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

Thank you, Lori. Good morning, ladies and gentlemen. Thank you for joining us for Evoqua Water Technologies’ conference call to review our third quarter 2018 financial results. Joining me on today’s call are Ron Keating, President and Chief Executive Officer and Ben Stas, Executive Vice President and Chief Financial Officer. After our prepared remarks, we will open the call to questions. We ask that you please keep to one question and a follow-up to accommodate as many questions as possible. This conference call includes forward-looking statements, including our outlook for fiscal 2018. Actual results may differ materially from expectations. For additional information on Evoqua, please refer to the company’s SEC filings, including the risk factors described therein. On this conference call, we will also have a discussion of certain non-GAAP financial measures. Information required by Regulation G of the Exchange Act with respect to such non-GAAP financial measures is included in the presentation slides for this call, which can be obtained via Evoqua’s website. All non-GAAP financial results have been reconciled and included in the appendix section of the presentation slides. Unless otherwise specified, references on this call to full year measures or to a year refer to our fiscal year, which ends on September 30 each year. Means to access this conference call via webcast were disclosed in the press release, which was posted on our corporate website. Replays of this conference call will be archived and available for the next 7 days. With that, I would now like to turn the call over to Ron.

Thank you, Dan. Good morning. We appreciate your interest in Evoqua and you joining us for today’s call to review our third quarter results. Over the course of the first year being a public company, we have used this webcast to provide background information on Evoqua. Following my brief background comments, we will go directly into the quarter’s results. Please turn to Slide 3. Evoqua is the leading provider of comprehensive water treatment solutions in North America with a great history of servicing customers’ needs and a strong team of people. Our purpose is focused and clear transforming water and enriching life. We provide systems, services and technologies to 38,000 customers with over 200,000 customer installations that generated trailing 12 month revenues of $1.3 billion and $227 million in adjusted EBITDA, a 17.1% margin. Our business spans a diverse range of industries and includes the 20 largest U.S. companies in each of the pharmaceutical, food and beverage, hydrocarbon processing, chemical processing and power industry. Please turn to Slide 4. I would like to start off by providing some key insight to the themes we are seeing and how we are strategically thinking about the business. As a new public company, we communicated our growth strategy and I am pleased to say that we are delivering. First, we are experiencing robust growth in the core business, specifically in our industrial and products segments. The municipal business could have performed better in the third quarter, but the pipeline is strong, which bodes well for coming quarters. Overall, demand trends are favorable. Our order book is strong and growing and we are well positioned for a strong fourth quarter. We have seen the industrial wastewater market emerging and we have taken actions to leverage our capabilities and products internally as well as through…

Thank you, Ron. Please turn to Slide 12. For the third quarter, reported revenues increased approximately 10% to $343 million. Pro forma revenues normalized for acquisitions were up almost 5% driven by growth in the industrial and products segments. Revenues from capital projects again outpaced service revenues during the quarter, mostly in the industrial segment. Our process and utility water business continues to grow and we are seeing accelerated growth in industrial wastewater applications well above market rates. These wastewater capital sales are initially larger and lower margin than processed and utility water. We expect our increased capital business to provide attractive and profitable service and aftermarket sales. As Ron discussed, our service revenues were flat year-over-year, primarily due to downtime from redeployment of Evoqua treatment assets to new locations following the earlier than expected completion of a large remediation project. Additionally, we experienced temporary lower productivity as we deploy state-of-the-art field service software systems and provided training to service technicians. Third quarter adjusted EBITDA grew by 5.2% versus the prior year to $58 million or 16.9% of sales. As Ron indicated, municipal shipments we anticipated in the third quarter were shipped in July and we also expect to deliver in the fourth quarter a larger aquatics project that has been on hold. During the quarter, we actively increased prices across the business to offset higher commodity costs. For the quarter, the net negative price impact was approximately 175 basis points on gross margin. We saw price realizations improve significantly in June and expect to continue to accelerate in Q4. Our outlook assumptions also expect commodity costs to stabilize in Q4. Please turn to Slide 13. For the third quarter, our industrial segment had revenue growth of almost 18% year-over-year to approximately $182 million, with pro forma revenues up approximately…

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

Do you hear me okay?

We got you now.

Okay, good. Thanks. Maybe I would like to start on the key themes on Page 4, Ron and just if you could clarify the third bullet on municipal. Were you going to strategically change the mix from large capital projects? Maybe just clarify are you trying to move away from the large projects? I know last quarter, we talked about the opportunity that once you invest in these, you get a $0.22 aftermarket stream. And I just want to get that clarification on – is this really a change or do you think this is going to happen over time based upon your mix?

