Evoqua Water Technologies Corp (AQUA) 2018 Q3 法說會逐字稿

Good morning, and welcome to the Evoqua Water Technologies Third Quarter 2018 Earnings Conference Call. (Operator Instructions) As a reminder, this conference call is being recorded, and your participation implies consent to our recording of this call. If you do not agree with these terms, please disconnect at this time. Thank you.

I would now like to turn the call over to Dan Brailer, Vice President of Investor Relations. Please go ahead.

Thank you, Lori. Good morning, ladies and gentlemen. Thank you for joining us for Evoqua Water Technologies' conference call to review our third quarter 2018 financial results. Joining me on today's call are Ron Keating, President and Chief Executive Officer; and Ben Stas, Executive Vice President and Chief Financial Officer. After our prepared remarks, we will open the call to questions. (Operator Instructions)

This conference call includes forward-looking statements, including our outlook for fiscal 2018. Actual results may differ materially from expectations. For additional information on Evoqua, please refer to the company's SEC filings, including the risk factors described therein.

On this conference call, we'll also have a discussion of certain non-GAAP financial measures. Information required by Regulation G of the Exchange Act with respect to such non-GAAP financial measures is included in the presentation slides for this call, which can be obtained via Evoqua's website.

All non-GAAP financial results have been reconciled and included in the appendix section of the presentation slides. Unless otherwise specified, references on this call to full year measures or to a year refer to our fiscal year, which ends on September 30 each year.

Means to access this conference call via webcast were disclosed in the press release, which was posted on our corporate website. Replays of this conference call will be archived and available for the next 7 days. With that, I would now like to turn the call over to Ron.

Thank you, Dan. Good morning. We appreciate your interest in Evoqua and you joining us for today's call to review our third quarter results. Over the course of the first year being a public company, we've used these webcasts to provide background information on Evoqua. Following my brief background comments, we will go directly into the quarter's results.

Please turn to Slide 3. Evoqua's the leading provider of comprehensive water treatment solutions in North America with a great history of servicing customers' needs and a strong team of people. Our purpose is focused and clear: transforming water and enriching life.

We provide systems, services and technologies to 38,000 customers with over 200,000 customer installations that generate trailing 12-month revenues of $1.3 billion and $227 million in adjusted EBITDA, a 17.1% margin. Our business spans a diverse range of industries and includes the 20 largest U.S. companies in each of the pharmaceutical, food and beverage, hydrocarbon processing, chemical processing and power industry.

Please turn to Slide 4. I would like to start off by providing some key insight to the themes we are seeing and how we are strategically thinking about the business. As a new public company, we communicated our growth strategy and I'm pleased to say that we are delivering.

First, we're experiencing robust growth in the core business, specifically in our Industrial and Products segments. The Municipal business could have performed better in the Q -- in the third quarter, but the pipeline is strong, which bodes well for coming quarters. Overall demand trends are favorable. Our order book is strong and growing, and we are well positioned for a strong fourth quarter.

We've seen the industrial wastewater market emerging, and we have taken actions to leverage our capabilities and products internally as well as through our acquisition strategy, enhancing our market-leading position. Processed water opportunities continue to grow, but our industrial wastewater pipeline is growing faster.

We're capturing industrial wastewater capital projects and are prepared to support the profitable service and aftermarket business that typically follows. Approximately 65% of our industrial business is serviced, and we expect this to grow through multiple initiatives, including Water One Assurance and acquisitions like ProAct Services, which we just completed.

Our Municipal business is unique given our very large installed base. Our strategy is to harvest this space with smaller, more profitable aftermarket products, brownfield retrofits and service opportunities while being highly selective on new capital projects. This strategic focus will leverage our portfolio of aftermarket and engineered system solutions through the municipal market while also serving our internal industrial and products segment channel.

Over the prior 2 years, we've booked several large and profitable municipal capital and retrofit projects. During 2018, fewer of these large opportunities have met our return hurdles. And instead, we have focused on smaller, more profitable opportunities in the pipeline that have led to a record order book with attractive aftermarket projects. We believe our municipal segment is well positioned for the fourth quarter as a result.

We continue to invest in our Products segment, both organically and through M&A, to broaden and enhance our portfolio of solutions. Our 2016 Neptune-Benson platform acquisition positioned us solidly in the aquatics market. This acquisition was followed by 5 additional tuck-in acquisitions that filled product portfolio gaps within our Products segment and broadened our capabilities to penetrate other industrial markets.

Overall, we're largely agnostic between R&D and M&A as we refine and enhance our technology capabilities. Our order book is quite strong, and we expect another strong performance from Products in the fourth quarter.

We've taken a disciplined and return-focused approach to our capital allocation strategy. We will continue to prioritize our cash to invest in high-return growth opportunities, followed by M&A, and then debt reduction. Ben will provide a couple of high-return projects examples during his remarks in future slides.

