth. And so when you take a giant step back and hopefully that 10 year chart gives you perspective, There is probably a 2 point headwind to our overall growth because of what we're seeing and absorbing through that commercial headwind. But I don't think we're seeing anything that gives us pause that the perspective going forward is different than what we've already baked into to our thinking.

Speaker 4

Understood. Appreciate the detail. Margin performance has been quite strong in the last 4 quarters. You mentioned the synergy realization is the plus of the $50,000,000 plus. So wondering if you're willing to quantify that?

Speaker 4

And then looking forward, how should we think about normalized core incrementals? We've always thought low 30s is kind of the right range, given the structurally improved profitability of Zurn LKs. Is that still the right normalized incremental to think about? And then finally, we know there's a lot of supply action underway. Perhaps you can speak to the drop through that we may see going forward.

Speaker 3

Yes, I think you've got it all. Obviously, the $50,000,000 plus, I think it's something we committed to 2 years ago. The 1st year we spent sort of attacking some of the more addressable things and doing the work to get to that next 25, which we clearly, I think the work is done and now it's just simply going to read through the results. And so whether it's 50 or 55 or 60, I'm not sure that it matters all that much other than to know that the business is entirely integrated and we've sort of stopped keeping score on the discrete synergies because they just keep coming through as a consolidated number. In terms of what to think about as an incremental margin going forward, I would say that we've always said 30% to 35%.

Speaker 3

I think that given some of the structural things that we've done and maybe some of the mix positive attributes of drinking water that number is probably closer to 35 than 30. And obviously there's a handful of supply chain actions that we've been working that are essentially complete and we'll begin to accrue some of those benefits into next year. So I would say from an execution standpoint in and around the LK synergies, the structural changes we've made as a result of combining the 2 businesses and some of the perspective things we've done, we feel like we're very much on track to accelerate margins going forward from here and the incremental earnings growth will be that 35% plus or minus.

Speaker 4

Understood. Thanks again.

Speaker 1

Yes.

Operator

Your next question comes from the line of Andrew Buscaglia with BNP Paribas. Please go ahead.

Speaker 5

Hey, good morning guys.

Speaker 2

Good morning. Good morning.

Speaker 3

So, yes, it's along the

Speaker 5

lines of those margin comments. Just wondering, you guide to 25% or so in Q3 EBITDA margins, which would imply a little bit of a tick down. I'm just wondering what can you walk through the puts and takes there? Maybe it's seasonal, but your historical sometimes move differently. But I'm just trying to understand why this tick down or what's behind that comment?

Speaker 3

Nothing. I mean, I think when you look through it, approximately 25 is 25.3. I mean, so I don't think we're trying to be too cute. I can't give you a reason why it goes to 25 other than we're trying to guide with some with less precision, if that makes sense. And so there's nothing discrete that I can give you to get to a lower number.

Speaker 3

Yes.

Speaker 2

I would just say, Andrew, I think H1 and H2 margins can look a lot alike based on the guidance framework we gave. I think Q4 typically is a step down in margin from what you see in Q3, just given the seasonality and the lower sales volume in Q4. But overall, I'd say H1 and H2 can look a lot alike.

Speaker 5

Okay. And you talked a little bit by end market, some of the trends you're seeing. Can you talk a little bit more how you guys would define things on the business division level with water safety, flow systems, hygienic and drinking water. Can you talk about some of the trends you're seeing versus last quarter improving or worsening?

Speaker 3

Yes, I would say that there's no substantial change. I mean, when you look at our business and the revenues, I mean, we participate across the whole build cycle. So I would say each of the business segments or sectors or whatever you want to call it is performing sort of as you'd expect given where they participate in a particular cycle and in a particular vertical. So I would say there's no change across the board. There is a there's some seasonality to drinking water based on the school year, and when that work can actually be done.

Speaker 3

But aside from that, no significant change to how the business groups are performing inside of the verticals, from last quarter.

Operator

Okay. All

Speaker 5

right. Thank you, guys.

Operator

Your next question comes from the line of Andrew Crewe with Deutsche Bank. Please go ahead.

