Xylem Inc.

Welcome to the Xylem fourth quarter and full year 2018 earnings conference call. At this time, all participants have been placed on a listen-only mode, and the floor will be open for your questions following the presentation. If you would like to ask a question at that time, please press star 1 on your touch-tone phone. If at any point your question has been answered, you may remove yourself from the queue by pressing the pound key. We ask that you please pick up your handset to allow optimal sound quality. Lastly, if you should require operator assistance, please press star zero. I would like to now turn the call over to Matt Latino, Senior Director of Investor Relations. Please go ahead, sir.

Thank you, Thea. Good morning, everyone, and welcome to Xylem's fourth quarter and full year 2018 earnings conference call. With me today are Chief Executive Officer Patrick Decker and Chief Financial Officer Mark Rakowski. They will provide their perspective on Xylem's fourth quarter and full year 2018 results and discuss the full year outlook for 2019. Following our prepared remarks, we will address questions related to the information covered on the call. I'll ask that you please keep to one question and a follow-up and then return to the queue. As a reminder, this call and our webcast are accompanied by a slide presentation available in the investor section of our website at www.xylem.com. A replay of today's call will be available until midnight on February 28th. Please note that the replay number is 800-585-8367, and the confirmation code is 998-2239. Additionally, the call will be available for playback via the investor section of our website under the heading Investor Events. Please turn to slide number two. We will make some forward-looking statements on today's call, including references to future events or developments that we anticipate will or may occur in the future. These statements are subject to future risks and uncertainties, such as those factors described in Xylem's most recent annual report on Form 10-K and in subsequent reports filed with the SEC. Please note that the company undertakes no obligation to update any forward-looking statements publicly to reflect subsequent events or circumstances and actual events or results could differ materially from those anticipated. Please turn to slide three. We have provided you with a summary of our key performance metrics, including both GAAP and non-GAAP metrics. For purposes of today's call, all references will be on an adjusted basis, unless otherwise indicated, and non-GAAP financials have been reconciled for you and are included in the appendix section of the presentation. Now, please turn to slide four, and I will turn the call over to our CEO, Patrick Decker. Thanks, Matt, and good morning, everyone.

We have a lot to cover, so I'm going to hit on a few highlights from our 2018 results. Then I'll turn it over to Mark to provide some additional details. As I reflect on this past year, one of the things that stood out to me is the momentum that we built on the top line. We delivered our strongest growth to date as a public company with 8% organic revenue growth. We saw healthy advances in each of our businesses with a number of important achievements, including several successful new product launches and strategic project wins. We also saw 9% organic orders growth this past year. Fourth quarter orders were up double digits and showed strength across all of our businesses. We see continued strength in our bidding pipelines across the entire company. We see strength across our transport and applied water businesses. And it's worth noting that a growing portion of our orders and recent wins are for longer lead time projects in our treatment, census, and AIA businesses. This tells us that our markets appear to be very healthy over the near and long term. And it further strengthened our conviction around our 2019 and longer-term growth prospects. For adjusted EBITDA, we saw an improvement of 80 basis points, which was in line with our guidance of 19.5% for the year. Operating margins were slightly short of our guidance for the year at 13.7%, up 60 basis points, excluding purchase accounting year over year. We saw benefits from productivity, volume leverage, and price realization, which accelerated throughout the year. Partially offsetting these gains were inflationary pressures, sales mix, and funding our strategic investments. Much of that investment has been focused on our measurement and control solution segment. This is aimed at capturing significant revenue opportunities across our businesses. The investment also capitalizes on our first mover advantage in providing new digital and analytic solutions. We expect this to moderate as we enter the second half of the year. I'm very pleased with the benefits that we're already realizing from this strategy. Since the census acquisition, we've won more than $100 million in contracts that will provide revenue synergies, and we expect to announce another exciting and significant deal this quarter. Adjusted earnings per share were up 20%. Our full-year free cash flow conversion was below our expectations. We took measures in late Q4 to maintain customer service levels impacted by component shortages by building inventory of critical items, and we made strategic purchases to manage tariff impacts. we remain confident in our ability to deliver free cash flow conversion at or above 100% in 2019 and beyond. So in summary, while there are certainly areas for us to work on, I am pleased with our strong momentum as we head into 2019. Let me now spend a few minutes on the progress we're making on our top strategic priorities that enable us to meet our long-term financial commitments and maintain the company on a path of sustainable growth and margin expansion. The first is accelerating profitable growth, which encompasses our initiatives to drive commercial excellence, grow in emerging markets, and further strengthen innovation and technology. First, commercial excellence. I'm encouraged by market share gains across a number of our business lines. I also want to expand upon our team's execution on price. We can attribute about one point of the organic growth we saw this past year to our commercial team's pricing efforts. and we see continuing strength throughout 2019. I am very proud of what our sales and marketing teams have demonstrated here in terms of commercial leadership. In emerging markets, we delivered 11% revenue growth, and orders momentum continued in our key focus markets of China, India, and the Middle East. Advancing innovation is another core element of our longer-term growth strategy. Our team delivered 120 basis point increase in our vitality index to over 25%. And we are pleased by the accretive growth rates and margin profile of these new offerings. We're also excited about a number of new technologies that we'll bring to market in 2019. These offerings combine our data, analytics, and software capabilities with our installed base. And this is enabling us to bring entirely new solutions to our customers as we aim to help them address their biggest challenges of water scarcity, affordability, and resilience. As I already mentioned, we remain sharply focused on our continuous improvement program. In 2018, we achieved $157 million in savings, a 6% increase in the previous year. We still have plenty of runway on our CI journey and see more efficiency opportunities as we penetrate deeper in the company and across our functions. To that end, We are now planning the next stage of our business simplification efforts, which we spoke about at our last Investor Day. This is the next progression in our plan, which we've timed to avoid disrupting our focus on growth and the integration of new businesses over the last 18 months. This work will now further simplify our business structure, eliminate waste and bureaucracy, and allow us to move faster and with greater agility to better serve our customers. We will also focus on further manufacturing and supply chain efficiencies, from footprint optimization SKU rationalization, and improvements to our cost of quality. We expect the execution of the majority of these actions to begin in the second half of 2019. We estimate up to 100 basis points of savings on a run rate basis, with most of the benefit in 2020 and the balance in 2021. This work reinforces our confidence in achieving our 2020 targets, and it positions us to be more efficient and focused for the long term. We continue to put our capital to work in smart, disciplined ways. This allows us to develop organically, as well as acquire the solutions we need to best address our customers' challenges. These investments have focused on disruptive technologies and solutions, and we will continue to remain steadfast in our approach to that area. We continue to return capital to shareholders. Today, announcing a 14% increase in the dividend, consistent with our commitment to growing our dividend in line with earnings growth. We are very proud of our talent, and we continue to strengthen our team through a number of investments in development programs, strategic hires, and the talent that joins us through acquisitions. And finally, we are a purpose-driven company. In 2018, we advanced our commitment to be a company that creates both significant economic and social value. We've achieved our original five-year sustainability goals one year ahead of schedule, and we are set to release ambitious new goals this spring. We're honored to have been recognized by a number of external organizations for these efforts, yet we can and we will do more in terms of the solutions we provide, our social impact in areas like disaster relief, and our environmental footprint. Sustainability is increasingly important to our people, our customers, our investors, and the community, and it's a key priority for Xylem. So now let me turn it over to Mark.

