Evoqua Water Technologies Corp (AQUA) 2021 Q1 法說會逐字稿

Hello, and welcome to the Evoqua Water Technologies First Quarter 2021 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.

Thanks, Laurie, and thanks, everyone, for joining us for today's call to review our first quarter 2021 financial results. Participating 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 expectations for the second quarter and the full year of fiscal '21 -- 2021, as well as expectations relating to the impact of the COVID-19 pandemic, order demand and end market drivers, execution of our digital strategy, the acquisition program, the market for treatment of emerging contaminants and other potential growth drivers. Actual results may differ materially from expectations. For additional information on Evoqua, please refer to the company's SEC filings, including the risk factors described therein.

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

With respect to our guidance, we have not presented a quantitative reconciliation of the forward-looking non-GAAP financial measure, adjusted EBITDA, to its most directly comparable GAAP financial measure because it is impractical to forecast certain items without unreasonable efforts due to the uncertainty and inherent difficulty of predicting the occurrence and financial impact of in the periods in which such items may be recognized. 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. Please turn to Slide 3. As stated in prior calls, our priorities remain focused on the health and safety of our employees, ensuring business continuity and customer uptime and improving our balance sheet and the liquidity of the company. The impact of COVID-19 pandemic has varied across our diverse set of end markets, but we're encouraged as we look into the future with the anticipation of the vaccine rollout. We're investing in growth opportunities, solidifying customer relationships, broadening our portfolio of solutions and extending our geographic reach through our M&A program. We believe our future is bright. And while we plan for the future, we are focused on navigating the challenges at hand.

Please turn to Slide 4. Our first quarter results were largely as expected. We were pleased with the overall execution of the business even as compared to a strong prior year from Q1 of fiscal '20, which was the last non-COVID-19 impacted quarter. Additionally, this is the last quarter in which we'll have the MEMCOR business in our prior year comparison.

Our book-to-bill ratio was north of 1, and we continue to see solid bookings and a robust opportunity pipeline comprised of both outsourced water and capital projects across a diverse set of end markets. First quarter organic revenues were down slightly with ISS impacted primarily by side access challenges due to COVID-19 and strong prior year capital revenues, particularly in microelectronics. APT had a solid quarter with notable strength in the APAC region. Price/cost was slightly favorable, and we're closely monitoring potential commodity inflation trends in the coming quarters.

We are pleased to report adjusted EBITDA of approximately $45 million, with margin improving by more than 100 basis points over the prior year supported largely by positive operational execution and realignment initiatives. Cash flow was strong with a conversion rate well north of our 100% target, supported by strong net working capital performance and increased profitability. Liquidity continues to increase and remains above $300 million with net leverage stable at 3x.

Please turn to Slide 5. We continue to develop and enhance our strategy around sustainability. We think about sustainability in 2 ways: first, our handprint, enabling our customers to become more sustainable through our solutions and service offerings; and second, our footprint, driving Evoqua to become more sustainable within our own internal operations.

To highlight a recent emerging contaminants win, we are pleased to receive a $1.25 million order from a municipal drinking water treatment plant in California to provide turnkey solutions with a 3-year service contract to remove PFAS chemicals. Our solution includes 6 vessels, ion exchange media and service through 2024. The service contract also includes extended service for our previously installed granular activated carbon solution on another well site, which is also online to treat PFAS and other emerging contaminants.

We're also working to continually improve our operations internally and minimize our own impact. Our safety incident rate is a primary focus of our operations and as we focus on internal operations as well as service our customer sites. We dedicated a tremendous amount of time to safety and to the review and root cause solution when it occurs. We are pleased to reduce our safety incidence in FY '20 by 30% overall from the prior year. We will not be satisfied until we're at 0 incidents, but we are pleased with our progress.

Sustainability is integral to our business. It is what we do. We're preparing to release our 2020 sustainability report this spring, and we look forward to your feedback. The report will highlight the progress we have made internally to advance sustainability and expand our governance structure while providing more details on our handprint and customer sustainability impact.

Please turn to Slide 6. Our business has been resilient and sustainable and 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 2017. Our overall revenues have grown at a compounded annual rate of approximately 5%, with adjusted EBITDA growth of 9% during this time. These numbers have adjusted down from the slide we had previously shown due to the removal of FY '16 and the impact from the sale of MEMCOR. The business continues to operate on a steady and profitable growth trajectory as we adjust for the divestiture.

We primarily pursue capital projects to ultimately drive stable, recurring and profitable service and aftermarket growth. Currently, our service business comprises 41% of our trailing 12-month sales, while service and aftermarket combined make up approximately 60% of our business.

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 and believe our model will continue to serve us well during this uncertain period. This can be seen in the strong performance of our service business during the periods impacted by COVID-19.

