Evoqua Water Technologies Corp (AQUA) 2018 Q4 法說會逐字稿

Good morning, and welcome to the Evoqua Water Technologies Fourth Quarter and Full Year 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.

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 fourth quarter and full year 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 current outlook for first quarter and full year fiscal 2019, statements regarding our two-segment realignment actions, and expected restructuring charges and cost savings for fiscal 2019 and beyond. 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 and the 10-K, which is expected to be filed on or before December 11. We expect to file an 8-K shortly after the 10-K filing with 3 years of historical quarterly two-segment results.

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 historical 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.

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 fourth quarter and full year results.

As you know, we announced our preliminary results on October 30 and announced our company realignment to a 2-segment business effective as of October 1.

Today, we will provide more insight into the results, the two-segment rationale and the current 2019 outlook.

Please turn to Slide 3. Our Industrial segment had solid sales growth in the fourth quarter and full year. We've been working on a digital water strategy that is well underway. As part of that strategy and after the successful completion of our pilots, we launched our Water One initiative officially this past month. Our Industrial and Municipal businesses reported service revenue growth, and we expect to see that growth continue into 2019.

Apart from our aquatics product line, which I will discuss in a moment, our Products segment had solid sales and EBITDA growth in the fourth quarter and for the full year. Free cash flow was strong in the quarter, primarily driven by working capital improvements, and for the full year our conversion rate was 80%, up from 17% in the prior year. We're disappointed with our full year results and have taken actions to address our challenges and to strengthen our market-leading position.

An ERP integration at Neptune-Benson, supply chain disruptions influenced by tariffs and the delay of a large aquatics project primarily led to our fourth quarter challenges. These primary factors were concentrated in our Products segment's aquatics product line, Neptune-Benson and in our Municipal segment and will be addressed on the next slide.

Our market remains strong and improvement actions are well underway. The two-segment realignment to streamline and simplify our business is progressing, and we expect to see benefits materialize by the third quarter of 2019. In 2019, we intend to focus our efforts primarily on profitable growth, operational excellence, cost management and free cash flow generation.

Continued improvement in free cash flow is expected to come from working capital management, focusing M&A activity on CapEx-like tuck-in transactions and managing growth capital expenditures to the highest return investments.

To mitigate the risk of rising interest rates, we've entered into an interest rate hedge representing $600 million or approximately 2/3 of our credit facility.

Finally, we've incorporated a free cash flow metric in the management's 2019 incentive compensation program. We enter our 2019 fiscal year with a clear focus on executing our plan, maintaining our high level of customer service and meeting shareholder expectations.

Please turn to Slide 4. We continue to benefit from a stable and recurring flow of revenue growth. As you can see on this chart, approximately 44% of our revenue is derived from services, which are stable and recurring with a 99% renewal rate on our annual service contracts. The chart shows quarterly revenues and adjusted EBITDA on a rolling 12-month basis. Over the last 3 years, we've consistently reported quarterly LTM revenue growth through Q4 2018. Adjusted EBITDA has grown steadily for the last 11 quarters, except for this last quarter's performance. With our action plans underway, we have confidence in our ability to extend our market-leading position, and we expect to be back to consistent LTM growth in the second half of 2019 with a stable growing outlook for our fiscal year.

Please turn to Slide 5. We have highlighted the segment drivers for the fourth quarter performance by bridging our reported fourth quarter 2017 adjusted EBITDA of $71 million to our fourth quarter 2018 adjusted EBITDA of $61 million.

The Industrial segment reported an increase in adjusted EBITDA and performed generally in line with our internal expectations.

Our Municipal segment adjusted EBITDA was down approximately $2 million and was modestly below our internal expectations.

Our fourth quarter 2018 corporate costs were up approximately $1.5 million versus the prior year given the higher incremental costs of operating as a public company.

The Products segment is comprised of 5 businesses, including aquatics and disinfection, which is one of our highest margin businesses. The aquatics and disinfection business represented approximately 48% of the Products segment's 2018 full year adjusted EBITDA, compared to 63% in 2017. The aquatics product line within the aquatics and disinfection business is primarily comprised of Neptune-Benson.

The fourth quarter challenges were isolated to the Neptune-Benson product line as we migrated the business onto the company's SAP system, dealt with supply chain disruptions influenced by tariffs and experienced a large project delay. In November, we completed the migration of the business onto our SAP system.

Regarding supply chain disruptions, Neptune-Benson sells a very high-margin filtration system that has critical components sourced from China that partly created our challenge. We've taken mitigating actions which should address this issue in the second half of 2019.

Because of these challenges, the aquatics and disinfection business' 2018 fourth quarter adjusted EBITDA declined 62% versus the prior year and was down 26% for the full year versus 2017.

Excluding aquatics and disinfection, the Products segment's adjusted EBITDA grew approximately 12% in the fourth quarter and approximately 39% for the full year.

For the full year, we're pleased with the Industrial segment's performance and the Products segment, excluding the aquatics product line. We understand the challenges facing the Municipal segment, and our organizational realignment is expected to streamline and simplify the overall business.

