Evoqua Water Technologies Corp (AQUA) 2019 Q4 法說會逐字稿

Good morning, and welcome to the Evoqua Water Technologies Fourth Quarter and Full Year 2019 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, Erica, and good morning, everyone. Thank you for joining us for Evoqua Water Technologies' conference call to review our fourth quarter 2019 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. We ask that you please keep to one question and a follow-up to accommodate as many questions as possible. This conference call includes forward-looking statements, including our expectations for fiscal year 2020 as well as expected costs and benefits associated with our 2 segment realignment and our execution of our digital strategy. 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 included in the presentation slides for this call, which can be obtained by Evoqua's Investor Relations 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. We're very pleased to report revenue and adjusted EBITDA results that were at the high end of our full year 2019 guidance. The business generated strong organic order growth, strong sales growth, record earnings, record free cash flow and significant leverage improvement. Our outlook continues to be positive as customers demand for our broad portfolio of sustainable solutions remains healthy, as evidenced by our robust pipeline of opportunities and double-digit order growth for the fourth quarter and for the full year.

Over the past year, we've taken steps to reposition the company for long-term profitable growth in an attractive and expanding water market. Our organization has responded well to the 2 segment realignment, and customers are benefiting from a more effective and coordinated sales effort. Our digital strategy has advanced over the past year, and our expectations for both customer water-managed opportunities and Evoqua-outsourced water benefits are increasing.

Customers increasingly look to Evoqua to solve their most complex water treatment challenges and as a partner to outsource their water treatment needs. To advance our leadership position, we have invested approximately $140 million in growth capital over the past 4 years, while also making 13 acquisitions and a recent majority investment in Frontier Water Systems to fill targeted technology and market gaps.

We continue to not only manage our investments into the business but are also shaping our portfolio around the most attractive and customer-aligned portions of our offering. Following this strategy, we recently announced the divestiture of our MEMCOR product line to a strategic partner, which will further strengthen our balance sheet while providing ongoing access to these world-class advanced filtration technologies. We will continue to take actions to drive our strategic plan and position the organization for organic and inorganic revenue growth.

As the world moves to a more circular and sustainable economy, we believe we are well positioned to assist customers with recycle and reuse needs. At our recent company leadership meeting, we added sustainable as our fourth corporate value joining integrity, customers and performance. We're actively engaged in helping our customers meet their sustainability goals. Additionally, we're taking actions to improve our portfolio of sustainable solutions and drive company goals, including the expansion of our sustainability program in 2020.

Please turn to Slide 3. We're very pleased with our overall results for the quarter. In the quarter, we generated revenue growth of nearly 13%, driven primarily by organic growth of approximately 12%. For our fiscal year '19, revenues were up almost 8% with more than half of that coming from organic growth. Order growth was up double digits on a full year basis for both segments. APT had outstanding revenue growth of approximately 21% for the quarter with 4 out of the 5 divisions growing double digits, and we're particularly pleased to see our aquatics product line post a strong performance for the year.

ISS also reported solid revenue growth of approximately 8% in the quarter, driven by both services and capital. We have completed the first year of the 2 segment realignment, and we've made significant progress in streamlining our go-to-market structure. We expect to see additional customer benefits materialize in 2020, while the new structure continues to deliver efficiency. We delivered free cash flow generation of $111 million and a conversion rate of well over 200% of adjusted net income for the year.

We successfully financed growth capital investments during the quarter, including a large outsourced water asset, which increases our overall cash returns and enhances free cash flow. We announced the signing of our agreement to divest the MEMCOR product line and our acquisition of a 60% stake in Frontier Water in early October. We expect to apply most of the net proceeds from the MEMCOR divestiture to further reduce our leverage below the current 3.8x. At the end of the fourth quarter, if we include the expected net proceeds from the MEMCOR divestiture, our pro forma leverage is approximately 3.5x.

Please turn to Slide 4. There are significant water challenges emerging in the market that provides attractive growth opportunities for decades to come. Emerging contaminant removal is a mission-critical competency of Evoqua, and there is no one size fits all technology that can be used in treating challenging contaminants. Our service network, combined with our extensive mobile fleet and comprehensive treatment portfolio, favorably positions Evoqua to help solve the most challenging water problems for our customers.

