Xylem Inc.

welcome to the Xylem first quarter 2019 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 touchtone 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 now like to turn the call over to Matt Latino, Senior Director of Investor Relations.

Thank you, Bridget. Good morning, everyone, and welcome to Xylem's first quarter earnings conference call. With me today are Chief Executive Officer Patrick Denker and Chief Financial Officer Mark Rakowski. They will provide their perspective on Xylem's first quarter 2019 results. 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 Investors section of our website at www.xylem.com. A replay of today's call will be available until midnight on June 2nd. Please note the replay number is 800-585-8367, and the confirmation code is 298-7515. Additionally, the call will be available for playback via the investor section of our website under the heading Investor Events. Please turn to slide 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 Zion'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. Good morning, everyone. Thanks for joining us to discuss our first quarter results. We continue to see strong top line growth and healthy demand in the first quarter, but frankly, we were disappointed with missing our guidance for margin and earnings. Lower margin performance was driven by the mix of products that we sold and operational factors that we should have identified and planned for, most notably in our sales and operations planning process. We take our commitments very seriously, and we care deeply about doing what we say we're going to do, as our track record has shown over the past five-plus years. And we've taken corrective actions to address these shortfalls. We are pleased with our continued growth momentum, remain very excited about our ongoing growth prospects, and an achieving healthy margin expansion for the remainder of this year and well beyond. Now, let me review some of the other key details. We once again delivered solid organic revenue growth of 6% in the quarter. We saw gains across all of our end markets, highlighted by the continued mid-single-digit growth in our largest sector, utilities. This continues to represent above-market growth in a healthy market. From a geographical standpoint, the U.S. market produced strong revenue growth with an 11% increase year-over-year. This included double-digit growth in utilities and at least mid-single-digit growth in our other end markets. The emerging markets continue to be healthy and build momentum as well, up 12% overall, with particularly strong performance in Asia and Latin America. India and China saw strong gains once again. India increased 58% with growth in transport and treatment, as well as the beginning of our deployment of a large census metrology project. China was up 14%. And looking forward, we remain very confident about long-term growth opportunities in these markets. Turning to orders, we saw a 4% increase in the quarter. This is on top of 10% orders growth in the first quarter of last year, and there are clear signs of contended strength with a 10% growth in backlog. Another important achievement, which is reflected in our backlog growth, is our recent deal with Philadelphia Water, announced in early February. This project focuses on smart metering infrastructure that incorporates our FlexNet communications technology. It's an example of the kind of synergistic deals since the acquisition of Census that we are now uniquely positioned to secure and execute by leveraging strengths from across our portfolio. It's also a key milestone because with this award, we have now won contracts that represent nearly $200 million of revenue synergies, which exceeds our previously stated revenue synergy goal from the 2017 Investor Day of between $150 to $175 million. It further highlights the power and sustainable long-term growth profile of our portfolio. Based on the strategy we've executed and acquisitions made, we are now positioned to offer solutions that target the most crucial issues facing our customers. Challenges like water affordability, water scarcity, and resilience. This is accelerating demand for our solutions. Our advanced infrastructure analytics, or AIA platform, is a clear example of this. That platform saw accelerated market momentum in the quarter with orders growth of over 30%. we are building a robust pipeline with increasing interest in utilities in the U.S. and a growing presence in Europe and Asia. Now let me turn now to our margin performance, which was impacted by two primary factors. The first was unfavorable revenue mix over the expected test and European aftermarket and service revenues. The second was unfavorable overhead absorption in a couple of our key factories due to some demand planning decisions we made to optimize our inventory levels. Simply put, we should have had a better process in place to align forecasted demand with production. We've taken steps to address our sales and operating planning process, and we are confident that these margin effects are largely behind us. I'm now going to hand it over to Mark, who's going to give additional detail on the quarter. Mark? Thanks, Patrick. Please turn to slide five, and I'll begin with our first quarter results. I'm pleased with the continued market momentum we saw throughout the first quarter. Organic orders growth of 4% was in line with our expectations, very solid considering the tough comparison for last year's 10% growth. Revenues were up 6% in the quarter and at the high end of our revenue guidance. We had strong revenue growth across the majority of our geographic regions led by the 12% growth in emerging markets and 11% growth in the U.S. China continued its strong growth trend with revenues up 14%, with growth across each segment. Western Europe declined 2%, which was in line with our forecast and driven by a tough comparison to last year's first quarter, where we had a significant software sale and several large treatment project deliveries. Each of our end markets grew in the quarter, with continued strength in the utilities market up 6%, and 12% growth in commercial building services, which benefited from strong price realization, better-than-expected market conditions, and new products. The industrial and residential end markets both delivered solid growth of 4%. Adjusted operating margin for the quarter was 10.8%, down 30 basis points from the prior year. Cost reductions from our productivity programs and accelerating price realization of 170 basis points were more than offset by inflation, growth investments, and weaker sales mix. Part of the weaker mix of revenue was driven by lower-than-expected sales in our high-margin test and service and aftermarket businesses in Europe. We also had lower-than-expected overhead cost absorption in our applied water and water infrastructure segments. This was driven by lower production levels during the quarter to better align inventory with market demand to optimize working capital. As Patrick mentioned, we've taken actions to better align our sales and operating planning processes and have put this operational issue behind us. Earnings per share in the corn were 52 cents, up 12% over the prior year, excluding foreign currency translation. Please turn to slide seven, and I'll review our segment results. Water infrastructure, organic orders grew 2% in the quarter. This growth is on top of a tough comparison of 13% orders growth last year, where treatment orders grew 27% from several large project links. Segment backlog was $700 million at the end of the quarter. with $525 million shippable in 2019. This is up 5% over last year. Our treatment bidding pipeline, which we view as a bellwether of the health of the underlying utilities market, grew mid-single digits this quarter, driven by growing project work in India and new opportunities in North America. Water infrastructure revenues grew 7% in the quarter, Transport application revenues were up 7%, benefiting from high single-digit growth in both the utility and industrial end markets. The strength in utilities was fueled by strong aftermarket sales and stormwater resilience work in the U.S., and mid-teens growth in China from wastewater project deliveries. Industrial revenues were driven by our dewatering business, which was up 12% in the quarter with good growth in the mining and construction markets. Treatment application revenues grew 4% in the quarter from project deliveries in the U.S. in emerging markets, where momentum remains strong. Emerging market revenue growth was 10% driven by India, which grew 19% in China, which grew 21% in the quarter. With many of the major utilities in China now completing projects to comply with water regulations, we're turning our focus to smaller and medium-sized utilities to build or upgrade their treatment facilities to meet these regulations. We see a significant opportunity for growth in this segment of the China market and our pipeline for these projects is expanding. In Western Europe, Revenues were down as expected from lapping large treatment project deliveries last year. However, sales from our aftermarket and service business were softer than expected, which negatively impacted our mix of revenues and margin. Operating margin for the segment increased 110 basis points to 12.4% compared to last year. Cost reduction, strong price realization, volume leverage, more than offset inflation, a weaker sales mix, investments to grow our business and lower overhead absorption. Please turn to slide seven. The applied water systems segment delivered 6% organic orders growth over the prior year. Segment backlog was $222 million at the end of the quarter, with $194 million due to ship in 2019. This is up 12% over last year. Segment revenues in the quarter grew 7% versus the prior year, and we saw solid growth across each end market led by commercial building services. Geographically, we saw broad-based organic growth with the U.S. up 7%, Western Europe growing 4%, and we had very