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Welcome to Cott Corporation's Second Quarter 2019 Earnings Conference Call. [Operator Instructions] This call will end no later than 11:00 a.m. Eastern Time. The call is being webcast live on Cott's website at www.cott.com and will be available for playback there until August 22, 2019.This conference call contains forward-looking statements, including statements concerning the company's future financial and operational performance. These statements should be considered in connection with cautionary statements and disclaimers contained in the Safe Harbor statements in this morning's earnings press release in the company's annual reports on Form 10-K and quarterly reports on Form 10-Q and other filings with U.S. and Canadian securities regulators. The company's actual performance could differ materially from these statements, and the company undertakes no duty to update these forward-looking statements except as expressly required by applicable law. A reconciliation of any non-GAAP financial measures discussed during the call with the most comparable measures in accordance with GAAP is available on the company's second quarter 2019 earnings announcement released earlier this morning or on the Investor Relations sections of the company's website at www.cott.com.I'll now turn the call over to Jarrod Langhans, Cott's VP of Investor Relations.
Good morning, and thank you for joining our call. Today, I'm accompanied by Tom Harrington, our Chief Executive Officer; and Jay Wells, our Chief Financial Officer.Tom will kick things off by providing his thoughts on a number of activities within our business segments, including a discussion on some of our ongoing initiatives and our operational performance during the second quarter relative to our expectations. He will then turn the call over to Jay for a discussion of our second quarter consolidated financial performance as well as the results of our key operating segments and thoughts on the full year. And Tom will conclude with a few thoughts before we move to Q&A.With that, let me now turn the call over to Tom.
Thank you, Jarrod, and good morning, everyone.I am pleased with the performance of the company over the first half of the year, in particular the adjusted EBITDA performance relative to prior year and compared to consensus in the second quarter. Overall, the business performed well and would have been even stronger if the FX headwind had not increased.On the operational front, we continue to execute against the initiatives that we've outlined in the past and fully expect them to contribute to our growth over the coming quarters and years. Within our Route Based Services businesses, we've seen improved results from our European operations. Our customer growth programs have been the most successful since we acquired Eden Springs in the middle of 2016. Execution of our high-density area sales and marketing efforts as well as other country specific activities are delivering net customer growth in most key markets. We have enhanced our footprint through organic growth and tuck-in acquisitions in countries such as Poland where HOD water is enjoying good growth and where we are building meaningful route density as a result of our actions.We are also pleased with the extension of our booth program into the United Kingdom. Sales productivity is meeting expectations and over ¾ of the new customers are residential. This is an important development as we look to implement actions in the coming years to develop the underpenetrated residential market across our European operations.Turning to our U.S. Route Based Services business. We continue to see good top line and EBITDA growth even with the general inflation in the U.S. over the last 18 months. As you are aware, the freight costs we faced were a headwind in 2018. However, we are pleased they are now largely resolved. While more recently we've seen some wage inflation given the low unemployment rate, these costs have been offset by our pricing initiatives.Importantly, as the U.S. route based business is our largest business, it's nice to see that we delivered 5% HOD Water top line growth in the quarter when excluding the Mountain Valley acquisition. Consistent with historical seasonality, the team drove this growth through the delivery of good net customer growth, continued improvements in our customer satisfaction and service levels as well as improved pricing. We remain confident that the investments in the customer experience that we are making will contribute to our future growth.Although these route based service activities all come with investment, we believe that they are positioning our company for success and continued growth as we look out over the next 3 to 5 years. As an update, we have implemented enhanced communications with our customers in the U.S. in advance of the implementation of the new mobile app which is on target for Q4 rollout. We've introduced more relevant consumer offerings through products such as our Mountain Valley brand, Sparkling Ice and branded Sparkling Water and Seltzers. We are increasing penetration of case pack water that we sell into our returnable customer base. Best to think of this effort as cross-selling a new package to our customer.We continue to develop new and expanded channels of customer acquisition such as the new e-commerce platform, which enables