PFAS, which has received significant publicity recently, is a complex and growing threat to the safety of our water supply. The treatment adoption rate, while still early, is highly variable and driven in part by public perception. Regulatory and legislative enforcement requirements are still evolving and differ between federal, state and local authorities. While still early stage, we have more than 30 U.S.-based PFAS treatment installations, and that number has the potential to grow quickly over the coming years. These installations include municipal drinking water, military bases, industrial sites and testing in landfills.

We have multiple technologies to remove PFAS from water, including fixed and mobile assets, and we're investing in expanding that portfolio. In addition to providing treatment solutions, we're also actively investing in new technology trials aimed at developing and expanding PFAS destruction technologies and capabilities. We expect the scope and specifics of federal, state and local regulations to play as a key factor in determining the PFAS market size and growth rate, but we're assuring that Evoqua is equipped to address the needs.

Please turn to Slide 5. As a cornerstone of our strategy, we remain focused on growing our highly recurring and digitally enabled revenues. As a result of many macro trends, water treatment complexities are increasing, and we are investing to address these challenges. Through recent efforts, we're beginning to incorporate IoT technologies into our vast products portfolio to boost efficiency, enable predictive maintenance, protect assets and provide predictable total ownership cost to our customers.

This connected strategy often leads to customers choosing outsourced water like our Water One program after seeing the significant benefits of our connected management systems. Evoqua's digital strategy has made significant progress during the year. We launched our Water One program nationally 1 year ago, and we're on track to meet or exceed our 3-year goal of digitally enabling $90 million to $100 million of existing sales with more than 1,000 basis points of margin improvement across that portfolio.

Please turn to Slide 6. Overall, the business continues to benefit from stable and recurring revenue growth. This graph presents our revenue and adjusted EBITDA on a rolling 12-month basis from quarter-to-quarter since 2016. Our overall revenues have grown at a rate of almost 9% with adjusted EBITDA growth of approximately 20% during this time. We continue to see strong growth of product revenues of 11% pulling through and accelerating service revenue growth, which is now over 5% compounded annually since 2016. As we've previously discussed, the nature of our business is subject to quarterly variability. However, we have high visibility into our revenues from products and services on an annualized basis.

Please turn to Slide 7. Acquisitions will continue to be an important part of our long-term strategy that supplements our organic growth. Over the past 4 years, we acquired 13 companies, 9 of which added to our product and technology portfolios and 4 that extended our geographic or vertical market reach. We're very pleased with our most recent acquisition of a majority stake in Frontier Water, marking our 14th transaction. Frontier is a great technology investment providing cutting-edge biological treatment solutions for the removal of selenium and other heavy metals from flue gas desulfurization systems, coal ash ponds and mining applications. We are very pleased to welcome the Frontier team to Evoqua.

In early October, we also announced our agreement to divest of our MEMCOR product line to DuPont. We have enjoyed a decades-long relationship with DuPont as we have delivered integrated membrane-based systems and solutions into the marketplace. This transaction allows us to focus on growing our businesses that are digitally enabled with highly recurring revenues while maintaining access to world-class filtration technologies through our existing and trusted partner.

I will now turn the presentation over to Ben to review our financial results and our 2020 outlook.

Thank you, Ron. Please turn to Slide 8. For the fourth quarter, revenues grew $46 million or approximately 13% over the prior year to $412 million. Organic revenues grew nearly 12%. Integrated Solutions and Services revenue grew approximately 8% and Applied Product Technologies revenue increased 21% over the prior year. Foreign exchange negatively impacted overall revenues by approximately 1%. Adjusted EBITDA was $79 million, up approximately 30% versus the prior year for an overall margin of 19.2%. Fourth quarter profitability and margins benefited primarily from volume leverage, favorable price/cost and 2 segment realignment benefits, but was partly offset by foreign exchange and strong capital revenue growth.

Please turn to Slide 9. For the full year, revenues increased approximately 8% to $1.44 billion versus the prior year. Service revenues grew over 10% with products growing by 6%. Organic revenues were up approximately 5% with both segments delivering double-digit order growth here. Foreign exchange negatively impacted revenues by almost $14 million or 1%. Adjusted EBITDA increased 8% to $235 million versus the prior year to a 16.3% margin. A combination of multiple factors drove the increase, including volume leverage, realignment benefits, price/cost, while being partly offset by mix and foreign exchange.