I would now like to turn the call over to Ben to review the fourth quarter and the full year financial results.

Thank you, Ron. Please turn to Slide 6. For the fourth quarter, revenues grew by approximately 3%, driven by growth in the Industrial segment, partly offset by declines in the Municipal and Products segments.

Adjusted EBITDA was down 14% to $61 million, driven by previously discussed challenges in the aquatics product line and Municipal segment. Adjusted EBITDA margin was down 330 basis points to 16.7% versus the prior year. During the quarter, we estimate price cost was negative by less than $2 million. We will continue to improve pricing actions across the business to offset projected inflationary and tariff-driven cost interests.

Please turn to Slide 7. For the full year, revenues grew by approximately 7% over the prior period, driven by the Industrial and Products segments. Pro forma growth contributed 4% and tuck-in acquisitions contributed approximately 3%. Adjusted EBITDA increased by $9 million or 4.4% over the prior year, but margins were adversely impacted by higher inflationary cost, capital mix and underperformance in the high-margin aquatics product line. These margin pressures were partly offset by pricing benefits and cost-reduction initiatives.

Please turn to Slide 8. Fourth quarter revenues for our Industrial segment grew over 9% versus the prior year, driven by demand in power, hydrocarbon and chemical processing markets. Capital revenues contributed approximately 40% of sales increase as we continue to see growth in industrial wastewater recycle and reuse opportunities. Adjusted EBITDA increased approximately 2%, while margins were impacted by mix and higher cost.

For the full year, Industrial revenues increased over 13% with pro forma growth of approximately 7% over the prior year. Power market demand and remediation projects were the drivers. Excluding acquisitions, capital sales contributed to over 80% of full year sales growth. This higher capital mix impacted overall profitability combined with higher inflationary cost. Adjusted EBITDA grew almost 13% for the full year to $169 million, while adjusted EBITDA margin was flat to last year at 23.2%.

Please turn to Slide 9. For the fourth quarter, the Municipal segment revenues were down approximately $2 million to $78 million, driven by lower capital sales and supply chain disruptions influenced by tariffs. Project-related revenues decreased approximately $4 million versus the prior year. Aftermarket sales were flat and service revenues grew by over $2 million. As a result, adjusted EBITDA was down approximately $2 million to $13 million and margins were down approximately 250 basis points to 16.4%.

For the full year, revenues were down approximately $6 million or 2% over the prior year, driven by $5 million of lower project sales, $5 million of lower aftermarket sales, offset by price gains and service growth of over $4 million.

Adjusted EBITDA declined almost $8 million over the prior year for 13.7% margin. Drivers of the year-over-year decline in adjusted EBITDA and margins were lower sales volume, mix, inflation impacts and the previously discussed supply chain disruptions.

Please turn to Slide 10. The Products segment fourth quarter revenues decreased approximately $5 million in the quarter or 5% versus the previous year. The underperformance of our aquatics product line had a significant impact on overall segment's performance.

Adjusted EBITDA for the fourth quarter declined by approximately $7 million to $16 million or 18.3% margin compared to the prior year, driven by the aquatics product line.

For the full year, revenues grew by approximately $14 million or 4% compared to the prior year. The aquatics and disinfection business revenues were down approximately $20 million, partly offsetting $25 million or 19% growth from the remaining 4 businesses.

Acquisitions and divestitures contributed approximately $4 million and foreign exchange contributed $5 million of growth.

Full year adjusted EBITDA was down approximately $2 million to $76 million for a margin of 22.4%, driven by the aquatics and disinfection business, offsetting approximately 39% adjusted EBITDA growth for the remaining product businesses.

Please turn to Slide 11. We're pleased with the fourth quarter's free cash flow generation of approximately $33 million. We finished the year with free cash flow of approximately $50 million for an 80% conversion rate, up from 17% in the prior year. Working capital improvement was the primary driver.

In Q4, we added a $150 million tack-on to our first lien term loan to fund the acquisition of ProAct and for general corporate purposes. This tack-on increased overall leverage 0.4x to 4.1x adjusted EBITDA.

Our capital allocation priorities are focused on reducing net debt, high returns investments and tuck-in acquisitions. We also have secured a $600 million interest rate cap, representing nearly 2/3 of our credit facility to migrate rising interest rates. Our current average cost of debt is approximately 5.2% as of September 30.

Please turn to Slide 12. With a strong year of high returns investments in 2018 with CapEx totaling almost $81 million or 6% of sales, we invested approximately $47 million above maintenance CapEx, including $14 million for a large outsourced water project and over $11 million for mobile service asset capabilities and capacity. Maintenance CapEx represents approximately 2.5% of sales. Net working capital improved sequentially from Q3 as a percentage of sales. The addition of ProAct increased overall working capital by approximately $7 million or 0.5% of sales.

I would now like to turn the call back over to Ron to review the two-segment structure and our 2019 outlook.