Thanks, Patrick. Please turn to slide five, and I'll begin with our full year results. First, I'm very pleased with our top-line performance this year as we beat the high end of our revenue guidance with 8% organic growth. This reflects strong growth across all of our end markets. We also saw robust organic growth in all major regions, with emerging markets in the U.S. leading the way at 11% and 9% growth, respectively. Our revenue performance benefited from solid underlying market growth, but also from the outstanding work of our commercial teams to gain share and ramp up our price realization. Operating margins for the year were 13.7%, up 60 basis points from the prior year, excluding purchase accounting impacts. This reflects continued traction in our productivity initiatives, which delivered $157 million in savings, as well as volume leverage and accelerating price realization. Partially offsetting these improvements were higher levels of inflation, higher investments to drive longer-term growth, unfavorable mix, and negative currency impacts. Adjusted EBITDA margin was up 80 basis points to 19.5%. We reported adjusted earnings per share this year of $2.88, an increase of 20%, and at the higher end of our original 2018 guidance. Our free cash flow conversion finished below our expectations this year at 64%. our cash conversion metrics in both 2017 and 2018 were impacted by large non-cash tax items. Excluding these fourth quarter items, our cash conversion was 75% this year, which was below our target. As Patrick mentioned, the primary driver of this miss was our working capital performance. The timing of our strong sales growth late in the fourth quarter and the impacts of higher raw material inflation and strategic pre-buys of inventory to manage tariffs and component stocks drove working capital higher by $140 million in the quarter. As a result, year-end working capital increased 50 basis points over last year to 19 percent of sales. To give you perspective on the impact that the timing of our Q4 sales and strategic inventory build had on our year-end working capital, our 12-month average cash conversion actually improved by over four days from December 2017. So I'm confident in both the improvements we're making to our working capital processes and that working capital improvement will once again become a source of cash for Xylem in 2019. So, please turn to slide six, and I'll review the fourth quarter results. We were pleased and a bit surprised by the strength of the acceleration in demand through the fourth quarter, which drove sales above the high end of our outlook. Organic orders were up 10 percent, with high single-digit growth in both water infrastructure and applied water, and 18 percent organic growth in measurement and control solutions. Revenues were up 9 percent organically in the fourth quarter, which was on top of 7 percent organic growth in the fourth quarter of 2017. Acquisitions contributed 2 percent growth, and foreign exchange was a 3 percent headwind. From an end market perspective, the utility segment was up 10 percent organically. This growth reflects strength across nearly all regions in applications globally. and is encouraging given the tough compare to the double-digit organic growth in last year's fourth quarter. Industrial markets were up 8%, driven by continued strength in North America, Europe, and Latin America. Commercial markets had a very strong quarter, growing 17%, with double-digit growth in the U.S. and Asia-Pacific regions. Certainly, some of the strong demand in the U.S. was driven by the timing of announced price increases. As a result, we expect to see solid but moderating demand in our commercial business for Q1. Our residential business was flat in the quarter. Operating margin for the quarter was 15.1%, which was up 30 basis points versus the prior year, excluding purchase accounts. This was lower than our expectations as continued margin expansion in water infrastructure and applied water were muted by margin contraction in the MCS segment. I'll review the details of each segment's margin performance in a minute. Against the backdrop of supply chain challenges from tariffs and constrained electronic component supply, I'm very pleased with our team's performance in delivering earnings per share of 88 cents. an increase of 16 percent year-over-year. Please turn to slide seven, and I'll review our segment performance for the quarter. Water infrastructure orders grew 7 percent organically year-over-year. This growth was driven by sustained strong demand in North America and emerging markets, particularly in treatment. We exited the quarter with total backlog of $620 million, up approximately 7% organically year over year. Of this amount, $480 million is due to ship in 2019, which is up 6% on an organic basis. Our treatment bidding pipeline grew 10% this year, driven heavily by U.S. activity in large projects in India. the treatment pipeline remains a strong barometer for us as to the health of the water utility market. Water infrastructure revenues grew 9% year-over-year on an organic basis, and foreign exchange was a $24 million headwind. Revenue in the emerging markets was up 18%, with much of the growth coming from our treatment business. Particularly noteworthy was the 37% growth in China, We saw more than 40% growth in treatment and more than 30% growth in transport as we've continued to see demand for our products benefit from both the new regulations around water quality as well as our investments in product localization. India was down slightly in the quarter due to the lapping of large custom pump project deliveries in the prior year. With our current backlog and growing project pipeline from new wastewater treatment regulations, we expect India to be our fastest growing market in 2019, with over 30% organic growth. Western Europe was up 7%, led by high single-digit growth in transport, where we saw strong OPEX activity across several countries. The segment grew 4% in the U.S., with solid growth in both the wastewater transport market and industrial dewatering business. Treatment growth was impacted by project delays that moved into the first quarter. We're also encouraged by the high single-digit organic orders growth during the quarter. Operating margin for the segment increased 80 basis points to 20.7%, the highest level in our history. This reflects our continued progress in driving productivity, as well as volume leverage and accelerating price realization. Please turn to slide eight. Applied water orders grew 8 percent organically over the prior year. Overall, we exited the quarter with backlog of $200 million, up 5 percent organically compared to last year. Our shippable backlog for 2019 is about $185 million, which is up approximately 15% on an organic basis. Revenue in the quarter grew 10% organically versus the prior year. The growth was driven by the commercial and industrial end markets, which were up 17% and 7% respectively over the prior year. In the U.S., Revenue was up 14% year over year, with growth across all three end markets. Most of that growth was driven by strong project activity and price realization in both our industrial and commercial applications, both of which grew double digits. Emerging markets revenue grew 13%, reflecting strong commercial growth in China and India, as well as for industrial applications in Latin America. Segment operating margin in the quarter increased 30 basis points to 17.2 percent year-over-year. Strong productivity of 390 basis points and price realization of 220 basis points more than offset increased inflation, which was impacted by tariffs and currency impacts. Now, let's turn to slide nine. Measurement and control solutions orders grew 18 percent organically over the prior year, and revenue grew 11 percent on an organic basis. For census, revenue in our water business increased 16 percent, driven by growth in the North American market. Our gas business grew 23 percent, mostly from large North American project deployments. Electric was down 5 percent in the quarter, due to the lapping of project deployments in North America. And our advanced infrastructure analytics business grew high single digits on a pro forma basis, driven by the delivery of projects in the U.S. and Europe. We continue to see success in bringing the AIA platform solutions to new markets through existing Xylem channels and relationships, including first-time wins in several countries. We're also encouraged by the strong consumer interest in these new solutions and the order growth we saw this past year. Now moving to margins. Adjusted EBITDA margins in the quarter were down 160 basis points year-over-year to 17.3%. Adjusted operating margin for the segment decreased 280 basis points to 7.5%. We've been accelerating our investments in these businesses to drive market share gains with our census solutions and capitalize on our first mover advantage in our advanced infrastructure analytics business. Our investments impacted margins by 270 basis points year over year in the quarter, and we're largely in line with our expectations. During the quarter, and despite the tremendous efforts of our supply chain team, we saw increased supply constraints for electronic components. This impacted both our material costs by an additional 100 basis points and revenue mix by over 100 basis points in the quarter and put more downward pressure on operating margin than expected. We will continue to aggressively manage the electronic component pressures to minimize impact to our customers, and expect supply constraints to ease after the first half of 2019. We expect component shortages and project mix to continue to impact margins primarily through the first quarter of 2019, with improving mix, moderating investment levels, and volume leverage driving strong margin expansion for the second half of 2019 and 100 basis points of improvement for the full year. Now, let's turn to slide 10 for an overview of cash flows in the company's financial position. We closed the quarter with a cash balance of about $300 million. We invested $66 million in capital in the quarter and returned $38 million to our shareholders through dividends. We repaid $200 million of debt in the quarter, bringing our leverage down to 2.7 times. This represents the midpoint of our target leverage range, which we achieved as planned and for the first time since the census acquisition in 2016, and we remain committed to maintaining our investment-grade credit rate. I've already discussed our working capital performance and my confidence that working capital will be a source of cash flow in 2019, enabling us to deliver cash conversion of at least 105%. Please turn to slide 11, and Patrick will cover our 2019 outlook.