Please turn to Slide 5. Overall, third quarter revenues were up double digits, which follows a double-digit growth in the second quarter. Revenue growth was balanced between pro forma organic growth and acquisitions.

Overall adjusted EBITDA was up more than 5% versus last year's third quarter. This fell within the 5% to 10% year-over-year guidance we provided during our second quarter call. Our third quarter EBITDA reflected the Municipal and Products segments shipment deferrals as anticipated and higher commodity costs that were discussed last quarter in our call. We're seeing evidence of our price increases taking hold and are confident in the price mix outlook going forward.

We go into the fourth quarter with a very strong order book across all segments and a book-to-bill ratio north of 1. Evoqua's well positioned coming out of the third quarter, and our team is focused on achieving our fourth quarter and full year expectations.

The organization is responding well to market pricing and inflationary pressures as well as to the uncertainties surrounding trade tariffs. We have aggressively implemented pricing actions across the business and began to see results in the month of June. While we're not immune to the direct impact of tariffs, our strong North American base of business puts us in a relatively strong position.

Please turn to Slide 6. Our Industrial segment had solid double-digit year-over-year revenue growth, and we continue to see strong capital growth. Our unique ability to provide full water life cycle solutions allows us to move with the shifting market demand and thus take advantage of the higher level of investment our industrial customers are making in wastewater projects. We see this as more evidence that our Industrial customers are working to manage their complete water footprint more efficiently and are turning to Evoqua for minimum liquid discharge and full life cycle solutions.

The Industrial segment EBITDA was primarily impacted by 2 now fully resolved matters. During the quarter, a large and profitable wastewater reclamation project was completed, and the cost to redeploy that fleet of mobile assets had a negative impact on our revenue and margins. These assets have now been fully redeployed and will return to producing clean water and positive revenue with new customers in the fourth quarter.

Also during the quarter, we implemented a new [brand of] service software system that provides enhanced functionality aligned with the upcoming national rollout of our Water One Assurance program. During the software implementation, service productivity was impacted from the required training and learning curve that comes from this level of process optimization and redesign.

For Q3, our Municipal segment was down versus the prior year due to the timing of a large capital project in 2017 and a delay in large aftermarket shipments inside of the third quarter. In this quarter last year, we were servicing a contract with a large domestic municipality to engineer and retrofit 3 wastewater plants which it did not repeat in 2018. The bulk of the shipments and accompanying profitability provided a challenging comparison. These brownfield retrofits are typically large and profitable and fits squarely within our strategy.

We're not pleased with this segment's performance, but we have visibility to factors and we anticipate better quarters ahead as we deliver against the growing backlog that has been focused on aftermarket parts and service across our large installed base. We are pleased to note that shipments deferred in Q3 were delivered in July already. Overall, we believe our strategy to harvest our installed base optimizes and derisks our profitable growth plans.

The Products segment had a very solid third quarter with broad-based double-digit revenue growth across most of its divisions. Profitability was excellent, with a 28% EBITDA margin inside of the third quarter. We have an exceptionally strong order book moving into the fourth quarter and continue to see momentum gaining across most divisions in the Products segment with a book-to-bill ratio north of 1. We expect to deliver several larger aquatics projects in Q4, including projects that were on hold and deferred from Q3.

Please turn to Slide 7. We have significant visibility into our business over a 12-month time frame with a stable and recurring flow of profitable growth. As you can see on this chart, approximately half of our revenue is derived from services provided, which are stable and recurring with a 99% renewal rate on our annual service contracts. We report sales by profits, which includes capital and aftermarket shipments and by service.

Since 2016, we have generated a compound annual growth rate of almost 10% for total sales, with product sales growing more than 15% and service sales growth over 3%. Product sales have exhibited strong growth as we have positioned the company to capture industrial wastewater share, have increased our emphasis in our Products segment's sales strategies and included our expanded portfolio from our acquisitions.

We expect our service business growth to also increase following strong capital sales and the increasing use of our technologies, including Water One Assurance. As also shown, adjusted EBITDA grew nearly 30% during this period, reflecting the strong incremental margins in the business.

Please turn to Slide 8. The capital portion of our business, by its nature, can experience unexpected deferrals from time to time, which may impact quarterly revenues and margins. While this variability may impact revenues and margins at a particular quarter, we're confident in our expectation that the business will generate long-term incremental growth when viewed over a trailing 12-month basis, as shown in the previous slide.

The first quarter is typically our weakest quarter, with each quarter becoming sequentially stronger, resulting in the fourth quarter producing our seasonal peak margins. We have highlighted the implied fourth quarter revenues and adjusted EBITDA ranges needed to achieve our affirmed full year outlook.

We are expecting revenues of $367 million to $397 million for the fourth quarter and $79 million to $89 million of adjusted EBITDA. Our strong order book and our traditional seasonality provide the basis for our implied revenue expectations. For adjusted EBITDA, seasonality, mix, increased price realization and cost management will become important drivers.