Please turn to Slide 10. For the fourth quarter, Integrated Solutions and Service revenues were up approximately 8% to $248 million. Capital revenues were up approximately 12%, while service revenues were up approximately 8%. We saw solid growth from customers in the microelectronics and chemical process industries during the quarter. Organic revenues grew over 6% in the quarter. Two acquisitions contributed approximately 2% to growth. Order growth was up double digits in the fourth quarter, driven largely by capital and outsourced water projects. Fourth quarter adjusted EBITDA increased approximately 14% to $61 million versus the prior year, primarily due to higher volumes, improved pricing and acquisitions growth. Adjusted EBITDA margin was 24.7%, up 130 basis points over the prior year. The benefit of volume leverage, favorable price/cost and restructuring were partly offset by mix from strong capital sales.

Please turn to Slide 11. For the fourth quarter, Applied Product Technologies segment revenues increased approximately 21% to $165 million with 4 of the 5 product lines growing at double-digit rates. Foreign exchange negatively impacted revenues by approximately $3 million or 2%. We're pleased to report that our highly profitable aquatics product line reported double-digit revenue and adjusted EBITDA growth for both the fourth quarter and the full year. For the fourth quarter, adjusted EBITDA grew 56% to $37 million for a margin of 22.7%. Improvement was driven by volume leverage, 2 segment realignment benefits and favorable mix, partly driven by strong aquatics product line sales growth.

Please turn to Slide 12. Capital expenditures in the fourth quarter were approximately $25 million, slightly down from last year, while full year CapEx increased $8 million over the prior year. Outsourced water projects and mobile fleet expansion drove most of the growth investments. During the quarter, we financed $22 million of growth CapEx investments, including a large outsourced water project and mobile assets. On a year-to-date basis, capital expenditures were $89 million or approximately $51 million net of growth CapEx financing. Net working capital increased $14 million in the fourth quarter over the prior year, which includes approximately $2 million from acquisitions. Increase in working capital is primarily driven by sales volume growth. Working capital improved 20 basis points over the prior year and 130 basis points sequentially from the third quarter.

Please turn to Slide 13. Free cash flow for the quarter was $81 million. Full year free cash flow was $111 million, exceeding 200% of adjusted net income. Leverage improved sequentially from 4.2x to 3.8x in the quarter, driven by both adjusted EBITDA growth and strong cash generation. Additionally, we expect debt paydown from the net proceeds of the MEMCOR divestiture will further improve our balance sheet flexibility. At the end of the fourth quarter, considering the net proceeds from the MEMCOR divestiture, pro forma leverage is expected to be approximately 3.5x. Our current weighted average cost of debt is approximately 5.4%.

Please turn to Slide 14. We're pleased with the momentum we have built as we enter the new fiscal year, but we're also monitoring uncertainties that could unfold throughout the year. Tailwinds going into 2020 include a strong close to the fiscal year with solid order book growth, notable sales execution benefits from the 2 segment realignment, a strong pipeline of opportunities and favorable macro water trends. The global economy is growing, but there are concerns that the growth rates may be slowing. The order book continues to be strong delivering partly -- driven partly by outsourced water service contracts, which tend to convert over a longer period of time. We continue to invest in commercial talent in a tight labor market to execute on our strong pipeline of opportunities. Geopolitical risk also creates potential for currency fluctuations.

Please turn to Slide 15. Our key assumptions for 2020 include the following: We're taking a balanced approach factoring in order conversion timing and the potential for slower growth macro environment. Price/cost is expected to be neutral to slightly positive. We expect to see approximately $4 million to $6 million of annualized restructuring cost benefits. We also have the potential for higher employment costs associated with a tight labor market and investments front-end capabilities to execute on our robust opportunity pipeline. We're targeting 2020 free cash flow conversion to be higher than 100%. We expect 2020 tax expenses be between $10 million and $20 million, which includes the MEMCOR transaction. We expect diluted shares count to be approximately 120 million shares, and we have factored in the impact of the MEMCOR divestiture into our sales and adjusted EBITDA outlook.

Please turn to Slide 16. We have good visibility into our business over a rolling 12-month basis, as we discussed earlier. This chart highlights our historic quarterly and seasonal variability over the past 4 years. However, over the course of a rolling 12-month period, this variability tends to normalize. As reflected on this chart, we expect to see our 2020 quarterly adjusted EBITDA pattern to be similar to fiscal 2019.