Yes, Deane. So, thanks for the questions. They are great questions. In the last quarter, when we talked about $0.22 aftermarket off of large projects, that’s referring to our industrial business. So where we are selling industrial systems that we are going back and we are servicing, that’s where we get the $0.22. So, it’s really around that segment of the business that we have invested very heavily in and we are seeing very good growth there. On the municipal piece, what we have highlighted pretty much from the beginning is we want to make sure we are focusing on mining the installed base that we have today. All dollars are created equally in the municipal space as we know. And when you get out and it’s a three-way bid and rip the envelope and the lowest price wins with very Ts and Cs, that’s not always attractive business. So more than 100 years of installs with very iconic brands, the field is very ripe for us to go out and make sure that we are targeting retrofit and rehab projects and focus very heavily on aftermarket products going into that market. So, we are not chasing huge capital projects in the municipal space. We are really focused on making sure that we are there servicing the installed base that we have today that’s very good margin business.

Alright. That’s real helpful, because it really doesn’t sound like a strategic change. It’s just – this is your higher profit opportunity on your installed base. So I am glad you clarified that. And then the second question on price cost, are you still expected to be neutral by the fourth quarter and just some insight into going after price here. Has there been any give up in volume? Did you lose any market share and just how receptive had customers been to these pricing actions?

Yes. So, on the price cost we still expect to get close to neutral in the fourth quarter. We probably still have a little bit of a gap on what’s going on with the tariffs and some of the commodity costs that we are trying to make up. So, we got some good traction in June as we highlighted during the remarks earlier and we expect for that to continue through the fourth quarter, still having a little bit of challenge in the fourth quarter as we have discussed actually in the last call. So going forward though, customers have been very receptive. It’s just we are doing it at the time that we have the ability on the contracts to raise price as well as driving some of the surcharges that we have the ability on. But again, if you think about the segments of business we are selling products, very receptive, no issue at all. Industrial has been very receptive as contracts have come up and we can go on and raise price. Municipal is the one that’s a little more tough, because you lock in pricing on a municipal contract that makes it much more difficult. You have to wait until that renewal comes as well, but no loss of market share. In fact, we continue to gain market share as shown in our top line results that we are really pleased with.

Thank you.

Thanks, Deane.

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

Hey, guys. Good morning. Thanks for taking the questions. On Deane’s question, the 170 basis points impact on gross margin from price cost this quarter, it sounds like it doesn’t get back to even in Q4, but are we thinking 100 basis points headwind or can you kind of quantify how much you get back in the fourth quarter?

Yes, I think we will get back a little bit about 30 to 50 basis points on the pricing offsetting the costs. So we will still have a little bit of an impact in the fourth quarter with our forecast that we have against commodity prices, but we get pretty close to neutral.

Okay.

Brian, the price came through as we expected. That was the good news. And again, as Ron said, most of it was in June. The cost increase was a bit higher than we expected. We are a little negative in Q3, but we accelerated actions in the quarter and expect to get very close to neutral, but there is some slight risk to that in Q4 and that’s assuming a stable situation on commodities for Q4.

Okay, great. That’s helpful. My second question is just on the municipal segment, can you guys – I might have missed it, but can you provide a little bit of quantitative color around backlog and order growth, because it does seem like even if you exclude the impact of the large retrofit project revenue that you outlined in the quarter, the segment was flat to down a smidge. And I think we have generally have been thinking this is a low single-digit grower for you, but it seems like some other water companies in the space maybe trending a bit higher in that vertical in recent times. So just wondering if you can help reconcile a bit and maybe provide some color as to what you are seeing here into year end?

I will give a little color into it and then I will let Ben do a little bit of quantification, but just as far as the business goes itself, where the spending is going is in the treatment train that we play in versus the infrastructure that’s transmitting water through. So, a lot of spending you have seen from some peers in the industry have been around the infrastructure more than the treatment train. We are seeing a very strong pipeline in retrofit and rehab, which is good. That’s the business that we have gone heavily after. And as we look at our pipeline of incoming orders in our CRM system, the backlog or at least the pipeline of what is to be bid is significantly higher than prior year. So we are feeling good about the overall outlook of it. We do still focus on this business being a low single-digit growth business and anticipate it will continue that way for quarters to come. And that’s really where the focus is though. Again, where we are going after retrofit and rehab, not really large projects, but we want to make sure we are mining the installed base that we have inside the business.

