Xylem Inc.

Welcome to the Xylem second quarter 2019 earnings conference call. At this time, all participants have been placed on a listening 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 now like to turn the call over to Matt Latinos, Senior Director of Investor Relations.

Thank you, Maria. Good morning, everyone, and welcome to Xylem's second quarter 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 second 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 investor section of our website at www.xylem.com. A replay of today's call will be available until midnight on September 1st. Please note the replay number is 800-585-8367, and the confirmation code is 847-9137. 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 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. Good morning, everyone.

Thank you for joining us today to discuss our second quarter results. Overall, we were pleased with our performance in the quarter, which reflected continued strong revenue growth and margin expansion. Our organic top-line growth was broad-based, driven by solid demand across our end markets, and with orders and revenue growth tracking in the mid-single digits. This result marked our eighth consecutive quarter of at least mid-single-digit organic revenue growth. This reflects the results of our focused investments that are bringing new solutions to the water sector, and we believe will drive sustainable, attractive margins. we also delivered solid margin expansion of 50 basis points in line with our guidance. In addition, we delivered earnings per share of 79 cents, which was also in line with our expectations. That represented a 10% year-over-year increase, excluding foreign exchange translation. As a result of seeing continuing healthy growth, we are narrowing our organic revenue guide and raising the midpoint to the upper end of the range. As a result of near-term mix, and targeted investments to accelerate and sustain our growth, we are narrowing our EPS guide to the lower end of the range. We'll get into each of them in a bit more detail. Looking at the composition of our top line, our regional and in-market mix is robust. We turn in solid performance in each of our in-markets, led by high single-digit growth in both utilities and commercial. Regionally, we deliver particularly strong momentum in the U.S. and in our largest emerging markets, China and India. each of which grew double digits organically. The high growth in China and India is very pleasing, given we've invested considerably in product localization, and our investments there are clearly paying off. Europe has seen some softening in certain markets, most considerably Italy and Germany, driven by broad-based industrial weakness. Generally, the rest of Europe shows a steadier picture. Mark will take us into the segment detail in a moment, but I would like to quickly point out that all three segments of our business have turned in solid performances. However, there is a more dynamic picture in MCS. We're very happy with the progress and growth of our census business. Its revenue growth is outpacing Xylem overall, turning in 9% global growth in the quarter and solid double digits in North America. Our new AIA platform in MCS is in an earlier phase of its growth ramp. The acceleration of customer interest is reflected in a 60% expansion of the total AIA deal pipeline over the past 12 months, led by a doubling of opportunities within the new digital solutions portion of that platform. Moreover, the size and incremental margin profile of that pipeline is very attractive and will be highly accretive to Xylem. The conversion of project to revenue has been slower than expected, however. As with any new disruptive technology, Our digital platform represents a new approach for customers, so many are prudently taking time to validate the solutions and savings. As that validation progresses, we are, in fact, seeing expansions of Project SCOPE. Despite slower conversion, the expanding market opportunity we are uncovering continues to affirm our long-term investment thesis. Our approach is to invest just ahead of the adoption curve in order to be positioned to realize the benefit of our first mover advantage and bringing digital intelligence to the water sector. To that end, we are scaling our sales and marketing capacity and continuing to add incremental capabilities to the AI platform, both organically and through M&A, as we build out and integrate the portfolio. Lastly, before turning over to Mark, I do want to take this opportunity to shine a light on our commitment to sustainability. In developing our new 2025 goals, we took a bold, aspirational approach. In many industries and business models, positive sustainability outcomes are a cost of doing business. For Xylem, positive sustainability outcomes are a result of doing business. The technology that we sell address water scarcity, water affordability, and resilience to climate change, all while dramatically reducing our customers' energy consumption. So the more business we do, the more technology we deploy, the more sustainability benefit we generate for the customers and the communities that we serve. The complete list of our commitments is in our sustainability report, and a summary of our five signature goals is in the appendix to this earnings package. They are commitments to our shareholders and stakeholders alike. Every bit as strong is our commitment to deliver robust growth and financial returns. Now let me turn it over to Mark.