strong growth of 16% in the emerging markets led by China, which grew more than 30% driven by new project activity. Segment operating margin for the quarter was 15.6%, which reflects 110 basis points of improvement compared to last year. Cost reductions and 300 basis points of price realization more than offset higher inflation, lower overhead absorption, and foreign exchange headwinds. Now please turn to slide eight. Measurement and control solutions had 5%, organic orders growth in the quarter, which is on top of 12% orders growth in last year's first quarter. Total backlog for the segment was $980 million at the end of the quarter, up 16%, with $400 million shippable in 2019, which is up 19% year-over-year. We continue to gain momentum in the segment with new contract wins. We expect growth and margins to ramp throughout the year as previously announced contract wins, including our recent win with Philadelphia Water, will begin to deploy later in the second half of this year. Segment revenues grew 5% organically in the quarter. The water business grew 15% driven by strength in the North American market from continued demand for our eye pearl meters and AMI deployments for smaller and mid-sized utility customers. SAS and other service revenues were down 3% as expected as the segment lapsed the large software sales in Europe during the first half of last year. Energy, which is a combination of our electric and gas offerings, saw revenues decline 7% due to the lapping of the Alliant project deployment from last year. Test application revenues were flat in the quarter and below our expectations as the shipment of a large project was delayed by a customer into the second quarter. AIA organic revenues grew 10% in the quarter with growth across multiple regions. Strong customer interest continues for these new solutions, and we're penetrating new markets as we leverage existing Xylem channels in customer relationships. Segment operating margins contracted 420 basis points to 7.4%. Benefits from volume growth and cost reductions were more than offset by inflation. The unfavorable mixed impact from last year's high-margin software sale and investments to accelerate the growth of our AIA platform. We were also impacted by lower-than-expected revenues in our high-margin test business. The good news is that we saw some improvement in the availability of components and expect that challenge to be largely behind us by the end of the second quarter. We continue to outlook strong margin expansion for the second half of 2019, driven by improving mix, the scaling of our AIA platform, and volume levels. One new challenge we're working through are border crossing delays that we're experiencing in getting product from our Mexican supplier into the U.S. The team is managing this well to minimize impacts to our customers. Now let's turn to slide nine for an overview of cash flow and the company's financial position. We closed the quarter with a cash balance of $275 million. We returned $83 million of cash to our shareholders in the quarter through share repurchases and dividends. We invested $69 million in CapEx during the quarter, which is modestly higher than our full-year run rate and primarily related to timing. Investing in the business remains an important driver of growth for us. That said, we will remain disciplined and continue to forecast full-year capital spending between 2030 and $240 million. Our working capital increased 15.9%. This is in line with our expectations and driven by the inventory bill during the second half of 2018 to address tariff and component issues. These inventories will be worked down over the next two quarters, and we expect our working capital and free cash flow conversion to continue to improve each quarter. Cash flow from operations improved over 30% from last year's first quarter and free cash flow conversion improved substantially. As a reminder, the first quarter is our seasonally weakest cash flow period as we build inventory for the back half of the year. We continue on track to meet our full year target of 105% free cash flow conversion. On a final note, Earlier this quarter, we announced a new credit revolver tied to our sustainability performance. This is the first of its kind in our sector, and we're pleased to be able to align the interest of our shareholders to more efficient financing with our focus on sustainability and social value creation. Please turn to slide 10, and Patrick will cover our 2019 in-market outlook. The view of our end markets for the full year remains largely unchanged from the guidance we provided on our last earnings call. While we will lapse some tough year-over-year comparisons, the growth that we saw in the first quarter, combined with healthy orders and backlog, reinforces our confidence and our growth momentum for 2019. I'll quickly run through some key points for each one of our end markets. In the utilities market, we still expect solid growth in the U.S., where we continue to see strong project backlog, and a very healthy aftermarket business. Even with top comparisons to the balance of the year, we still expect mid-single-digit growth in the U.S. We are moderating our outlook for Europe slightly, as we saw some softening from uncertainty in the U.K. In the emerging markets, China and India continue to lead the way. Regulation is expanding in both countries, and adoption of our advanced treatment technology and other core infrastructure work is accelerating. We therefore maintain mid-single-digit growth expectations for the overall utilities market. In industrial, we continue to expect low to mid-single-digit growth as we foresee moderation in the second half of the year. While mining and construction boosted first quarter growth, we do expect general slowing consistent with our last outlook. In commercial, we saw another quarter of strong growth driven primarily by activity in the U.S. and China. We do expect that the market will moderate in the back half of the year, and we will also face challenging comparisons. However, our performance in the first quarter and outlook based on order demand gives us confidence to raise the outlook for commercial for the full year slightly to mid-single digits. Our residential outlook remains at low single-digit growth. Signs of a flattening U.S. housing market, low single-digit growth in Europe, and a mixed outlook across emerging markets all remain unchanged from our guidance last quarter. Now, please turn to slide 11, and we'll provide an update on the rest of our guidance for 2019. As we just discussed, we started the year with solid top line growth and continue to expect to deliver organic revenue growth of 4% to 6%. We are adjusting our operating margin outlook to a range of 14.5% to 14.9%. This represents healthy expansion of 80 to 120 basis points. We expect similar improvement on an adjusted EBITDA basis, which will bring it to a range of 20.3% to 20.6%. This updated outlook takes into account our performance last quarter and stronger dollar for the remainder of the year. Let me pause for a moment and talk about other actions we're taking to improve our margin profile. We first talked at our 2017 Investor Day about our overall approach to business simplification, which included two primary components. First, the implementation of a global business services platform, which represents the simplification of a number of our back office functions. I'll come back to this in a moment. Second, broader organizational opportunities to do further management delaying and elimination of other duplicate support functions. Since that time, we've advanced this effort to reduce complexity within the organization, allowing us to be faster and more agile so we can serve our customers better. These actions are being taken as we speak, and we expect to see modest savings this year with the bulk of the savings being realized in 2020. Now, turning back to our four-year guidance, we are revising the adjusted EPS to a range of $3.12 to $3.32, which reflects a reduction of $0.04 for the stronger dollar and $0.04 for the shortfall in the first quarter. This represents solid growth year over year of between 8% and 15%. And finally, we continue to expect at least 105% free cash flow conversion and are on track to do so. Let me now turn it back over to Mark to walk you through some of the other full year and second quarter details. On slide 12, we're providing the seasonal profile of our business as well as highlights of our updated 2019 planning assumptions. We continue to expect 4 to 6% organic growth for 2019, which breaks down by segment as follows. We expect 5 to 7% growth in water infrastructure. 3 to 5% growth in applied water systems, and 4 to 6% growth in measurement and control solutions. We're now assuming a yield rate of 112, which was the average for the month of April, and we've included that in our FX sensitivity table in the appendix. We are increasing our forecast for restructuring and realignment costs for the year to $60 to $70 million. The increase relates to the actions Patrick covered earlier related to organization simplification. The increase in estimated restructuring charges will largely be recorded in the back half of this year, with the majority of savings being realized in 2020. Our estimated tax rate for 2019 remains at 19.5%. Now moving to the second quarter. We expect total company growth in the range of 4 to 6%, led by continuing strength in the U.S. municipal market, as well as broad-based growth in China and India. We expect second quarter adjusted operating margins to be in the range of 14.3 to 14.5%, representing 50 to 70 basis points of expansion over the prior year. We expect continued strong margin expansion in both our water infrastructure and applied water system segments driven by cost reductions, volume leverage, and improved price realization. We expect margin expansion of about 20 to 60 basis points from our MCS segment, which reflects moderating impact from the component supply and mix challenges