Please turn to Slide 7. Acquisitions have been an important growth investment over the past 5 years, and we're continuing our tuck-in strategy. We utilize acquisitions as a proxy for R&D activity and capital growth investments. Our targets have been and will continue to be focused on filling product portfolio gaps, penetrating target vertical markets and expanding our geographic footprint.

Since 2016, we've acquired 16 companies, 10 of them supporting the development of our product and technology portfolio, and 6 expanding our geographic and vertical market service reach. We consider all of the acquisitions with the exception of Neptune-Benson to be tuck-in-sized transactions. Our last 2 acquisitions, Aqua Pure Technologies acquired in September and Ultrapure & Industrial Services in December are excellent fits in our ISS service model. These acquisitions enabled us to expand our service reach in the Ohio and Texas markets, respectively.

Our opportunity pipeline remains robust. And we're currently focused on expanding our industry-leading geographic service network. We expect to continue our acquisition program while also improving our net leverage profile.

Please turn to Slide 8. Last quarter, we highlighted multiple organic growth drivers for both segments. New product introductions were highlighted as one of the APT drivers. We've recently introduced the Neptune-Benson Defender FP-Series regenerative media filter. This product is an expansion of the classic Defender product line, which is currently used in large aquatic theme parks, zoos and aquariums.

The Defender FP is targeted for a market of what we estimate to be over 31,000 medium-sized applications, including health and fitness swimming pools, swim schools, luxury clubs and municipal parks, which more than doubles our addressable aquatics market. This product is a highly sustainable replacement to sand filtration, providing an improved swimming experience using less water, having a smaller footprint, reducing energy consumption and using less chemicals. The Defender FP ultimately helps to provide a healthier, safer and more sustainable environment. We look forward to sharing new APT product innovations over the next several quarters.

We're also pleased to have been awarded the 2020 Frost & Sullivan Best Practice Award for Product Innovation in the water infrastructure market in the APAC region. This region is highly competitive and a global leader in the water market treatment market, making this recognition even more special. Last year, we added senior leadership talent in the region and opened an office in India. I'm very proud of our APT team and the success they've had.

I would now like to turn the call over to Ben.

Thank you, Ron. Please turn to Slide 9. The first quarter reported revenues were $322 million. Organic revenues, excluding the net impact of recent acquisitions, the divestiture of MEMCOR and the impact of foreign exchange were down 3.5%. Demand varied by end market with growth in health care and pharmaceutical services, capital decline in microelectronics and service declines in refining. Regionally, we expect -- experienced solid growth in Asia Pacific.

For the first quarter, adjusted EBITDA was $44.8 million for an overall margin of 13.9%, up 130 basis points over the prior year. Cost controls, operational efficiencies and realignment benefits contributed to adjusted EBITDA growth. The first quarter of the prior year included MEMCOR sales of approximately $14 million and adjusted EBITDA of approximately $1.3 million. Price/cost was slightly favorable in the quarter.

Please turn to Slide 10. Our Integrated Solutions and Services segment first quarter revenues were down 5.9%. The decline was driven primarily by the timing of large capital projects in the prior year, temporary delays in annual maintenance in the oil and gas end markets, and COVID-related impacts to service and aftermarket revenues primarily due to restricted site access and higher service costs and productivity impacts associated with COVID-related safety protocols.

Our digital strategy continues to enhance our profitability with digitally enabled revenues growing double-digit rates. And customers' interest in our capability remains very high, particularly as customers restrict site access due to the pandemic.

Adjusted EBITDA declined to $43 million due to higher absorption costs from lower volume and unfavorable mix. Ongoing cost controls and favorable price/costs partly offset the decline. Adjusted EBITDA margin for the quarter was 20.1%, down 130 basis points from the prior year.

Please turn to Slide 11. Applied Product Technologies first quarter revenues were $107 million, down 8.9%, which included the impact from the MEMCOR divestiture on December 31, 2019. Organic revenues increased 1.4%, driven by strong growth in the Asia Pacific region. FX positively impacted sales by 185 basis points. As we commented earlier, MEMCOR's Q1 prior year revenues were approximately $14 million. Adjusted EBITDA for the quarter increased over 20% to $19 million. Adjusted EBITDA margins increased 430 basis points to 17.7%. Operational execution and cost containment actions favorably benefited APT profitability.

Please turn to Slide 12. Capital spending, primarily for outsourced water orders was slightly over $17 million for the quarter and flat versus the prior year. As we previously mentioned, our pipeline remains solid with a combination of outsourced water and capital opportunities. We are closely monitoring the pipeline given the uncertainties of the pandemic.

