Good morning and welcome to the Evoqua Water Technologies second quarter 2018 earnings conference call. [Operator Instructions] As a reminder, this conference call is being recorded and your participation implies consent to our recording of this call. If you do not agree with these terms, please disconnect at this time. Thank you. I will now turn the conference over to Dan Brailer, Vice President of Investor Relations. Please go ahead.

Thank you, Crystal. Good morning, ladies and gentlemen. Thank you for joining us for Evoqua Water Technologies conference call to review our second quarter 2018 financial results. Joining me on today’s call are Ron Keating, President and Chief Executive Officer and Ben Stas, Executive Vice President and Chief Financial Officer. After our prepared remarks, we will open the call to questions. We ask that you keep to one question and a follow up to accommodate as many questions as possible. This conference call includes forward-looking statements, including our outlook for fiscal year 2018. Actual results may differ materially from expectations. For additional information on Evoqua, please refer to the company’s SEC filings, including the risk factors described therein. On this conference call, we will also have a discussion of certain non-GAAP financial measures. Information required by Regulation G of the Exchange Act with respect to such non-GAAP financial measures is included in the presentation slides for this call which can be obtained via Evoqua’s website. All non-GAAP financial results have been reconciled and included in the appendix section of the presentation slides. Unless otherwise specified, references on this call to full year measures or to a year refer to our fiscal year, which ends on September 30. 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 seven days. With that, I would now like to turn the call over to Ron.

Thank you, Dan. Good morning. We're very pleased to report our second quarter 2018 results. To begin today’s call, I want to provide some background on Evoqua’s business and the markets we serve. Because we're a new public company, we will provide more information on our business profile, our competitive differentiators and our market strategy through the fourth quarter. Following that, Ben will walk through our second quarter of 2018 results. Please turn to slide 3. When we arrived at Evoqua in 2014, we found a business with tremendous potential, market leading technologies, a great history of servicing customers’ needs and a strong team of people. We defined our purpose, transforming water and enriching life, simple, focused and clear. We're the leading provider of comprehensive water treatment solutions in North America. We provide systems, services and technologies to 38000 customers with over 200,000 customer installations that generating trailing 12 revenues of 1.3 billion and 224 million in adjusted EBITDA, a 17.3% margin. Our business spans a diverse range of industries and includes the 20 largest US companies in each of the pharmaceutical, food and beverage, hydrocarbon processing, chemical processing and power industries. Please turn to slide 4. In 2014, we initiated a series of changes by creating segments and divisions, aligned by vertical markets or technologies. We focused our sales and marketing strategy on all service solutions, deploying our technologies, supported by ongoing service and mining our installed base. We invested heavily in our team, aligned our RD&E spent at the highest market priorities and established a systematic and targeted approach to M&A that augments our R&D and organic growth. As you can see, the businesses responded well, delivering solid and improving year-over-year sales and profitability results. Please turn to slide 5. We’re the number one player in water treatment,…

Thank you, Ron. Please turn to slide 13. For the second quarter, reported revenues were up over 11% to 334 million, pro forma revenues normalizing for acquisitions were up almost 7%, driven by growth in the industrial and products segment and acquisitions contributed more than 4%. Capital project growth outpaced service revenues during the quarter, mostly in the industrial and municipal segments. As Ron mentioned, this has created some mixed pressure, but will provide a solid base for future growth in our highly profitable service and aftermarket businesses. Second quarter adjusted EBITDA grew by approximately 31% versus the prior year to 58 million, 17.3% of sales, a 270 basis point expansion in EBITDA margins. We experienced inflationary cost pressures during the quarter and a productivity challenge due to weather and capital mix. We also continued to invest for future growth to support our robust pipeline. Volume leverage and cost management contributed to margin expansion, offsetting inflation, growth investments and productivity challenges. Please turn to slide 14. For the second quarter, our industrial segment had revenue growth of 13% year-over-year to 181 million with pro forma revenues up approximately 6%. The major drivers of organic revenue growth resulted from capital for waste water recycle reused applications in the power, HPI and CPI markets as well as general strength across most industrial end markets. EBITDA grew approximately 18% and margins expanded to 23% of sales, a 100 basis point improvement over the prior year. The EBITDA margin improvement was driven by volume leverage, cost initiatives and acquisition synergies, while partly offset by capital growth mix. Capital revenue growth is expected to lead to more profitable service and aftermarket sales over the medium to long term. Our Water One Assurance pilot in Boston is nearing completion as we prepare for a national rollout…

[Operator Instructions] And our first question comes from the line of Deane Dray with RBC Capital Markets.