Please turn to Slide 17. Our forward year revenues outlook is in the range of $1.4 billion to $1.46 billion and adjusted EBITDA in the range of $230 million to $240 million. The growth rates on this chart are adjusted for the pending MEMCOR divestiture on a pro forma basis for comparative purposes. We expect to see the first half adjusted EBITDA to be in the range of 40% of the 2020 midpoint, which is in line with a typical year. As commented on Slide 16, we expect to see our 2020 quarterly adjusted EBITDA pattern to be similar to 2019.

Please turn to Slide 18. We remain committed to these long-term targets over the next 3 to 5 years. Our go-to-market strategy is increasingly focused on digitally enabled recurring revenue growth and more comprehensive solutions to drive additional customer benefits.

I would now like to turn the call back over to Ron for closing remarks.

Thanks, Ben. Please turn to Slide 19. Through the tremendous work of our industry-leading team, we delivered strong results for the year and are looking forward to another solid year in 2020. Our 2 segment realignment is resulting in customer benefits yielding strong order growth, and we're continuing to invest heavily in our team and talent development. Water One and our overall digital strategy is on track, and we're working to leverage our connected assets to more efficiently manage multiple outsourced water opportunities. As a company, we're well positioned to benefit from macro water trends and the increasing challenges from emerging contaminants.

We saw favorable year-over-year pricing benefits in 2019, and we will continue to be diligent in our pricing initiatives in 2020. Free cash flow was strong, providing increased balance sheet flexibility. We expect growth CapEx spending to continue as we invest to meet customer demands and to service our very strong order growth. Additionally, we will continue our acquisition strategy of manageable, attractively priced tuck-ins to supplement our organic growth and fill identified gaps allowing us to better serve our customers. We go into 2020 with momentum, and we're confident that our market position is strong and improving through the actions of our dedicated team members.

We will now open the call to your questions.

(Operator Instructions) Our first question comes from Deane Dray with RBC Capital Markets.

Maybe we could -- first of all, congratulations on a strong rebound year and especially fourth quarter and cash flow. So congrats to the team. Maybe we can start with where and how the growth rate where you may be having some slowing that Ben mentioned. There might be some slowing. Where might you be seeing that?

Yes. So Deane, we watch across many vertical markets, as you know, we play in. We've had fantastic order book growth, as we talked about, and we highlighted again on this call. A lot of the orders that we have are longer-term orders. So it would be a long-term service contract that we'll sign in ISS that will go over multiple years. So it's really good for us as we look out into the future years on the visibility and the recurring nature of our revenue, which we continue to highlight. Where we're seeing a little bit of slowdown with -- as Ben talked about, even on the slide with some of the macroeconomic trends, is in the pipeline that we're looking at. And we're seeing not a cancellation and not a stop, but a pause. And those would be in the power markets, a little bit in chemical, hydrocarbon processing, around larger projects that customers have considered and they've asked us to give them prelim quotes on. They would be in the pipeline. And then they seem to be hesitating or just making decisions to pull the trigger a little slower than we've seen in some of the historical years.

That's helpful. And then just a quick question on the MEMCOR divestiture. 5 years ago, it might have been considered very surprising to see an exit, but this is very much a stand-alone business, not a lot in the way of service around it. So what were the factors in consideration that this was not a business that was core to Evoqua?

I think you actually hit it in your question, and it's more project-based. It's less service and aftermarket-based. It's a longer aftermarket tail. We're very focused on making sure that we're investing in businesses that are highly repeatable, highly recurring. We see a service tail on the backside. We can digitally connect them, so that we can drive the business more effectively and efficiently with good predictability. The other thing about MEMCOR -- it was the only business we had that made membranes. We have partnered with membrane manufacturers for many years, and certainly DuPont we were selling it to for many decades. And we are a design source and assemble against best-in-class products on the membrane side. So it made sense for MEMCOR to be aligned with DuPont where we still have great access to those tremendous products that they manufacture.

Our next question comes from Nathan Jones with Stifel.

I'd like to square a little bit some of the commentary on order rates versus what looks to be about zero organic growth in the guidance for 2020. I mean, you've talked about having double-digit order growth across both segments for the full year. I think you've given us a little bit of an idea that some of these things might be a few years out in realizing some of the revenue from those orders. Can you talk about -- is it typical for you to see these orders be that long-dated rather than converting to revenue in 2020? What kind of growth that might bake in as we get out into '21 and '22? And has the duration of the backlog increased as you've shifted the portfolio more into the digital areas?