Thanks, Mark. As we discussed, we entered the year with solid top-line momentum, and we're confident in our trajectory and focused on achieving our 2019 targets and long-term strategic goals. For 2019, we expect to deliver organic revenue growth of 4% to 6%. Our adjusted operating margin is forecast to expand 100 to 150 basis points to the range of 14.7% to 15.2%. Let me pause and acknowledge that we realize one of the keys to achieving our margin expansion in 2019 and staying on track to our 2020 targets is to now begin delivering a creative margin improvement in the MCS segment. We expect to drive 100 basis points of margin expansion despite contended investment and component supply cost pressure in the first half of 2019. Now back to the outlook. We expect adjusted EBITDA to improve by 100 to 150 basis points, which would bring it to a range of 20.5 to 21 percent. At the bottom line, we expect to generate adjusted full-year earnings per share in the range of $3.20 to $3.40. This excludes restructuring and realignment costs of about $30 million. Adjusted EPS growth is projected to be in the range of 11 to 18 percent for the year. Finally, as Mark discussed, we expect to continue to generate solid cash from operations. and this will enable us to deliver free cash flow conversion of at least 105 percent in 2019. Please turn to slide 12. Now let's review the expected in-market growth for 2019. First, utilities, which make up about 50 percent of our revenue, are expected to grow in the mid-single digits. As we saw in 2018, we expect water and wastewater spending to remain healthy, particularly in the U.S. and emerging markets. This includes mid to high single-digit growth in our water infrastructure business, as well as mid-single-digit growth in the MCS business, reflecting timing of project deployments. In Europe, the outlook is mixed, and we expect low single-digit growth there in total. We are encouraged by the continued infrastructure investments in locations like India, where wastewater regulations are leading our healthy treatment backlog. In both India and China, we expect to grow double digits. Our industrial end market, which represents roughly 35% of our revenue, is expected to be up low to mid-single digits. Growth in the U.S. is expected to moderate slightly in the second half of the year compared to the last two years, however, still up mid-single digits. We expect the emerging markets to continue to gain strength in India and Latin America. Industrial applications in the Middle East are expected to soften a bit, and we expect China growth to moderate slightly to low to mid-single digits. Our commercial end market, which constitutes about 10% of our revenue, saw considerable growth in 2017 and 2018. We expect this to remain healthy in 2019. The U.S. and Western Europe will provide low to mid-single-digit growth, and overall, we expect the commercial end market to grow low to mid-single digits in 2019. And finally, in our smallest end market, residential, which is about 5% of our revenue, we anticipate low single-digit growth. With a flattening U.S. housing market and a highly competitive replacement market, U.S. and European growth is expected at flat to low single-digit levels. Emerging markets growth remains healthy as secondary clean water demand continues in China and greater Asia. Now, Mark will give you a few additional details on the 2019 outlook.