Thank you, Ben. Please turn to Slide 13. As Ben reviewed, our business has historically been divided across 3 segments that initially allowed us to focus on our core markets. However, as we've grown and added several acquisitions, we realized the need to evolve our structure to optimize our ability to quickly serve customers and channel partners. For example, our teams in the Industrial segment began offering carbon solutions for emerging contaminants such as PFAS removal into the municipal market. Meanwhile, our Municipal segment products, such as CoMag and MEMCOR, were being sold into the Industrial market. And finally, the Products segment was selling across Industrial, Municipal and the recreational markets.

We heard from customers that multiple salespeople, all with the local business cards, were serving their needs but offering different pieces of the solution. We recognized that we can better serve the needs of our customers and more effectively deploy our solutions by addressing the silos that existed between our products and services organizations.

As we turn to the future, we set forth a strategy that enables us to better leverage our broad portfolio and the expertise that exist across our businesses. Fundamental to the success of that strategy is aligning our organization around customers and partners by organizing ourselves based on how they want their problems solved and how they seek value.

When we reflected and analyzed how this happens, it's in 2 distinct ways: through the solutions and services we deliver directly and through the suite of products and technologies we offer primarily through third-party channels. As such, we've created 2 new segments: the first, Integrated Solutions and Services, which will include the former Industrial segment as well as the municipal services group that offers odor and corrosion control solutions to municipalities in North America. The second, Applied Product Technologies, which will include our former Products segment as well as our municipal products provided through our wastewater technologies and advanced filtration businesses. We expect this structure to allow us to better serve our customers and partners by eliminating internal barriers.

Please turn to Slide 14. Moving forward, the Integrated Solutions and Services team is focused on servicing the North American market. We're moving from a pay-by-service model to embracing programs such as Water One, which take advantage of our portfolio, our service network and our innovative digital solutions.

As previously discussed, through Water One, we deploy complete solutions to enable and optimize customer performance through a pay-by-use model. We're also moving away from regional account selling to a more national account focus allowing us to better leverage our national footprint and technical talent.

Meanwhile, the Applied Product Technologies segment will move from individual product sales to offering customers a suite of technologies that best fit their needs. The Applied Product Technologies team will sell through our Integrated Solutions and Services segment and through our established third-party channels across the globe, allowing us to expand our reach and impact underserved markets.

We expect to incur onetime charges of $17 million to $22 million associated with our new two-segment structure over the course of the next 2 fiscal years.

These charges should fall within 2 categories: structure and integration cost of $10 million to $12 million and footprint, product rationalization and other costs for $7 million to $10 million. Benefits associated with this structure should begin to materialize in the third quarter of 2019.

Please turn to Slide 15. I look at 2019 as being the continuation of building our foundation. We've made significant progress improving the company since the days we were operated as a division of our former owner. As we systematically work through the necessary steps in positioning the company for the future, we'll be focused primarily on 3 main priorities: delivering profitable growth, expanding our margins through operational actions and increasing our free cash flow. Our first priority will be to focus on the execution and implementation of the new structure to drive profitable growth. Our go-to-market strategy will allow us to get closer to the customer with an opportunity to more effectively offer a full range of solutions and services. Pricing actions and margin expansion initiatives will be key components to this priority. We're deploying our Water One digital platform that is utilizing on-demand pay-by-the-gallon capabilities to better serve our customers and lower our operating cost. We're taking several operational actions to drive margin expansion. We expect our two-segment realignment to streamline and simplify our supply chain, engineering and back-office operations to deliver solutions and services more effectively.

As we've discussed earlier, our digital deployment will be an important part of our future, and we believe we have the capabilities, the service network and the customer base to drive installations broadly and to expand our market-leading position.

Third, we plan on free cash flow generation -- plan to focus on free cash flow generation through working capital management and by prioritizing investments to the highest return growth opportunities. We've also altered our incentive compensation plans for the first time, now incorporating a free cash flow metric.

Please turn to Slide 16. As you can see on this slide, we're outlining our key assumptions for establishing our full year 2019 outlook. We expect revenue growth for the full year to be between 3% and 7%. We anticipate inflationary cost and tariff challenges; however, we plan to continue taking price and cost-reduction actions throughout fiscal year 2019.

Our two-segment organizational alignment is underway. We've already begun streamlining and simplifying the business, and we expect to see benefits beginning to materialize in Q3. Free cash flow is an important metric for us. We're forecasting free cash flow to be greater than 80% of adjusted net income. We do not expect to be a U.S. cash taxpayer in 2019, and we're forecasting the full year tax expense to be between $12 million and $20 million.

As of September 30, 2018, we had approximately 114 million shares outstanding.

Please turn to Slide 17. The capital and projects 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 results in a quarter, we're confident that the business as historically shown will generate long-term incremental growth when viewed over a trailing 12-month basis.

We have a seasonal cadence by which we expect to see revenues and adjusted EBITDA improve sequentially throughout the year.