Yes. So Nathan, the duration of the backlog has increased. And we -- it is typical to see longer orders that cover multiple years. And you have to look at both businesses. ISS has a fair amount of that in the service orders that we'll get that are longer-standing contracts. That has extended into longer years and longer cycles. So we're very pleased with that. It gives us very good visibility into what the outlook is. I would say that on the top line and the bottom line, as we look at next year, we took a very balanced approach in the guidance we're giving. APT is a little faster book-to-bill, and you saw that in a lot of the results we had and represented in the fourth quarter. We expect to see continued good growth going into next year. But we want to make sure that we're very balanced around the back end of the year with some of the macroeconomic trends that are potentially on the horizon. But I do think that we've got a fantastic product portfolio. The demand is there. The long-term demand is there. We just realized that as we look at FY '20, we've got to be very balanced and make sure that we're continuing to give the right outlook and the right tone and tenor in the track record that we've established over FY '19.

Never hurts to be a little cautious on the outlook. Is it fair then to say that you have a stronger first half of the year built into the guidance and a weaker second half of the year built into the guidance based on potential uncertainty out in the second half of the year?

Yes, Nathan, that's correct. When you look at Page 16, we expect to see FY '20 to be very similar to FY '19. And you look at that chart and you see 60% in the second half with 34% of the EBITDA coming in the fourth quarter, we have the least visibility to that at this point in time. So as we look to the uncertain macro situation, industrial production has been under stress. And we're saying, all right, what's going to happen in the book-to-bill business, particularly within APT in that latter part of the year. We just don't have that good a visibility at this point in time. So we're maintaining conservatism, even though we're not seeing that right now in our current order rates, and our pipeline activity is healthy. But we think it's prudent. We don't want to have to get into a point in time where we're looking at second half of the year and things change and have to adjust guidance.

Our next question comes from Andrew Kaplowitz with Citi.

This is Eitan Buchbinder on for Andy. Adjusted EBITDA margin for the year expanded 10 basis points to 16.3%, and the midpoint of your guidance implies another 10 basis points improvement to 16.4%. With the 2 segment realignment benefits set to layer in further, could you talk about the potential for margin expansion in 2020?

Yes. Eitan, we do feel like there's a good opportunity for margin expansion as we do go into 2020. Again, back to the commentary I gave on the prior one. We took a very balanced approach in the year. One of the things that we're looking at -- and we've gotten much better at being able to do a backlog growth forward. We're looking at our pipeline. We realize where we need to make investments to ensure that we are expanding our product portfolio and into the recycle/reuse much more of the wastewater treatment side in the industrial space and a closed-loop system. And a lot of these things, what we'll do is we'll do our first article development and creation, which will go in at lower margins. And then the follow-on projects coming outside of that are much higher margins because we've done the engineering upfront. So we've got a little bit of that balanced into what I'd call a balanced outlook into next year around top line and bottom line. That if these move faster and as they go through more quickly, we see repeats, there could be some nice margin pickup as we get to the latter half assuming the macroeconomic trends stay bullish.

That's helpful. And this quarter had double-digit organic growth in 4 out of the 5 product lines in APT and 3Q also had growth in 4 out of the 5 businesses. Could you talk a little bit about the different pieces of growth in the segment?

Yes. Again, we saw, as we said, 4 out of 5 businesses. Some of the businesses, we saw the real benefit is businesses that we've had some struggles with before. So I specifically mentioned the aquatics business that we're very pleased to see performing quite well. That's on the heels of FY '18, where we had challenges in the aquatics business. We were able to roll our systems in across that business. We have great visibility against it. We realigned the manufacturing. And in fact, we just announced that we're going to be moving into a new innovation center in Coventry, Rhode Island, which is where the headquarters of that business is. So we can bring customers in. They can see, touch and feel the product. So we're seeing that really very broadly across the segment. Again, 4 out of 5 did extremely well, and we anticipate that will continue as we enter into FY '20.

Our next question comes from Brian Lee with Goldman Sachs.

I guess maybe just following on, on the last question. Incremental margins were pretty strong in both ISS and APT this quarter. Can you maybe speak to some of the drivers there? And if near-term trends should hold and you maintain these kind of incrementals into 2020, I'm a little confused as to why that doesn't seem to be reflected in the drop-through based on the guidance for revenue and EBITDA growth being sort of in line with each other.