Thanks, Patrick. Please turn to slide five, and I'll begin with our second quarter results. Our overall growth momentum continued in the second quarter with organic revenues up 5 percent. Organic orders were also solid, up 4 percent on a tough comparison of 8 percent growth last year. Most geographies saw healthy revenue growth led by the U.S., China, India, and Australia, which each grew double digits. However, we did have some specific pockets of slowing within Europe in Latin America due to negative prevailing economic conditions, which we expect to continue into the second half of the year. All in markets saw positive organic revenue growth led by 8 percent in utilities, which was on top of a tough comparison of 11 percent growth in 2018. This was supported by mid-teens growth in the U.S., where we saw robust growth across both the OPEX and CAPEX sides of our utilities business. The industrial market was up 2%. Healthy project business and price realization in the U.S., combined with the continuation of strong construction and mining activity in our dewatering business, was partially offset by moderating industrial demand in several regions. Continued strength in the U.S. and double-digit growth in emerging markets drove commercial market revenues up 7 percent year over year. The residential market grew 1 percent, which was in line with our expectations. Adjusted operating margin for the quarter expanded 50 basis points to 14.3 percent. This was primarily driven by 280 basis points of cost savings from our productivity programs and 200 basis points of price realization which more than offset inflation, unfavorable mix, and provided funding for our growth investments. Earnings per share was 79 cents in the quarter, up 10 percent versus the prior year, excluding foreign currency translation. Please turn to slide six, and I'll review our segment results. Water infrastructure maintained its top-line growth momentum with 4 percent organic water and 6 percent organic revenue growth in the quarter. It's worth noting this performance was on top of a tough comparison of an 11 percent revenue increase last year. Segment backlog was up 2 percent to $684 million at the end of the quarter, with $449 million shippable this year. While our shippable backlog for the remainder of 2019 is flat, For 2020 and beyond, it is up 10% organically, a very positive sign for future growth momentum in the segment. The U.S. market was up mid-teens in both utility and industrial end markets. Several large CapEx treatment projects and steady OpEx spending drove our strong utilities performance. Industrial was driven by another strong quarter from dewatering. which continues to benefit from a healthy construction rental market. Emerging markets were up 3 percent, driven primarily by double-digit growth in China, more than offsetting declining demand due to economic weakness in Latin America and project timing in the Middle East. Western Europe declined 1 percent overall, reflecting low single-digit growth in utilities which was more than offset by softness in the industrial market. Segment operating margins grew 130 basis points to 19.1%, driven by productivity savings, price realization, and volume leverage. I'm very pleased with the work the teams have been doing to continue to drive cost savings, capture further price and share to fund our growth investments and expand margins. Please turn to slide seven. The Applied Water Systems segment delivered 4 percent organic revenue growth and 1 percent organic orders growth in the quarter. Steady order activity in North America and Asia was largely offset by slowing orders in Europe. Overall backlog was $216 million at the end of the quarter. $175 million is expected to ship this year, which is up 5 percent organically year over year. Geographically, applied water results were led by the U.S., up 7% with growth across all end markets. Results were mixed in emerging markets, which were up 2% overall, led by double-digit growth in China, partially offset by declines in Latin America and the Middle East. Western Europe was down 4%, primarily from lower market demand reflecting economic weakness in certain countries. End market revenue growth was led by commercial, which was up 7%, while industrial revenues increased 1%. Growth in both end markets was driven primarily by delivering on a healthy project pipeline and price realization in the U.S. Segment operating margins were 16.8%, Inflation negatively impacted the segment's margins by 450 basis points, which included roughly 100 basis points of tariff-related costs. However, the team did an outstanding job capturing 350 basis points of price realization and driving 320 basis points of productivity to deliver 60 basis points of margin expansion in the quarter. Now, please turn to slide eight. Measurement and control solutions grew order 7% in the quarter and delivered 6% organic revenue growth. Segment backlog grew double digits year-over-year to $964 million, with $340 million expected to ship this year. As Patrick mentioned earlier, we continue to see strong momentum within Census, especially the North American water business, which grew nearly 20% in the quarter. Software and services revenues were down 9%, primarily due to the lapping of a large high-margin software sale in Europe last year. The energy business grew 4% despite lapping last year's large Alliant project deployment, and our test business revenues were up 1%. Segment operating margins were 8.7%, 40 basis points below the previous year and modestly below our expectations. Adjusted EBITDA margins were down 30 basis points to 18.2%. Higher volume, price realization, and productivity were more than offset by unfavorable mix in investments to grow our new AIA platform as well as pursue large AMI deployments. There are a few moving parts to the MCS margin story that are important to unpack to understand the dynamics and relative trajectory of the components within the segment. Our census business had a terrific quarter. Organic revenues grew 9 percent and orders grew 13 percent. Census EBITDA margins of 20 percent expanded 180 basis points driven by volume leverage, price realization, and productivity savings. Revenues across the AIA platform were down low single digits, primarily due to delays in converting several large projects. This also had a meaningful impact on segment margins compared to our expectations as the digital solution revenues have a very attractive margin profile. Despite the delay in converting projects to revenues in the quarter, we continued to invest to scale our digital solutions business globally to position us to leverage our first mover advantage. Year-over-year investments to build out our digital intelligence solutions, as well as global commercial and service capabilities, reduced segment margins by about 100 basis points in the quarter. Importantly, we see very strong customer engagement and growing interest in our expanding digital solutions project pipeline. And we continue to expect this business will be an important source of revenue growth in margin expansion for the future. Please turn to slide nine for an overview of the company's financial position. Our cash balance at the end of the quarter was $383 million. we returned $43 million to our shareholders in the quarter for dividends. $60 million was invested in CapEx, which is in line with our plan, and we continue to expect our full-year CapEx spend to be between $230 and $240 million. Our working capital in the second quarter increased 160 basis points year-over-year to 21.1%. This primarily reflects timing as we continue to be impacted by inventory pre-buys at the end of the prior year, as well as inventory build in the first quarter related to tariffs and Brexit. This will be worked down through the back half of this year. Free cash flow conversion in the quarter was 45 percent, which improved quarter sequentially, but is below the prior year, largely reflecting the year-over-year timing related to working capital and CapEx investments, as well as higher cash tax payments we made in the second quarter of 2019. Keep in mind that the first half of the year is a seasonally weaker cash flow period than the second half, where we have historically generated between 75 and 90 percent of our full-year cash flow. We continue to forecast improvements as the year progresses, and we remain committed to our target of 105 percent cash conversion for the year. Please turn to slide 10, and Patrick will cover our 2019 in-market outlook.