consumers to order and reorder returnable 5-gallon water through the significant online retailer. As you know, we began test-marketing during the second quarter in a few cities in Georgia and are expanding across the State of Florida during Q3. We are working with our customer on the timing of a further expanded rollout, and we're excited to add another channel of customer acquisition to our current portfolio of customer acquisition tactics.We continue to make improvements and investments in our digital customer acquisition capabilities through search engine optimization and search engine marketing initiatives as well as executing on new tuck-in targets across the Mountain Valley distribution network. We continue to work on developing state-of-the-art equipment offerings for our customers. For instance, we will introduce a new and improved water/coffee dispenser called the Aqua Barista, which is a combo unit that dispenses water and K-Cups as well as an IoT, Internet of Things, enabled filtration water cooler later in the year.In terms of the new patented filtration technology, we will be introducing a solution to the market that we believe will provide us with a competitive advantage in terms of retaining and attracting new customers. This new patented filtration technology meaningfully extends the life of the water filter, will require far fewer service interactions and in turn we expect will increase customer satisfaction.We plan to shift the dialog with the customer from, when did you last change your filter, to a solution that provides high quality safe drinking water transparently through the introduction of an app that enables customers to confirm their water quality in real time, which we believe will alleviate any fears they may have about water quality, which as you know, has been a longstanding issue relative to municipal water supply in some markets across our footprint.We will then utilize this technology to proactively contact the customer if we see any changes with their water quality and communicate when it is time to replace the filter. With this new technology and investment in an expanded sales team, we anticipate good growth from this channel over the coming years. As we've noted in the past, the filtration channel for us is a separate and distinct channel from our HOD Water channel as filtration is generally not the most economical solution for our core HOD Water customers in a small commercial channel.When looking at the water filtration segment of our business compared to HOD Water, historically, we've only seen around 3% of our total quits compared to water filtration. Naturally, if filtration is what a customer wants to move to, we would expect that these customers would convert to a Cott solution.Our typical commercial HOD Water customer is a small business with 10 to 15 employees that generally utilizes a water cooler in their customer-facing areas such as the waiting area at a doctor's office, a dentist's office or an auto repair shop. But the cost to install filtration unit and extend the water line in these types of locations is not cost effective. We believe that HOD bottled water provides the lowest cost solution for this customer base.In terms of water filtration, we target larger businesses as the economics for the customer can be better and therefore the installation of the unit and a 3- to 5-year contract or rental agreement typically makes the most sense.Elaborating more on our customer experience initiatives. The overall goal of our business and service proposition is to position the customer at the center of everything we do and to strive for flawless execution on all customer interactions. The idea of the ultimate customer experience is not a new one to our business, but a mindset that we've been reinforcing for a number of years.The evolution started back in 2015 when we invested in our state-of-the-art customer contact center in Lakeland, Florida, where we have around 500 associates who service approximately over 3 million calls per year. This customer contact center has evolved into a world-class center, and these investments are paying off in improved service satisfaction as we've consistently seen reductions in calls per customer alongside lower customer churn.After rolling out our new state-of-the-art contact center, we invested in a platform designed to improve and assist us with the route based delivery system, utilizing a handheld iPhone for route sales representatives or RSRs where we create a seamless solution for our RSRs to get their routes, delivery schedule, to learn what the customer's special instructions are and to plan out their day utilizing best-in-class technology.These tools are real-time in nature, so we're able to see where our RSRs are located at any point in time during the day, what inventory they still have on their truck and how far along they are on their route. This transactional data is then married up with Omnitracs, our investment in routing software that enables us to do more efficient route planning. We continue to see good progress with route logistics and we'll continue to develop our skills on this platform as we look to invest in our operations in order to continue to leverage our business and create margin expansion.And looking at our overall customer initiatives, think of our initial efforts as building the foundation, and most importantly, building customer