Please turn to Slide 18. As you've heard today, we're taking a number of actions to improve the business and to create long-term shareholder value. We believe no other company has the reach, scope, scale or product range that Evoqua offers. We acknowledge the underperformance to our expectations have been our challenge and not the challenge of fulfilling customer demand. We continue to deliver to our customers, satisfying their needs at the time that the services and solutions are requested, even though it may not meet the timing or the outlook we originally expected.

As we have discussed, the Q4 challenges were primarily driven by the aquatics product line and Municipal segment. We expect our municipal business to normalize as we progress through 2019. However, we expect to see Q1 challenges from mix, supply chain and the aquatics product line. Given these circumstances, we're providing first quarter guidance, but intend to return to annual guidance going forward.

In the first half of the year, we'll be working through the challenges that impacted our most recent quarter and 2018 performance. We expect to have the impact from the organizational realignment and the Neptune-Benson SAP integration behind us, and we will focus on our core business.

We anticipate mix impacting our business in the first half of 2019 as lower-margin capital projects temporarily soften our margins. The market has been receptive to price increases and we should see gaining momentum as the year progresses.

For the second half of 2019, we expect to see improved service revenues beginning to take hold as well as early benefits from our Water One rollout. We also expect positive benefits from the realignment to begin both in cost synergies as well as customer sales efficiency. We're forecasting a normal seasonal pattern to occur with a stronger second half. Free cash flow is expected to improve with the conversion rate greater than 80%, while continuing to invest in growth.

We currently forecast first quarter total reported revenues to be in the range of $305 million to $320 million, representing growth of approximately 3% to 8%.

Adjusted EBITDA is currently projected to be in the range of $34 million to $38 million, representing a decline of approximately 15% to 5% for the reasons previously mentioned.

We currently forecast full year total reported revenues to be in the range of $1.38 billion to $1.44 billion, representing growth of approximately 3% to 7%.

Adjusted EBITDA is currently projected to be in the range of $220 million to $240 million, representing growth ranging from 2% to 11%.

Please turn to Slide 19. Our focus and expectation to achieve 4 key metrics in the next 3 to 5 years remain steadfast. With the organizational changes we're undertaking and our confidence in the business, we expect to extend our market-leading position over this time frame. We project to grow revenues organically 3% to 5% annually and to achieve a 20% adjusted EBITDA margin. Our organizational realignment actions, the expected shift of mix from capital to more profitable service and aftermarket and our operational execution will be important drivers to profitable growth. Free cash flow will be a significant focus as we balance investing and high-return projects and strengthening the capital structure. We target free cash flow to adjusted net income to be at least 100%.

Finally, we want to deliver and maintain a net leverage position in the range of 2.5x of adjusted EBITDA to provide the capital strength and capacity to invest and grow the business.

We will now open your call to questions.

(Operator Instructions) Your first question comes from the line of Michael Halloran of Baird.

So let's start with a couple of guidance questions here. First, on the growth assumed for 2019, could you give some color on how you get to that range? How much of that 3% to 7% up is pricing? How much is acquisitions? And then what is your order book and backlog today saying? And how does that help kind of frame where that 3% to 7% is?

So we're looking at about -- at this point in time, we're being relatively conservative. We're looking at about 2% to 3% organic, okay. The rest of that would come from price and acquisitions.

And I would say, Mike, the order book looks very good, and we have strong backlog as we go into the year. One of the things that we're certainly being cautious on is the timing at which we're projecting some of the business to flow through the quarters just given some of the past history with delays that we think.

And then on the margin side, when you look at some of the cost pressures you had in the fourth quarter, obviously, they're lingering into the first quarter. Could you try to bucket out some of those costs for us and give us some sense for what those dollar numbers might look like that you're assuming for pressure? And how much of this is transitory once you get past the first quarter of next year?

Yes. So one of the things that we've discussed in prior calls is when we anticipated getting the cost price/mix balanced out, we've forecasted Q4 to be about $2 million worth of impact on the negative side. It was slightly less than that as we came through the quarter. But with the continued challenges on tariffs coming into the last quarter of this calendar year, first quarter of our fiscal year, we're certainly being realistic around what kind of impact that could have as we go into the first half. So we're continuing with price actions. And as you guys know, we're on contracts that are annual on around a lot of our service applications. We also have some longer lead time projects that we deliver to across some of the businesses. And so it's tougher to get price increases on those if they would have already got the orders. So as we progress through the fiscal year, we'll see continued increases on the pricing that will yield the benefit and offset the material cost increases that we're seeing.

What about some of the other ones like the supply chain side, are you including that on the pricing side and some of the aquatics issues?

That's being included in that. And so as we look in the first quarter of the fiscal year completing of the supply chain with the cost increases and just some of the challenges in negotiating component supply back and forth, where we're actually bringing product in from international locations, certainly China, and then in some cases, we're even delivering projects into China. It's created some delayed negotiations around supply both from products or components coming in and also products that we're shipping into China.

Your next question comes from the line of Deane Dray of RBC Capital Markets.