Please turn to Slide 9. Over the past 2 quarters, we provided a deep dive look into the Industrial and Products segment. This quarter, we will review our Municipal segment. This segment draws on more than 100 years of application history and technological leadership with leading iconic brands that have been installed into the market. We recently have focused this group primarily on the wastewater portion of the market, which has the highest growth potential.

As wastewater systems and workforces age, we are well positioned to harvest our large installed base providing aftermarket parts, retrofit products and services. We're selective on new capital projects, pursuing opportunities that meet our growth and profitability criteria, primarily in the areas of environmental compliance and capacity expansion.

Our service capabilities are focused on odor and corrosion control, which have seasonality attributes driven by hot weather and minimal rainfall. As a result of refocusing the business over the past 3 years, we have seen EBITDA margins improve over 500 basis points. Our win rate is continuing to improve, and we're quickly becoming the partner of choice for municipalities that are updating and upgrading their systems against new capacity requirements and nutrient regulations.

Please turn to Slide 10. Our future revenue growth will come from both organic sales initiatives and through a systematic M&A process. We utilize M&A to fill gaps in our product portfolio to penetrate desirable vertical market segments or to expand our geographic reach. We believe tuck-in acquisitions are low risk and capital efficient by nature, and we are successfully integrating these businesses into our organization.

We closed the ProAct Services acquisition on July 26 and are very pleased to welcome the ProAct employees into the Evoqua family. ProAct's March 2018 trailing 12-month sales of approximately $54 million and EBITDA of approximately $12 million will be a strong addition to Evoqua and to our Industrial segment. ProAct's fleet of 900 mobile assets will provide temporary and mobile water treatment service solutions as we continue to expand our water service offerings within the industrial market.

Please turn to Slide 11. Since 2016, we have completed 11 acquisitions. We have used these transactions to fill portfolio, vertical market or geographic gaps in our Industrial and Products segments. These transactions have accelerated our penetration into new and existing markets while expanding our suite of customer offerings and enhancing our capital growth rate reflected in our results. We will see the same follow-on service and aftermarket growth from these acquisitions that we also experienced in the traditional Evoqua business.

Overall, we are agnostic between M&A and R&D for new product development, and we believe that there's a very large pipeline of outstanding opportunities at attractive multiples. We expect to expand our service reach, enhance our technological capabilities and accelerate our sales and profitability growth rates through our disciplined M&A process.

Going forward, acquisition candidates continue to be mined through multiple channels, and we believe that we have become the acquirer of choice. Our pipeline of qualified acquisition candidates continues to grow, and we expect to announce more transactions in the coming quarters.

I would now like to turn the call over to Ben to walk through our financial results and to review our 2018 outlook.

Thank you, Ron. Please turn to Slide 12. For the third quarter, reported revenues increased approximately 10% to $343 million. Pro forma revenues normalized for acquisitions were up almost 5%, driven by growth in the Industrial and Products segments. Revenues from capital projects again outpaced service revenues during the quarter, mostly in the Industrial segment.

Our process and utility water business continues to grow, and we are seeing accelerated growth in industrial wastewater applications well above market rates. These wastewater capital sales are initially larger and lower margin than processed and utility water. We expect our increased capital business to provide attractive and profitable service and aftermarket sales.

As Ron discussed, our service revenues were flat year-over-year, primarily due to downtime from redeployment of mobile treatment assets to new locations, following the earlier-than-expected completion of a large remediation project. Additionally, we experienced temporary lower productivity as we deployed state-of-the-art field service software systems and provided training to service technicians.

Third quarter adjusted EBITDA grew by 5.2% versus the prior year to $58 million or 16.9% of sales. As Ron indicated, Municipal shipments we anticipated in the third quarter were shipped in July, and we also expect to deliver in the fourth quarter a larger aquatics project that has been on hold.

During the quarter, we actively increased prices across the business to offset higher commodity costs. For the quarter, the net negative price impact was approximately 175 basis points on gross margin. We saw price realizations improve significantly in June and expect to continue to accelerate in Q4. Our outlook assumptions also expect commodity costs to stabilize in Q4.

Please turn to Slide 13. For the third quarter, our Industrial segment had revenue growth of almost 18% year-over-year to approximately $182 million, with pro forma revenues up approximately 9%. The major drivers of organic revenue growth came from capital sales for wastewater recycle, reuse applications in the power, HPI and CPI market as well as general strength across most industrial end markets.

Adjusted EBITDA grew 11% to over $38 million, driven by volume increases and acquisitions, which offset negative price cost impacts. Adjusted EBITDA margin was 21% of sales, down 140 basis points over the prior year. The primary drivers of the margin decline are: mix from higher capital revenues, temporary absorption, productivity impacts and inflationary costs. Temporary absorption productivity impacts were the result of the redeployment of mobile assets from a major remediation project to new jobs and the branch service software implementation and related field technician training that was previously discussed.