Hey, just like to start in the change in guidance here and then very specifically, the first factor on the increase in the capital projects and we always view these as a high quality problem in that you're going to increase your installed base and get access to a revenue stream on the aftermarket. But just give us a sense of what the timing issue on these projects, were they not in the budget, that they get pulled forward and were they not part of the guidance originally?

Yeah. Deane, so to your point, we consider it a very high quality problem. We actually like the fact that we've got good capital installs going out, but it does create a bit of a mix shift for us. So as you look at what happened, there is a few larger projects going out that are having installation revenues that go upfront and the installation revenue is typically a little lower margin in the service and aftermarket tail, but the great news is is that we're seeing increase in revenue. We’ve raised the guidance there, because we see a very strong pipeline for that and we have a very good backlog that we will continue to benefit from with the service and aftermarket tail that comes behind.

Got it. And then the other factor on the higher inflation costs, maybe just for Ben. Can you walk us through the whole price cost dynamic and can you size for us how much price you got through in the quarter and what was the material cost inflation?

So we haven't seen much price yet, Deane. Those actions are underway and will be coming as we head into the second half of the year, but we did get a little more cost than we expected. As we look forward to Q, it wasn't a huge amount in the quarter, but we saw it late in the quarter when the costs were coming through as we head into Q3 and Q4, we’re expecting to have in the range of 2 million to 3 million in Q3 of additional commodity costs. We’ll start seeing the price in Q4 based on the actions and for the year, we're expecting an additional 2 million of headwinds net for the second half of the year.

And that additional 2 million is reflected in the current guidance?

It is.

And then just one last question if I could, can you discuss the factors in the other expense corporate expense line.

The other corporate expense line?

Just the corporate expense, it looks like it was higher than what we were modeling for, any particular factors you would call out?

Yeah. We had some first follow-on expenses. We will get you the details offline on that. I don't have them at my fingertips, but there were some other expenses in there related to the refi and the first follow-on.

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

Just following up on some of the guidance change that you did take the top end of the adjusted EBITDA guidance down by 10 million. It sounded like, a couple of low single digit maybe of that explained by higher raw material costs, before you get to offset that with price. What are the other factors that have gone into the reduction in the top end of that guidance?

Yeah. Nathan, it’s mix. It's the capital mix that we're seeing now as a higher portion of the revenue than what we had originally planned, but again as speaking to the question that Deane had earlier, that’s a very good news for us longer term, it’s one reason we raised the top -- the revenue guidance as well because we've got a strong pipeline coming through, we've got a strong backlog and what that does for us is give us a tremendous follow-on and service and aftermarket coming behind.

I get that. It is, I think Deane said, rich paper problem is a high problem. Does it imply though, I mean, if you have a heavier mix of capital projects, that should be accretive to the overall EBITDA if service revenue is still at the same level. So is there any implication here that the service revenue in ‘18 may be a little lower than you originally thought?

No. I think again it's the timing on when the projects are going out and the timing in the second half and we're seeing capital being installed and the service follow-on. So it really is the commodity move and then the mix move that’s making a change. It’s not the service side not growing as quickly, it’s staying pretty steady.

And then with the increased level of capital projects going out, can you maybe give us some color on the timing of those new installations moving into an aftermarket and service revenue generation?

Yes. So, basically, we've got about -- over the next 6 to 12 months, those will be installed and will start turning service and revenue aftermarket dollars coming and typically you can think about any dollar of capital that goes in and generates around $0.22 of service and aftermarket for us on an annual basis. So, and it's a very long tail. So it really is a very positive outcome. We're pleased to be winning these projects and we're confident we're taking share and providing more to our customers.

And projects pretty much immediately start generating aftermarket and service revenue? There's not much of a lag to that?

Not much of a lag at all. I would say, service starts immediately and then the aftermarket typically is around 6 months.

Our next question comes from Brian Lee with Goldman Sachs.