Ladies and gentlemen, please continue to hold until the conference is restarted. And you're live.

Thank you.

And you may resume. And ladies and gentlemen, this is the operator. Today's conference will resume momentarily. And again, ladies and gentlemen, Pardon the interruption. We are having some technical issues at this time. Your conference will resume momentarily. You may resume your conference.

Yes, so this is Patrick, and sorry we apparently had some technical difficulties that I can assure you were not planned. So we're going to go back, and we're going to go back to slide 13. I realize that some of my comments may be redundant here, but it's important as we talk about this section of the call that you hear it in its entirety. So sorry about that. A little over two years ago, we laid out our financial targets through 2020 at our investor day. We continue to make solid progress and are on track for the high end of our organic growth target of 4% to 6%, notably having delivered 8% growth in 2018. Our adjusted EBITDA margin target is on track as well, having finished last year at 19.5% and an outlook for this year between 20.3% and 20.6%. This is clearly indicative of the strong operational expansion and volume leverage from growth that we've seen, which also strips out the noise from purchase accounting amortization. Our adjusted EPS is also tracking at the high end of our target of mid-teens growth, as we delivered 20% growth last year and 18% growth the year before. Our outlook for this year is at roughly 12% growth at the midpoint of our range. In the next area, adjusted operating margin, I realize there may be some questions about our ability to achieve our target in the 2020 timeframe while continuing to support our growth objectives. And while we have made significant progress, There are a couple of things that have changed since we laid out those targets back in 2017. First, earlier this month, we made the decision to delay the next phase of actions related to our global business services initiative. We decided to do this in order to optimize its implementation and minimize any potential disruption to revenue growth. Having said that, we remain fully committed to this opportunity, and we expect these savings to be realized, but delayed now into late 2020 and 2021. Second, the targets were set before we acquired Pure Technologies and the other businesses that we've acquired to build our new AIA platform. This platform and the growing demand for our digital solutions across the entire company is helping us set the pace for innovation in the sector. This is reflected in the strong growth we're seeing and the excitement around our integrated offerings. As a result, we remain confident in the longer-term margin expansion potential of this portfolio and expect margins to expand at least 100 basis points in 2020, with further healthy margin expansion in 2021 and beyond as we scale the capabilities we've been building in our new platform. With that, let's turn to slide 14 to wrap up the four questions. So, in closing, we continue to see strong demand for our solutions, and we're in the early stage of our digital journey, which is already reshaping the way water is managed for communities around the globe. While we had a disappointing quarter in regards to our margin performance, we have taken actions to ensure that we deliver our 2019 commitments while investing our business to realize the very attractive growth opportunities in front of us, as well as longer-term margin expansion opportunities. We are firmly committed to executing and creating value for our stakeholders, which includes enabling our customers to harness the power of technology to solve their toughest challenges and helping them transform the future of water. So with that operator, we'd be happy to take questions now.