As we've done in prior years, we're providing the seasonal profile of our business as well as highlights of our 2019 planning assumptions on slide 13. As Patrick discussed, we're guiding to 4 to 6 percent organic growth for 2019. This breaks down by segment as follows. We expect 5 to 7 percent growth in water infrastructure, 3 to 5 percent growth in applied water solutions, and 4 to 6 percent growth in measurement and control solutions. We're assuming a Euro rate of 114, which was the average for the month of January. We've included our FX sensitivity table in the appendix. And our estimated tax rate for 2019 is 19.5%. Moving to the first quarter, we expect total company growth in the range of 5% to 6%, led by continuing strength in the U.S. municipal market and emerging markets growth. We expect first quarter adjusted operating margin to be in the range of 11.3 to 11.6 percent, representing 20 to 50 basis points expansion over the prior year. While we do expect modest margin expansion for the MCS segment on a quarter sequential basis, we also expect the impacts of the component constraints in MIX to continue through the first quarter of 2019. Meanwhile, we expect strong margin expansion in both our water infrastructure and applied water segments, driven by continued cost reductions, volume leverage, and improved price realization. With that, please turn to slide 14, and I'll turn the call back over to Patrick for closing comments.

Thanks, Martin. 2018 was a year of solid momentum. We're very encouraged by the health of our end markets, as well as the growth in the organic and inorganic investments that we've made. We're also very pleased about the integration of our recent acquisitions, which are allowing us to provide new, disruptive solutions. We are managing through near-term challenges and supply chain disruptions in the marketplace, and we are confident in our near and longer-term targets based on growth and accretive margins in large deals, as well as the additional opportunity we have to remove costs and inefficiency. We are guiding in 2019 to what we believe is healthy top-line growth and margin expansion to execute on our 2020 financial targets. Now with that operator, let's open it up to Q&A.

The floor is now open for questions. At this time, if you have a question or comment, please press star one on your touch-tone phone. If at any point your question is answered, you may remove yourself from the queue by pressing the pound key. Again, we do ask that while you pose your question that you pick up your handset to provide optimal sound quality. Thank you. The first question will come from Nathan Jones with Stifel.

Morning, everyone. Good morning, Nate. Well, let's just start on those 2020 financial targets. I guess the big one is the 17% to 18% operating margin goal, which clearly requires a big ramp up in margins in 2020. So maybe if you could just give us a little more color on how you get there, what the buckets are that get you from 19 guidance here to at least to the bottom end of that range in 2020.

Sure. So this is Patrick. So I'd say, you know, first thing first, I mean, we believe we have a highly credible 2019 plan that we've gotten to here to get at least 100 basis points of expansion this year. Beyond that, let me give you some of the large buckets that we see for 2020. First, which is the biggest bucket, is our savings from continuous improvement and cost takeout. And that's all net of inflation. So that's our biggest bucket. That's, again, continued productivity on our procurement and lean journey. We also have savings that begin to ramp late 19 into 20 from our global business services initiatives, as well as the broader simplification that I outlined in my prepared remarks. The second area is, again, the core volume and price leverage that we expect to get. You know, even at the low end of our long-term revenue growth guide of 4% to 6%, we expect to see very good margin accretion and leverage flow through there. And then third is the large deals that we're getting right now from the census synergies and AIA. And those deployments start later this year and really later on in full fold in 2020. Additionally, as we commented earlier, our investments in the MCS segment do begin to moderate later in 19 and then moderate once again in 2020 from our 2019 level. So those are the four really big buckets that give us the confidence to be able to hit our margin guide.

That's helpful. Thanks. Maybe on the MCS investments here, I mean, you guys have obviously been investing heavily to drive growth there and demonstrating very good growth all across the portfolio. So I don't think anybody will have a lot of problems with that. Maybe you can talk a little bit more about the things that have been achieved with those investments, what's in the pipe to come to market maybe later in 19 and into 20 to continue to drive growth.

Sure. Yeah, so, you know, we, I'd say with respect to, first I'd say we're, you know, we continue to invest in all aspects of our portfolio. So we're investing, you know, certainly in our water infrastructure and our applied water businesses as well, especially about bringing new products to market. But specifically within MCS, You know, I'd say we're in the early stages of building out our offerings and embedded software and networking services and really looking to take full advantage of that first mover advantage. And I'd say, you know, given the strength and productivity we've had across the entire company, it's also afforded us the opportunity to accelerate growth of investments in four really areas. First is, again, building out this new advanced infrastructure analytics platform. Second is building out new offerings in electric and gas to support some of the large deals that we've secured and won there. You know, we're investing in designing specific products and specs for some of the international deals that you've heard me talk before about that we're pursuing. And then, again, lastly, building out a much broader networking and software solution capabilities. Beyond that, in terms of getting any more specifics, I'd probably hold back from there at this point in time. There will be more to come in that regard. But, again, we feel very good about the pipeline of deals that are out there that we're pursuing right now that really are a result of these new offerings.