I guess first off, can you talk Ben about what’s embedded in your 2018 outlook here for contribution margin and then the couple of moving pieces here with respect to mix and the price cost dynamics? And then I guess how would you think about that level for 2019, are you anticipating that it’s still the liability to targets that you laid out in the past?

Our long term contribution margins are not going to change. We do have some short-term impacts that Ron described and again, it’s the three factors I talked about, it’s the capital mix shift, which is temporary. There's a timing impact due to some product shipment that we're going to go and keep, we expect to go in Q4. Those are high profit shipments and that does create a little bit of a challenge, but it's really timing that will be recovered in Q4. And then the third factor is inflationary impacts, mostly which are commodity, but also other types of inflationary impacts that again is the timing impact and price utilization will follow as we are executing on the price utilization. So I don't know that it's -- we should think about our incrementals differently at this point in time. It's just a temporary timing different as price realization kicks in and as the mix normalizes to our traditional level.

And then just on that pricing front, a number of your peers on the space have talked about implementing price increases or having already done so and maybe being on their second, a third price increase the past year. So are you guys – I know you said you’re engaged in pricing actions as we speak, but nothing has actually been falling through as of yet. Is that due to sort of the booking nature of some of your capital projects and that having more of a lag effect and timing issue in terms of getting prices across or maybe can we speak to sort of why some of your peers may have been quicker to implement some pricing actions. I know that the products and the project activity is not apples-to-apples, but just wondering how we should parse out the differences between your model and others.

Yeah. So if you think about that Brian, the capital projects are a little longer cycle, and so – and they are ones that we would have bid historically. So our new projects that are going on and that we are bidding now, we are getting the price increases on those. And then on our service contracts, they are typically annual contracts. So as those have come to a renewal time, we’re able to increase the prices on those, which will flow through in the next year. So it’s a little longer cycle for those price increases to flow through on annualized contracts.

The delays in the muni waste water projects, can you just speak to what impact it had on the quarter, is that all back in 3Q? I will pass it on. Thank you.

Most of that will be back in Q4. It is purely timing in the waste water division within your municipal area, but yeah, that did have an impact in the quarter as likely it has an impact in Q3 with a recovery in Q4, but it is timing as well.

Our next question comes from the line of Steve Tusa with JP Morgan.

Can you just maybe talk about the free cash flow ramp, in the second half? You’re still sticking with about 100% conversion or greater than that for the year. And I guess what is going to third and fourth quarter look like.

So we're not going to give quarterly guidance, but we're sticking for 100% for the year and the ramp will get us to that 100% for the year that we have in our current outlook.

So there is no kind of linearity in that, you should, seasonality, linearity in the second half on that number.

There is and fourth quarter will be the strongest.

And then I guess the third quarter kind of implied EBITDA is around 60 million at the midpoint, is that kind of the right ballpark?

That's right zip code. Yes.

Our next question comes from the line of Andrew Kaplowitz with Citigroup.

It’s [indiscernible] on for Andy. So just on working capital, so working capital after taking up year-over-year, it's been more stable over the past few quarters there and I know you talked about around 15% for the rest of the year, I think, but can you give us some color maybe on how you're thinking about a target level of working capital going out beyond this year and do you see potential opportunities to continue to keep working capital down below the mid-teens level.

Sure. I mean, we're targeting mid-teens right now. A lot of that depends on the mix of the business, higher capital puts more stress on working capital, because it's a longer cash conversion cycle. As services and aftermarket kick in, it's a quicker cash conversion cycle, so as our mix changes, we should be able to do better, but we also have working capital initiatives in place to drive further improvements, particularly in DSO and DPO.

And then just maybe digging into the products segment for a minute here, 14% pro forma growth on a tough comp. It seems like a pretty strong number there. So can you talk about, I know, there's some lumpiness in the business, but can you talk about sort of the underlying growth rate in products overall and your visibility, especially in some of your overseas markets there?

Yes. The products business for us is a very strong growing business. We're really pleased with what they've done. As we've articulated numerous times, we expect the products business to be high single digit growth and it’s performing as such. In fact, it’s exceeding that. It’s a global business, so if you think about the first half of the year, our China business has grown by 35%, 30% in the most recent quarter and we’re really pleased with the outlook. We’re providing more products into solutions there that are displacing traditional methods of treatment. And what that’s doing is getting on in the platform and creating a very nice pull through for us long term.