First quarter net working capital was 13.2% of LTM Q1 sales, an improvement of 90 basis points over the prior year quarter. Over the long term, we anticipate a mid-teens net working capital to sales range, given some projects may have varying amounts of working capital requirements. We continue to actively manage the quality of our accounts receivable and inventory levels.

Please turn to Slide 13. As Ron mentioned in his opening comments, managing the business to maintain balance sheet flexibility and strong liquidity continues to be one of our corporate priorities, given the uncertainties resulting from the pandemic. Operating cash flow was $15.6 million for the quarter versus $4.7 million in the prior year. You can see over the past 4 years, we have increased operating cash flow from approximately $29 million to almost $170 million on a Q1 LTM basis.

Adjusted free cash flow was almost $10 million for the quarter, which was 133% of adjusted net income. Our net leverage ratio finished 3x adjusted EBITDA, which was down almost a 0.5 turn from the prior year and stable compared to the fourth quarter.

Our weighted average cost of debt is approximately 3.4%, an improvement of 160 basis points over the prior year. The reduction is driven by lower market rates and a lower credit spread. We were very pleased to receive debt rating upgrades from S&P and Moody's during the quarter, driven by several factors, including continued improvement in operations as well as cash flows, working capital progress and leverage reduction.

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

Thanks, Ben. Please turn to Slide 14. This updated chart represents our current expectations for order demand in our primary end markets for Q2, incorporating insights from our sales and operations teams. We serve a broad and diverse set of end markets as represented on this slide. Our smallest end markets are on the bottom of the page, each representing low to mid-single digits, rising in size to the top, accounting for approximately 20% of our FY '19 annual revenue.

Looking back, our first quarter performance was largely as expected. We noted solid demand in health care, pharma, municipal drinking water and food and beverage. PFAS treatment opportunities continue to drive municipal drinking water opportunities. Overall, we expect to see varying order demand in the second quarter, with 7 out of 10 of our primary end market segments expected to be neutral or growing. The outlook for aquatics and refining is a little more negative, but both of those market segments are not large drivers in the overall revenue for the company. We'll be happy to address detailed questions about specific end market drivers during the Q&A section.

Please turn to Slide 15. In summary, the pandemic continues to present challenges to the global markets, and we are maintaining our priorities to protect our employees, service our customers and preserve our financial strength. We will continue to show our resiliency, operating through the pandemic as a stronger company.

Our order book is growing, and we're actively engaged with customers in helping them solve complex water problems across multiple end markets. Our large installed base, market-leading service footprint and our world-class portfolio of component technologies and solutions positions us well for ongoing growth.

Our first quarter results were solid and largely as expected. We are pleased to drive profit margins higher through execution and operating efficiencies. Our digital capabilities continue to expand, enhancing our outsourced water offering, and the market interest is growing. We've been pleased to see double-digit growth in our Water One digitally enabled service offerings.

We're a highly sustainable company by the nature of our business. Every day, we're helping our customers meet their sustainability goals. The demand to treat emerging contaminants is expanding. We have applications treating PFAS, microplastics, heavy metals and other complex contaminants, and we expect these markets to grow for the foreseeable future. We're seeing increased demands for wastewater solutions across the municipal, industrial and waste-to-energy markets. Recycling and reusing water is a trend that will continue to fuel growth in our front-to-back treatment solutions.

The first quarter's free cash flow, liquidity and overall balance sheet stream for solid. We welcome the Ultrapure & Industrial Service team to Evoqua, and our M&A pipeline is robust with tuck-in opportunities and we expect to remain active while continuing to improve our net financial leverage.

I will now close by commenting on our outlook. The challenges from COVID-19 continue to limit visibility and we're navigating dynamic market conditions. Based on our current view and consistent with last quarter, we're maintaining our outlook of full year revenues and adjusted EBITDA to be flat to up slightly versus 2020.

In the appendix on Slide 17, we provided the 2021 guidance framework, noting potential drivers of upside and downside. Given our visibility into the second quarter, we anticipate revenues to be between $325 million to $340 million, and adjusted EBITDA to be between $48 million and $52 million. Also consistent with prior fiscal years, we anticipate the first half adjusted EBITDA to deliver approximately 40% of our full year's EBITDA.

I will now open the call for your questions.

(Operator Instructions) Our first question comes from the line of Mike Halloran of Baird.

So just want to get some thoughts on how you're thinking about cadence through the year.

I'll start and let Ben add in, Mike. But just as we talked about, we typically see 40% of the EBITDA come in the first half of the year, 60% in the second half. If you'll remember, the first quarter of this year was impacted by COVID, where the first quarter of last year was not. And then as we look at the second quarter, we actually had January and February that really weren't impacted by COVID in 2020. It really hit us in March. And so we're starting to actually lap the COVID years, and we feel good about the back half, given what it looks like in our order activity. Ben, you have a comment?