Brian, this is Ben. Yes. So when you think about looking to the outlook, we -- first of all, we've got about $2 million of upside to our 2 segment realignment benefits in APT earlier than expected. So Q4 was bolstered by that and that helped. In addition, price/cost was a benefit. But as we look to the future, we also see the potential for a tight labor market pressure on some wages that we want to make sure we factor in. And as Ron mentioned, making sure that we -- on these longer-term projects that the initial engineering is more expensive. It puts a little weight on margins early on, but then the repeat engineering on these wastewater projects becomes much more profitable. So as we look at that pipeline, we factored in additional costs associated with being able to execute on these orders for these initial wastewater projects. But those are the main drivers as we think about the outlook. And then as I also previously mentioned, we have the least visibility to the second half of the year and particularly the fourth quarter, and we wanted to make sure that we didn't get out over our skis in terms of our guidance. Okay?

And Brian, I think just to add to Ben's comment. Again, we took a very balanced approach as we look forward. The other thing that, as we've discussed, and he discussed the mix a little bit. Once these first recycle/reuse a lot of the larger wastewater projects go in around industrial customers, the follow-on after that because that engineering is done and then the service that comes from it as well will be higher margin. But those are in the out years once segment is sold and they're actually executed.

Okay. Great. That's helpful color. And then just a second question on the cash flow. Obviously, very good this year, and then you're targeting over 100% again in 2020. So kind of turning around that part of the story, which I think had been a concern for some investors. So now with the MEMCOR sale, you'll get net leverage down to 3.5 turns, much above the long-term target. So maybe flipping the question a little bit where this used to be a concern. Is this something where you could be a bit more offensive? How do you think about further delevering from here, getting to that targeted range of leverage ahead of the 3 to 5-year time line?

Our goal is certainly to continue to create balance sheet flexibility and generate strong free cash flow. We are going to stick to our priority uses of cash. We have a lot of great investment opportunities. But as the service orders continue to grow, and the base of service revenues continue to grow, particularly with the outsourced water, it helps our cash flow conversion cycle. In addition, the exit of MEMCOR, MEMCOR was a long cash flow conversion cycle. That will also help and take less -- take some pressure off the free cash flow. But we still have a lot of nice tuck-ins in the pipeline. We have a lot of opportunities to invest both organically and inorganically, to execute on the strong order book, and we're going to continue to do that. One other item we're going to also focus on is PFAS and making sure that we have the proper technologies and investments in place to address the continued trend in emerging contaminants, okay. But yes, we should be able to continue to see leverage reduction as we head through 2020.

Our next question comes from Andrew Buscaglia with Berenberg.

So on the divestment of MEMCOR, divestments were not something I was quite expecting at this stage. Are there -- can you quantify or maybe talk to how many more divestments you think are in your portfolio or not where -- are not businesses that you deem part of the long-term strategy?

Andy, we're really pleased with the portfolio that we have. In fact, what we've been investing in is making sure that we're driving more product technologies that are deployed through other integrated solutions and other integrated solutions like we do. We identify technologies through our ISS business, where we go out and design, source and assemble, and we either align with or purchase those technologies to bring into our portfolio. I think that we're very comfortable with the balance of what we have, and we're very comfortable that the products that we have fit our manufacturing portfolio and the capability. So I would say that we're comfortable with the portfolio we have with the exception of some gaps that we still want to go after on acquisitions. MEMCOR was just one that was a heavy manufacturing. Producing membranes is something that is not in our core competency, nor has it been. And so it just made the most sense to align that with a membrane and a materials company that we could have access to the products on the go forward.

Okay. All right. That's helpful. And then you had some interesting commentary on Water One, kind of where you stood with that exiting 2019. Do you have some goals or some expectations you want to set for us as it pertains to Water One? And how that's something that we can look to, to track to see how you guys progress there?

Yes. So the quantification of Water One stays with what we've articulated before. We said we would convert $90 million to $100 million of our service deionization business over to Water One platform over the next 3 years. We're 1 year into that cycle, and we are well on track for what that looks like. We also said it would deliver 1,000 basis points of margin improvement across that portfolio of business, and that is holding very true. The thing that we talked about in this -- today is taking the digitally enabled to a higher level and deploying it across more of our product portfolio. I would anticipate, as we go forward, it's not going to be the fall-through that we would see in a Water One of 1,000 basis points, but it's going to be a predictability and a stickiness on our revenue and our aftermarket because we can see and we can predict at what point we're going to need a service or we're going to need to do an aftermarket trade on some type of installation that our customers will use. So that's what we're trying to drive is that digital connection across more of our portfolio. So thinking about $1.4 billion in revenue that's going to be somewhere around 30% to 40% over the next 5 years that we would expect to see.