The Boston Water One Assurance pilot was a success, and we are ramping up for a national rollout in September. We remain committed to our 3-year plan for 1,000 basis points margin expansion on the conversion of 90 million to 100 million of base service business sales, with an expected CapEx investment of $23 million.

During the quarter, we were awarded an industrial wastewater contract with a large food agribusiness firm to expand its existing wastewater treatment system. This opportunity is greater than $30 million and facilitates the company's production capacity expansion and allows the treated wastewater to be discharged directly into a nearby river rather being -- than being sent to a local municipal wastewater plant.

Please turn to Slide 14. For the quarter, Municipal segment revenues of approximately $69 million were down $4 million or 5.8%. Revenues were impacted by a previously discussed deferral of aftermarket shipments that have been shipped in July as well as capital timing. Adjusted EBITDA was lower by approximately 34% to slightly over $8 million. Both mix and volume impacted profitability.

During the quarter, we were awarded a BioMag wastewater system in a large U.K.-based municipality to meet environmental discharge requirements while also providing future capacity expansion. Conventional treatment methods would have required a large expansion at a higher cost. The BioMag system is expected to increase treatment capacity by 25% within its existing footprint. This municipality will be Europe's first wastewater treatment plant with Evoqua's BioMag system, which has been used in U.S. facilities for more than 7 years.

Please turn to Slide 15. Our Products segment revenue grew approximately 10% to $92 million, driven by strong year-over-year demand across most of our end markets. Pro forma revenues increased 6% over the prior year. Favorable foreign exchange rates benefited sales by approximately $2.5 million.

Adjusted EBITDA increased 22% to approximately $26 million and improved to 28% of sales, an increase of almost 300 basis points. Volume leverage, inclusive of mix, ongoing cost-reduction initiatives and acquisition synergies contributed to higher profitability. During the quarter, we were awarded an order for multiple Neptune-Benson Defender filters in an international aquatics facility.

Please turn to Slide 16. Our strong sales growth from higher-than-expected projects has resulted in increased investments in working capital. Additionally, we have increased our capital expenditure for high-return outsourced water projects. We continue to target our long-term goal of 100% free cash flow conversion annually. But we believe making the investments described above is in the best interest of the business on a long-term basis.

Our leverage at the end of the quarter was 3.3x adjusted EBITDA. In support of our acquisition of ProAct Services, we closed a $150 million first lien term loan add-on with a resulting pro forma leverage of approximately 3.7x adjusted EBITDA. We are comfortable with the near-term leverage, and we have sufficient flexibility to continue to fund our growth initiatives and additional acquisitions. Our weighted average cost of debt for the quarter was approximately 5.4%.

Please turn to Slide 17. Capital spending in the quarter increased to $23 million, approximately $12 million greater than last year. This year-over-year increase in CapEx supports a variety of high-return projects. Of the $23 million CapEx, $14 million was in the Industrial segment. I would like to quickly highlight 2 of the high-return projects in which we are investing.

We're in the process of completing a large outsourced water project with a long-term contract for a large chemical processing company in which we will provide purified water for their operations. During the quarter, CapEx for this project was approximately $6 million as we target a first half of 2019 completion date. Once completed, we expect to enter a separate financing agreement for the majority of the $20 million of total capital costs. This project has an IRR in the 40% range.

During the quarter, we invested over $6 million in our water treatment mobile fleet that is used to meet the growing demand in wastewater remediation. Typically, our mobile fleet assets have a payback period of less than 3 years and an overall fleet utilization between 80% and 90%. The combination of our mobile fleet and the 900 mobile assets recently acquired from ProAct Services significantly enhances Evoqua's industrial wastewater utility and processed water capabilities as well as our fast response to temporary on-site treatment capabilities.

Looking forward, we will be rolling out our margin-accretive Water One Assurance program, and we expect to see approximately $23 million in capital spending to be spread over the next 3 years. We expect the payback on Water One Assurance investments to be between 2 and 3 years. We continue to expect CapEx to sales to be in the range of 4% to 5% for the full year.

Working capital increased approximately $28 million sequentially from Q2 to $223 million. As discussed on the last slide, working capital was impacted by strong capital and product-related sales in the Industrial and Products segments and corresponding longer-cycle accounts receivable. We continue to target working capital in the mid-teens range as a percentage of revenue.

Please turn to Slide 18. Organic revenues continue to grow at the high end of expectations and are being supplemented by M&A. We're adapting well to the higher demand for our products and services and to price-cost challenges through expense and working capital management, in addition to accelerated price actions.

The mix shift to larger projects has put short-term pressure on margins growth and working capital, but this shift will lead to more profitable service and aftermarket business in the long run. While free cash flow is not at the level we anticipated, the use of cash supports strong sales growth and high-return investments.

We have also implemented initiatives that further align management performance incentive with our investors. And with strong and growing order book, we anticipate continued favorable results.