Yes, sure. Hi, Mike. So again, we're thinking about a 40-60, approximately a 40-60 split EBITDA first half to second half, which is very much aligned with traditionally what we see. But again, that's subject to COVID uncertainty and variability, right? I mean the business normally is very stable and steady on an LTM basis, but quarters do fluctuate from time to time. And COVID has the potential to cause those fluctuations to be a little more significant. But certainly, each half of the year is more stable than any quarter and a full year is much more stable. So right now, we're thinking about 40-60, first half to second half.

And maybe an update then on how you're thinking about what the order trends mean today, how that impacts the next couple of years of orders. In other words, Water One success, build on operate, a lot of these outsourced water initiatives, you're starting to gain some traction. Book-to-bill is really favorable. It has positive implications for out years. Maybe just an update on how that's tracking and how you're thinking about those? And what kind of information you can do to help us understand what that cadence can look like as you start moving beyond the short term?

Yes. So the long-term outsourced water contract business is expanding in this environment and continues to be strong. And I think the pandemic has the potential to have expanded that some at the expense a bit of short term capital. Capital is an area where we're seeing companies be very cautious in that regards, which potentially accelerates their interest in the long-term outsourced water-type contracts. So when you look at our order book, it has certainly shifted more towards services and outsourced water. So that bodes well for the business long term. But again, the timing of capital projects and the pandemic has certainly put some short-term pressure on capital.

The other area that we also highlighted is there's been some pressure on -- particularly in the refining area of the business, on the customer turnaround, which is on-demand services for those types of turnarounds. Now they can't delay those forever, and they will have to accelerate. So it's a timing impact. But as we work through the pandemic, that's another area that it created some short-term softness in Q1.

Yes. Mike, as you review Slide 14 with what we showed on the end market outlook, the end market outlook is related to our order activity that we typically are seeing in the second quarter given the feedback from our sales and operations team. So we always try to give guidance against this. And to Ben's point, the refining and marine businesses have been a little less. And then microelectronics is really tied to higher comp in the prior year.

Your next question comes from the line of Nathan Jones of Stifel.

I would like to start off just talking a little bit about inflation. Oil prices and steel prices have both come up pretty considerably from the bottom. Oil still down year-over-year, but steel is up quite a lot year-over-year. If I think back to 2018, there was some timing mismatches between when we had that steep rise in input costs and your ability to pass that through. I know you said first quarter of '21 had some slight positive price/cost dynamics. Can you talk about what you're expecting here over the next few quarters? And maybe how your pricing model is different now than it was in 2018.

Yes. Nathan, it's a great question. And we are watching the commodities very closely. Steel prices has, as you related, jumped quite heavily over the past few months. What we've done versus 2018, we've got very good models that we are staying in tune with the index as we get good visibility from our suppliers. We have limited the amount of time that our quotes will live. And so we have a much shorter cycle on the amount of time that a quote is actually good. And then once we are locking in projects, we are hedging the old-fashioned way. We're buying the commodities as soon as we lock it in. So we know what a fixed price is and fixed cost is.

As we look at the year, first quarter we said was slightly favorable. We anticipate the full year to be slightly favorable, looking at what projects we have in the pipeline, what we're working against and also where we see the commodities moving. There will be a little bit of pressure in various quarters, but we think the overall year will turn out to be neutral to slightly up.

That's very good news. Maybe just a couple of questions on the order rate here. You said that were positive in the quarter, book-to-bill is above 1. Any color you can give us on what the actual order rates were of growth year-over-year? And how you're expecting that to progress as we move through the year?

Yes. I mean the book-to-bill stayed above 1. It -- we were pleased to see that in the first quarter even with some of the year-over-year revenue changes given COVID and order rate changes. We expect -- and we typically -- we don't give really the numbers over that. We just know the backlog is growing. As you look at the full year, we expect it to be in line with our guidance that we've already given, flat to slightly up. And that is, again, we're coming into 5 months of non-COVID in the first half of the year that we didn't have last year. So there's always some challenges as you look at the COVID and the COVID visibility. But we're seeing, as we showed on Slide 14, the end market is performing as we expected, and we're, again, giving a little color around that with that slide.

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

Can we start with the comment in ISS? You were impacted by the timing of some large projects. Can you just give us some context there with these outsourced projects? Would they -- what was the reason for the pushout? Was it COVID-related? And then when do you think they actually start to be in effect?

Yes. So just to be clear on that, Dean, that was prior year strong capital demand in microelectronics, right? And so again, this is -- the end market still remains robust. There's a lot going on in microelectronics. The end market is experiencing supply chain disruptions, as you're aware of. And so that's -- but it tends to be lumpy for us when we get these orders, just like all capital is. But overall, we had a very strong first half last year in microelectronics. So we're facing these tough comps this year.