Ron, was hoping to start with a perspective on the challenges you all have faced and how you've addressed them since going public, and I think you've been real transparent here on the call kind of taking us through what are market conditions versus execution issues like the Neptune problems and ERP. Would you just kind of take us through what and where have you been surprised on the market conditions? And then where have you had challenges on the execution and include forecasting as well because I think that's been kind of a bumpy quarterly process for us. And I really think it's helpful how you show on an annual basis how smooth, but the quarterly challenges that you might face, could we start there, please?

Yes, sure. Thanks, Deane. I think it's a good question. Obviously, we've had some challenges as we expect projects to go in certain quarters that they don't necessarily go. It's one reason we continue to show the annual guidance, and we also show the LTM charts that you see in here. So one of the things that we're doing as we go into 2019 is making sure that we're balancing the forecast against the more consistent run rate business without creating a lot of variability around what some of the quarterly larger project shipments do. So we're trying to balance that coming into the first half of the year and make sure that we know it's going to go through the fiscal year, but it's just -- predicting the exact timing has been difficult. That's one reason as we talked about when we first became a public company, we're only giving annual guidance and not quarterly guidance because there can be variability from 1 quarter to the next against the projects. We've taken some hard lumps on that as you guys know. And so we're trying to be very reasonable and realistic in what we're forecasting going forward and lessons learned around execution inside of those. The other thing that has, I would say, been a challenge for us this year has been the inflationary cost and the impact that it's had on business that is contracted. So the timing that you can actually raise your prices and see price realization come through versus the timing of the material cost challenges when it can be a lot more short-cycled because we're buying from suppliers, and then we're delivering at our long-term contract has been a little more difficult for us. So we've taken the right actions in being able to address that and addressing it very quickly. But it comes over time. So we're taking the actions, but those occur as the end of contract comes and we price against the new contract going forward. So it's really just building the timing in around that as a public company versus what we dealt with as a private company. And then I think as we're going forward, the acquisitions, we've done 12 acquisitions over the last 18 to 24 months. We've integrated all of those with the exception of 3 very successfully, and then the Neptune-Benson one was a challenge for us. It was a larger acquisition, very profitable business, and their ERP system was a paper system that was challenged on the back end. So changing that over to SAP created a challenge for us in the fourth quarter.

That's real helpful. And then maybe some comments on the realignment. Intuitively, it makes a lot of sense, and it -- certainly, it flows better in terms of capital projects versus services and that alignment makes sense. But why wasn't this addressed before? I mean, you had the opportunity when you guys were private. Did that ever come up in terms of an opportunity or was it because like Neptune came into the portfolio late and this is something that you came and thought of after that transaction?

Yes. It's a great question. And we've actually been asked this question a couple of times by different routes. And what we had to do, we started our acquisition pipeline and really executing on that in '16. And so continued that as we went public last year and have continued through this year. We've created a critical mass around our portfolio of technologies that we can now align around technology verticals versus market verticals where it was a little bit of a mess. We've also seen the opportunities really to pull these great technologies into other industries that they may not have been housed in, in the municipal business we're in and also Industrial with these emerging contaminants of PFAS and PFOA that we're coming in with the right solutions on. So being able to do this and align it around the channels to market is cleaning up the organization very effectively and allowing us post-acquisitions with critical mass inside of our full technologies to deploy these solutions more globally. So we're excited about it. It's going to be a fantastic benefit for us in the long run, and ultimately, our customers ask us to do it. So that's one of the reasons that we did it. They wanted us to make it more simple for them to do business with, and it's created a great benefit and we're seeing it in the pipeline of the order activity that's coming through. So we're really pleased with what the outlook is.

Great. And then just last question for me. And one of the positives here has been the cash flow and also your commitment to this 100% of conversion. And is this -- just to clarify, there are going to be opportunities for you to do more of this outsourcing and Water One and there's probably adjacencies there, but the idea that there'll be growth CapEx in your plans and how much of that is baked in when you say 100%? Will you toggle below that for the right opportunities, but just what's the context of 100% as a goal?

Yes. So Deane, I would say, the 100% is where we want to be as an average. We'll toggle above and below in certain years depending on what the opportunities look like on our outsourced water. As you know, that is a big driver for us going forward. It's a big driver of revenue growth as well as profitability and the unique position that we have with our national footprint and the network of being able to actually operate our customer system is something we want to make sure that we're leveraging where the opportunities exist. So when the investments come for Water One, the investments come for outsourced water and us truly being there just providing our customer quality and quantity against a specification they have because they don't want to make clean water, they want to make product. We want to enable them to do that. So as we identify opportunities to deploy more capital, we may dip below, and thus, that's a little bit of what you see in this past year and the coming year. But we're thrilled with the outcome from 17% last year to 80% this year, I think, is a great step in the right direction.

Your next question comes from Nathan Jones of Stifel.

This is Adam Farley on for Nathan. Just following up on Water One. Can you give us a little update on the initial traction you guys are seeing? Is it better, worse or the same as you had expected?