Our full year outlook remains unchanged with total reported revenues to be in the range of $1.34 billion to $1.37 billion, representing year-over-year growth of 7% to 10%, and adjusted EBITDA to be in the range of $235 million to $245 million for year-over-year growth in the range of 13% to 18%.

Consistent with prior estimates, we expect our worldwide tax expense, excluding discrete items, to be between $11 million and $13 million for fiscal 2018. Our 2018 global blended statutory tax rate is expected to be between 24% and 26%, unchanged from the prior quarter.

Our effective tax rate is subject to quarterly volatility due to our current valuation allowance position. We expect our 2018 annual effective tax rate to be approximately 22% to 24%, excluding discrete items. While our effective tax rate is subject to short-term quarterly volatility, we do not expect to be a cash taxpayer in fiscal 2018 or fiscal 2019 based on current tax code provisions.

Consistent with our assumptions, we expect our end markets will remain healthy, stable and that inflationary market supply chain challenges remain manageable in the realization of our outlook. We will now open the call to your questions.

(Operator Instructions) Our first question comes from the line of Deane Dray of RBC Capital Markets.

Do you hear me okay?

We got you now.

Okay, good. Maybe I would like to start on the key themes on Page 4, Ron, and just if you could clarify the third bullet on Municipal. Now it -- were you going to strategically change the mix from large projects -- large capital projects? Maybe just clarify, are you trying to move away from the large projects? I know last quarter, we talked about the opportunity that once you invest in these, you get a $0.22 aftermarket stream. And I just want to get that clarification on -- is this really a change? Or do you think this is going to happen over time based upon your mix?

Yes, Deane. So thanks for the questions. They're great questions. In the last quarter, when we talked about $0.22 aftermarket off of large projects, that's referring to our Industrial business. So where we're selling industrial systems that we're going back and we're servicing, that's where we get the $0.22. So it's really around that segment of the business that we've invested very heavily in, and we're seeing very good growth there. On the Municipal piece, what we've highlighted pretty much from the beginning is we want to make sure we're focusing on mining the installed base that we have today. All dollars aren't created equally in the municipal space, as we know. And when you get out and it's a 3-way bid and rip the envelope and the lowest price wins with very heavy Ts and Cs, that's not always attractive business. So more than 100 years of installs with very iconic brands, the field is very ripe for us to go out and make sure that we're targeting retrofit and rehab projects and focus very heavily on aftermarket products going into that market. So we're not chasing huge capital projects in the municipal space. We're really focused on making sure that we're there servicing the installed base that we have today that's very good margin business.

All right. That's real helpful because it really doesn't sound like a strategic change. It's just -- this is your higher profit opportunity on your installed base. So I'm glad you clarified that. And then the second question on price cost, are you still expected to be neutral by the fourth quarter? And just some insight into going after price here. Has there been any give up in volume? Did you lose any market share? And just how receptive have customers been to these pricing actions?

Yes. So on the price cost, we still expect to get close to neutral in the fourth quarter. We probably still have a little bit of a gap on the -- what's going on with the tariffs and some of the commodity costs that we're trying to make up. So we got some good traction in June, as we highlighted during the remarks earlier. And we expect for that to continue through the fourth quarter, still having a little bit of challenge in the fourth quarter as we've discussed actually in the last call. So going forward though, customers have been very receptive. It's just we're doing it at the time that we have the ability on the contracts to raise price as well as driving some of the surcharges that we have the ability on. But again, if you think about the segments of business we sell in Products, very receptive, no issue at all. Industrial has been very receptive as contracts have come up and we can go on and raise price. Municipal is the one that's a little more tough because you lock in pricing on a municipal contract that makes it much more difficult. You have to wait until that renewal comes as well. But no loss of market share. In fact, we continue to gain market share, as shown in our top line results, that we're really pleased with.

Your next question comes from the line of Brian Lee of Goldman Sachs.

On Deane's question, the 170 basis points impact on gross margin from price cost this quarter, it sounds like it doesn't get back to even in Q4. But are we thinking 100 basis points headwind? Or what -- can you kind of quantify how much you get back in the fourth quarter?

Yes, I think we'll get back a little bit about 30 to 50 basis points on the pricing, offsetting the costs. So we'll still have a little bit of an impact in the fourth quarter with our forecast that we have against commodity prices, but we get pretty close to neutral.

The price came through as we expected. That was the good news. And again, as Ron said, most of it was in June. The cost increase was a bit higher than we expected. We're a little negative in Q3. But the -- we accelerated actions in the quarter and expect to get very close to neutral. But there's some slight risk to that in Q4, and that's assuming a stable situation on commodities for Q4.

Okay, great. That's helpful. My second question is just on the Municipal segment. Can you guys -- I might have missed it, but can you provide a little bit of quantitative color around backlog and order growth? Because it does seem like even if you exclude the impact of large retrofit project revenue that you outlined in the quarter, the segment was flat to down a smidge. And I think we generally have been thinking this is a low single-digit grower for you. But it seems like some other water companies in the space may be trending a bit higher in that vertical in recent times. So just wondering if you can help reconcile a bit and maybe provide some color as to what you're seeing here into year-end.