Okay. Just one more on CapEx. And, Mark, thanks for the explanation on working capital. That helps a lot on free cash flow. CapEx has increased pretty significantly over the last couple of years. I know a lot of that is growth CapEx, localizing production. CapEx for 2019 looks like it's staying at about the same level as 2018. Where do you see that shaking out in the long run once you get through kind of this investment cycle to localize and drive growth?

Yeah, I mean, that's a good question, and certainly one that we talk about with the team and the board. I think we are at the upper end when you think about capital as a percent of revenue. We have ramped that up. That has been a function of the investments we've been making. Some of those investments that Patrick talked about just a moment ago is for new products. There's tooling that we're building. We've got a lot invested in engineering, and software, some of which gets capitalized. So clearly, when you look at those components, and then even dewatering this year, we had a huge ramp up in demand, and we had to build capital in some capacity to meet demand. We're building out our smart hubs in AIA, and that requires not only you know, P&L-related investment around on-the-ground support in sales and engineering. But also, you need tools. You need pipe divers. You need smart balls. You need trucks. And so we've really hit a point, I think, this year and into next year where you're going to see a higher level of investment as a percentage of sales, and that starts to moderate back towards where we've, you know, where we've been.

Yeah, I would just add, Nate, I would say, again, this is Patrick, I would say much like Mark talked about in his prepared comments around working capital and cash conversion, I'd say the same thing around CapEx, and that is there is no structural change here in the capital intensity of this business. It really is the timing around the things that Mark alluded to here, and we would expect that to moderate back to kind of normal levels. So nothing that we are particularly concerned about here.

Okay, thanks very much for the help. I'll pass it on.

Okay, thank you.

The next question will come from Mike Calleran with Baird.

Hey, good morning, everyone. Good morning. So let's just start on the order side and the pipeline. Obviously, underlying trends remain healthy. It doesn't sound like there's any time to slow down. Can you give a little color on how customers are looking at the world right now, any hesitancy in pipeline conversion from their perspective, and Any color around that would be great.

Sure, Mike. You know, this is Patrick. So, you know, we're keeping our ears close to the ground, obviously, on each one of our end markets. So let's start with utilities. We really aren't seeing or hearing any indications of a slowdown. Again, you know, if you think about the 10% increase in our bidding pipeline on treatment, which is a really good indicator, and that's, you know, That's on a very big bidding pipeline. So, you know, at some point in time, you'd expect that to kind of be tough in terms of year-over-year compares, but it continues to expand there. And that is consistent, whether it be in North America and certainly in the emerging markets. As we indicated, you know, we think Europe is next. You know, it'll moderate to kind of low single-digit growth in 2019, but we're not seeing any change in trajectory here, which is quite encouraging. Now, you know, we also feel that a fair amount of that is share gains. But, again, the overall market seems to be healthy. You know, on the industrial side, again, you know, 35% of our total revenue, you know, they're our channel partners. You know, we go heavily through distribution. They, again, continue to see strength in the market. Again, we are calling for some moderation. here in the second half of this year. We're not seeing that yet, but we're calling it. We're expecting that there will be some tough comps year over year that are out there. Not sure if that's helpful, but we're not seeing it right now in terms of any slowdown.

It's all good, but we're also mindful that You know, there's a chunk of our business that's short cycle, right? And when these things hit, they hit quickly, and we're sober to that fact. But as Patrick said, we have our antennae up. You know, we're talking to our teams and customers constantly. We're all over the pipeline. So right now we're not seeing those signs.

Sounds good. And then another customer question, what's the receptivity been – as you're trying to bring some of these MCF solutions, you know, the technology, connectivity, analytics to the broader platform, particularly on the infrastructure side? Seems like it's good receptivity. I know you referenced in the prepared remarks some incremental product offerings coming this year. Would love to hear some early thoughts there.

Yeah, we've been very encouraged. I think the – where I start, Mike, is the – we're able to have very different kinds of conversations today at different levels of the organization, more senior levels of the organization than we've had before. Because if you think about any company going in and speaking to, let's take the utility, irrespective of what the utility's biggest challenges are, if you've only got one or two products to offer or a couple of pain points you can address, you spend your time trying to convince them those are the pain points they need to be addressing. we're able now to go in with confidence and first have a conversation around what are the biggest challenges that you believe you have or that the data shows that you have with a pretty high likelihood that we also then have the product, the technology, the offering to solve that problem. And so we're able to be seen as even more objective and consultative in the conversation. Now, that's early days. We don't have that selling capability across the board. I don't want to get ahead of ourselves, but that's certainly where we're going. And so I see a high degree of receptivity from the utility operators and CEOs because they want to be able to have that open, candid, objective conversation. You know, where we see a lot of the opportunities here and where we see a lot of synergies is new wins and interest across the emerging markets. where, you know, as they're building new infrastructure, they don't want to build dumb infrastructure. They want to build smart infrastructure. And so they need the help to be able to know how to best optimize that, and that's why we're seeing a lot of the receptivity there. And then, you know, when you think about the fact that previously Pure and the other advanced infrastructure analytic businesses that we've acquired have we're pretty much largely North America, and to some extent European businesses, not a lot of presence in the emerging markets, and that's where we're seeing a lot of excitement from customers.

That's helpful. And then last one, just the water infrastructure margins, obviously really robust in the quarter. Anything in there that you don't think is sustainable relative to revenue levels and normal seasonality?

No, it's pretty clean, and it's What we saw is a real push on productivity and savings and really kind of a catch-up on pricing to offset what had been a little bit of a headwind from inflation and really good progress on that. So nothing unusual, and we expect to continue to see those trends in 2019 with more growth more pickup on price.

And I would just add there that I think it's important that we note that we're managing a portfolio here. And so we're allocating capital every day, every quarter, each year. And so we continue to invest In water infrastructure, we continue to invest in applied water. Obviously, as we begin to see the ramp up in MCS margins here, that affords us the opportunity to further invest in those two pieces of our portfolio because there's a lot in the pipeline from a new product development standpoint and sales and marketing efforts that we'd like to be able to do here. But, you know, we'll continue to manage that as a portfolio over time.