Thanks, Mark. Our view on in-markets for the remainder of the year includes some small changes in the guidance we provided last quarter, and we will now be narrowing to the upper end of our original growth guidance range. Our healthy orders and backlog support confidence in our growth expectations for the balance of the year and beyond. In the utilities market, we now expect mid- to high-single-digit growth led by a solid U.S., where a healthy aftermarket environment and our project and deal pipeline in water infrastructure and census provide confidence in our outlook. Regulatory mandates and core infrastructure investments in China and India are also expected to continue. In industrial, we now believe our growth outlook is closer to the low single digits. While the U.S. market continues to be steady and our applied water project pipeline remains robust, the we do expect there to be some moderation in the second half. We are also seeing weaker economic conditions in certain European countries, which we believe will impact us through the balance of the year. Our outlook for the commercial market remains unchanged at mid-single digits. Our residential outlook is now flat to low single-digit growth. Please turn to slide 11, and we will provide guidance for the remainder of 2019. We started the first half of the year with strong top-line growth of 6%, and continue to expect to deliver organic revenue growth in the mid-single digits of 4 to 5 percent in the second half and 5 to 6 percent for the full year. We are adjusting our operating margin outlook to a range of 14.3 to 14.5 percent. This represents healthy expansion of 60 to 80 basis points. We expect adjusted EBITDA to be in a range of 20 to 20.2 percent. This updated outlook takes into account our performance to date and also reflects the softer growth in Europe and project conversion timing in our AIA business. Having said that, we will continue to drive healthy margin expansion across our entire platform so that we deliver our commitments for this year and beyond. Moving on to adjusted earnings per share. We are narrowing our outlook to a range of $3.12 to $3.22, which reflects the items I just mentioned regarding margin. This represents year-over-year growth of between 8% and 12%. Finally, we continue to expect 105 percent free cash flow conversion, and we are executing on our plans. Let me now turn it back over to Mark to walk through some of our other full-year and third-quarter details.

Thanks, Patrick. Slide 12 includes a seasonal profile of our business as well as highlights of our planning assumptions. By segment, we are narrowing our full-year organic revenue growth guidance as follows. We expect 6% to 7% organic growth in water infrastructure, 3% to 4% in applied water, and 5% to 6% growth in measurement and control solutions. We have lowered our full-year estimated effective tax rate from 19.5% to 19%. We continue to assume a Euro rate of 112, and as usual, our FX sensitivity table is located in the appendix. Our restructuring and realignment costs of $60 to $70 million remain unchanged for the full year. In the third quarter, we expect an overall company growth rate of 4 to 5 percent, led by a steady U.S. utility market and continued growth in China and India. Our expected growth rates for the third quarter by segment are 4 to 5 percent in water infrastructure, 3 to 4 percent in applied water, and 5 to 6 percent for measurement and control solutions. Third quarter adjusted operating margin is expected to be in the range of 15 to 15.1 percent, representing 40 to 50 basis points of expansion over the prior year. Measurement and control solutions is expected to expand segment margins 20 to 40 basis points in the quarter. We expect 40 to 60 basis points of margin expansion in water infrastructure and 30 to 50 basis points of improvement in applied water systems. Now, please turn to slide 13, and I'll turn the call back over to Patrick for some closing comments.

So, to wrap up, we're demonstrating solid and consistent growth with healthy margin expansion. we're pleased our teams are working hard to outperform the market, enabling us to meet our financial commitments while also continuing to invest in future growth. We have healthy top-line momentum and strong project backlog, which gives confidence in continuing mid-single-digits revenue growth through the second half into 2020 and beyond as we continue to drive solid margin expansion. In that regard, we also look forward to providing you with an updated view of our long-term targets and strategy at our 2020 Investor Day, which we are targeting to be sometime early next year. We will have more details to come on this in our third quarter earnings update. So with that, operator, we're happy to take questions.

Thank you. The floor is now open for questions. At this time, if you have a question or comment, please press star 1 on your touchtone 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 questions that you pick up your handset to provide optimal sound quality. Thank you. Our first question is coming from the line of Nathan Jones of Stiefel.

Good morning, everyone. Hey, good morning, Nate. I'd like to talk a little bit more about the reduction in the margin guidance here. There's no change to the restructuring and realignment costs. The revenue numbers here are still pretty strong, so it doesn't look like you see anything structurally that needs to be addressed in the business. So maybe if we can start with AIA because you guys called out mix and investments as the two main causes for the reduction here. Can you talk about the investment trajectory in AIA? I think it was supposed to begin to ramp down as we went into the back half of the year. Is this related to delays in the projects ramping up or is it because you see more opportunities to go after? Just some color around that.