Our next question comes from the line of [indiscernible] with Raymond James.

Thanks for taking the question. First on the M&A front, as I've been counting up all of the industry wide buyouts in the field of water technology, I think I've gotten to something like 19, year-to-date, you guys have done two of those of course. Is it fair to say that the competitive landscape on the buy side of these deals it becoming tougher and tougher, more and more competitive than it has in years past?

It’s interesting in it, it really depends on the size of the acquisition target we’re going after. Typically the ones that we’ve done as we articulated to you guys are primarily tuck-ins. These are generally bilateral negotiations that we're doing with an owner or an entrepreneur that we are bringing their product portfolio into ours. We're acquiring them to get geographical vertical reach. So it really has not created a difficulty for us on the competitive front as we’re going after the acquisitions we’ve been targeting.

Interesting. Municipal segment, down a little bit year over year on the top line, not EBITDA. This quarter, I think it was also down. Last quarter, is it realistic to expect that the comp will turn positive before the end of the year or is it going to continue to be kind of a flat to down segment?

No. It will turn positive before the end of the year. Again as Ben spoke to, there is some project timing on some of the larger projects, we have a backlog, but we actually were up 1% this quarter over the prior year same quarter and we anticipate as we actually articulated early in the business rollout, we're looking at low single digit growth for municipal and we're still on that same track.

Our next question comes from the line of Joe Giordano with Cowen.

As you go through with Water One Assurance, can you talk about like what the implications are on my capital working capital needs for you, if you're taking on the upfront cost and how that changes maybe free cash flow dynamics as you transition towards that kind of offering.

So the Water One Assurance program is really a CapEx. That's really investment in terms of the working capital, we're really talking about receivables that would be on the growth, but there's not going to be huge working capital impact on Water One Assurance. Again, the cash used is really on CapEx.

What kind of magnitude on the CapEx Ben?

So we’re going to invest 23 million over the next three years to rollout the Program.

And that will cove like the full rollout that you were talking about, like talking 200 million of installed base that you’re trying to.

Yeah. What we’re targeting in that, Joe was 50%. So that is what we have built into the model. Now, what we’re seeing in Boston is we’re seeing a much higher take rate on our second pilot, which is a much larger pilot as you know. We’re proving out again a lot of the analytics through this rollout on the second pilot and with that take rate picking up, we see that across the nation being the similar type take rate, then we would have to take the CapEx up. But right now, with the 50% rollout, we would expect a 23 million coverage.

Great. And then just a question on the industrial side, it looked like the margins of the acquired businesses seem to be substantially higher than the core business, can you just give any kind of color on that and how the future pipeline is, I feel, looks relative to those kind of numbers?

We got to remember those acquired businesses also include some synergies as well that’s helping those margins. Again, these are good businesses and we're also seeing some cross selling of those businesses, some of these projects that we are winning that Ron talked about earlier across divisional selling is directly a result of the acquisitions where we are now having a more comprehensive solution in the marketplace. So all of this leads to good news for the future, but again, the acquired businesses are nice businesses that have been accretive.

[Operator Instructions] It comes from the line of Nish Damodara with Baird.

Just a quick one, what kind of acquisition contribution you’re expecting from Pacific Ozone?

It’s relatively insignificant. It will get much more of an impact next year.

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

Thank you, Crystal. Thank you all for participating in our earnings call today. As we highlighted in the call, we feel we're very uniquely positioned to be the solutions provider of choice for the water industry. Our technologies are channeled, and our extensive service footprint truly makes us able to partner with customers. You may have seen recently that a Evoqua was named the Water Company of the Year by both the water intelligence and the water technology company of the year by Frost & Sullivan, we’re really very pleased to receive these recognitions, again speaking to the goals of our team as members all around the globe of Evoqua of exceeding our customers’ expectations and making sure we're providing them with best in class solutions. We’re very proud of the legacy we have and very optimistic about delivering sustainable results for the future and I look forward to speaking with you all again. Thank you.

Thank you. That concludes today’s Evoqua Water Technologies 2018 second quarter earnings conference call. You may now disconnect your lines at this time and have a wonderful day.