satisfaction through improved service capabilities. Now we are focusing our investments to drive further customer loyalty and revenue per customer by interacting with the customer directly and providing them with the communication tools that they desire. Once we are satisfied with the effectiveness of the platforms we have built in the U.S., we will then export them to Europe.Moving to our Coffee, Tea and Extract Solutions business. We believe the competitive environment will be less of a challenge for us as we move into the back half of the year. That said, even in this competitive environment, we delivered good coffee volume growth during the quarter of 3% and delivered extract volume growth of 24%. With this consistent growth in our core coffee business and the full year expectation for extracts to grow 30%, we're confident that our Coffee Tea and Extract Solutions segment is on the right track, growing market share and is poised to move past the short-term challenges and return to a consistent revenue and EBITDA growth story as we move into 2020.Switching over to a new initiative that we rolled out this year: environmental, social and governance. We've made good progress in the development of our ESG programs, but we're still early in the process, though we are trending in the right direction. As part of our planning in growth, we are building our strategy in internal capabilities to meet our environmental goals of achieving Alliance for Water Stewardship and carbon-neutral certifications.We are also working with ESG rating agencies to ensure our current efforts are reflected in their assessments and have seen our Sustainalytics scores improve from our efforts, moving up to the top third of our industry. We expect our scores to improve along the way as we continue building our ESG programs and engaging with rating agencies.I'd like to now move to a quick update on our annual strategic review process. We officially began our annual strategic review process late in Q2. And although this is a fluid process that is ongoing throughout the year, this is the time that we look back over the past few years and forward over the next 3 to 5 years and perform a thorough review of our businesses. The process provides an opportunity for our entire leadership team to review past successes and identify areas for opportunity while reviewing historical internal performance data, reviewing external third-party data as well as other analytics, including feedback from investors and to align and develop the actions we need to take in order to ensure our continued success as a business.This process enables us to reinforce our commitment and focus on efforts that accomplish a number of important objectives such as ongoing succession planning and employee development as well as customer, operational and other strategic investments, all of which lead to and support predictable organic revenue growth in both segments with a minimum expectation of 2% to 3% of revenue growth; maintenance of a robust pipeline of M&A targets in the RBS reporting segment that drives a minimum 1% to 2% of revenue growth; and a continued focus on free cash flow management.With that, I'll turn the call over to Jay where he will review our second quarter results and provide an update on full year expectations before I wrap things up and we move to Q&A.
Thank you, Tom, and good morning, everyone.We continue to see good top line performance with revenue up 6% when you exclude the impact of foreign exchange, the sale of Cott Beverages LLC and the change in average cost of coffee, driven by growth and pricing benefits within HOD Water and good price mix and extract growth within our Coffee, Tea and Extract Solutions segment.Gross profit, excluding Cott Beverages LLC, which was sold in February 2019, increased 5%. Our gross margin as a percentage of revenue was up 50 basis points to 51.8%, driven by fixed cost leverage as a result of good top line growth.SG&A expenses increased to $284 million compared to $275 million due to the addition of selling and operating cost associated with the Mountain Valley acquisition; general inflation which was mitigated through pricing actions; and increased sales and operating expense within our Coffee, Tea and Extract Solutions segment associated with increased coffee volumes, offset in part by the sale of Cott Beverages LLC.Adjusted EBITDA was $84 million compared to $81 million as the growth in revenue and corresponding fixed cost leverage was offset in part by a $5 million increase in sales and operating costs within our Coffee, Tea and Extract Solutions segment as well as increased foreign exchange headwinds with our Route Based Services segment.Adjusted free cash flow from continuing operations was $12 million of usage primarily driven by the timing of working capital in the quarter. In terms of free cash flow cadence, we typically see free cash flow usage in the first half of the year as we build inventory and prepare for the busy summer season. And then we see good cash inflows in the back half of the year.Turning to returns to shareholders. During the second quarter, we returned approximately $28 million to shareholders through $8 million in quarterly dividends and $20 million of share repurchases.Moving to our full year outlook. We continue to expect revenue to be over $2.4 billion, inclusive of increased FX headwinds of around $25 million or