Sure, I'll take that first, Nate. I think it might be helpful for folks to understand kind of what's the, you know, kind of what's the waterfall or bridge on the net EPS reduction in terms of lowering the, you know, the lower end of the guidance range. You know, you're really looking at about four cents is coming from, again, the weaker Europe, just given how rich that margin is on our business. And so we are reflecting that into our guide right now. Secondly, probably about $0.04 attributable to AIA, and that is a combination of the slower ramp in terms of converting projects to revenue than we expected, although we are seeing scope increase and we're seeing the funnel, as I mentioned before, has more than doubled in the digital solutions piece of that platform, so we're very encouraged. And based upon that, we are holding our investments So there's a little bit more in there that we have for investments than we originally had talked about. And then the way we've been mitigating that $0.08 kind of impact is about $0.03 coming from stronger performance, most notably in the U.S. utility market that we expect to continue through the balance of the year.

And you mentioned restructuring. I mean, we've talked about that on our last call, and we have a number of actions that are well underway related to simplifying the organization, improving our speed and agility. And those are tracking to our expectations.

Maybe another one on AIA here. I think the anticipation from these projects was that they began to ramp up kind of later in 2019 and really started to hit stride in 2020. and drove some pretty good growth, potentially double-digit growth in the MCS segment next year. Does that push this out a little bit? Do you still see those ramping up later in the year? Is that kind of number in 2020 still in play, or has this shifted to the right a little bit here?

No, I'd say it's still in play for 2020. And what we also see, you know, if we step back and you've done a good job, Nate, in kind of parsing, you know, there are two pieces of this MCS segment. And I think folks oftentimes tend to lump them all together. You know, two very different pieces. There's census, which is really being driven by good core North America water growth, which is a combination of day-to-day business, but also, you know, we are seeing, you know, we're winning a number of AMI, large AMI deals today. in that space. And so that's certainly going to drive very strong growth late this year in MCS, but also certainly in 2020 and beyond. The second piece is AIA. And even within AIA, there's the traditional core pure, you know, the pure business that we acquired. But there are also a number of these smaller, there are about seven of these smaller technologies that we've acquired over the last few years that we've built out to be our digital solutions platform in that business. And that's really the, you know, our core pure business actually continued to grow nicely in and pretty much on plan or above plan in the quarter and for the full year. It really is that new digital solutions platform that we're seeing tremendous uptick in the funnel, but converting those from a concept into orders and revenue has taken a little longer than we had anticipated. So net-net to your answer, We see no change in kind of outlook for 2020. If anything, this further strengthens our view on that based upon the quality and the degree of uptake in terms of customer interest.

That's useful. Carla, thanks very much. I'll pass it on.

Okay.

Thanks, Nate.

Our next question comes from one of Dean Dre of RBC Capital.

Thank you. Good morning, everyone. Good morning, Dean. Hey, I'd like to pick it up right there where you ended off with Nate. So on MCS broadly, and thank you for emphasizing that distinction between census and AIA, census is executing really well from our perspective. And we did note that one of census competitors negatively pre-announced this quarter and looks like they're losing share and you all seem to be outgrowing the market nicely. So that's good news. Thanks, Dean. So on AIA, so not too surprised that it's taking time for this from project wins into revenue. You all have disruptive technologies and the water industry is notoriously slow to adopt. So the way I look at it, and I just would love to hear your comments on how each of these factors might be at play. But there's three factors. So do you have the right, and I'll take you all three, do you have the right pricing model yet on these? Because our customer is balking at the price, you know, the network as a service, contingency kind of payments. So do you have the right model or are customers just notoriously slow to adopt and are just taking their time? or is it macro worries before that you're a little nervous about throwing the switch and committing to the capital? So how do these three factors play out?

Sure. No, you've laid it out well, Dean. The two factors I would pretty much – I would certainly eliminate the last, which is any kind of macro fiscal concerns. We're not seeing that. And if anything, what we're seeing, part of the reason why there's as much excitement as there is, and we're seeing scope expansion – in a number of these areas is because what we're really hitting at in a big way here is the affordability issue. And so these technologies, as you well know, and others may or may not know, are really getting at the affordability issue in terms of how do you take large-scale CapEx projects and make them more affordable? And secondly, how do you extend the life and performance of the existing assets? So all of those play very well into the whole affordability equation here. What that literally leads to is there is still some work that we're doing around making sure that we've got the optimal revenue model here in terms of how we share value in that, given how much we're able to disrupt. But I would say right now the predominant issue is that these are breakthrough technologies. Utilities are conservative, as they should be, and so they want to make sure that they validate the the savings, the functionality of this, and it is new and disruptive. And so what we're seeing, though, is the reason why there's such an increase in the funnel at this point in time is word is spreading. Utilities are talking to each other and sharing the pilots that they're looking at getting involved in. And so I really think that this is simply a matter of timing of ramp. The margins that we see in terms of incremental margins are extremely high. attractive, very accretive to the overall asylum, so there's no change in outlook there. And so that's why we're still so encouraged, and that's why we've said, you know, we still need to continue our investments in this, you know, slightly ahead of the adoption curve. You know, we're not going to go crazy about it because we don't need to, but we're still very, very encouraged by what we see.

That's great to hear, and I really do like seeing the additional investments, even though there's a margin hit associated with it. That's, from our perspective, it's the right thing to do. And then just a second unrelated question. Lots of anxiety about trade tensions, but it looks like your China business continues to churn very nicely. Maybe just characterize the tone of business, the funnel in China, where there are opportunities. Thanks.