Yes, absolutely, it's a great question. So we've launched Water One nationally as an official rollout last month, and we're really pleased with the initial response we're getting. So today, we have more than 500 installations spread throughout the U.S., and what we're seeing, we had anticipated a 50% take rate. We're seeing around a 70% take rate right now, and it's totally dependent on a customer space and some of the regulatory requirements in the areas, but where they have space, there's no regulatory challenges, then we're getting a 90-plus-percent take rate. But we are pleased with the rollout and how it's progressed so far.

It's great to hear. Just shifting thoughts to Products. Now it's been -- that -- the large projects were delayed a couple of times. What's the current status of the project? And what's your expectation for the shipment of the project?

With the larger products project, that -- it has been delayed, and it's been delayed because of job site constraints. And so the challenges in getting the job site there and ready as you can imagine, a project that's going to take the amount of water filtration products that we're shipping to that area is a very large project. We are not the critical component in the timing of that project being available. We're one of the things that goes in towards the end when they're ready to start filtering water. So that's why we've basically taken it out of the first half of the year. We anticipate it will go throughout the year, but we're not putting a specific quarter in, but we would expect the back half.

Your next question comes from Brian Lee of Goldman Sachs.

I guess, first question I had was just on the guidance cadence here. It sounds like there is a little bit of a difference between the sales cadence and the EBITDA cadence, if you could just walk us through a little bit? It sounded like the sales impact in fiscal Q1 is going to be relatively minimal from some of the issues that impacted Q4, just looking at the guidance of year-on-year growth that's implied for the quarter versus what you're saying for the full year. So is that right? And then, I guess, the second question will just be on the EBITDA margin due for '19. It looks flattish versus what you just reported in '18, but obviously, starting off on a much lower base. So a lot of the pickup is back-half weighted. So if you could maybe walk through some of the puts and takes that need to play out for the EBITDA growth to really accelerate into the back half, maybe what the biggest drivers are?

Yes, Brian, so I'll start, and then I'll hand it off to Ben. On the first quarter, the earnings versus the sales guidance is really around mix and a continuation of what we discussed in the fourth quarter. So it's the supply chain cost increases that we're driving through, offset by pricing that's coming. We anticipate a little bit more challenge on the tariff and the cost side in Q4 or Q1 of our fiscal year or the calendar year. And it's really tied much more to mix. We've got some larger capital projects going out in the first quarter of our fiscal year that have a slight impact as I discussed in my opening remarks. I'll pass it to Ben a little bit for the back half of the comments on project investments.

So we see the previous project investments that we've made with capital pulling through the services and aftermarket in the second half. So mix becomes a positive force in the second half driven by services, also the contributions from Water One and digital conversions as well. Price realization coming through in the second half mitigating the recent inflationary impacts that we've had and the benefits of the realignment we should see beginning in Q3 and starting to come through in the second half.

Okay, fair enough. No, that's helpful. Then maybe just my second question around the capital allocation priorities. I know you guys have kind of stuck to your knitting here, but just wondering if you have any thoughts around a buyback given what the stock's seen in terms of a pullback?

At this point in time, we're not contemplating a buyback. Obviously, that's something we'll continue to look at, but we believe that our first priority would be debt reduction -- net debt reduction.

And growth capital. We'll continue to invest in growth capital as we're going forward.

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

Kind of back to the earlier question about the uplift in EBITDA in the course of the year. What credit are you ascribing in that to alleviation of tariff-related costs? Or are you assuming that it's just status quo forever?

Yes. So Pavel, what we're anticipating is that our pricing actions take route and start getting on the topside of that in the back half of the year. And that's something that we had discussed actually on our prior calls around when we anticipated that to happen would be potentially in this first quarter. However, with continued tariff challenges and some of the supply chain disruptions we're seeing and longer lead times coming from some of our sub-suppliers, we have pushed that to later in the year that pricing will offset beyond top of the cost increases.

Okay. And if and when tariffs subside, how would you adjust prices at that point? I mean, would you essentially undo the price increases or would you keep them?

The answer is no. I mean, as we've talked about on the way up, there is a bit of a challenge in cost because what happens is we're on longer-term contracts that we bid and we hold those contracts until the end of the contract. On the way down all the way and even in a standard environment, we're able to get the price increases passed on to the value we're providing because, again, we're in a very unique position supplying our customers with great products and services, and we'll continue to hold that. We think there is a long-term benefit to the business model in the way we operate and plus a lot of the cost changes that we're making in efficiency opportunities around Water One and the digital connected solutions, I think, give us a great long-term upside around margin expansion.

Okay. And lastly, given that you're obviously focused on internal cost reduction and restructuring efforts, is it fair to say that until those programs are largely concluded you're going to be taking your foot off the pedal, so to speak, with regard to M&A?

What you'll see on M&A is what we discussed in the remarks as more CapEx-like tuck-in acquisitions. So if it is a product that needs to be developed for -- to build out our product portfolio, easy tuck-ins are very nice to do that versus an R&D investment that would take a long term or a longer cycle to be able to bring those to market. So we really will make decisions around what it looks like on tuck-ins for product gaps, tuck-ins for geographic gaps or vertical markets, but these are going to be smaller tuck-in acquisitions we're focused on.