All right. That's helpful. And then that leads me to the next question is, we are seeing the impact of the mix shift to doing -- getting more water outsourced contracts. And this is exactly what we want to see you doing. It increases recurring revenues. But the mix shift is happening, where you're going to have your capital sales. And can you quantify for us how much we're seeing in the first half of this mix shift? Is there any way that you can pinpoint some of that for us?

Yes. Deane, I'll talk just briefly to the trends we're seeing. I'll let Ben talk about quantification. But the trends are very positive, and this really speaks to the strategy we rolled out around Water One, the digitally enabled recurring revenue and service. And we've seen that become more robust as we've gone through repeat quarters on COVID and customers are dealing with that. They are just coming back to doing what their cores are and they are letting us do our core competency, which is provide them quantity and quality of ultrapure water. So the good news about it is we're seeing that mix shift, as you spoke about, that we've been discussing for several quarters. and the value that's going to come in that long-term was steady, recurring, repeatable revenue is very good. Ben, do you want to talk quantification at all?

Yes. We don't really disclose orders. But what I can tell you, Dean, is the order growth we are seeing is in services. The capital area, obviously, is the challenge, and the services is offsetting that. So that's -- we are seeing that transition happen just as you articulate. But again, as you know, is capital books out over a much shorter period of time than these long-term service contracts. So as we go through this, this is great long-term for the business, but it does create some short-term pain.

That's -- yes, that's exactly the way we're looking at it. And on the capital outlay for these outsourcing projects, that's all reflected in your current free cash flow performance this quarter. Is that correct?

That's correct.

It is.

All right. Good. So you're still doing well in excess of 100%, even with that growth capital -- growth CapEx?

Yes. That is correct.

All right. And then last question for me. Any update on your share in PFAS remediation projects? When it first came up a couple of quarters ago, you said you had a lead position. We know with the administration change that it is likely to be more emphasis on PFAS remediation by the utilities. And any update here in terms of how your position would be helpful.

Yes, dean, that's a great question. With the new administration, there is a highlight and an emphasis on this. Our share remains consistent with what we've reported in prior quarters, where we're coming in around 1/3 of the opportunities. We watch that pipeline very closely, and we actually highlighted another win that we got in a California water district around resin that's a contract through 2024.

So what you're going to see is those will be contracts that are going to come over the next 5 to 7 years. They'll grow. The good news about them is it's capital contracts that have follow-on service and aftermarket revenue that's very good because you have to make sure you're maintaining that system. And what we've seen in a pipeline that's expanded, it's somewhere in the neighborhood of $100 million over the coming years. But those are longer-term projects that will be service-driven as well.

And just to be clear, do you have the capacity to be able to go after all of these projects as they become available? Are you capacity constrained in any way?

We are not. We have the capacity, and that's one of the benefits of dealing with Evoqua is you have a multiple technology solution approach that we go after. So it's not one size fits all around just try to stick one solution in. We have a broad range and a very complete solution portfolio that we can make sure we have the right technologies applied to the right challenge in the PFAS.

Your next question comes from the line of Patrick Baumann of JPMorgan.

A quick question on the end markets. It looks like you're guiding power to be up in the second quarter, and you were guiding for the first quarter power to be down a little bit. What's the change there? Is there an improvement in the market? Is it something specific to your order profile? Just kind of curious what you're seeing there.

I think again, this is speaking to what we have in expectation against our order activity in the quarter. And the power market for us has been some of the increases in the LG guidelines. So we've been very focused on that, looking at really a lot of the sustainability actions that the power companies are doing, and they're coming to us as a solution for increasing challenged micro contaminants that they're dealing with.

Okay. And on the acquisition pipeline, do you guys see anything more size -- I assume the recent deals you did were kind of more small bolt-ons, tuck-ins, you correct me if I'm wrong. Anything kind of bigger than bolt-ons that you're looking at in the pipeline?

Yes. Not at the moment, Pat. We're very comfortable with the tuck-in strategy that we've been executing on. The two that we just did, as I highlighted in the -- my opening remarks were we're expanding our service footprint in Texas and Ohio. That's where we're putting a pretty strong emphasis this year. As we continue to drive steady recurring, repeatable revenue, we want to make sure that we have the proper footprint there to execute on the opportunities. And it is either we go in with greenfield CapEx start-up or we find the right opportunity in a tuck-in acquisition that's a bolt-on. And as we highlighted, we've done 16 acquisitions since 2016, 10 have been in product portfolio, 6 in the service acquisitions. And so we're -- we shifted a bit of the focus to service tuck-ins over the next year.