The floor is now open for questions at this time. If you have a question or comment, please press star one on your touchstone 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. And our first question comes from Dean Dre. with RBC Capital Markets.

Thank you. Good morning, everyone. Hey, good morning. Hey, maybe we can start with the first quarter and the margin miss here. And Patrick, I apologize. I missed like the first minute or so of your opening remarks. But the next layer of detail, when you talked about, you know, lower factory absorption and demand planning decisions, That said, we need more help there in understanding what actually went wrong. Oftentimes that's an ERP decision or just, you know, in the chain of linking the demand with the actual factory deployment and inventory commitments and so forth.

Sure.

You know, what went wrong and how the degree of confidence that it's fixed.

Yeah, I'll speak first and then Mark can add some color here as well. So, yeah, to be very clear, what we're talking about in here is, As you recall, we built up inventories at the end of December ahead of the expected tariff increases and some component shortages. So we came into the year knowing we had higher inventory levels. And you recall that actually had led to some of the blip in free capital conversion last quarter. So we made the conscious decision to work down those inventories, you know, in the factory. The disconnect was in terms of that getting translated by a couple of factories into a financial forecast. that we would have built into our guidance originally as we came out for the quarter. That's where the miss occurred. And we've taken the, you know, we've taken the actions now within our supply chain organization and the finance team at the factory level to make sure that disconnect was resolved and does not reoccur. Yeah, Dan, part of it is making sure we have the right folks involved in those conversations at the right levels. Also, we, you know, as we work through this, beginning of April, we, you know, Tony and the team working on a Kaizen to make sure that we completely worked through, you know, where some of the gaps were. So we make sure this does not happen again.

And can you size for us between those three factors, mix, factory, absorption? I understand the mix had to have been that order push out at AIA, but size for us the mix of the three, including FX?

Yeah, in terms of the mix, it wasn't AIA. That was our analytics business or test business. And also we saw softer than expected revenues in our aftermarket and service business in Europe. And that impact in the quarter was, you know, roughly, you know, 25, 30 basis points. And then on the absorption, just on this absorption point, I want to, make sure that you understand that investors, this is an isolated incident in a couple of factories. It isn't across all of our factories and we do have our hands on it, but it did impact both AWS and water infrastructure by approximately 45 to 50 basis points in the core.

Got it. And then the second question on the push out,

of the margin target, the 17% to 18% by 2020. It sounds as though one of the tripping factors was this slower rollout in the global business services.

So what was the contribution expected to be? Was it 100 basis points there? And why was it not ready? So maybe start there.

Yeah.

Yeah, Dean, so if we go back to Investor Day in 17 and we laid out kind of the various drivers of the margin walk to that expansion target, about 100 basis points was going to come from what we called broader business simplification, of which, you know, part of that was global business services, which is all about the back office simplification, where we're talking about finance, IT, you know, HR, work day implementation, et cetera. The other piece of that 100 basis points was broader organization simplification, which are the actions that we just announced here in the call today and foreshadowed back in the last earnings call. So those are the two big drivers. We're still going forward with both. But what we've said, and I've said in the past, that, you know, doing a global business service implementation, we have the experience in doing this and we understand the importance of getting it right and not letting it become a distraction or disrupt the front end of the business in terms of top line demand. We are in the midst of that implementation. We've learned some things in the first couple of phases of rollout that caused us earlier this month to say we're not putting a hold on it. We're simply spreading out the timeframe to make sure that we don't rush it and that we get it right. And that's the single biggest driver to why we're pushing out the margin target expectations beyond 2020. And then, as you can also see, you know, we have been making, you know, other investments behind this new AIA platform that was not in the original 2017 Investor Day discussion. Yeah, so maybe just a little bit of color in terms of where we're at. You know, we had our initial wave implementations in January of this year in the U.S. So it's, you know, a meaningful part of our revenues. And that included new ledger, you know, new master data, new processes for order to cash, record to report, procure to pay. And, you know, parts of the implementation are going well. Other parts are not where we want them to be. And it's taking a little bit more effort and time than we'd like relative to, getting our financial information. So we have work to do to optimize these processes. And as Patrick said, you know, we're going to get this done. We are going to get savings, but we're going to do it right. And so we've, you know, we've pushed the ways out that we had scheduled for, you know, currently to, you know, later in the back of the year, and that's going to push out the entire implementation. Yeah, so, Gene, one other thing I would add, and this is, I'm sure, on the minds of those on the call, you know, I want to be clear. We could have made the decision to take a bunch of other additional costs out, including cutting some investment to make our 17 and 18 margin targets. That's not our approach because of the growth and the health that we see in the portfolio and the attractive margin accretion from this growth over time. So I just want to be clear that it's not as if we didn't have areas we could go whack at. But that's not going to be our approach here.

Got it. And just one last clarification, and then that'll be all for me. But the clarification on the delayed implementation on global business services, Patrick, you said it in the prepared remarks. I just want to make sure I understand where the timing of the initiative starts and when do the savings start coming into the P&Ls, just to clarify that.

Yes. Hey, Dean. Yes. So we had – You know, we had very modest amount of savings in 2019. Big part of the savings, you know, in the original timeline in 2020 with the, you know, the remainder flowing through in 2021. And now that has moved out, you know. Almost a year. Yeah, effectively about three-quarters is the phasing out, Dean. So it's why you don't – we won't get nearly as much as we'd expected in 20. We'll get that in 21 at a larger scale than we originally planned.

Got it. Thanks for all the color. Okay. Thank you.

And your next question comes from the line of Nathan Jones with Stiefel.

Good morning, everyone. Hey, Nathan. I guess we can stop endlessly talking about the 17% to 18% margin target now. Just a question on the miss and the internal part of that in 1Q. You guys certainly have a reputation for not making those kind of internal errors. Maybe, Mark, you can talk a little bit more about what was behind that, how isolated you think it is, Have you reevaluated the internal FP&A processes to make sure that this kind of thing doesn't come up again? Because it is pretty unusual for you guys to have this kind of thing.