over 1% for the year and green coffee commodity costs, which has continued to be low, resulting in a full year revenue impact of around $15 million, albeit this is simply a pass-through. But as I said, even with these factors, we see over $2.4 billion of revenue in 2019.Moving to adjusted EBITDA. The current Bloomberg consensus figure of $328 million is reasonable relative to our full year outlook when looking at the current macro environment. As we reaffirmed in our press release this morning, our full year free cash flow guidance remains at $150-plus million.Let me now cover the operating performance of our Route Based Services segments. The Route Based Services segment saw revenue increase 6% on an FX-neutral basis. We continue to have good growth in our HOD Water channel where FX-neutral revenue grew around 6% overall and 4% excluding Mountain Valley despite rain above historic norms in many of our geographies. This growth was driven by increased volumes in part from a stronger customer base, which was up approximately 3% year-over-year excluding Mountain Valley as well as increased revenue per customer.Gross profit increased 4% to $272 million, driven primarily by revenue growth. Gross profit as a percentage of revenue was roughly flat at 59.6% as growth within this segment was offset by negative foreign exchange.SG&A expenses increased to $238 million compared to $229 million due primarily to the addition of selling and operating costs associated with the Mountain Valley acquisition and general inflation, which has been mitigated through pricing actions. SG&A expenses as a percentage of revenue were roughly flat at 52.2%.Operating income was up 5%, while adjusted EBITDA was up 3% at $80 million as revenue growth and the ensuing operational leverage was partially offset by a negative foreign exchange impact.Overall, we've been pleased with the performance of our Route Based Services segment during the quarter as we have been able to demonstrate the strength of the business, the elasticity of pricing and have continued to invest in our customer experience, including new technologies, customer service and new SKUs and also invest in our people who are the most important component of our shareholder value creation model.Let me now cover the operating performance of our Coffee, Tea and Extract Solutions segment. As Tom mentioned, we continued to take market share in the second quarter with a 6% increase in adjusted revenue through 24% growth in extracts and continued growth in coffee and tea pounds sold.Gross profit improved to $42 million compared to $37 million, driven by increased volumes and operational leverage, improving gross margin as a percentage of revenue to 27.7% compared to 25.7%. SG&A was $39 million compared to $34 million, driven primarily by increased selling and operating costs, which in turn resulted in adjusted EBITDA of $9 million.All in all, we were pleased with the results of our Coffee, Tea and Extract Solutions segment as the business was able to generate good volume growth in both pounds of coffee sold and liquid volumes sold to offset the pricing pressure that was experienced as a result of the competitive environment. This pricing pressure is expected to begin to subside in Q3, and although Q3 is typically the least active quarter for this business, we would expect to see continued volume growth in Q3 and we would expect to leave Q4 with both top line and bottom line growth as we exit the year, putting us in a strong position as we enter 2020.I will now turn the call back to Tom.
Thank you, Jay. Before we close, I just wanted to reiterate what our long-term expectations are for this business, albeit there will be a few puts and takes along the way.First, we look to generate between 2% and 3% organic revenue growth each year, driven primarily by our U.S. Route Based Services division, which saw 5% HOD Water growth this quarter when excluding the Mount Valley acquisition. We would then look to add to that growth with another 1% or 2% of growth through tuck-ins. The organic revenue growth should then generate $10-plus million of organic EBITDA growth and another $5 million to $10 million of tuck-in EBITDA growth.As I look back over the last few years, I believe we have performed fairly consistently at generating both organic and tuck-in growth to our Route Based Services operations even with the increased foreign exchange headwinds we've seen. Although we've seen competitive pricing in our Coffee, Tea and Extract Solutions segment and some of the synergies associated with our corporate cost which resulted from the sale of our legacy business, we are well set up for the future.Let me also revisit our expectations for 2019. As Jay mentioned, we expect revenue to be over $2.4 billion, including the additional FX headwind and continued low coffee commodity cost of green coffee. And moving through adjusted EBITDA, we believe the current consensus figure is reasonable and in line with our full year outlook. We do believe that Q3 and Q4 are slightly imbalanced but in aggregate, we expect to deliver the full year current consensus. We remain committed to our full year free cash flow guidance of $150-plus million.Before I pass the call over to Jarrod, I want to thank all of the teams across the business units for delivering a good quarter and for remaining focused on delivering on our full year commitments. Thank you.