Sure. Thanks, Dane. So, you know, as I think Mark may have mentioned, so we expect, you know, double-digit growth in 2019, which is down from 23% in 2018, so it moderates slightly. But, you know, so two-thirds of our business in China is tied to the utilities and is relatively well-protected. You'll recall that even during the last downturn in China, that part of our business didn't actually decline. It actually held pretty steady and strong. And what's really driving that is Again, water environment quality continues to be a top policy mandate for the Chinese government as driven by the citizens of the country. And so we still see very strong pipeline on the bidding side, et cetera. The area that we do keep a close eye on as well is the other third that is tied to industrial and commercial building. We've not seen any downturn in that business. We don't see any signs of such there. So we remain still quite bullish on China. One of the questions we also get is, you know, given that we're servicing kind of critical government infrastructure, is there any risk that we could be targeted at some point in time? And we don't see that. I mean, we keep a close eye on that. We don't see it right now because, as you've seen, Dean, when you visited our facilities there in China, you know, we are a Chinese company in China. I mean, you know, we have the total look and feel of a Chinese company. It just happens to have access to global leading technologies along the way, and so we really don't see that we have a threat there.

Thank you.

Thank you.

Our next question comes from the line of Scott Davis of Mellius Research.

Hi, good morning, guys.

Good morning, Scott.

I'm trying to get a sense of, I know it's very different by business for you guys on inventory levels and such, but Some of the declines you saw in Western Europe, would you attribute a certain percentage of that to inventory destock, or do you have line of sight on sell-through that's pretty consistent?

Our view on that, Scott, is that there is clearly a slowing in economic conditions Certainly, we've seen that in Italy. We've seen that in Germany and in a couple of other countries. And so it's really not an overstocked position relative to what's been sold into the channels, but just more of a slowing in the broader economies of some of these countries.

Yeah, we would say, Scott, that we certainly don't see really anything being attributed to a destocking of inventories. And we've got quite a good line of sight on the businesses there in Europe, which tends to be more of a direct channel. We do have some indirect, but we've got a healthy direct channel as well.

Yeah. I know it's tough. There's lots of nuances there. And just as a follow-up, I know Pure is a really cool asset, but you also paid a pretty good price for it, too. It wasn't free, so... How is the tracking versus the deal model? Are you getting the kind of revenue take rates that you expected? Or should I say it a different way? With you guys as the owner, have you been able to really drive that model to your liking?

Yes, Scott. I think... You know, there's still plenty of demand. One of the things that we've been working on and investing in is growing out our international business. And, you know, there's a lot of activity. This is all new to our teams. We're leveraging the existing commercial capabilities that we have there. You know, and frankly, that's one of the areas that we need to to continue to invest in so we can accelerate some of the growth for opportunities that are clearly there. There's a lot of demand. But, you know, as we've talked about it, it's a very different value proposition. It's a different set of selling skills. You know, there are solutions. And so we're migrating up that curve as well. That's probably a little bit slower we would have liked at this point, but it's not for lack of underlying customer excitement and demand.

Yeah, the way I'd characterize it, Scott, is, you know, there's the pure – there's the asset of pure technology that we acquired, and that certainly has always been intended to serve as the kind of fundamental platform of some of these new digital solutions that we've acquired through other startups. And so, you know, the pure business is delivering as we expect this year. It's on plan. The plan obviously driven by deal models. So that piece is there. I think what you're seeing right now and you hear us talking about the pushing out of some of the AIA demand is really being driven by the other small startups that we put together and are integrating into a new digital solutions platform. So when we talk about some of the validation of savings and delays in some of the adoption in terms of getting it through procurement, At the utility, we're really talking about the digital solutions part of the AA platform, not really the pure piece. Okay.

Very helpful. Thank you. Good luck, guys. Okay.

Thank you. Our next question comes from one of John Walsh of Credit Suisse.

Hi. Good morning.

Good morning.

I guess the first question around the margin bridge implied in Q4 is, Can you kind of help unpackage, you know, what swings in terms of mix, in terms of restructuring savings, just to kind of get comfortable with the ramp there year on year? I think a bunch of it probably comes from leveraging the better organic sales growth in Q4. But, you know, any way to help unpackage that in actual buckets, you know, would be helpful.

Sure, John. Yeah, no doubt. Nice ramp there in Q14. Typically, that is our highest margin quarter, and you hit on one of the drivers. It's just there's really good volume leverage. The other thing is that I think you touched on also, and we talked earlier, one of the questions related to cost reductions from some of the restructuring actions that we've put in place that really ramp, you know, significantly in Q4 relative to the timing of when folks are leaving. And I would also mention that the, you know, the inflation comp starts to get a lot easier than what we've been living with in the first half of the year as some of these, you know, tariffs lap. Our component shortages are lapping. And we're going to see better mix, too. We're going to see better mix in a number of our businesses, including MNCS. I mean, we had a lot of volume last year that had low margins related to some of these large deployments where it was installation related. So those are really the key drivers that give us confidence that we'll see that ramp in Q4.