So the growth rates, we do expect to be consistent with what we have talked in the past in that low single-digit growth rate for the year. The quarter was tough because of some difficult comps. We had some relatively large aftermarket shipments in Q3 of the prior year and they are expected to go more Q4 this year, one of which those shipments have already occurred in July. So it is a timing impact Q3 to Q4 on a year-over-year basis and we do expect a relatively healthy recovery in Q4 from a year-over-year growth rate perspective in the margins.

Great. Thanks, guys.

Thanks, Brian.

Your next question comes from the line of Steve Tusa of JPMorgan.

Hi, guys. Good morning. How are you?

Good morning, Steve.

The add-backs to adjusted EBITDA were a little bit higher than we were expecting, any color on the stuff from Slide 22?

Sure. So, the biggest change versus what you probably had in your assumptions, were two items, one was the losses on FX on intercompany loans that was a pretty healthy amount, about $8 million. That was partly offset by a gain on the property sale of Australia, which was a good guy. And then also the transaction cost associated with the recent acquisition, but as far as the rest of the outlook, we are still in line with our restructuring as previously communicated, stock comp’s essentially the same. All other items are essentially the same. The one that will vary is transaction cost depending on how we do deals and again, the intercompany fluctuations on the intercompany loans, the gains and losses on FX. Okay?

Okay. And then on free cash flow conversion, I think Slide 16 says 35% conversion year-to-date, you guys kind of talked down a bit 100% conversion obviously something you try and import longer term, but you talked about prioritizing some investments here, what do you think conversion will ultimately kind of settling out this year now?

Yes, Steve. So right now, we are looking at 50% to 80% is what we think it should settle out. When you look at the free cash flow conversion and we have actually done pretty well in our trade receivables. We have seen about 100 basis points improvement on our trade receivables, trade working capital in total. It’s really been the project based working capital where we have seen the significant investments. When you look at it sequentially and on a year-over-year basis that’s the big mover that makes up the majority of that working capital increase and again, that’s predominantly in the industrial business and to a lesser extent, in inventory and the products business, but that’s the area, all other metrics, DSO and our days in inventory are relatively the same, certainly improved much from Q4, but it’s really about those work – or capital related working capital, okay?

You said 50% to 80%, 50% to 80%?

Correct.

Okay. So that implies something greater than 100% in the fourth quarter, so fourth quarter should be a good converter here?

It should be, yes.

Okay, great. Thanks a lot.

Steve, one other thing I didn’t mention is we did have the earn-outs for some acquisition that was also in the transaction cost associated with recent acquisitions that were successful and achieved their earn-outs, okay?

How much was that?

Around $3 million in rounded numbers.

Okay, great. Thanks a lot. Thanks for the detail.

Your next question comes from the line of Andrew Kaplowitz of Citi.

Hey, good morning guys.

Good morning, Andy.

Last quarter, you mentioned that your service business across the company was relatively steady, but it looks like it’s been relatively stagnant over the last few quarters. I know you expect aftermarket sales growth to kick in here, but why do you think service growth has stagnated given your overall industrial and municipal markets have been really, really strong? I know you mentioned comps here, especially in municipal is there any sort of execution improve or what’s the visibility do you have to resume service growth?

Yes. So there is a couple of things that are showing up in that, Andy. And one thing that service really follows the capital sales on the industrial side, where we have been selling a lot of our capital sales on the industrial side, it’s been on the wastewater treatment and the recycle reuse, that typically follows about 12 months later where in a lot of cases processed water follows immediately after the installation. So, it’s a little bit of a timing impact on that. We also had as we identified actually during the remarks, a very large wastewater service contract that finished early. We had to relocate about 25 assets that were on a very strong contract around recycling, reusing the water and actually cleaning up that water. And as we did that, it had a little bit of an impact time wise on the quarter. Though I would anticipate we come back into our historic range of service growth as we go into the coming quarters.

Okay, that’s helpful. And then if I think about the Q4 guide in order to make the midpoint, you have to have a significant step up in adjusted EBITDA margin and it looks like it’s around 22% from 20% last year, that’s after you were down a bit in Q3. Could you just talk about your line of sight to this forecast? I know you mentioned a good order book, we know about price versus cost. Anything else that helps you get margin backup in Q4?

Well, so we have some relatively discrete shipments, particularly in the aquatics business that are very high margin that we expect to go in Q4, so that should help us as well and then the overall services coming back online, those assets that were redeployed, that’s very high margin. And as they come online in Q4 that will help and then also some of the disruption, temporary disruption that we had in Q3, we don’t have in Q4. Those are the main drivers that help that margin lift. I think if you look at the year-over-year growth in terms of EBITDA, it’s very consistent with what we had in the prior year in the same quarter.