Yes, makes sense. Okay. And then maybe a quick one for Ben. I think I got the numbers right on the near term guidance. It seems like it implies margins are down year-over-year. What's the driver of the margin decline, if I'm right about that in the second quarter in terms of the guide?

Again, it's project timing. Last year was a very strong -- first half of last year was very strong microelectronics that were very profitable. So...

Got it. Got it. So it's just the base, which had a good margin mix in it basically last year?

Yes. Yes. And again, it's the typical quarterly lumpiness that we have from time to time that normalizes over the year.

Your next question comes from the line of Saree Boroditsky of Jefferies.

You talked about microelectronics facing some tough comps in the first half of the year, but the end market remains favorable. So do you expect this market to improve in the second half? And how should we be thinking about that?

We do. We expect it to improve in the second half. I mean again, what Ben referred to earlier was just year-over-year comps with the prior year with large installations and orders that we had. But the microelectronics market overall is very favorable for us on both the outlook for projects that are going to come as well as the services offered.

And then I believe you saw demand in China bounce back starting last quarter, and you noted strength in APAC for APT in this quarter. So could you just talk about what you're currently seeing in China and if there are any lessons there that we can apply to the other regions as hopefully the vaccine allows facilities to start opening up?

Yes. Our team in China is fully operational and executing. It's been very good. In fact, we saw, as you referred to, a very nice bounce back in the second half of last year that's continuing to show strength. We see that strength both along the pharmaceutical side as well as highlighted in microelectronics and other business areas that we supply technologies and modules. We're also very pleased to, as I highlighted in the comments, open up our operation in India that is going to provide us some opportunity going forward. Things that we brought to the -- back to other markets that we should follow in the operations is, and we've done that from the very beginning, was make sure that our supply chain was very robust, very sustainable, and we didn't run into component technology challenges.

The other thing that we've done is just ensure that we have the right protocols in place that our team is able to continue to operate. And through this entire COVID challenge and the pandemic, our teams and our major operations and facilities have continued to run very effectively and very efficiently. And we thank the team members that are part of Evoqua that have been delivering on that.

Your next question comes from the line of Andy Kaplowitz of Citigroup.

So obviously, you've had significant tailwind from the segment alignment that you've done, focused on APT, but you did record in this quarter, higher APT margin and lower sales. I know some of that is likely MEMCOR. But could you give us any more color on how to think about the tailwind from a cost-out perspective at APT going forward?

Yes, sure. So MEMCOR was certainly a part of that. But also the post-MEMCOR footprint actions that we've taken and optimization actions also contributed to that. And then we've mentioned those footprint actions, but that also sets us up well for the future. The APT team has done a great job of really improving its overall operational effectiveness post-MEMCOR and streamlining a lot of the aspects of their business. So the majority of it was really related to the actions taken by APT and better execution.

They also -- that business also has a lot of mix, right? And that can impact it quarter-to-quarter. But long term, these actions should bode well for the continued improved profitability of APT.

That's helpful. And then you mentioned the transition to wastewater continues to fuel growth. Maybe you could give us a little more color into what you're seeing with industrial customers? Given COVID and maybe the difficulty that customers have staffing their business, do you see maybe a faster evolution to more outsourcing now? What are you guys doing about that transition?

Yes. We actually are seeing an improvement in the adoption rate around outsourced water, and that's something Ben actually spoke to earlier in the call. And it is, it's having an impact, as we see, and you see a little bit on capital sales that are taking more time. They're stretched out over longer-term contracts that are coming in because customers, as a part of COVID and I mentioned earlier, they want to focus on their core competency, which is producing a product or providing service not providing ultrapure water to their own applications. They're relying on us to do that.

So it's been very positive for us. It's quite favorable. Even in my opening remarks, speaking about recycling -- recycle and reuse of wastewater in the industrial space, we're seeing that continue to gain momentum and gain growth. And I think that's going to be a growth market for the foreseeable future.

Companies are doing what they need to do to provide sustainability into the marketplace and to be a more sustainable company themselves. We are very focused on ESG. We actually enable sustainability inside of our customers, speaking about our handprint. And that is ultimately, going to drive very long term, very steady, repeatable revenue when companies are saying, recycle and reuse, let's minimize our liquid discharge and let's make sure that we're doing what's right for the environment. And frankly, Evoqua, you're the right partner to bring in with solutions that are treatment from the front end to the back end, back to the front. So it's an exciting time in the marketplace, and I think we'll see that continue to grow.

And just one more quick one for me. Municipal budgets. I mean you're pretty bullish on municipal, it looks like, going forward. Anything you're seeing there as we start the new calendar year? Seems like customers are spending when they need to spend, but you tell me any more color that you'd give?