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

Can you just maybe give some color on the amount of add-backs to expect in 2019 restructuring and all that other stuff?

Yes. We've outlined that, Steve, on Page 14 of the deck, our total expected spend. The majority of that spend will happen; the cash will roll out over 2 years, but the actual -- we'll accrue a lot of that expenditure, at least 2/3 of it to 3/4 of it, this year.

Okay. And any other costs or that's really the only major add-back? I mean, I think there is stock comp and some other stuff as well, just kind of all those EBITDA add-backs, what's the number for -- is that basically just the restructuring?

If you want stock comp, that'll...

Just the total number is fine, including all that stuff.

So right now, we're looking at about $22 million in stock comp.

$22 million in stock comp next year?

Exactly.

Okay. What was the number this year, again, just remind me?

About $16 million.

Okay. So why is that going up?

We will have some additional benefits for employees associated with further alignment where they will have the opportunity to purchase shares at a discount. In addition to that, certain portions of the compensation will be aligned, particularly the ELT to stock compensation versus cash-based compensation.

Okay. So kind of $45 million in total add-backs some like -- in that range?

That'll be the range, yes.

Okay. And then just on the flip side, you said no cash taxes in...

Depending on acquisitions, we would have to -- if we did any transactions, I'm not including potential transactions in that, okay?

Sure. On the free cash flow side too, you said no cash taxes in 2019. So that means your kind of adjusted free cash flow number does assume basically euro cash taxes as well, right. I mean, that runs to your free cash flow?

U.S. cash taxes.

Okay, got it. And is that something you can have visibility on into kind of 2020 and '21? Or is -- how sustainable is that, just remind us?

We have a large amount of NOLs at this point in time, over $100 million.

Okay, got it.

(inaudible) only, okay?

Yes, absolutely. And is there any thought to when you won't be reporting adjusted numbers in the intermediate term? I mean, it's just a pretty significant percentage of kind of the actual adjusted number of these adjustments? Any kind of color on when you guys will go to kind of a more normal way of reporting all this stuff?

So Q4 '20 is when we expect the majority of the current restructuring, the two-segment restructuring, to roll off and be completed. There -- in addition to that, depending on M&A and transactions and acquisitions, there'll be always some that we associated with onetime event. But the majority of it would be finished by Q4 '20.

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

Ron, I want to follow up on your comments on Neptune-Benson. I know you've said that you've integrated most of your acquisitions well, you're going to do bolt-ons now for a while, but how do you avoid the kind of system integration that you've had in aquatics going forward? And why do you think the M&A is still proxy for R&D and CapEx because those seem to have higher risk for you guys than those organically to spend your cash?

Yes. So Andy, I would say the one that we've had a challenge with was strictly Neptune-Benson. The other ones have gone very well and -- in the integration as well as -- the system integration as well as the business operation integration. So when we're able to buy these at sometimes around 5 post-synergy to 7x, there is a real opportunity to go ahead and leverage some growth by bringing that product into our product portfolio to build it out. So the challenge we had with Neptune-Benson was much more the system that they had been operating on and converting into an SAP system where it was basically a paper process ERP system that was very manual and very challenged as we cut it over to SAP. Most of the other acquisitions that we've done as I talked about we've integrated very quickly. We've taken them into the business. Neptune-Benson was just a larger acquisition and a different vertical market than we've historically served. So building out our product portfolio in the industrial and the product technology side even with deploying in the muni and residential -- or I mean, sorry, muni and recreational, there's good opportunities because we already have the foundation there that we can leverage. It really helps mitigate challenges from acquisitions as we go forward on that.

Ron, and then can you talk a little bit more about the implications of going from the 3 business segments to 2 by consolidating municipal services with Industrial and municipal products with Products. So you're effectively suggesting that you're really not going to pursue more large municipal projects and maybe you could talk about the state of the municipal markets given they continue to be somewhat underwhelming for you guys?

Yes. So the municipal business overall is one that we still are very focused on. And the reason we're consolidating municipal services in, it's a route-based service, just like our industrial operations. So what we're deploying is technology and tools to service technicians so we can drive route density, effectiveness and their capability of serving their customers. When it was over in Municipal and not in Industrial, the focus was heavily on Industrial. Bringing that full-service footprint together makes a lot of sense to us. We serve more than 3,500 actual end-use municipal applications and as route-based services where we can take advantage of consistent locations across the industrial side and bring it together. On -- and then on the Products side, we're still going to go after the municipal business we've been hitting for quite some time, but if you think about a full flow sheet, when someone's putting in a multi-hundred million dollar system or a $1 billion system even if we're providing $20 million, we're providing really a product into the flow sheet solution that they're after with the municipality. So it's just more -- creating a more consistent approach into how we're going to attack those markets and those opportunities plus taking those technologies across the industrial business like our CoMag and our ultrafiltration MEMCOR products that historically we haven't carried across as products. So it's an opportunity for us to make sure we're leveraging all of the capabilities we have in the technology tools across the business and markets.