Thanks, guys.

Your next question comes from the line of Nish Damodara of Baird.

Good morning, everyone.

Good morning.

Just wanted to follow up a little bit on that mentioned the larger projects that are set to ship, can you give us a little bit more color on kind of the size and materiality and any moving pieces that could potentially cause them slip out of fiscal 4Q?

Yes. So the aquatics projects, when they typically go, they are very high margin and those are going into large water parks. This has been one that we highlighted and actually received the order quite sometime ago, but it’s been delayed based on the prep of the site and them getting ready. Currently, it was scheduled to ship in Q3. They pushed it to Q4. It’s still scheduled in Q4, but I would say as you think about large projects, they can range anywhere in the aquatics space from $3 million to $10 million in top line and typically those are somewhere in the 50% EBITDA range.

Okay, great. That’s helpful. And then just give us a little more color too on the current capital structure in the wake of the ProAct deals kind of moving pieces and particularly, how you guys are thinking about managing your kind of peak versus floating rate debt situation, how we should be thinking about how interest expense has been tracked from here?

So interest expense, expect about a little over $1 million more in Q4 from our current levels that we saw in Q3. Our leverage is about 3.7x post new issuance and we should de-lever there in Q4 with the same sequential improvement as we originally expected from Q1 to Q2. So, we should see about 0.2 turns of an improvement on to that level into Q4.

Okay. That’s helpful. And then last one for me, ProAct contribution for this year, I just wanted to clarify, is that included in the current guide or should we be expecting incremental sales and EBITDA to layer on?

No, it’s included in the current guidance, because we are only getting about 2 months of that. And then you have got to think about the disruption of transitioning from being a standalone into coming into the company and the integration. So, it’s very minimal.

Thanks. That’s all I had.

[Operator Instructions] Your next question comes from the line of Joe Giordano of Cowen.

Hey, guys. This is Tristan in for Joe. Thanks for taking the questions. Ron, just a quick clarification, I think on Brian’s question earlier, you said you see muni spending being more dedicated to infrastructure spending than treatment per se. Is that correct? And if so are you seeing – when do you expect this to revert at some point?

I am sorry, can you repeat the question?

Sure. I think Brian asked you before in terms of the spending that you are seeing at municipal, is it more infrastructure related or treatment related and you said the formula was probably higher right now. How do you see this evolve?

Yes, yes. So what I was talking about is where we play versus where a lot of the spending has been. So a lot of the spending has been on the infrastructure, meaning the distribution system to get water from treatment systems out to households, out to businesses, areas that is used, so pipes and pumps and things of that nature. The treatment itself – so the treatment system itself is where they are spending on retrofit and rehab as well as there are some new capacities going in, but we focus a lot more on the retrofit and rehab and that’s where the sweet spot for Evoqua’s product line goes based on our installed base.

Thanks. And then I am curious on your thoughts on what are the advantages of working with the public sector rather than in the private sector or vice-versa, I understand that government buyers have – they are all about mission and delivery and taking care of the citizen. And I guess the private sector has to respond to shareholders or the profits they have to watch, so little bit of – if that brings different motivation there, I am just curious of how you think about that?

Yes. I think certainly there are different motivations there. And I think as you look at the public sector, they are very focused on making sure its continuity. It’s not a lot of change and they are very anxious to come out and look for new technologies, but it takes quite a while for them to believe that the new technologies have been proven and to install them into the public works environment. So that’s why we are trying to bring new technologies out such as our BioMag CoMag. You have heard Ben reference a product that we actually got our first sale into the European market with that product line and that technology. It really enables the public markets to be able to increase capacity at an optimal spend level. So, it’s a great opportunity for us to deploy new technologies into the public sector. The private sector seems to be much more focused on bringing technologies in and making sure they are optimizing new installations as well as looking at being able to do it at the lowest operating cost and make sure that they are focused on deploying technology, so both of them are very attractive markets. I guess you have to have our technologies proven a little longer prior to the public sector being willing to install those.

Thank you.

Your next question comes from the line of Pavel Molchanov of Raymond James.

Thanks for taking the question. I want to ask a high level question that I asked 3 months ago as well which is as you look at M&A opportunity is it’s obviously very much a sellers’ market in the water tech space. ProAct was your second largest deal ever, how competitive is the landscape from kind of a buy sider’s perspective and what are valuations tracking?