Yeah, it's a really good question. And, you know, as I mentioned just a moment ago, you know, we've got a lot of factories, you know, a few dozen or more around. And this was really in three factories. And it all gets down to this sales and operations planning process, right, signals from our commercial teams into the factories and then translating that into financial outlook. And we had, you know, the communication around that process needs to be really, really tight. particularly as you're going through some changes and, you know, as you're trying to balance inventories and making sure that, you know, we do what we say we're going to do and not more, but also making sure we are getting good signals from the commercial teams into the factory. So, you know, and, you know, so there's a whole line of communications including finance, that's required. And quite frankly, they, you know, they weren't as tight as they needed to be. And part of it is making sure we've got the right leadership in those calls to – in that process to make those calls. So it's isolated. We know where the breakdown occurred. And I can assure you this is a hot topic with a senior leadership team and senior finance folks to make sure that it doesn't happen again. And it boils down to really good communication. Yeah, I think all I would offer up here is not to further, you know, pile on to what Mark's laying out.

And again, ladies and gentlemen, this is the operator. Today's conference will resume momentarily. Again, ladies and gentlemen, this is the operator. Today's conference will resume momentarily. And again, ladies and gentlemen, this is the operator. Today's conference will resume momentarily. Until that time, please hold. And you're live.

Okay, sorry about that, Nate. I don't know how much of the answers you heard.

We cut out right as you started talking, Patrick.

Okay, you missed some good stuff. Yeah, yeah, yeah, you missed the best part of the call. The... So, you know, your comments around this is very much unlike us. As I said, we take these things very seriously, and we own this. We're on it. I think the thing that was unique here, not to so much explain, but, you know, why this time around, I think it's the first time in a long while that we've been in a situation where we were purposely working off so much inventory, you know, towards our working capital numbers in a couple of our factories, and, you know, it was missed. in terms of the handoffs and communication in terms of what the absorption impact would be on the factory as a result of that. So that's the piece that Mark and the finance team are all over, and we've got the right leaders involved on the commercial side and the factories to make sure those things have been corrected and don't happen again.

Okay. So I guess my second question here is going to be back to the fundamentals of the business now. Order rates in the quarter are still pretty healthy, 4% against a pretty tough comp of 10% last year. Are there any markets where you're seeing any slowdown in order growth? I thought maybe Europe, maybe industrial. I thought maybe commercial, but you're taking guidance for that up. Just any color you have around the order trends you're seeing?

Another good question. So really, the only area that we have seen some level of order softness, and it impacted from the quarter, and we think it will be for the balance of the year, is some softness in Europe, which is really driven by the uncertainty in the U.K. And so, again, the U.K. was down 3% on its own in first quarter, and we're expecting to be down kind of, you know, mid-single digits or so in Q2, and maybe low single digits for the full year. So that would be the one area I'd say we're seeing softness. some softness, we think it's still purely a timing issue as we've worked through the uncertainty there in the UK. Other than that, we saw strength across the board. I would also give color on the 4%. Not only is that, again, say, a harder compare from last year of 10, but we also had a large treatment project that we'd expected to win and we expect to win, didn't get awarded in March. It's likely to get awarded here in Q2. That would have normalized us back up to probably mid-single business or so in order growth. So we still feel quite confident around the momentum behind the business.

Great. Thanks very much. I'll toss it on. Okay. Thank you.

And once again, if you do have a question, you may press star 1 on your touchstone phone at this time. And also, if you could, please limit your question to one question and one follow-up. And your next question comes from Scott Graham with BMO Capital.

Hey, good morning. Hey, Scott. I'm glad you can hear me. I hope you can hear us for the time being.

Well, we'll see. The question is young.

The MCS margin was obviously pretty difficult in the quarter, and I know you explained some things, but you're expecting from at least what I heard before you cut off, Mark, that you're expecting the margin to be up in the second quarter. And maybe just kind of, you know, erect that bridge for us, because that's a big swing. You're... Unfortunately, you cut out a little. I think what I heard, Scott, was a kind of a bridge in terms of how things get better in Q2 for MCS?

That's correct, yes.

Thanks.

Okay. Yeah. So, a couple of, you know, there's a couple of things. One is the fact that the, you know, we will continue to scale our AIA platform and, you know, there's good margin drop there. We'll also see an improvement in mix as well as, you know, we'll start to see some moderation of, you know, the impacts on tariffs. But it's really a combination and component shortages. But it's really mix, better mix, better scaling around our AIA platform and a little bit more a little bit of less challenge, if you will, in our supply chain. Are you still there, Scott? Well, I am now. Yes. Sorry. Okay.

Okay.

When you say you're expecting better mix, mix is always difficult to predict. I know that, you know, you've given some explanation, but you're seeing in your delivery book, a better mix for the second quarters. Is that kind of? Yeah. Uh, and a couple of, uh, a couple of pieces to that nature pieces are, uh, the lapping of the Alliance installation, which, uh, had, you know, you know, low margins on the install because we were subcontracting that workout. So that's a big chunk. And then, you know, we expect a, uh, much better mix of, um, and a higher mix of water, and that carries higher margins than the energy, you know, electric and gas. Those are really the two big drivers. Yes. Scott, we've got – in this business, we've got really good visibility into backlog because of these large deals that we've won and the margin profile of those and when the – installs are expected to occur, and then we've got good insights into what the day-to-day kind of replacement business is, and so in that regard, that's what gives us great confidence that we're going to see the margin expansion in the second half of the year relative to Q1. Yeah, the other thing, too, we got off to a late start in price, you know, kind of driving price in the business, and really didn't have much, if any, last year. We had a little bit in Q1. We've gone out and raised some prices, and that does ramp up in Q2 in the second half of the year. So that'll be some help as well. So the preponderance of the guy down on the margin is MCS largely first. Let me make sure I understand that question. When you say the guy down, not – No, no. Actually, the guy down, Scott, is really tied to two specific things. And I know with the call dropping here a few times, it may have been missed. The guy down is specifically $0.04 for currency, and that's just kind of restriking it at the latest euro rate. And then the second is just a miss in Q1. You know, we recover, you know, maybe a tad of it, but, you know, we're basically saying right now we're not counting on recovering that. We're not going to go slash cost just to probably recover that. It would come back on other investments we need to maintain.