Maybe just a quick one for Ben. The restructuring savings, you said it starts to kick in Q3. Why can't it happen or why can't it start to kick in faster? Is it more fixed capacity take out on to consolidating some people? Why wouldn't you get the cost out really starting pretty quickly?

Well, we certainly don't want to create disruption as we're doing this and so we want to be very thoughtful, planful, and we want to have appropriate transitions in place as we do this. So we make sure that as we set expectations to Q3 that we have the time to do this the right way and we don't have any negative impacts associated with customers. We want customers to only see positive impacts as the result of this. So we're going to be very thoughtful in terms of how we do this.

Your next question comes from the line of Andrew Buscaglia of Berenberg.

Just a quick one for me. With the aquatics push out, what were the underlying factors that influenced that? I'm just trying to get my arms around something like that nonrecurring and elsewhere in your business?

Yes. So the underlying factors on the aquatics push is really the -- it was a large project that customer didn't have their job site ready, and so we've been anticipating this one to shift for quite some time, and when a customer says, I'm not ready to take those high-value components, then we have to delay. So it's not something that was in our control. On the supply chain challenges, it's some critical components that were coming out of China that we had extended lead times to be able to complete products to ship to other projects, and what we're doing there is we're going through another supplier or a couple of other supplier qualifications that come out of different geographies so we've got a balance on this.

Okay. And then on your 3% or so of your sales are related to municipal customers, with the project-based work, are there any concerns or are you hearing any concerns with those types of customers around rising interest rates or in tariffs or maybe any hesitation on their part that could lead to a similar situation?

No. We're not hearing that on municipal because if -- generally, the municipal projects are longer time frame and we have milestones that we're completing percent of completion against, again, and then the delivery comes at the end. The other thing that we're hearing from municipal is we're seeing the pipeline pick up quite a bit against some of the new contaminants that they're challenged with, very much like the carbon services we're providing to municipalities around PFAS and PFOA. So some of the issues there, we're actually seeing a pickup in the pipeline on the municipal side.

Your next question comes from the line of Joe Giordano of Cowen.

You touched on R&D earlier. If we're going to be in a situation where M&A kind of slows down a little bit, if I just look at R&D in gross terms or as a percentage of sales, we're pretty low this year, is that a number that has to step up in the absence of more material M&A?

I think, it's no. Joe, the R&D is really tied to the product sales. So that's what you have to apply it against if you look at our percentage. When you think about our service sales and our integrated solutions, what we do is we're technology agnostic, we design source and assemble what our customers need, and then we service it on the backside. So really you would take that percentage against the product sales, and it's a fairly reasonable percentage when you look at the amount of business it supports.

And then when I think through the restructuring savings, can you talk into like the major buckets. I mean, I get the back-office side, but can you tell us how like consolidating these 3 segments, where the $15 million to $20 million or whatever -- your $17 million to $22 million of savings, it's a big number. So what are the major buckets of that?

So I think what you have on there is the structure and the integration of the businesses where we have had historically 15 divisions and we're bringing that down around technology platforms into larger divisions with less overhead and less back-office. That's where a lot of the opportunity comes from. The other thing that we're able to get out of that is we're available to get economies of scale where we're creating centers of excellence in our manufacturing and our sourcing and supply chain opportunities across the 2 businesses. And then as we look at the footprint and the footprint of our service facilities, where we've had a footprint for municipal, a footprint for light industry, a footprint for heavy industry, there's a real opportunity and then around some of the acquisitions with ProAct and others, we're able to go in and get critical mass. For instance, one of the things that you guys will see if you're coming on our investor tour next week is we're going to see the Houston location that historically was 4 different locations in Houston, that's consolidated down to one. So those types of opportunities are tremendous potential for us against savings as we go forward with the reorganization.

And maybe just last for me. When you think about the guidance that you're giving today versus when you gave full year guidance for last year, like when you're going through your planning, how would you say the conservatism maybe -- if there was something that you would have done thinking, hey, maybe 50-50, we get this, maybe less, or you put in the number or this you take -- like how would you rank the level of optimism, conservatism into, I guess, back half things that you'll have to kind of guess on a little bit more?

I would say you balanced it pretty well in the way you just articulated. I think as we came forward out of the gate as a public company and we had been rolling on very good opportunities as a private company and the growth that we've shown over the past 3 years is shown in the presentation. I think we just have -- we have to make sure that we are much more measured and thoughtful in what we're rolling forward into annual guidance.

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

Thank you. So thank you all for participating again in the call today. As we discussed through the call, we feel like we're uniquely positioned to be the solution provider of choice. I ultimately want to thank the employees inside of Evoqua for their tremendous efforts through 2018 and their dedication as we roll into a very successful 2019. We're proud of the legacy. We're very optimistic about the future and on delivering sustainable results into the future and creating great shareholder value. So thank you very much for your time. We look forward to speaking with you again soon. Thanks.

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