Thank you, gentlemen. [Operator Instructions] Thank you for your time. Operator, please open the line for questions.
[Operator Instructions] Your first question is from Judy Hong with Goldman Sachs.
So I guess, Tom, you commented on the EBITDA projection for the full year. If I look at consensus, it's around $330 million, which does imply a pretty big acceleration in the back half. So number one, can you just walk us through what is sort of the delta from first half and the second half in the context of what gets better? And then I guess if you kind of take a step back and looked at your EBITDA projection beginning of the year, how do you think it's evolved, certainly given that FX has become more negative and, obviously in the first half, you had some pressure on some of the operating cost increases.
Thanks, Judy. Looking at EBITDA performance for Q3 last year, we saw a good EBITDA performance, with 11% growth versus the prior year. In Q4, we incurred higher cost in the quarter, resulting in 3% growth versus the prior year. With the lower hurdle we're lapping in Q4, we estimate that EBITDA growth for the back half of the year would be weighted more heavily naturally to Q4 based on those cycles. If you look at those growth, we for sure have FX headwinds. We would expect them to taper off towards the end of the year. And we did have, as you recall, the management incentive hurdle from Q4, which we clearly won't have this year. So that's how we think about the change quarter-over-quarter. And of course, we have the growing -- improving, not growing -- improving performance of S&D as we cycle through all the competitive pricing issues we've had in the past.
And I think you asked about FX versus when we started the year. As I mean everybody sees, the U.S. dollar continues to strengthen, and as the year has gone on, has probably provided a $5 million to $7 million headwind.
And then just on -- the second question is just as you're going through the annual strategic review, I'm just wondering how you're thinking about the coffee business strategically going forward. It sounds like you do expect the competitive environment to get better in 2020, potentially setting up for a better year from a performance standpoint. But when you kind of think about how that business fits in strategically, can you just comment on how you're approaching that as you're going through the strategic review?
Yes. It's really early in the process, Judy. So we've had our initial discussions, but I wouldn't articulate them yet as strategic. We have meetings over the next 6 to 8 weeks, and I think we would have clarity as we move through the year. In terms specifically of the coffee business, the headwinds are about behind us, as we've noted. We're happy with the performance. We've gotten through that pricing competitive issue, and we've begun to return to growth frankly in Q4, and we think that business is set up quite nicely for 2020.
Your next question is from Kevin Grundy with Jefferies.
A question on capital deployment. Can you talk a little bit about what the pipeline looks like for tuck-in M&A? How are you thinking about deleveraging versus buyback? It looks like you've exhausted the existing share buyback authorization, but of course, with the stock down here, it would seem like that would be a sensible consideration relative to what you're seeing from a tuck-in M&A perspective. Maybe you could comment on that. And then I have a follow-up.
Yes, in terms of the tuck-ins, we articulated that would be at the high end of the range on those tuck-ins, that it remains our expectation. We have a good pipeline that some we would execute this year, but a developing pipeline as we move into 2020. So no material change to our confidence in the ability to deliver the M&A pipeline on a go-forward basis. In terms of current capital deployment, it's really about investment in innovation and organic growth. A lot of that innovation is clearly in our investments against the customer experience, which we think enhances our business short and long-term in terms of retention rates, and ultimately, at the end of the day, revenue per customer. We would look to accelerate at the higher end of this range on our tuck-ins, so closer to 60% than 40%. So we continue with the quarterly shareholder. You're absolutely correct. We have exhausted the share buyback, and we'll continue to review larger acquisition opportunities should they come up. So we continue to do our diligence. The markets remain frothy from our view.