Our next question comes from Pavel Molchanov with Raymond James.

I was fascinated by the disclosure of the EBITDA multiple on MEMCOR 13x EBITDA and, as you said, not a lot of recurring revenue in that segment. If that's kind of the going rate, the market valuation these days for a pure hardware supplier, is that indicative of the rest of water tech? And I'm particularly asking this from the perspective of you guys being buyers, right. Is everything that expensive?

That's a good question. It is not overly indicative of water tech when we are a buyer. And the reason it's not indicative of water tech when we're a buyer is because what we're identifying are smaller technologies, new investments, new products that can't get to market without the right channel. So what we're able to do is go in and align and acquire at much better multiples because what we have on the backside is the ability to be able to take these companies and take these products to market much more effectively. If you're going in and you're a subscale company trying to sell to a very large conglomerate, they don't have the confidence in giving that solution to a subscale company and putting their operation at risk. Someone like Evoqua with the channel we have, we have 90 service branches. We're in a -- within a 2-hour radius of 95% of the U.S. population. We cover the map around being able to service industrial customers. We're able to buy at the right levels to pull these through inside of our product portfolio around design, source and assemble.

Okay. That's helpful. One more question on M&A. When you did the deal with Frontier, you took a controlling stake but stopping short of buying it outright. I think historically you've generally done M&A at kind of 100% level. (technical difficulty) case.

Sorry. You broke up on me there a little bit. But I think you're asking why we did not buy 100%. And the reason is we wanted to partner with the team at Frontier. The 2 founders of the business are very visionary entrepreneurs around water treatment and emerging contaminants. We wanted to make sure that we all stayed in this engaged very effectively together. We had access and really a lot of the availability to sell the portfolio of products as well as develop some new products for emerging contaminants with the Frontier team. So we really like what we found there. We were confident that they had a good operating model. They needed the ability to scale up and operational execution around larger projects to be able to go after, just as I mentioned. And so that was the reason that we bought a controlling stake versus buying 100%.

Our next question comes from Joe Giordano with Cowen.

So I want to get back to margins a little bit again. And Ron, I get -- I appreciate your points that you've made about putting in the engineering upfront and then you get the service tail and it's at higher margin that comes through in the back end. That makes a lot of sense. But at the same time, to be fair, we're looking at like third straight year of the same margin level and all 3 down from '17. And when I think about that gap from where we're looking at exiting '20 to the 3 to 5 -- to the longer-term guidance of 20% margin, that assumes if year 1 is kind of 0 growth there, then we're talking overall 130 bps a year for the next couple. So what gives you confidence that in that magnitude of step-up post 2020?

So Joe, as Ron mentioned earlier, you're not going to necessarily see the improvement every year as you convert the business to more of a subscription-based business, particularly in these areas where we are first article engineering. But the service revenue and the profitable service revenue pull-through is going to occur when that order book starts to convert into revenue, which has a longer period of time. So we do expect -- if you say, how are we going to get to 20%, we expect to be able to get 80 basis points on average per year to be able to do that, but it's not going to necessarily happen each and every year, all right. And in addition to that, as we mentioned earlier, we were cautious with the second half because we have the least amount of visibility. And particularly with APT, which is some of the higher-margin businesses have the potential -- we want the visibility there in the second half of the year, and we could get hit with mix.

And Joe, I think that's the key is what Ben talked about is some of the mix components that we're dealing with and some of the projects, just like we highlighted earlier. But what you are going to see is with volume that comes through that's where we're going to continue to be able to ramp this up and grow into the 20%, getting more to -- and again, more of our volume, more of our business, more of our mix that is going to recurring and repeatable revenue as we deploy our digital solutions across. We're getting the margin improvement. I mean, we're still very early days, 1 year in. As you guys know, we did not predict a lot of volume or profit from the digital connected world. What we're seeing is that play out in the deployments that we have. So if we continue to carry that across, that's where you'll really see the margin fall through. So it's ramping over time.

Okay. And then just on my follow up. One -- I just wanted one quick clarification. Did you say you thought the digital part of your business is going to 30%, 5 years from now? I just want to make sure I heard that correct. And then...