Yes. Thanks, Pavel. Actually, it is a competitive market as we have discussed on the last call and we have discussed with you historically. The opportunities though for good assets certainly are there. One of the real values that Evoqua has brought to the market is we have become the acquirer of choice for small tuck-in acquisitions. So, if it’s a sizable acquisition, something like a ProAct, you are seeing multiples tend to trend in the higher direction, but what ProAct does for us is it opens up very large market segments we historically have not played in by adding a capability to us that is in the size range we typically don’t play. So, if you thought about our mobile assets going in, we are going to treat somewhere from 1,000 to 10,000 gallons per minute. ProAct is going to be in the space below that typically around 300 to 400 gallons per minute. So, it gives us a totally new market segment to go after, it gives us some more real opportunity. But where you find small tuck-in acquisitions, they are looking for the channel to market. So they are looking for the channel to market with the right partner, which Evoqua has become and those are still very reasonably attractive multiples. So, it’s not something that it’s a feeding frenzy with everyone going after the small tuck-ins, because historically, they don’t know about them.

Okay. And I know you don’t typically breakout all of the cost variables in your kind of gross margin targets, but what is the role of the tariffs not just steel and aluminum, but other kind of raw materials as well in the commodity input cost pressures that you have alluded to?

There is not a lot of direct impact associated with the tariffs and we don’t source a tremendous amount from China directly, but there is a knock-on effect that we are seeing. Example we would source a lot of resins from a U.S. supplier that is out of capacity, because they are being tasked because of tariffs from China. So this is what we are seeing and we are seeing it particularly in the areas of steel, plastics, pumps, valves and components, but a lot of it has to do with the knock-on effects associated with tariffs versus the direct effect of the capacity constraints within the U.S. We are also seeing extended lead times from suppliers, that’s putting more pressure on that. So normally, we could take 1 to 2 weeks and they are being pushed out further as capacity begins to become filled which is also put additional pressure.

Okay, appreciate it, guys.

Your next question comes from the line of Adam Farley of Stifel.

Hi, good morning. Thanks for taking my questions. Have you guys called out broad-based revenue growth in industrial capital businesses? I was wondering if you could give a little more color on like specifically what end-markets or geographies are leading that growth and then also if you could maybe parse out how much of that is market growth versus share gains?

Yes. So, Adam thanks for the question. It’s good questions. I would tell you that primarily the growth in the industrial market is all coming from North America, which is where we play the majority. The end markets that we are seeing growth in are – majority of them in the heavy industry market. So, the power market has been very good for us, continues to be strong with ash pond dewatering, a lot of the regulations there. Food and beverage has been really good for us. So as we have done some acquisitions of ADI and ETS specifically over the past few years, that’s opened up a new market segment for us to go after and we are going into the food market very heavily. So with those types of expansions and acquisitions, I would say it’s not market growth that’s driving it, it is us taking share and us providing more broad solutions into the marketplace that we serve and into our core customers that we have historically served in other water treatment areas.

Alright. That’s really helpful. And then kind of shifting gears to Water One Assurance, can you just provide a little more color? I know you talked about the CapEx investments, but you could just talk about the progress on the rollout, maybe some of the capture rates and just how you guys are strategically thinking about the business as you rollout in September?

Yes. So the business is rolling out very well. As we mentioned earlier, we have done two pilots. So we did Birmingham, Alabama, that was our first pilot that was extremely positive. So, following Birmingham, we took it to Boston, which is a much more broad market we are going after. It’s a market that we want to make sure that we are servicing all size customers there. For Birmingham, we only went after the large customers. We have learned a lot on that. So, it’s been really good for us. We have learned that in some applications we need one that you can hang on the wall versus place on the floor. We needed to make sure that we created a better alignment with the connectivity in some of the components that we are reusing and we needed to optimize and streamline our installation process. So in doing that, it’s been very positive. And I would say, in Boston, we have seen about an 85% to 90% take rate. So we are very pleased with what we are seeing there and we are seeing the subsequent margins come through as we anticipated. So the next rollout for us is in September, where we are going to go more broadly across the nation and we are going to do it market by market. We have this planned over the next 3 years. And so over the next 3 years, we anticipated and built in half of that business being on the take rate, but with what we have seen in Boston, I think it could be higher than what we built into the model already.

Alright. Thanks for taking my questions.

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

So thank you all for participating in the call today. As we have discussed before, we feel we are uniquely positioned to be the solutions provider of choice. Through our technologies, our channels to market and our extensive service footprint, we are truly able to be a partner to our customers and we feel like the top line is showing that as we have been driving it through and we are looking forward to the future. I would like to thank our employees for all their dedicated efforts and we are looking forward to completing a successful 2018 and look forward to 2019. We look forward to speaking to you again soon and thank you very much.

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