Yes. And you look at the share buyback, Kevin. I mean we have utilized all of the available allocation for this year, but also we've bought back almost $100 million of stock over the past year. So really when you look at how I plan deployment of my capital and liquidity, we've really utilized the amount of cash I have available for that for sure.
One follow-up and then I'll pass it on. Just the gross margin progression or margin progression broadly in Route Based Services in the back half of the year and your level of visibility on the margin improvement there that will be required to deliver on the consensus numbers, which you guys indicated that you're comfortable with, can you comment on the level of visibility between the pricing that's in place, some of the operating cost pressure that you saw in the first half of the year, which seems like it should subside a bit, particularly around labor. Can you just comment on sort of the level of visibility here in the back half of the year.
Yes. Let's start with the production issue that was in the tail, right? So while we did incur the incremental temp labor and unplanned overtime largely as a result of the wage inflation, the team did a good job in cost down actions in the second quarter that at the end of the day has mitigated that cost. Frankly, the team did better than we thought. So we don't see that as a particular challenge as we move into Q3 and Q4 as we sit here today.
And if you want to look at pure -- the margin on EBITDA between now and the remainder of the year, keep in mind that we're still going to have some FX headwinds going through the end of the year. But as we still be having pretty good headwinds in Q3, we should be holding relatively flat on an FX-neutral basis and then seeing more upside in Q4.
Your next question is from Amit Sharma with BMO Capital Markets.
Tom, your tone on the RBS top line, it certainly looks better than it has been, right? 5% growth in the quarter. You have a number of initiatives still coming online. Customer service app, filtration in the fourth quarter. I mean as we look to 2020, what do you think like -- 2% to 3%, you want to stick with that? Or could there be an upside as some of these initiatives start to help you from an organic top line perspective?
Yes. We're focused on how we finish the year and ensure that we deliver on our 2% to 3% and 1% to 2% in terms of organic and tuck-in. We have FX-neutral, enjoyed good revenue growth. But it does produce some challenges to us, right, as an impact, particularly in Q3 and Q4. Look, I think 2020, our first step about how we look to the future is around this strategic review process and what do we see over the next 3 years. And then after we align on what that is, we start the process of what's the annual operating plan, and we're frankly not there as I sit here today.
I mean Amit, you look at the year and how we're guiding to get to the $2.4 billion. I mean in Q1, we had about 6% growth on an FX-neutral basis -- 6% in Q2. But really viewing the back half of the year, we see that more normally down to, we say between 4% to 5%, so let's say, 4.5%, really to hit the $2.4-plus billion. So I think on the back half of the year, you see more of a normal range and that will continue into 2020.
Got it. And then on the near term, you did talk about the large e-commerce customer expanding. Can you talk about that a little bit in terms of how quickly could it ramp up, does it have any margin implication for the RBS business? And then comment on pricing environment easing in the [ CTE ] category. Is there potential for you to pick up some additional wins if pricing is normalized there?
I will take the e-commerce question first. Look, we're in -- while we're expanding to Florida in the quarter, it's a significant number of zip codes, and we're very focused on ensuring that we execute effectively with that new customer base and we install it. And Amit, just think of this learning from our past experience with the customer acceleration back in the days with the booth program, call it, 2016. So we've learned from that experience and are being judicious on the rollout. In terms of margins, we're happy with the margin structure of that business. So we don't anticipate that it would have a negative impact on our existing U.S. RBS business. So we're quite happy with where we are at the moment. In terms of coffee, pricing pressure has in fact eased and we will see our business turn around as we move through Q3 and Q4. We referenced some sales investments. So we would expect that we would win our fair share of new customer opportunities as we move into 2020. And remember, the team -- our S&D team did a good job extending contracts into the future, so we don't see a large risk of competitive pricing on our installed base, if you will. And we're happy with the 3% and the forecasted 30% growth and that's pretty aligned with our expectations.