Yes. I think what you're seeing, Andy -- and this is one of the reasons that we stay pretty bullish on it, and you see that being highlighted as green in our markets. One around municipal drinking water, which we spoke around. It's emerging contaminant treatment, so PFAS, microplastics, et cetera.

On the wastewater side, we have such a long history of installations inside of the North American wastewater systems. Customers are doing retrofit and rehab on their wastewater systems because they're not going in with massive projects to do very large expansions. They're making sure what they have is actually operating at spec. And in doing that, that brings us in for retrofit and rehab work.

We've had a little bit of a difficulty getting on-site through COVID with some of those. But our team has done some pretty remarkable things. We're actually taking out electronic glasses, so people can look at it, point at it. Our engineers can be on the phone. And they can highlight, take a look at this area, this may be where we need to be replacement or rehab on some of the systems. So we're getting creative around how to operate in the new norm. And that's a little bit of what you see about some of the bullishness on retrofit and rehab in the municipal wastewater side.

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

Maybe just a couple real quickly on the guidance here for 2Q. That is representing the first quarter where you're fully lapping MEMCOR. So is that correct, there's no MEMCOR divestiture impact embedded in there? Are there any other divestiture impacts that you would be -- anything to kind of call out there?

No, it's only MEMCOR.

Okay. Great. And then you made a comment earlier, I think, in response to another question about the margin guidance and mix for Q2, microelectronics, and be kind of project-heavy and that -- that being a mix, which is driving down margins for Q2 on a year-on-year basis. Fair to assume that, that's mostly coming out of ISS, so we may see a similar trend where ISS is weaker into Q2 versus APT kind of holding up a bit better here?

Yes.

Okay. Fair. And then earlier question, Ben, I think in relation to commodities and cost inflation. Can you kind of level set us again as to where you have the most exposure, commodity-wise? If you can quantify it, that would be great. And then are you starting to see that impact already? Or just what's sort of embedded in the outlook as you think about navigating the current and go forward cost environment?

Yes, sure. So chemicals, plastics, steel, these are the kind of the larger commodities that we have in terms of impact.

Any sort of quantification and also commentary around kind of what you're seeing real-time versus what you think kind of the outlook is embedding for you for -- cost-wise?

I'll let Ben speak to quantification on this, but I will say that we have been very focused on watching what's happening with these commodity movements. And in fact, as we go through them, we get real-time prices, real-time quotes from our team. As we're giving quotes to customers, we're making sure that our supply chain organization is connected with our suppliers. We've got a lot closer loop than we had back in '18 to an earlier question we had. And so as we're doing that, we're locking in quoting against longer-term quotes, but we're also limiting the amount of time the quotes are. So we felt pretty good through the first quarter and feel like price/cost, as we look at the year, will be neutral to slightly favorable. But Ben, you want to talk?

Yes. I think based on what we see at this point in time, again, I think it's neutral to slightly favorable. Commodities can move, right? It's a market that can move fast one way or the other. But at this point in time, we're monitoring it very closely. We are also staying very disciplined in our pricing actions and are prepared to respond accordingly. But I think based on what we see at this moment, neutral to slightly favorable price/cost for the year would make sense for us.

Okay. And maybe just last one, if I could squeeze it in. With respect to price actions, are there any price actions that you've taken already? I know it's early in the year, or any contemplated here in the next month or so?

We have. We've already taken price actions. And actually, we will continue to do that through the year. One thing you may remember is that our contracts typically are annual contracts around services. So where we see commodity movements, it's 1 year renewals. It gives us an opportunity to make the -- take the right price actions as we see commodities move because we aren't setting long-term contracts typically on our live industry services.

Your next question comes from the line of John Walsh of Credit Suisse. (Operator Instructions) There is no response from that line. Your next question comes from the line of Joseph Giordano of Cowen.

This is Francisco on for Joe. So I wanted to get your outlook on ISS, basically, where -- when you think it's going to begin to ramp up again? Is there maybe sort of a margin tipping point where the service revenue starts to push that materially higher from here?

Yes. I think again, we have tough comps in the first half. We have a lot of COVID challenges, site access. And we also have, as we mentioned earlier, some of the challenges in some end markets like refining, where they've delayed some of their annual maintenance. So a lot of it depends on vaccine rollout effectiveness. Hopefully, the second half of this year. We don't have the COVID -- we have COVID-neutral comps, if you will, for the second half of this year. And hopefully, some of the access issues, et cetera, abate and the virus is successful, and we should see a better second half for ISS.

And Francisco, I think one thing I would point to is, in Slide 14, that gives the outlook for the end markets that we play in. And typically, you can glean from that what the North American markets that ISS is typically serving. And refining and marine has been a pretty big pullback. What Ben talked about earlier with micro, with year-over-year comps has been tough. But we think that in the back half of the year and the beginning of next year, we're going to see site access open up a little more and the service opportunities flow better.