Yeah, the other thing I would add is on that mixed comment, just to make a finer point there is, you know, last year's project revenue was heavily oriented towards the energy side of the equation with heavy install and lower margin on that, whereas the mixed this quarter in Q4 is going to be heavily water, which carries a much larger, you know, incremental margin on it than it does on the energy side.

Gotcha. And then thinking about the current order growth, I mean, Obviously, you've been 4% now the last two quarters on very tough comps. You still have very difficult comps here in the back half. But, you know, as we think about, you know, the mid-single-digit growth construct kind of going forward and into next year, you know, what do you need to see in terms of margins or what do you – I mean, in orders, or what are you guys looking for in terms of an order acceleration potentially in the back half, and what drives that?

Yeah, so I – I'd lay it out this way. If you look at our three segments are going to be behaving, I think, are going to probably diverge a little bit here in ways that you haven't seen over the last, I'd say, year and a half to two years, where they've all, you know, they've each kind of been running in that mid-single-digit growth in terms of both revenues and orders. That begins to diverge a little bit. So we do expect that applied water will likely moderate back to more of a GDP-level growth. We hope to outperform that, but that would be in that kind of low single-digit range. And we're seeing some of that right now play out, as you saw in the orders and market commentary. Water infrastructure has historically been in that mid-single-digit growth, both in terms of orders as well as organic revenue. And as we mentioned in the quarter, it was up 4% orders, but it was against an 8% comp last year in water infrastructure. We don't see that changing, so we feel good about that. And then really what you begin to see happening here is MCS begins to ramp. And so we do expect those order growth to continue to grow, you know, increase in terms of the rate, as well as the organic revenue growth, both back half of this year, but also certainly in 2020 and beyond. So you're going to see a little divergence there amongst the three segments that gives us confidence around that mid-single-digit organic growth continuing.

Great. Thank you. Thank you.

Our next question comes from one of Ryan Connors of Boning and Scattergood.

Great. Thanks for taking my question. I wondered if you could actually talk a little bit more about the order book from a pricing perspective and just give us some take on the success you're having getting priced in this environment, and if so, where.

Yeah, Ryan. We've seen really good success in terms of We continue to get price in U.S. They actually led the way and were early to drive good price realization. You saw that particularly this quarter in AWS, which had 350 basis points of price. Europe, you know, got on board a little bit later. and even emerging markets now is driving for price. And I think, you know, most encouraging was what we saw in MNCS, particularly around the census business, where they are not only driving, you know, very strong volumes, but also driving good price as well. So when you think about, you know, backlogs, I mean, our strongest backlogs are in MNCS. A lot of that is census, and we feel pretty good about that.

Okay. And then my other one was just you've talked a lot about utility and census and AIA, but you haven't really gone as much into the industrial side, and you did have kind of a negative revision to your outlook there. Can you just kind of unpack the different pieces within industrial and what's – where the outlook is still better and where the headwinds are coming from?

Sure, yeah. So, on the industrial side, let me comment on the full year rather than, you know, giving you a headache quarter by quarter. On the full year, you know, we continue to see solid growth in the U.S. and really there it's the fact that we're really tied to more of a general light industry. You know, most of the products we sell there are, you know, on the periphery of an industrial complex and so As long as these complexes are up and running, they're going to burn through our pumps and our treatment needs. We see that continuing to grow at a healthy clip. We also see positives in dewatering on the rental side. We continue to see a very healthy market there. I would say outside of the U.S., it's mixed. You see strength in parts of Asia. We also see definite softness in Europe and across the Middle East. In Europe, it's not entirely broad-based. I mean, it's really concentrated on a certain number of markets. We do see some divergence there in Europe. But right now, you know, we're just calling that. We're trying to be prudent here. It's a very short-cycle business, as you well know, for us on the industrial side.

Okay. Thanks for all the color.

Yeah, no worries.

Our next question comes from one of Walter Liptack of Seaport Global.

Hi, thanks. Good morning. Good morning. I wanted to ask one about the AIA investment. Considering the delays, is that changing anything about your M&A pipeline or your thoughts about timing of deals or other technologies that you might need? Not at all.

Not at all. As I mentioned before, but it's worth reiterating, when we think about you know, M&A and utilities, because we do think about this predominantly by in-market or vertical, not exclusively, but that's certainly one lens that we look at it through. I'd say on the utility side, we do have a very robust platform now of solution sets that we can bring to the utility customers, both on the clean water side, the wastewater side, and the outdoor water side. But that's not to say that we don't still have, as we're in there talking to these leaders and learning even more about what some of their other pain points are, you know, there's still, you know, a few things out there that we would like to bring into the portfolio. They'll, again, be, you know, smaller tuck-in type acquisitions. So, no, it doesn't change our view on that. It quite frankly makes it more robust. But having said that, there really aren't that many more things out there that we really have line of sight to that we're interested in at this point in time. We're really focused now on executing the platform that we've built.

Okay, great. And then just a couple on the sector outlooks. You mentioned in industrial, the second half in the U.S. being a little bit weaker. Is that just related to some of the PMIs that have come down and generally slower industrial, or is there something else going on?