I'll give a little color into it, and then I'll let Ben do a little bit of quantification. But just as far as the business goes itself, where the spending is going is in the treatment training that we play in versus the infrastructure that's transmitting water through. So a lot of spending you've seen from some peers in the industry have been around the infrastructure more than the treatment train. We are seeing a very strong pipeline in retrofit and rehab, which is good. That's the business that we've gone heavily after. And as we look at our pipeline of incoming orders in our CRM system, our -- the backlog or at least the pipeline of what is to be bid is significantly higher than prior year. So we're feeling good about the overall outlook of it. We do still focus on this business being a low single-digit growth business and anticipate it will continue that way for quarters to come. And that's really where the focus is, though. Again, it's -- where we're going after retrofit and rehab, not really large projects, but we want to make sure that we are mining the installed base that we have inside the business.

So the growth rates, we do expect to be consistent with what we've talked in the past, in that low single-digit growth rate for the year. The quarter was tough because of some difficult comps. We had some relatively large aftermarket shipments in Q3 of the prior year. And they're expected to go in more Q4 this year, one of which that -- those shipments have already occurred in July. And so it is a timing impact Q3 to Q4 on a year-over-year basis. And we do expect a relatively healthy recovery in Q4 from a year-over-year growth rate perspective in the margins.

Your next question comes from the line of Steve Tusa of JPMorgan.

The add-backs to adjusted EBITDA were a little bit higher than we were expecting. Any color on the stuff from Slide 22?

Sure. So the biggest change versus what you probably had in your assumptions were 2 items. One was the losses on FX on intercompany loans. That was a pretty healthy amount, about $8 million. That was partly offset by a gain on the property sale of Australia, which was a [good guy], and then also the transaction costs associated with the recent acquisition. But as far as the rest of the outlook, we're still in line with our restructuring as previously communicated, stock comp's essentially the same. All other element -- all other items are essentially the same. The one that will vary is transaction cost depending on how we do deals and again, the intercompany fluctuations on the intercompany loans, the gains and losses on FX, okay?

Okay. And then on free cash flow conversion, I think Slide 16 says 35% conversion year-to-date. You guys kind of talked down a bit 100% conversion, obviously, something you're turning towards longer term, but you talked about prioritizing some investments here. What do you think conversion will ultimately kind of settle in at this year now?

Yes, Steve. So right now, we're looking at 50% to 80%. This will -- we think it should settle out. When you look at the free cash flow conversion, and we've actually done pretty well in our trade receivables. We've seen about 100 basis points improvement on our trade receivables and trade working capital in total. It's really been the project-based working capital where we've seen the significant investments. When you look at it sequentially and on a year-over-year basis, that's the big mover that makes up the majority of that working capital increase. And again, that's predominantly in the Industrial business and to a lesser extent, in inventory and the Products business. But that's the area -- all other metrics, DSO and our days in inventory are relatively the same, certainly improved much from Q4, but it's really about those work -- or capital-related working capital, okay?

You said 50% to 80%, 50% to 80%?

Correct.

Okay. So that implies something greater than 100% in the fourth quarter. So fourth quarter should be a good converter here?

It should be, yes. Steve, one other thing I didn't mention is we did have the earnouts for some acquisition that was also in the transaction costs associated with recent acquisitions that were successful and achieved their earnouts, okay?

How much is that?

Around 2 point -- around $3 million in rounded numbers.

Our next question comes from the line of Andrew Kaplowitz of Citi.

Last quarter, you mentioned that your service business across the company was relatively steady. But it looks like it's been relatively stagnant now -- stagnant over the last few quarters. I know you expect your aftermarket sales growth to kick in here, but why do you think service growth has stagnated, given your overall industrial and municipal markets have been really, really strong? I know you mentioned [difficult] comps here, especially in Municipal. Is there any sort of an -- execution [improved]? What's the visibility that you have to resume service growth?

Yes. So there's a couple of things that are showing up in that, Andy. And one thing that -- service really follows the capital sales on the Industrial side, where we've been selling a lot of our capital sales on the Industrial side, it's been on the wastewater treatment and the recycle, reuse. That typically follows about 12 months later where, in a lot of cases, processed water follows immediately after the installation. So it's a little bit of a timing impact on that. We also had, as we identified actually during the remarks, a very large wastewater service contract that finished early. We had to relocate about 25 assets that were on a very strong contract around recycling, reusing the water and actually cleaning up that water. And as we did that, it had a little bit of an impact time-wise on the quarter. Though I would anticipate we come back into our historic range of service growth as we go into the coming quarters.