Speaker 6

Hey, thanks. Good morning, everyone, and congrats again to Dave. I want to circle back on the orders commentary that they were kind of off in line with the company growth this quarter. So I think that means low single digits. Just like can you give any color on was that steady throughout the quarter?

Speaker 6

Maybe was there any change as the months progressed? And if you're willing, like anything on July would be helpful. Thank you.

Speaker 3

Yes. I don't think there's anything to talk about. I think the order rates that we saw throughout the quarter were consistent. They remained consistent through July to sort of deliver the kind of guidance and outlook that we've provided. So I don't think there's anything to me that was at all surprising or different.

Speaker 3

It was very steady, has been very steady really throughout what's now the 1st 7 months of the year.

Speaker 6

Okay, great. That's helpful. And then on the supply chain, I think things looking ahead, I know in the past have been quantified as potentially around $10,000,000 of a net benefit in kind of 2025. Is that still a good framework to think about those benefits or has that changed at all?

Speaker 3

Yes. I think that the framework is correct. I think that the only qualitative thing is the run rate is probably closer to 10%. I think there's a lot of moves that are done. There's some that are underway.

Speaker 3

And obviously, we've prioritized the larger impact things towards the front end. There may be some things that take a little bit longer to work their way through. But I think from a yield perspective in 2025, I think somewhere between 5% and 10% is the right way to think about it.

Speaker 6

Okay, great. Thank you.

Operator

Your next question comes from the line of Nathan Jones with Stifel. Please go ahead.

Speaker 7

Good morning, everyone. Good morning. You guys are making it tough to come up with questions with strong margins and no change in any of your outlook. So I guess I'll ask a couple of questions around capital allocation. You have been fairly consistent repurchaser over the last couple of years since the Okay deal was done.

Speaker 7

You have stepped it up in the first half of twenty twenty four. Can we anticipate a continuation at this kind of run rate? Do you anticipate being a net repurchase of shares more than offsetting dilution?

Speaker 3

I think the way we've approached it Nathan is we look at the intrinsic value of what we think the company is worth. And when we feel like it's undervalued relative to that, we do a little bit more. When we think it's getting closer, we do a little bit less. I think on balance, we are going to be a repurchaser of shares, I think somewhat consistently moving forward. What that means in the Q3 and second half, we'll have to find out.

Speaker 3

But I think that if you look at last year, we did 125, Dave. We're sitting at 80. I think it's entirely realistic to think that we get close to that this year. We'll have to take a look, but that's how we think about it, Nathan.

Speaker 7

I guess, follow-up question I'll ask on growth initiatives. Can you talk about the major growth initiatives that you've got going on out there? I know there's some in the drinking water business, but maybe just any commentary around growth investments, growth initiatives that you're focused on in other parts of the business?

Speaker 3

We tried to cover a few of those last quarter. So we have some substantial growth runway in our commercial brass business. So think about sensor products that would go and compete against somebody like a Sloan. We've got a number of growth initiatives there, combination of new products and penetration with some critical key customers and verticals. That's moving along quite well.

Speaker 3

We have an initiative on our flow systems side where we've developed a bunch of new products over the course of the last 2 or 3 years, driven the specification and we're now seeing those commercialized. So that's got nice momentum this year and doing quite well. And then obviously the drinking water thing and I'll let Dave talk a little bit about the drinking water thing, but that is going to be for us the most important thing that you hear from us over the next couple of years. And obviously, the amount of time and effort we're putting into both the new product development that will occur later in this year and the 1st part of next year and the commercialization through K-twelve schools and healthcare will be a big deal. And a lot of it is legislation driven.

Speaker 3

Dave's been, I would say, in lockstep with that part of the business. So I'll let him talk about it.

Speaker 2

Yes. So maybe a couple of comments on drinking water, Nathan. In the quarter, we continued to see double digit growth within the installed base of filtered units here in the U. S. So for us and our team, the focus is really on increasing the number of filter units and then increasing the attachment rate of filters to those units.