Thanks, gentlemen. Appreciate it.

Thank you.

The next question will come from Dane Drake with RBC Capital Market.

Thank you. Good morning, everyone. Good morning, Dane. Hey, I'd like to start with the free cash flow guidance for 2019, the 105% or better. And maybe could you clarify whether you're baking in any of these working capital inefficiencies at the start of the year or any other tax noise? you know, the component shortages that require you to add a bit more to inventory. So any of those dynamics affecting the cash flow outlook?

Yeah, absolutely, Dean. We definitely took it on the chin in the quarter relative to, you know, some of these strategic, you know, pre-buys as well as whether that was for the tariffs or around the component shortages. And, you know, we also, as I mentioned in my prepared remarks, saw a big ramp-up in volume. And quite frankly, it was higher than certainly the we had forecasted above the top end of the range. And the timing of that in the quarter was such that there were, you know, that was $90 million of cash just in terms of volume. And that is going to normalize in, Both of those items, along with continued progress on improving our processes and efficiency, whether it's in receivables, we've got a lot of opportunity on the inventory side of things with supply chain and our S&OP, and payables. But those will reverse out in 2019. That's good.

And just sticking on the cash flow side, a couple points. One is You all talking about a higher volume at year-end, you're on the good side of being an outlier because we've heard a number of the industrial companies that saw just the opposite, that there was a lot of fall-off in December. So you've got that high-quality problem of handling that $90 million, so that's a positive. What about CapEx? How much for this year, any particular projects that you would highlight in terms of investment?

Yeah, I think, you know, we really pushed hard, and we did spend capital to grow out our AIA platform, as I mentioned. We've been running hard in terms of our engineering and development around a number of software projects components and products that ended up as capitalized software. And back to your point about nice problem to have, the demand in our dewatering business has really been running hot, so we've had to add capacity to the fleet as well. So those are nice problems to have, but certainly things that we needed to respond to. As we look out in 2019, though, Dean, will the investment level we expect to remain flat? Part of that is a function of getting out ahead of the curve, which we did in the, you know, the back part of 2018.

Yeah, and I think to your question, Dean, around, you know, are there any specific projects to be called out in 2019? One of the reasons why, you know, we're not able to say that it's moderating or declining is because we also need to absorb, and it's not a big-ticket item, but, you know, we're going to be, you know, likely kicking off... another greenfield expansion in India in terms of manufacturing capacity. Now, that won't all hit in 2019, but we're certainly going to be starting that in 2019. It's not a big-ticket item in and of itself, but it's enough to kind of hold these numbers flat year over year. And that's just really, again, to get ahead of the incredible demand we're seeing in India.

That's great to hear about those investment opportunities. And if we were looking at that pre-cash flow target for the year, that it feels to us that there's further upside to that 105%. But we'll see how this develops. And then as a follow-up.

I can assure you, Dean, we're working at it. We were disappointed in Q4, so it got our attention on the working capital side.

Good. And then in terms of the organic revenue guidance, everything looked pretty much as expected, if not a little bit better. The one that kind of jumps out at me is MCS. The four to six seems like they could be doing better, and maybe it's because we're all excited about the opportunities in AIA. Maybe they don't move the needle enough yet, but what is that upside at MCS that could potentially do better than what you're forecasting today?

Yeah, so the AIA platform is still a relatively small chunk of revenue for us at north of $100 million of revenue, and that is going to be growing a very healthy double-digit and is accelerating in 2019 versus 2018, both orders and revenue. It really is the census piece of the platform, and it really, Dean, it's very straightforward. It's assumptions around timing on project deployments. So, you know, we've got some very large deals that we've won. We have some that we are likely going to be announcing here in very short order. It just comes down to when those things hit. Most of them we believe will hit in 2020, which is what gives us great confidence around our margin expansion and growth in 2020. So obviously the timing of those things could move this around, but we're giving you our view kind of right down the middle of fairway right now. Great. Thank you. Thank you.

The next question will come from John Walsh with Credit Suisse.

Hi. Good morning. Good morning, John. So maybe just following back to that 2020 margin question, if I could ask it a little bit. differently so since you provided those targets you've had FX tariffs you've been getting some deals done I believe that that was an organic number and didn't contemplate deal dilution at the time just wondering if you're filling this bridge with things that would have been sitting in a contingency bucket or if you're filling it by kind of over executing on other parts of the plan to you know, think about this as not really an endpoint, but, you know, as a step to drive margins, you know, higher beyond, you know, that kind of range over time.

Yeah, sorry, this is Patrick. Sorry for that. No, it's a great angle on the question, John. The way I would articulate it would be, yes, there are things that have created levels of dilution on their own, that being deals and things of that nature from a margin standpoint. And this is a journey over time. You know, it doesn't end in 2020. And obviously, it won't be long and we'll be giving you, you know, targets beyond 2020. What I would say has changed here are a that give us the confidence. One is that we do see further opportunities to drive simplification and efficiency across the organization. Part of that obviously is by way of some of the integration synergies from the deals that we've done. Part of that is just simplification of our heritage businesses by further integration there and simplification. Certainly we're leaning on that lever harder than we had necessarily laid out at our original investor day, but it's based on opportunity. Two, as we've added other assets to the portfolio and we're getting more mature on our own continuous improvement, the whole lean deployment journey, we're now able to deploy those capabilities across those new assets. And so we've got a bigger pie to play with here in terms of driving efficiency both on the Lean Six Sigma side but also on the procurement side. So those are the areas that I would say that we are feeling even more confident about. And then, you know, what we indicated in Investor Day was that, you know, as we integrated Census, we would get a better feel over time as to what the investment profile would look like on a year-by-year basis. And so that moderates now that we're getting traction and, you know, seeing the benefits of what we've already spent on.