Okay, that's helpful. And then I think about the Q4 guide in order to make midpoint, you have to make a significant step-up in adjusted EBITDA margin. It looks like it's been around 22% from 20% last year. That's after you were down a bit in Q3. Could you just talk about your line of sight to this forecast? I know you mentioned a good order book. We know about price versus cost. Anything else that helps to get margin back up in Q4?

Well, so we have some relatively discrete shipments, particularly in the aquatics business that are very high margin that we expect to go in Q4. So that should help us as well. And then the overall services coming back online, those assets that were redeployed, that's very high margin. And as they come online in Q4, that will help. And then also some of the disruption, temporary disruption that we had in Q3, we don't have in Q4. Those are the main drivers that help that margin lift. I think if you look at the year-over-year growth in terms of EBITDA, it's very consistent with what we had in the prior year in the same quarter.

Your next question comes from the line of Nish Damodara of Baird.

Just wanted to follow up a little bit on that -- you've mentioned the larger Products projects that are set to ship. Can you give us a little more color on kind of the size and materiality and any moving pieces that could kind of be causing the slip out in fiscal 4Q?

Yes. So the aquatics projects, when they typically go, they are high margin. And those are going into large water parks. This has been one that we highlighted and actually received the order quite some time ago. But it's been delayed based on the prep of the site and them getting ready. Currently, it was scheduled to ship in Q3. They pushed it to Q4. It's still scheduled in Q4. But I would say, as you think about large projects, they can range anywhere in the aquatics space from $3 million to $10 million in top line. And typically, those are somewhere in the 50% EBITDA range.

Okay, great. That's helpful. And then just give us a little more color too on the current capital structure in the wake of the ProAct deal that's kind of moving pieces and particularly, how you guys are thinking about managing your kind of [pick] versus floating rate debt situation, how we should be thinking about how interest expense has been tracking here?

So interest expense, expect about a little over $1 million more in Q4 from our current levels that we saw in Q3. Our leverage is about 3.7x post new issuance. And we should delever there in Q4 with the same sequential improvement as we originally expected from Q1 to Q2. So we should see about 0.2 turns of an improvement off of that level into Q4.

Okay, helpful. And then last one for me. ProAct contribution for this year, I just wanted to clarify, is that included in the current guide? Or should we be expecting incremental sales in the data [to layer on]?

No, it's included in the current guidance because we're only getting about 2 months of that. And then you've got to think about the disruption of transitioning from being a stand-alone into coming into the company and the integration. So it's very, very minimal.

(Operator Instructions) Your next question comes from the line of Joe Giordano of Cowen.

This is Tristan in for Joe. Ron, just a quick clarification, I think, on Brian's question earlier. You said you see muni spending being more dedicated to infrastructure spending than treatment per se. Is that correct? And if so, are you seeing -- when do you expect this to revert at some point?

I'm sorry. Can you repeat the question?

Sure. I think Brian asked you before in terms of the spending that you've seen in the municipal, if it more infrastructure related or treatment related? And you said the formula was probably higher right now. How do you see it evolve?

Yes, yes. So what I was talking about is where we play versus where a lot of the spending has been. So a lot of the spending has been on the infrastructure, meaning the distribution system to get water from a treatment system out to households, out to businesses, areas that have used, so pipes and pumps and things of that nature. The treatment itself -- so the treatment system itself is where they're spending on retrofit and rehab as well as there are some new capacities going in. But we focus a lot more on the retrofit and rehab and that's where the sweet spot for Evoqua's product line goes based on our installed base.

And then I'm curious on your thoughts on what are the advantages of working with the public sector rather than in the private sector or vice versa? I understand that governing buyers have -- they're all about mission and delivery and taking care of the citizen. And I guess, the private sector has to respond to shareholders or the profits they have to watch. So it would have -- I guess that brings different motivations there. I'm just curious of how you think about that.

Yes. I think certainly, there are different motivations there. And I think as you look at the public sector, they are very focused on making sure its continuity. It's not a lot of change. And they're very anxious to come out and look for new technologies. But it takes quite a while for them to believe that the new technologies have been proven and to install them into the public works environment. So that's why we're trying to bring new technologies out, such as our BioMag CoMag. You've heard Ben reference a product that we actually got our first sale into the European market with that product line and that technology. It really enables the public markets to be able to increase capacity at an optimal spend level. So it's a great opportunity for us to deploy new technologies into the public sector. The private sector seems to be much more focused on bringing technologies in and making sure they're optimizing new installations as well as looking at being able to do it at the lowest operating cost and make sure that they're focused on deploying technology. So both of them are very attractive markets. We're -- I guess, you have to have our technologies proven a little longer prior to the public sector being willing to install those.

Your next question comes from the line of Pavel Molchanov of Raymond James.

I want to ask a high-level question that I asked 3 months ago as well, which is as you look at M&A opportunities, it's obviously very much a sellers' market in the water tech space. ProAct was your second largest deal ever. How competitive is the landscape from kind of a buy sider's perspective? And what are valuations tracking?