Understood. I'll finish it there. Thank you. Thank you.

And your next question comes from John Walsh with Credit Suisse.

Hi, good morning. Hey, good morning, John. Hey, I guess maybe the first question, just thinking about the strong order growth, the strong sales, I think you guys have done a very good job explaining what's happened with the margin, but it does lead to the question, you know, what's actually kind of in the backlog in terms of the margin and if that's still relatively healthy and if you're seeing margin backlog kind of still expand year over year. Any color around that would be helpful.

Sure, yeah, John. So, this is Patrick. Yeah, we do feel good about margins and backlog. We've got good visibility on that. I would say, again, it is a function of the mix between project work and kind of, you know, day-to-day book and ship business is healthy. Two, we have seen very good pricing traction, again, as you'll recall, over the course of last year, and that continues as we go forward here. We also, when you look at the mix of MC&F business, as Mark alluded to, where it's going to be a much heavier water business, which is a substantially higher margin than electric and gas, Those are the projects that we see in backlog in the second half.

Okay, so is it fair to say that the margin in the backlog is actually up year on year?

It is, yes.

Okay, all right. And then maybe just a question around the pipeline as you think around what's out there in the market in terms of acquisition opportunity.

Yeah, I think, you know, as we've said before, you know, we maybe just reiterate the key focus areas for us. You know, we've talked before about we do think that there continue to be opportunities. If I think about it first from a utility space perspective, we think we've got a great platform here. We do think there are opportunities as we continue to build out our AI platform, that there are both opportunities there to build out an even stronger kind of, you know, decisions intelligence type offering to utilities. We just did a small acquisition in Germany. It's very, very small, but it's a terrific artificial intelligence capability for inside the treatment plant. We closed that deal just about a month or so back. Small deal, but really excited about leveraging that on a global scale. So on the utility space, I think it will largely be just a series of tuck-ins and bolt-ons that will not be material from a financial perspective, but be material in terms of strengthening the solution to the customer. Beyond that, again, we continue to look at opportunities across the industrial water space. It's a fairly fragmented area. We do see there being some interesting ideas out there. Not foreshadowing or signaling anything there. You know, we'll continue to be disciplined there from a valuation standpoint. Don't see anything in the immediate term. But that's an area that we continue to keep our eyes and ears close to the ground on.

All right. Thank you.

Thank you.

And your next question comes from Joe Giordano with Cowan & Company.

Hey, guys. Hey, Joe. Good morning. Hey, Joe.

Good morning. So I just wanted to start on free cash flow. So you guys are maintaining your target for 2019 here. but you're also doubling up effectively the restructuring for the year. So kind of talk us through, given the, you know, some of the issues you faced here in 1Q, how conservative is that target? Did it get incrementally more aggressive by keeping it flat?

Joe, that's a good question. Relative to the impact of restructuring, a lot of that, what that really gets at is the timing of the accounting impact in 1Q. not necessarily all of the cash flows. So, we think that, you know, in terms of the cash flow related to restructuring, it may be up a little bit, but we're not expecting that to have a, you know, material negative impact on that free cash flow conversion.

So, most of the cash... Is that it to your question, Joe? So, you went from like 30-something to... 60 to 70 in restructuring, but you're saying most of that incremental increase, the cash impact of that is next year?

Yeah, and most of that is, you know, will be late in the year, and not all of that's going to be paid out in cash. That's what I mean. Okay, fine. Yep, yep. And I would say, Joe, what also gives us confidence around that cash conversion is literally just the decisions and work that was made in Q1 to work out inventories. And so, you know, that will have a conversion benefit in terms of helping to get to our working capital numbers. And I would say that, you know, there's still inventory built up there, you know, related to tariffs that will continue to work down through the course of the year.

Okay. And then next, I know Nathan said we're not supposed to talk about 2020 targets anymore, but I'm going to ask one. Sorry. You pushed the operating target, which I think A lot of people were hoping to see that you kept the EBITDA target. So I'm just curious now, are you effectively just pushing out the amortization and not the simplification benefit? Because, like, the EBITDA targets stand the same. So just curious as to how you square that.

You know, our EBITDA has been running ahead of and more in line with our targets than – than our operating margin. And, you know, obviously, a chunk of that is related to the amortization. So, you know, we're still expecting to be within the range of the EBITDA target that we put out there for 2020.

But effectively, like, the operating margin change was because of amortization and because of the push out of the global business service and the simplification.

Right.

So it seems almost like.

So obviously the, yeah, I'm sorry. Obviously the, you know, global business services impact is going to impact both operating margin and, you know, and EBITDA margin. The amortization related to our acquisitions, you know, continues to be part of that calculation. There's also, you know, there's taxes, there's interest. All of those are components. of EBITDA. Yeah, Joe, we'll finish this year roughly around 20.5% in EBITDA. So we're committed to 100 basis points for next year that'll be on both, right?

So we'll finish roughly in that target was about 21.5% to 22.5% on EBITDA from the investor bank. Okay, fair enough. Thanks, guys. Yep, thank you.

And your next question comes from Brian Lee with Goldman Sachs.

Hey, guys. Thanks for taking the questions. Good morning. Sure. Good morning. Maybe if I could just squeeze one last one in, maybe hopefully last one in for you guys on the long-term margin targets. Is this effectively just a one-year push out? Are you committing to those original targets in the 2021 timeframe, or am I being too finite in trying to pitch and hold you guys there?

Sure. Yeah, I mean, I think, you know, what we're committing to here, Brian, is, you know, we're confident around the 100 basis points of margin expansion next year. We think that trend line can continue in terms of just continued healthy progression on margins for some time to come. You know, not in a position here today to declare new targets for 21 and beyond. We'll do that, obviously, later this year as we, you know, get closer to the end of the year. We're talking only about 20, but we're getting new longer-term targets at that point.