Great. That's very helpful. And then just a quick follow-up on the muni expectations. You guys have seen some pretty good growth there. Do you expect the strong demand to hold through the rest of the year? And do you have any comments maybe on budget expectations?

Yes, we do. I mean we feel good about muni. That's the reason that both of those are green as you're looking at Slide 14, we showed. And it speaks to an earlier comment I made about the installed base that we have in the wastewater systems inside of North America that we've been providing products since -- for more than a century now. So it started late 18 -- or the late 1800s on one of our product lines. I mean so we're going back and we're doing retrofit and rehab to an installed base, which is fantastic for us. And that's where we see the municipal operator still investing money where they don't have huge budgets to go out and expand capacity. They certainly have the budgets for retrofit and rehab to make sure that they are operating at the specification of the plant.

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

Everything is kind of picked over at this point, but I had a clarification on Slide 14. Here you're talking about some of the comps from year-over-year comps in microelectronics. I guess that that's difficult from refining, kind of taking a step back. But can you just clarify? I thought -- I would think that you're seeing some easy comps in light and general industrial and maybe even some of the health care areas where we're entering that kind of year-over-year COVID comp.

Yes. So Andrew, again, yes, I'll hit that real quickly. What we're calling out on this is our Q2 expected demand. And if you look back at last year's Q2, and I made a comment earlier, the COVID impact did not really happen until March, whereas January and February were pretty robust. So we're now coming through in January and February, COVID-impacted months. This is the year -- the quarter, when we'll actually lap it compared to last year. March was really the only quarter -- or the only month of the second quarter impacted by that.

Okay. So it's just a 1-month impact? Okay.

Yes.

Our next question comes from the line of Graham Price of Raymond James.

This is Graham Price on for Pavel Molchanov. Just following up on a prior question. You mentioned in the slides that municipal drinking water and wastewater are both growth areas. But there's been some concern that because of the recession, munis have seen a shortfall in tax revenue to invest these days. Just kind of wondering how to think about that and sort of how to reconcile those 2 things.

Yes. So Graham, once again, on Slide 14, this is our outlook based on what we expect our demand in the second quarter in order activity to be. So municipal drinking water, we're seeing driven by PFAS and emerging contaminant challenges that they're having to invest in, even to the point of the municipal order I called out on one slide that we got in California that's a contract through 2024. So we're seeing some of that happen around drinking water.

On the wastewater side, it is retrofit and rehab against the installed base that we have in the municipal wastewater systems that have been there for quite some time. So us going back and replacing chain and scrapers, replacing different types of filtration, et cetera, that are there, gives us a good opportunity. And because of those of the rich installed base that Evoqua has had over many, many years, we're able to make sure that we're connected to those municipalities. And they're spending not on expansion, because that's where budget constraints come, but really just on making sure that they're operating at the design capacity. And that's -- aftermarket generally is something that does well when capital declined.

Got it. And then quickly for my follow-up. There's clearly a lot of appetite in congress for infrastructure, at least as a portion of the next COVID stimulus package. Just wondering your thoughts on what role water will play and then maybe especially as it relates to PFAS cleanup.

Yes. So we've been pretty involved in that around what the water role is going to be. We feel like where they're spending a fair amount of effort and energy is going to be more on the transmission system of water. So actually getting water from the municipalities and the municipal treatment system to the homes and to the homeowners into industry in general. So we think a fair amount of the spending is going to be occurring in transmission, not necessarily in treatment, with the exception of what I referred to in treatment being retrofit and rehab and us making sure that the system is operating at the design capacity of what it was.

We do believe PFAS will be something that they continue to focus on. And -- but we still think that's a 5 to 7-year time frame before it becomes really meaningful because they haven't even defined what the MCLs are yet. And what the limits are going to be as the EPA, even though they did call PFAS out as a hazard of substance.

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

So I'd like to say thank you to you all for joining us today. It's a pleasure to be able to present the close of the first quarter. We continue to be very mindful on what's happening with the pandemic in the second quarter. We continue to focus on the 3 priorities I called out earlier, and that's the health and safety of our team members; making sure that we're providing continuity of supply to our customer base and satisfying and serving their needs; and then ultimately, ensuring that we have balance sheet flexibility and the company's capabilities to execute are continuing to improve.

I would like to thank you for your interest. I would like to thank our team members for operating safely and providing just fantastic service to our customer base into the marketplace we serve. I hope you all stay safe, and I look forward to speaking with you again next quarter. Thank you, operator.

Thank you for participating in the Evoqua Water Technologies First Quarter 2021 Earnings Conference Call.