We think it's solid to up slightly. It's really what's driving the industrial growth change in our outlook is what Patrick mentioned before, which is really some of the softening conditions and, you know, some of the what would appear to be recessionary trends in parts of Europe. But, you know, U.S., we think, will remain pretty solid.

Yeah, I think it's in the U.S., if anything, it's more of a tough comp. you know, Tupper Comp in the second half of the year, kind of mid-single digit last year. So now we're saying that'll probably moderate back down to low single digit in the U.S. It's not, I think maybe kind of a little bit behind your question is, you know, is there anything going on in the channel, inventory levels? You know, we're not seeing that at least in our business.

Okay. Okay. It makes sense. And then, you know, small but residential, you talk about the U.S. flattening, but I think there's some other companies out there that are saying there's signs of strengthening going on in residential. Are you seeing any you know, hope that the low interest rates and good U.S. economy might be turning residential around finally?

We certainly, we always hope so. But, you know, it's not, again, it's not a large piece of our business. And so we, at this point in time, we kind of call it based on what we see right now. We haven't seen that kind of recovery. So we didn't feel it was prudent to kind of bake that into an outlook. Okay.

All right. Thank you.

Okay. Thank you.

Our next question comes from one of Joe Giordino of Cowan.

Hey, guys. Good morning. Hey, Joe. Hey, Joe. Hey, so I just wanted to go back to kind of the ramp as we go through the year here and just standing to check my math. So if we're looking at 3Q margins at like roughly 15 and you have a pretty narrow range for the full year expectation on adjusted office, Are we talking like comfortably over 17, you know, for 4Q? I know Mark talked through some of the things hitting in 4Q, but, you know, we've seen kind of modest year-on-year expansion through the year, a decline in 1Q, and then we're talking like 200-plus basis points in 4Q. So I just want to really make sure I understand how that plays out.

Yeah, Joe, I'd say I wouldn't say it's, you know, way over, you know, comfortably over 17, I think. you know, upwards of 200 basis points is certainly what, you know, what our expectations would be.

Okay. Is that including any of the benefits from, like, the back office stuff that was kind of getting pushed out, or is that still a 2020 phenomenon?

It's limited. I mean, we just launched our latest wave in July, but we're, you know, there are benefits there well behind the track from where we expected to be as we entered the year. And that still pushes out into 2020. So there's certainly more benefits ahead of us than in the fourth quarter.

I mean, you're looking roughly, Joe, at the right math. It's about 180 basis points of margin expansion in Q4. And as Mark mentioned earlier, it really is being driven by We do have other restructuring that we announced last quarter that is cost takeout, most notably within our European business, but also within our water infrastructure and NABS businesses. MCS had a little bit in there as well. That really ramps in Q4. You definitely have the attractive volume leverage given the mix of revenues that are going to be heavily skewed towards water infrastructure and MCS, which are going to be higher margins for us. And then as Mark pointed out earlier, we have some easier comps on the inflationary side, which is noteworthy when you look at a quarter sequential. That's about 50 bet itself.

Okay. Sorry if I missed this earlier. Is the big Philly order you got, is that in orders already? Is it in backlog?

Joe, it's in backlog. It's not in orders yet.

It's not in order yet. Okay, and when do you expect that to start hitting, and can you maybe talk through the timing of when that deploys into revenue and what the margin kind of is that accretive to MCS? How do we think about that?

Yeah, Joe, it's certainly our expectation is to see that start to hit in the back half of this year, probably more in fourth quarter, and it's, you know, full bore in 2020. It's a water deal, and so the margins are certainly attractive relative to the energy side of the business.

Okay, and maybe last for me, just more high level. If I think through bolt-on technologies that make sense for MCS, is there an obvious thing missing right now? Some of the stuff that you've bolted on recently, seems like it fit very clearly into what you were doing. But I guess as we fill out that portfolio, finding obvious holes is a little bit more challenging. So is there anything that strikes you as we can put a proxy out instead of doing R&D and figuring something out internally? We can go buy something. Is there a piece that is interesting to you, Patrick?

Yeah, I mean, there are still a few things that are out there. I'd probably prefer, Joe, not to comment on them publicly because to the extent that they are M&A, I don't want to drive the press up. But, you know, it's not a long list. I mean, there are still probably a few to a handful of things that are out there that would be, I don't want to say they're nice, you know, they're just kind of nice to have, but they would address some other pain points. So, you know, as you think about what we're really bringing to bear here is the capability of with our digital solutions platform to be able to go into utility and work with their operating folks and better understand how they can drive and improve performance of their existing assets and bring down the cost of the new capital that they're putting in place and get more out of what they already have. And so when you think about the landscape of a utility and what their operating budgets are driven by, both CAPEX and OPEX, There's a myriad of things that one can do by mining the data for them. And that's in a simple way what we're looking at doing in addition to others. And so, you know, we'll keep you guys abreast of acquisitions as they come along. They're not going to be large acquisitions. They are going to be tuck-ins and bolt-ons. And I think as we get to Investor Day early next year, that will be a good form for us to kind of paint the picture for everyone as to what are the gaps that we filled out here and what's the landscape that we're operating in.

Thanks.

Thank you.

Our next question comes from of Raymond James.