And I just add to that, yeah, we, you know, in terms of the investments, if you look at the model, we've run heavier sooner because of some of these opportunities. That does moderate. Also, in the model, we didn't have as much, you know, inflation built in, and we really, you know, we really got hit hard this year, and we've ramped up price, and we're going to be continuing to drive that into 2019. So there's There's more there than we anticipated in the model as well.

Gotcha. And then maybe just to follow on that, you know, when you think about price, there's obviously what you can get because of, you know, inflation where you're kind of passing through these costs. But, you know, there's been a big kind of concerted effort to increase, you know, your pricing entitlement, right, from what you're doing from a technology perspective, value-based. pricing. Can you talk about how, you know, if you had to deconstruct price, you know, what's more kind of value-added xylem price versus, you know, kind of material or inflation-related?

Yeah, I would say, you know, it's obviously hard to put a specific number on that, but I would say that directionally, if I use the 80-20 rule here, I'd say it's still 80% is just, you know, brute force, get out there, leverage, you know, leverage the fact that we've got to drive price to cover inflation, cover the tariffs, you know, those kinds of issues. While at the same time, certainly in each one of our businesses, at least the three segments, what I've been really encouraged by is the highly accretive margin profile of the new products that we've been bringing to market, whether they be products or different business models. And that's one of our big criteria in our new product development pipeline is it's got to be accretive in terms of growth rate, but also margin. for the company. So I say that's the kind of 20% if I pick the number to say that it's been more value-based pricing capability. And also the opportunity, I think. Yes.

Great. Thank you. Thank you.

Again, if you have a question, please limit yourself to one question and a brief follow-up. The next question will come from Ryan Connors with Boning Scattergood.

Great. Thank you. I want to actually stick with that very theme you were just talking about there and talk about the flip side of price cost and get your thoughts on, you know, if we do, you know, go into an environment of where raw material costs are more moderating than ramping up, you know, how does that impact your guidance assumption around margin? You talk about 100 and 150 basis points of margin upside. You know, if pricing, to what extent can pricing be sticky, and if raw materials come down, is there upside to that?

Yeah, so, Ryan, I'd say historically in these businesses, as we've gone back and looked at it, pricing has been pretty sticky. You know, when you've gone through an inflationary period and you've gotten price, it's unusual to then be seen as giving it away. Obviously, there's probably some on the fringe and the margin, but it's not a step function change. So if we were to see either moderating inflation or slowing down cost pressures there, we would expect that to be some net level of benefit. Hard to put a number on it at this point in time. It obviously depends on how much that price-cost dynamic moves. But it should be a net positive for us.

Got it. And then my other question, just wanted to probe on China a little bit. And, you know, we buy the story there of the new regulations and whatnot, but just wanted to kind of play devil's advocate and get your response to the fact that, you know, the strength is coming from treatment, which is generally a longer cycle business. And what would you say to the argument that, you know, maybe it's going to stay stronger for a little longer, it'll roll slower than, you know, some of the shorter cycle industrial businesses out there? And so I just want to get your thoughts on that dynamic.

Sure. Yeah, so to kind of break down China a bit here. So, again, we're expecting double-digit growth in 2019, which does moderate slightly from the 23% growth that we had in 2018, but it's still going to be, we expect, strong double-digit growth. Now, as you probably recall, we actually, two-thirds of our revenue in China is in the utility space. And that's historically been... pretty well protected. So when you think back, what, two, three years ago when companies were going through the shock in China and the downturn, we in the aggregate were down slightly. But even within that, our utility business never declined. It grew throughout that cycle. It slowed, but it grew. It was the industrial and commercial piece of the business, the other third, that took the big hit like our other industrial peers. So Your thesis is absolutely correct in that, one, the long lead time nature of the treatment orders and pipeline is what gives us great confidence that, you know, we don't see an overall slowdown impacting us in China in 19, certainly on the utility side of the business. Secondly, we're seeing very good growth in transport, you know, on the pumping, on the wastewater pumping side, which is very good margin business. That is more near-term, short-cycle business that remains strong. We are not – we're not prognosticating here, but we are building into our guide some slowdown in the industrial and commercial building piece of the market in the second half of the year, which is what really kind of helps moderate our growth from 2018. I shouldn't say help, but leads to that. along the way. But, you know, the other lever we've got there is this new AIA platform. I mean, we've got tremendous adoption across the Chinese customer base in terms of excitement in that area. Again, a small piece of business, but very promising for 19 and beyond.

Okay. Great stuff. Thanks for your time. Thank you.

The next question will come from Joe Giordano with Cowen.

Hey, guys. Good morning. Good morning, Joe. Good morning. Okay, so I don't want to keep talking about margins, but I'm going to, so apologies here. If you don't want to. If I look at 19, right, so the operating guide, I think at the midpoint it's something like 60% incrementals, and then to get from there to 20 is another – roughly 200 bits to get to the bottom end of that where you'd have infrastructure already at a pretty high level. I fully appreciate the comments about MCS and the spending and things like that that will moderate and lapping some of the big comps. But I guess I'm getting to It seems a lot easier to get there on EBITDA. And if we're in a situation where you hit EBITDA 2020 guidance but are a little light on the operating side internally in the way that you're running your business, is that a win? Is that something that you're driving towards in that way where you're meeting it but optically on the operating side it's a little different?

No, we're going after the operating piece. I mean, we lay out the EBITDA just because there is noise in there and, you know, deal accounting and things of that nature. But, no, we're measured on operating income. That's a third of our annual incentive plan. The other third is organic revenue growth, and the other third is working capital. And so, you know, we're – that's the way we're playing it, Joe.

Yeah, and I would say – next slide. For 2019, you know, we're going to continue to see good volume leverage. We're going to continue to drive price acceleration, and that ramped up nicely throughout the course of the year. I mean, we started Q1 at 20. We ended Q4 at 140 basis points, so that's a big element. We continue to drive productivity, and, you know, we've got the actions that and opportunities that Patrick talked about. We haven't seen the ramp yet from global business services. So there's a number of levers that we have that are going to be driving our operating margin expansion, which will, you know, play through to EBITDA as well.