Okay, fair enough. And then just a second question. You mentioned a couple times throughout the call this Philadelphia win, which is encouraging, especially in the context of the water business, that part of the mix picking up. Could you guys give us some kind of frame of reference in terms of how big this deployment is in relation to other water deployments in your backlog? And then Maybe related to that, I noticed the SAS business was a bit weaker in the quarter. I know there were some tougher comps, but does that reverse in the second half with this Philadelphia deployment, or are there other deployments that drive that part of the business in MCS back to double-digit growth later in the year? Thanks, guys.

Yeah, so the filling water bill, you know, it is sizable, and it is in our backlog now, and it really, it's not yet in the works, so we, you know, we secure the contract, but we book the awards as they place them on us, and we expect that really to be happening later this year, mainly into 2020. You know, the general size that we have here is similar to other deals that we've been out in the space, and you can think somewhere between Roughly $60 to $90 million is the ballpark. Obviously, it moves around a bit depending upon the final specs, et cetera, but it is a meaningful size deal. We do still see a number of other large deals out there in the pipeline that the team is going after, both in North America, but also we're still pursuing a number of them on the international side that are also both a combination of AMI metering deployments, but also broader link between that and our new AIA platform around things like water losses, non-revenue water, etc. So those would likely be announced either late this year or early next. And those would certainly be at attractive margins, accretive margins to the current portfolio.

And just quickly on the SAS question, the SAS mix any views into kind of when those trends pick back up moving through the year?

Yeah, we think the certainly, you know, we're already, you know, we saw a little bit of that. I mean, the issue in the quarter was simply specifically a compare of a large software sale that we did in Europe last year. It was one project. Again, you know, we don't want to get into expand two quarters. Expand two quarters. And so that will be behind us If you look at the rest of our SaaS offering, which is predominantly coming out of our AI platform, as well as the AMI side of the business with Census, we continue to see very good growth in health there. We talked about the 30% orders growth in AIA in the quarter. We see that accelerating based upon the market demand and the deployments that we're doing and expect that to be converting into organic revenue really in Q2 through the end of the year and onward. Thank you.

And your next question comes from Brett Lindsey with Vertical Research.

Good morning.

So, wait, did you guys hear me now? Okay, yeah, I wanted to come back to the margin bridge and specifically the cost inflation bucket. That actually worsened relative to Q4. And just wondering, you know, what some of the moving parts are in terms of, you know, the underlying components there. And then just on the strategic investments, that was actually a positive swing in water infrastructure and applied with a delta of about 150 bps relative to last, you know, Q4. Just timing on investments, would you throttle back a little bit? Any color would be good.

Yeah, you know, in terms of inflation, you know, it's largely in line. It might be up a little bit. I mean, there really wasn't any incremental impact related to tariffs. We've been seeing that already in the fourth quarter, same thing with components. You know, maybe a little bit in freight, but nothing material. And certainly as we look out over the course of of this year, we'd expect that to, you know, trend down as we, you know, wrap some of those tougher, you know, compares in the back half of last year. So, that'll decrease. Now, the second part of your question related to investments, was it AWS?

No, specific to water infrastructure and apply, just looking at the delta. You know, it was a drag at all of 2018 in Q4, but it was actually a tailwind here in the Q1.

Well, we still had some investments in water infrastructure. So, and we certainly did throughout, you know, on an enterprise-wide basis, most notably, you know, when you look at MNCS. So, you know, we are continuing to invest, particularly in that segment, but in other parts of our business as well. So,

Okay, good. And then just shifting to the restructuring, you know, up about $35 million at the midpoint. I know it's sort of back-end loaded, but where are the targeted opportunities, you know, at the segment level?

Yeah, so I'll kind of refrain from getting into too much of the inside baseball on details of the org moves as we're, you know, in the midst of doing those as we speak. It is broad-based. It's not really targeted, I would say, on any one segment. Each one of our three segments have opportunities here that we're going through in streamlining. And, you know, it is a broader de-layering and elimination of some of the duplicate support functions that we've got. So I probably wouldn't want to go into more color than that right now and maybe can share more with you on the next call.

Okay, good. And then maybe just one follow-up on the U.S. growth that's been – you know, very strong across the board. What's your sense of the underlying market rate or, you know, run rate here in those, you know, in those pieces of the business? And then, you know, as you examine those outgrowth factors, what are the big drivers? Is it channel, products, any color would be good?

Sure. Yeah, so I would say, you know, the predominant drivers that we're seeing are really, I would say, you know, threefold. First is because that U.S. number is a company-wide number. So, you know, in the U.S., you see, first of all, a continued healthy utility market. And we believe the utility market is growing really in kind of a mid-single-digit level. And what we're seeing there in terms of faster growth than that, we do believe, is market share gain. And that's predominantly within our transport business, but also treatment. Second driver is, you know, we, again, continue to see accelerated growth, especially in orders on the new AIA platform, which is heavily concentrated right now in the U.S., as well as some of the project wins within the census piece of the organization. I think in those, in both areas, we see those as being sustainable. The one that I would say we are expecting to see some moderation of growth would be within our applied water business on the industrial side in the U.S., where we've been running pretty hot there for the past, you know, year, year and a half. That has come from a couple things. One, you know, we made an organization move about a year and a half ago where we integrated the commercial team's around our applied water and our water infrastructure businesses. And we've been getting a large amount of revenue synergies there that reflect share gains by expanding channel, streamlining our distribution channels, and just, you know, incentivizing people to go out and sell the portfolio. And so, you know, there comes a point where you start lapping that. And so we would say that part of the business would begin to moderate down to probably more low mid-single digits at the back half of this year. So when you do the math on all that, that's why we're saying for the full year, while we did 11% in Q1, we do expect that to be more median to high single digits in Q2, and then blends out for the full year at somewhere in that high single-digit level for the full-year aggregation.

Okay, got it. I appreciate it. Thanks.