Yes. Thanks, Pavel. Actually, it is a competitive market as we discussed on the last call and we've discussed with you historically. The opportunities though for good assets certainly are there. One of the real values that Evoqua has brought to the market is we've become the acquirer of choice for small tuck-in acquisitions. So if it's a sizable acquisition, something like a ProAct, you are seeing multiples tend to trend in the higher direction. But what ProAct does for us it's it opens up very large market segments we historically have not played in, by adding a capability to us that is in a size range we typically don't play. So if you thought about our mobile assets going in, we're going to treat somewhere from 1,000 to 10,000 gallons per minute. ProAct is going to be in the space below that, typically around 300 to 400 gallons per minute. So it gives us a totally new market segment to go after. It gives us some more real opportunity. But where you find small tuck-in acquisitions, they're looking for the channel to market. So they're looking for the channel to market with the right partner, which Evoqua has become. And those are still very reasonably attractive multiples. So it's not something that it's a feeding frenzy with everyone going after the small tuck-ins because historically, they don't know about them.

Okay. And I know you don't typically break out all of the cost variables in your kind of gross margin targets. But what is the role of the tariffs not just steel and aluminum, but other kind of raw materials as well in the commodity input cost pressures that you've alluded to?

There's not a lot of direct impact associated with the tariffs (inaudible) don't source a tremendous amount from China directly. But there's a knock-on effect that we are seeing. Example, we would source a lot of resins from a U.S. supplier that is out of capacity because they are being tasked because of tariffs from China. So this is what we're seeing, and we're seeing it particularly in the areas of steel, plastics, pumps, valves and components. But a lot has to do with the knock-on effects associated with tariffs versus the tariffs -- versus the direct effect of the capacity constraints within the U.S. We're also seeing extended lead times from suppliers that's putting more pressure on that. So normally, we get things 1 to 2 weeks, and they're being pushed out further as capacity begins to become filled, which is also putting additional pressure.

Your next question comes from the line of Adam Farley of Stifel

Have you guys called out broad-based revenue growth in industrial capital businesses? I wonder -- I was wondering if you could give a little more color on like specifically what end markets or geographies are leading that growth. And then also if you could maybe parse out how much of that is market growth versus share gains.

Yes. So Adam, that's -- thanks for the question. It's a good question. I would tell you that primarily, the growth in the industrial market is all coming from North America, which is where we play the majority. The end markets that we're seeing growth in are -- majority of them in the heavy industry market. So the power market has been very good for us, continues to be strong with ash pond dewatering, a lot of the regulations there. Food and beverage has been really good for us. So as we've done some acquisitions of ADI and ETS specifically over the past few years, that's opened up a new market segment for us to go after and we're going into the food market very heavily. So with those types of expansions and acquisitions, I would say it's not market growth that's driving it. It is us taking share and us providing more broad solutions into the marketplace that we serve and into our core customers that we've historically served in other water treatment areas.

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All right. That's really helpful. And in fact, just shifting gears to Water One Assurance. Can you just provide a little more color? I know you talked about the CapEx investments. But can you just talk about the progress on the rollout, maybe some of the cash [arrangements], just how you guys are strategically thinking about the business as you roll out in September?

Yes. So the business is rolling out very well. As we mentioned, we did -- we did 2 pilots. So we did Birmingham, Alabama. That was our first pilot that was extremely positive. So following Birmingham, we took it to Boston, which is a much more broad market we're going after. It's a market that we want to make sure that we are servicing all size customers there. For Birmingham, we only went after the large customers. We learned a lot on that, so it's been really good for us. We've learned that in some applications, we need one that you can hang on the wall versus place on the floor. We needed to make sure we created a better alignment with the connectivity in some of the components that we're reusing. And we needed to optimize and streamline our installation process. So in doing that, it's been very positive. And I would say, in Boston, we've seen about an 85% to 90% take rate. So we're very pleased with what we're seeing there, and we're seeing the subsequent margins come through as we anticipated. So the next rollout for us is in September, where we're going to go more broadly across the nation and we're going to do it market by market. We have this planned over the next 3 years. So over the next 3 years, we anticipated and build in half of that business being on the take rate. But with what we've seen in Boston, I think it could be higher than what we built into the model already.

That concludes our question-and-answer period. I would now like to turn the call back over to Ron Keating for his closing remarks.

So thank you all for participating on the call today. As we've discussed before, we feel we're uniquely positioned to be the solutions provider of choice. Through our technologies, our channels to market and our extensive service footprint, we are truly able to be a partner to our customers. And we feel like the top line is showing that as we've been driving it through and we're looking forward to the future.

I'd like to thank our employees for all their dedicated efforts. And we're looking forward to completing a successful 2018 and look forward to 2019. We look forward to speaking to you again soon, and thank you very much.

Thank you. That concludes today's Evoqua Water Technologies 2018 Third Quarter Earnings Conference Call. You may now disconnect your lines at this time, and have a wonderful day.