Speaker 2

From a legislative perspective, we've talked about Michigan having passed the filter first legislation requiring all K-twelve schools and daycare facilities to have filtered water available. That was passed into law last October. Michigan is still in the process of rolling out just how schools get funding, the bills funded by the state of Michigan. And then there's also 3 other states that currently have legislation that proposed either late in 2023 or early in 20 24 that looks a lot like the Michigan Filter First legislation and those three states being Wisconsin, Minnesota and Pennsylvania.

Speaker 7

Thanks very much for taking the questions.

Speaker 6

Yes.

Operator

Question comes from the line of Mike Halloran with Baird. Please go ahead.

Speaker 8

Hey, good morning guys. So first question just on you commented on the stability on aftermarket side, the MRO side of the portfolio. Are you seeing much of a trend difference between the MRO side right now and the original equipment side in the portfolio?

Speaker 3

When you say original equipment, I'm guessing you mean

Speaker 8

new build. New build, sorry, new build construction.

Speaker 3

I think it depends by vertical. I think when we look through the retrofit, replace or break fix part of our business, that's pretty steady all the time. I think when you go to the new build side of life, obviously, institutional is stronger than commercial and residential. So I think it's sort of you have to unpack it by that, Mike. And I don't think there's any change to that.

Speaker 3

I would say that in aggregate, at present, retrofitreplace is growing less than newbuild institutional, but more than commercial newbuild, and probably a touch better than residential. So that's 45% of the business is retrofitreplace growing steadily in the low single digit range.

Speaker 8

Makes sense. And then kind of a growth algorithm question. If you think longer term now that you've more or less gotten through all the product rationalizations, you've had Alcana portfolio for a while now. How do you think about what your market outgrowth looks like? Is this a few points per year given all the initiatives you have relative to what the end markets are going?

Speaker 8

And maybe just unpack that a little bit?

Speaker 3

Well, if you look back over those 10 years and probably even a longer time frame, the growth algorithm has been a couple of points of market, a couple of points of price and a couple of points of outgrowth taken as a whole. And I think when you roll that through the various cycles between institutional, commercial, residential, they'll each have their own what's the right way to say it, institutional will be a stronger at times, commercial will be a little bit stronger at times, residential will be a little bit stronger times and parts of the cycle 1 will be stronger or weaker. And so the blended way to think about this is it's a country of 330 1,000,000 people that are moving and value education and healthcare. So that's sort of the steadying force and there's a massive installed base of things that need to be replaced on a somewhat regular basis or break and need to be repaired. And so when you roll that through, that's two points of market, two points of price, couple of points of outgrowth.

Speaker 3

I don't think anything has changed. If anything, longer term, the drinking water part of our portfolio should grow faster than the market and it will grow faster. As Dave pointed out, that's been something that's been true for a long time. And with the amount of effort and innovation we've been putting into it, I think I'm confident to say that I think it changes and probably gets a little bit better. So the current 3%, we're under growing by 3%.

Speaker 3

A lot of that is we're not as we haven't been as aggressive on price in the moment. And we're absorbing some of the commercial headwinds, but still growing at 3%. And so I think we see the opportunity to migrate back to that mid single digit growth with everything I see and the addition of drinking water.

Speaker 8

Great. Appreciate the time. Thanks.

Speaker 1

Yes.

Operator

Your next question comes from the line of Jeff Hammond with KeyBanc Capital Markets. Please go ahead.

Speaker 9

Hey, good morning guys. Just a couple cleanups here. In the Q, I think you break down commercial, institutional, all other and all other I think was down 8. I think you said resi was flat. So I just wanted to understand what the pressure was within that all other.

Speaker 9

And then just on the CAO CAO move, congrats to Dave and Mark on the new roles. Maybe just speak to some of the things Mark is going to really be focused on in that new role?

Speaker 2

Yes. Maybe I'll take the first part of your question, Jeff, just on the all others. So what you're seeing in the 10 Q is the GAAP reported number. So you got to remember there's this key rationalization that's impacting that number. And that's what's causing that to be down.

Speaker 3

Yes. So with respect to Mark, obviously, Mark and I have worked together for more than 20 years. He's been here 2018, CFO for 13. And as he reminded me yesterday, did 50 earnings calls. So, the nice thing about Mark is he understands our business inside and out, and he is a tremendous resource to both Dave and I and the broader company as we think about growing the business going forward.