Yes. We thought the connected part of our business could be -- can be 30% to 40% of our revenue that comes through. And that's because we're driving digital over into the product side as well, where we're getting feedback loops on at what point we need to change, go into aftermarket. We're getting a lot more visibility around it, also in some more of our services business that's not just service deionization.

Okay. That's helpful. And then if I could, on PFAS, I just -- when I talk to people about this, it just still feels a little bit like Wild West where people don't know how big this opportunity is. It's still kind of super early stage being scoped out. Like how do you see this playing out? Where do you feel like regulation environment is? And does anyone have a good kind of grasp on where this market really is?

There is not an overall strong grasp on where the market is. Right now what we've seen is about 100 PFAS installations around treatments in those range from a mobile system, all the way up to a capital system. We've won about 1/3 of those that we've gone after, and we're operating in those. These systems can be anywhere from $200,000 to $1.8 million on what we've seen in a capital system to a temporary service system. We're treating somewhere between 200 gallons per minute to 2,200 gallons per minute. So a lot of it is going to depend on where the government and the EPA sets the regulations of which they still have a period of time, about another 18 months, I believe, before they're required to set what the regulations are. But what you're seeing is local municipalities, local water districts that find a contaminant, and they're very concerned about it. I think the DoD estimated somewhere around $2.2 billion for a cleanup of the military bases. You would think 12% to 15% of that would be around water treatment. A lot of the others will be around construction and ancillary services that go on behind that.

(Operator Instructions) Our next question is from Patrick Baumann with JPMorgan.

Congrats on a strong end to the year. On the guidance for next year -- and I'm sorry if you answered this already. I missed a lot of the call. But could you just walk me year-over-year through the adjusted EBITDA bridge from 2019 to 2020? And I guess, I'm just curious because if you get $4 million to $6 million of restructuring synergies, savings and you're losing $8 million from MEMCOR, it would seem like the base for 2019 should be somewhat similar to what you reported. And I'm just curious with the revenue growth, why you wouldn't see more drop-through from that?

So as Ron mentioned earlier, we have some investments that we're making, particularly in new wastewater technologies, PFAS technologies, including destruction technologies, engineering for first article installs. So part of that restructuring benefits are being offset by investments we are making that will pull-through more profitable revenue later. But as we head into this first year and we want to convert this order book, we budgeted for those.

Okay. And magnitude dollar-wise, did you quantify that in terms of those investments?

Yes. It's pretty similar to the restructuring benefits. And then we also have factored in the potential for -- it's a tight labor market right now and attracting good technical resources is -- it's tight. So we got to make sure that we factored in not only the ability to track those resources but retain our existing resources, and we do expect to see some pressure -- potential pressure on wages this year.

And that would fall into that price/cost bucket or that's outside of that?

That's outside of price/cost. Price/cost is for commodities.

Okay, makes sense. And then last one for me. Just in terms of the difference in GAAP and adjusted EBITDA for next year. Do you see that difference converging a little bit next year? Or how would you describe kind of what you're expecting for add-backs, restructuring or other items for 2020?

Yes. We should see convergence. We will have some carve-out expense associated with MEMCOR that we'll talk about on our next earnings call once we complete the deal. But it should converge. Also share-based compensation, the IPO bonuses roll off. So that's going to be reduced substantially, probably about half of what it was in the prior year. And the other types of FX, the noncash FX piece is always variable. It all depends on what happens to exchange rates on the intercompany loans, but that's non-cash anyway. And the restructuring portion will be tailing off as we talked about with the 2 segment structure winding down and come to completion.

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 very much for joining us for the call today. We are awfully pleased with the closeout of our fiscal year '19. We're looking forward to a strong fiscal year '20. And I know that, as we discussed on the call, we took a very balanced approach to the way that we're looking at '20 and the way that we're estimating the '20 numbers. I would say that we continue to see a great demand for the products that Evoqua has to offer. We continue to see a tremendous opportunity as we've become focused as well as our customers are on driving sustainability and sustainable solutions. I would like to thank all of our team members across the Evoqua enterprise for the work that they do and thank our customers for trusting in us to take care of their needs. Thank you again for joining us. We'll look forward to speaking with you again next quarter.

Thank you. That concludes today's Evoqua Water Technologies Fourth Quarter 2019 Earnings Conference Call. You may disconnect your lines at this time, and have a wonderful day.