Okay.

And your next question comes from Walter Liptack with Seaport Global.

Hi, thanks, guys. Just have a quick follow-up on the first quarter margin issue. I just want to clarify that that was a problem that got taken care of, and that's behind us now.

Yeah, yeah, no, we – it's – both Patrick and I mentioned, and there was a couple of follow-ups on that. You may not have been on the line at that point. But, yeah, no, we've done quite a bit of work around that in terms of our sales and operations planning process. We know what the root causes are, and, you know, we've taken corrective action. So we do believe that is fully behind us.

Okay. All right. Thanks for that clarification. And then it sounds like despite – You know, some of the macro international things that are going on, that your order intake internationally still looks pretty stable for this year, and I wonder if you could just talk about that, you know, especially on the larger system side.

Sure, yeah. So, yes, we definitely are seeing continued robust demand pretty much consistently across you know, outside of North America, I would say the one exception to that would be, I did mention earlier, you know, some softness in the UK that affected our European results. So we're guiding Europe in kind of the low single digits for the full year. But the rest of international, certainly across Asia, we see continued very robust growth there in terms of orders and bidding pipeline. The same is the case within Latin America. We see some great results there. We see strength continuing in Eastern Europe. And I would say the Middle East is moderated, but is healthier now for us than it was last year. And so it feels pretty good right now, touch wood. And, again, the things we look at are things like baseline and backlog, and that's where we have our comments.

Okay. All right, great. Thank you, guys. Thank you.

And your next question comes from Andrew Buscalia with Barenberg.

Good morning, Andrew.

Andrew, your line is open. Please state your question.

What's that, Andrew?

Andrew, your line may be on mute.

Hey, guys. Why don't we go ahead? Yep, I'm here. Thanks for taking my question. Okay. Yeah, I just wanted to just delve into your guidance. You know, obviously, it's come up a few times on the call, just given it still implies a big rant. I'm questioning, you know, how conservative or if there's any contingency in place for some of the issues that occurred in Q1, and then you're talking about moderation in a number of areas, industrial, commercial, we talked about softness in the UK, Middle East moderating, applied water even. So your guidance is only reduced by the MIS and some effects, but where do you get this confidence and are you being conservative enough to meet your expectations for the year?

Sure, yeah, well, obviously we go through a lot of analysis and digging into these things before we put together, you know, a guidance for the full year. And certainly as we look to adjust it downward, you know, by definition we make sure that we build in appropriate contingency to be able to cover for a rainy day. Obviously we're not crowding NISTAT and Q1 for the reasons that we described, but we feel confident that we've got the appropriate range there. And, you know, the issues around the words moderation that I used, those are all embedded in the 4% to 6% organic revenue guide, which still gives us some room in the case that things soften. It also addresses that some of the costs do get tougher in the second half of the year from a growth standpoint, but we feel we've got all that reflected and embedded in our guide. Well, and I would point out a big, you know, certainly a big part of that's also our MCS thing, right? We have, you know, the comps are certainly much easier there, and we, you know, we have a ramp, big ramp in higher margin water business, scaling up AIA. So, you know, we have good confidence in that. We continue to drive productivity, and, you know, we expect that to, you know, ramp in, you know, throughout the course of the year. So, as Patrick said, you know, particularly after not hitting your numbers, we were particularly, you know, focused on making sure that, you know, we identified all of the potential risks out there and we had sufficient contingency to address.

Okay. And maybe just one more on your MCS side. You know, that was a bit disappointing this quarter, but, you know, where, some of the things like the energy applications due to lapping a volume project, the softness, something you had a tough time with the SAS piece. You know, maybe where did – wouldn't that have been expected? Or where did you miss in your guidance or your, you know, steering us to where that margin would be this quarter?

Yeah, the miss in the quarter, you know, we were a little bit below what we had outlooked, and that was primarily a function of mix. And, you know, we expected better sales growth in our high-margin test business. That's our analytics equipment and sensors. And it was flat. And, you know, that was really the difference between, you know, what we outlooked and what we delivered from a margin perspective. And just to be clear again, we're not talking about the AIA platform. We're talking about the traditional analytics piece of the MCS segment, which is very high gross margins for us. And it was a specific project in Europe that got pushed out and that drove the, you know, the shortfall there. And it hit margin hard just because of the gross margins in that business. Okay.

All right. That's helpful. Thank you. Okay. Thank you.

And your final question will come from Shireen Undavia with Raymond James.

Hi. This is Shireen. Good morning. Good morning. Can you hear me?

Yes, we can.

Okay. Yeah, this is Shereen on for Pavel. If I'm not mistaken, it's been over a year since your last acquisition announcement. That's a pretty long M&A hiatus for you, so I was wondering if there's an indication of private company valuation that have gotten too rich, or should we read anything else into that?

Yeah, no, it's a great question. I wouldn't read anything into – our kind of a year passing in terms of not doing M&A to do anything with valuations. I mean, obviously, valuations move around and they vary depending upon the target that you're exploring. But I think we just felt it was important to pause on anything of significance over the last year while we continue to focus in on the successful integration of both Census as well as Pure and building out this new platform, this new AI platform. And so since then, we have done a few small tuck-ins, bolt-ons, that are not material from a financial standpoint but are strategically. We continue to explore and will continue to be active in terms of M&A when the right opportunities present themselves strategically and financially. But, no, I would not read anything into it being a commentary on valuations.

Okay. Thanks.

Thank you.

And thank you. I will now turn the floor back over to Patrick Decker for any closing remarks or any additional remarks.

Sure. Well, again, thank you all for bearing with us here this morning on the technical difficulties. I know it was painful, at least on this end. And so I appreciate your patience through this and also by hanging on the phone a bit longer than we normally planned. Appreciate the ongoing support. Look, we look forward to getting back to you after our Q2 results. We appreciate all your support. Safe travels, and we'll be in touch soon. Thank you.

And thank you. This does conclude today's first quarter earnings conference call. Please disconnect your lines at this time and have a wonderful day.