Thanks for taking the question. Back on your comments regarding M&A, the fact that it's not a priority as you see it right now, given the amount of free cash flow that you're generating above and beyond the dividend, What are your latest thoughts on buyback as a way of deploying that surplus cash?

Sure. So this is Patrick. Just to clarify, my comment was not that we're not interested in M&A. I was specifically talking about the utility space and the bolt-on kind of digital solution. So, you know, we continue to see M&A as an appropriate enabler of our long-term growth in the company. And, you know, I've been on other calls as to some of the other areas that we're focused on, whether that be, again, continuing to look at areas in the industrial water landscape is one example, and there are others that are out there. There's nothing – I'm not foreshadowing anything here. All I'm saying is we continue to see that as a priority to deploy cash, but only for smart, disciplined transactions that are out there. So we would certainly be looking to do that before we would be talking about doing a share repurchase.

Yeah, you know, but we also recognize that, you know, unduly large amounts of cash on the balance sheet are, you know, not the, you know, they're not sustainable. So we'd look at, you know, if there's nothing out there that we expect to need it for, we'd certainly look at repurchasing shares.

Okay. Let me follow up on what you referenced at the very beginning of the call, which is your ESG targets. As I look at your set of targets, you know, separate from some of the kind of philanthropic or charity stuff, do you look at these as margin enhancers, or are they actually not the cost of doing these?

No, we view these things as very much, I mean, we try to be very clear when we speak externally as well as internally to our folks. And we actually had a great kind of podcast here internally just last week between myself and the executive sponsor of our sustainability program, who happens to be our general counsel. And she and I did a terrific event here, I think, with our colleagues, really reinforcing to them that we don't have a sustainability strategy that sits separate from our business strategy. They go hand in hand. And so the more that we are able to deliver on the signature goals that we laid out here, no doubt that's also good for business. But that's not the only reason we're doing it. You know, we're doing it because we really believe that we have the responsibility here to really make a big positive impact for our communities and our customers and our suppliers. But it's also all about making sure that we, you know, attract and retain the top talent across the landscape. And people nowadays, as you all know, They want to believe in something larger than themselves, and they want to work for a company that has a purpose. And we're not the only one out there. I realize that. But that's what's really driving these sustainability goals. It's good for business. It's good for the planet. It's good for everyone involved. And we have a unique opportunity and a role to play here in doing so. And that's why we wanted to move well beyond kind of motherhood and apple pie on just a few things that most companies talk about. In sustainability, we have an opportunity to make a much broader impact than just a few key areas.

I appreciate the perspective. Thank you. Thank you.

And ladies and gentlemen, we have time for one more question. Our final question will come from the line of Brian Lee of Goldman Sachs.

Hey, guys. Good morning. Thanks for squeezing in. Hey, Brian. Maybe two quick ones, and then I'll let us all wrap here. I guess on China, it sounded like results were pretty good, but then you did make a little bit of a fallout around slowing growth. China as part of the update for the industrial and market outlook here. Can you elaborate on that? Is that a general flowing in the macro, tougher comps, or is there something else going on there?

We wouldn't want to overstate any commentary around softness in the industrial in China. We had some tough comps there. It's a rather small piece of our overall business in China. So, you know, we're not probably in the best position to make a call on broader China industrial landscape. We're not seeing anything noteworthy there. I don't know, Mark, if you want to add any commentary.

No, you know, as you said, the comps are tough, and it's solid, it's steady, but, you know, we grew over 20%, you know, in the prior years, so. there's no underlying fundamental issue that we see.

Yeah. I mean, the primary driver of our growth in China is really the utility side, and it's really the investments being made by the government there across the board. And so that kind of masks, you know, what we see in the industrial space, which, again, is just really a tough comp. So no big read-through there on our part. Okay.

Fair enough. And then just on pricing, I know I think you had mentioned maybe last quarter that MCS, may see more of a tailwind in the second half due to some of the later pricing actions that played out for that segment. So I guess with some of the mixed commentary and the AIA conversion delays, is there any change in that view around pricing trends for that particular segment as we move through the back half? Thanks, guys.

Yeah, and I mentioned this in the prepared remarks, Brian. You know, one of the encouraging – encouraging things that we did see. The team really got after it this year, and we had, it was 100 basis points, maybe a little bit more of price improvement, and we'd expect that to continue through the remainder of this year.

And a big driver of that Brian, as we've mentioned before, I believe, is more so in the MCS business and certainly census than the other segments. You know, these are oftentimes long lead time projects that have already been locked in. And so until new projects are being executed, it's hard to get prices. So the team's done a great job on the more recent projects on implementing those price increases. And that's why you see it really ramp from the first half to the second half of the year.

And on replacement, you know, meters, endpoints being sold into the channel as well. Yep.

Okay. I appreciate the call. Thanks, guys. Thank you.

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

Well, thank you. Thanks for all of your time, interest, and support. We appreciate your involvement this morning. Thanks for the questions. I'm sure we'll see many of you at conferences and other places in between, so enjoy the balance of your summer and safe travels, and we'll be in touch on our Q3 earnings call. Thank you all very much.

Thank you. This does conclude today's Island Second Quarter Earnings Conference call. Please disconnect your lines at this time and have a wonderful day.