Speaker 3

So one of his biggest focus areas is going to be on the continued org and talent development process that we have and it's working effectively. But I think we think about it as how much more can we do because obviously as we acquire and grow, we're going to need more talent. And so the ability to do that organically will be really important for us. And particularly when you get into a situation like an LK, where the reality is it requires significant amount of resource and talent from the Zurn side to get to the synergies, the pivot to make some tough choices and we want to be in a position to do that and Mark is going to be at the forefront of that. And so when you think about an integration of a larger more significant business down the road, he's someone who could step in day 1, be ready to communicate how we do things, bring people along in terms of implementing the business system and things like that.

Speaker 3

So that's where his focus is going to be. And the 3 of us sit approximately 8 feet apart. So it's nice to have Mark in the fold doing some really important things for us for the future.

Operator

Okay, thanks. Your next question comes from the line of Brett Linzey with Mizuho. Please go ahead.

Speaker 10

Hey, good morning and congrats to Dave and Mark. I wanted to follow-up on the margin outperformance, so above the high end of the guidance range. I was hoping you could dimension the positive variances versus the internal forecast for the Q2. And then thinking about the forward guide, so you're betting some continued margin expansion in Q3, looks like it flattens out in Q4. Is that simply just reflective of the tougher sales comparison?

Speaker 10

Is there conservatism? Any color would be great.

Speaker 3

Well, Brett, I think we tried to communicate that, look, what's driving the margin performance, I think, are a lot of the structural things that we've talked about that are rolling through. And I also think that the continuous improvement that we are doing. So when we measure the number of continuous improvement activities we're doing, right? And we don't measure it to measure it. We measure it to deliver better earnings, better cash flow, improved lead times and things like that.

Speaker 3

And so sitting here today through the first half, the number of continuous improvement activities are up 42% year over year. So there's not one big thing, but that compounding benefit of our 2,400 people getting up every day and doing just something just a little bit better is what is driving the outperformance. I think it's not like we got surprised and bought materials that are a whole lot cheaper than we thought going into the quarter. You can't turn it off. It's just sort of that constant engine that's creating more and more productivity and cost savings.

Speaker 3

And so that's to me the biggest reconciling item that we think about because up 42% in a lot of small things adds up. And so I don't think it's going to slow down in the Q3. I don't think it's going to slow down in the Q4. I don't think it slows down in 25. But I don't think that there's anything that we're going to give you to answer the question other than it's just relentless continuous improvement across the board.

Speaker 10

That's great. No, I appreciate the color. And then just one follow-up on tariffs. It's certainly more topical given the political landscape. Could you just level set us on your sourcing exposure to China and Mexico specifically?

Speaker 10

And is there more work to do? And how can you modulate if the tariffs do step up here post November?

Speaker 3

Yes. I think one of the big things to recall is back in 2016 when the tariff situation all began, we took the position of the long term position of trying to find a supply chain for us that vastly deemphasized China. And we've been working at that continuously for, I would call it, 8 years. And so we feel like our supply chain with the work we've done over that timeframe and it's been a terrific job by our team puts us in a spot to I don't want to say skate around, but clearly become more advantaged than we are today with respect to tariffs and that's in China and Mexico. So I think we feel like we're well positioned to absorb what may or could happen.

Speaker 3

If it's different than that, we'll have to manage through it. But I think we're in a terrific spot to begin to reap some of the benefits of the supply chains we've altered over the last really 8 years.

Speaker 10

All right, got it. Congrats on the quarter again.

Speaker 4

Yes, thanks.

Operator

I will now turn the call back over to Brian Wendland for closing remarks. Please go ahead.

Speaker 2

Thanks, everyone, for joining

Speaker 1

us on the call today. We appreciate your interest in Zurn LK Water Solutions, and we look forward to providing our next update when we announce our Q3 results late October. Have a good day.

Operator

Ladies and gentlemen, that concludes today's call. Thank you all for joining and you may now disconnect.

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