Fair enough. When you talk about the China, you guys just kind of got into it. Can you size the China and India business for you guys right now?

Sure. Yeah. So China is, you know, China has now become our second largest market outside of the U.S., albeit still, you know, relatively small. So our revenue in China is roughly about $300 million. And, you know, that was about $170 million just a few years ago, just to give you a feel. So, again, you know, still not large numbers in the absolute, but growing very nicely. India is is just under $100 million of revenue, with an order book that is well above that here in 2019. But India is still a relatively small piece of our overall revenue, but just, again, going to be our fastest-growing market in 19 and 20.

The next question is from Pavel Malchanov with Raymond James.

Hey, guys, thanks for taking the question. On the M&A front, you've obviously been quite active this past year. As you're looking at valuations of prospective deals across the three segments, two kind of interlinked questions. Number one, are those deal multiples higher than what perhaps they have been over the past year? And secondly, among the three segments, which in your judgment present the most attractive M&A prospectivity today? Sure.

Yeah, so, you know, we've not seen, I guess, first of all, you know, the kind of deals that we do. You know, I'm very proud of our M&A team and our folks in the businesses as to how they cultivate these deal opportunities and relationships today. which has proven over time to help keep the multiples either in a really attractive spot or in a manageable spot. And so we've not seen any big move or expansion in multiples. Having said that, not for those reasons, you also, though, haven't seen us do a deal in the last 12 months. And so it's kind of hard to say at this point in time as to what there maybe is a gap between seller and buyer expectations. So But we're not seeing any big move there at this point in time. In terms of the question around the three segments, you know, first of all, we like all three. They each have interesting opportunities, but they play different roles. And so I would say that if you look at our water infrastructure space and you look at our NCS space, that's largely around the utility. And I think there you will continue to see us do smaller bolt-on tuck-ins to build out this new analytics platform as well as strengthen the digital offerings of our product lines along the way. But they're not going to move the needle in terms of capital outlay based on what we have line of sight to today. But then when I turn to the applied water segment and you think about our industrial water business there, we see potentially attractive opportunities in that space to further move that business up the technology curve and round out our solutions offering, you know, in that sense. So there are opportunities across the board. Obviously, we're prioritizing the digital and software component, but that's not at the exclusion of also defending our core product offerings, you know, when the opportunity presents itself.

All right. Appreciate it, guys.

Thank you.

The final question is from Brian Lee with Goldman Sachs.

Hey guys, good morning. Thanks for taking the questions and putting me in here. Good morning. Maybe a couple modeling questions here. First on MCS, it does look like the growth's derating here near term in Q1, and then You did mention some of the bigger deployments later this year, but maybe more fully materializing in 2020. So is it fair to say 2019 is a bit of a normalization year in terms of MCS growth, and you'd see acceleration in 2020, or do you actually think you can do better growth second half versus first half, even this year with the comps being tougher as you move into the back half?

Yeah, Brian, this is Mark, and Patrick had mentioned it, I think, briefly in the opening remarks, but also in response to a question. I wouldn't call, you know, 5% to 6% normalization. It really reflects timing of some of the large deployments we've had. And, you know, you've seen, you know, some of the big wins, the orders growth, and what's happening here is really just the timing of when those projects get deployed. And so we do expect a little better growth rate in the back half of 2019 and certainly into 2020, we expect to see significant acceleration of revenue growth.

Okay, fair enough. And then second question just on the free cash flow topic. I know there's been a number of questions here, but if you just look through the first nine months of the year for 2018, you were at 60% conversion, and that was already tracking well below the levels that you were at the past few years at the same points in each of those respective years. Why was 4Q shaping up to be such a swing factor for free cash flow conversion this year, and was it all timing related, or was there something else at play in 2018? And then maybe just to round it out, why doesn't that repeat in 2019? Thank you.

Yeah, sure, Brian. Good question. Typically, we generate a lot of cash in Q4. I mean, it's our best quarter, and so what What happened this year, a couple things, and one is timing around the very strong growth we saw, you know, later in the fourth quarter. And that was a $90 million impact on its own in terms of cash related to sales and receivables. And then as things got a little bit more pressured in terms of the component shortages, We, the teams got aggressive and we made some strategic buys there as well as some more on the, you know, related to tariffs to, you know, to lock in better pricing. And those, you know, both of those factors we'll work through and it'll be a source of cash in 2019. And we do expect, we don't expect those to be recurring and we expect a more normalized picture around our cash flow profile in 2019.

Yeah, Brian, I would just maybe wrap up that question with an additional view. Your question around maybe tracking below the previous year through the first nine months, that was really being driven by a couple of things. So we were tracking very well from a working capital improvement year-over-year standpoint through the first nine months of the year. And so as a result of that, we were also confident in our ability to fund some of the CapEx that Mark alluded to around the watering fleet, the CAP software on census, smart hubs and AIA. And then that's what drove some of the year-over-year declines of the first nine months. but we were expecting before we had these issues that Mark laid out around the supply chain constraints and just the big pop in receivables in December because of the heavy revenue month, we were expecting to be able to claw that back and be at or above 100% free cash flow conversion, and that really was the surprise for us. So, you know, that's on us. We own it. You know, we're rectifying it, and we're highly confident we're going to be, you know, at or above that 100% in 2019 and well beyond. There's no structural change here.

At this time, I would like to turn the conference back over to Patrick Decker for any closing comments.

Great. Well, again, thank you, everybody. Safe travels. Appreciate your continued interest and support. See you out on the road, and we'll talk to you again after our Q1 earnings call. Thank you all.

This does conclude today's Asylum fourth quarter and full year 2018 earnings conference call. Please disconnect your lines and have a nice day. Thank you.