Your next question is from Peter Grom with JPMorgan.
Just a quick one for me and then I had a sort of broader question. But did weather have any impact on performance in the quarter? And we're seeing favorable weather over the last -- and with favorable weather over the last month or so have you seen kind of any uptick in consumption trends?
Yes, I'll stick to Q2. We do see some weather impact particularly in our European operations. So it was certainly wet in the U.S., but it was nowhere near as warm in Europe as it was a year ago.So that has an impact, but that's baked into the performance that we had in the quarter and -- the 6% obviously includes a tougher cycle. So we're quite pleased with the performance overall on net revenue growth, FX-neutral, for the Q.
Okay. And then my second question is just on free cash flow. And I know a lot of this was timing related, but can you help us bridge to the $150-plus million growth in the context of the first half performance? And then just broadly, I think previously you had stated working capital is expected to be about flat for the year. Is that still the right target?
Yes, Peter, our free cash flow is historically back-end weighted. But I'll let Jay walk you through how we're thinking about it.
Yes. And as he said, it really was driven by free cash flow. And similar to last year, we did have 3 of our 4 interest payments in the front half of the year, so easier working capital in the back half. And then also we've talked about the FX headwind that is providing us a headwind on EBITDA which does flow through to free cash flow. Good news is that's more of a book headwind than not because I'm not repatriating the cash at this point in time. But we remain confident in the $150-plus million in a couple of different ways. One, if you look at our CapEx, which also was spent in the foreign currencies, so we're getting some benefits on CapEx. And you really look at our investment for the first half of the year has been $50 million. So we're definitely trending at the lower end of our $115 million to $125 million historic CapEx. So that will provide an offset. And in a similar -- we do see some additional pockets of working capital that we can take advantage of to offset the remaining FX that we're seeing.
Great. But you still think flat guidance from a working capital perspective is the right…
No, no, no. You look at the $5 million to $7 million FX as hitting us, let's say, FX or probably get a $2 million back in -- something like I said, or probably closer to the $115 million of our range, but then we will also see some working capital benefits to offset the other part of the FX headwind we're seeing.
Your next question is from Daniel Moore with CJS Securities.
I just wanted to hone in on Europe a little bit. In terms of the RBS business, it seems like you're seeing some pretty solid underlying organic volume trends despite macro being a little bit iffy. So kind of talk about those puts and takes and what's driving the success there on the ground?
Yes. So you recall we talk about high density and it really is an investment in customer growth in some of the markets in Europe, particularly those with the higher percentage of the population. So we're seeing [ year-on-year 2%-plus ] of that. Good execution and growth from those investments. So that gives us, despite all the other issues, we are expanding penetration in the commercial piece. Our booth program in the U.K. is rather exciting. It's meeting expectations on productivity, which is, if you think about a completely new channel of customer -- of our customer acquisition tactics in that country, and that's providing some good benefit as we, again, address that customer base there.And then we've referenced Poland in the script, so we've done some good tuck-ins that are strengthening some of our existing business. Poland happens to be one of those. And then of course, municipal water concerns on the eastern part of our business would be a little bit higher than in the western part of our European business. So we could see good consumption there. So I think we're benefiting from a number of the tactics the team has successfully implemented over the last couple of years and coming to fruition here in the summer of 2019 thankfully.
Helpful. And Jay, just a little housekeeping item but on the adjusted free cash flow was about -- between $8 million and $9 million in terms of acquisition integration. Where do you expect that to come in for the full year?
Thanks, Dan. Good question. As we're still integrating, it would be a kind of very rough guess. But I would say, you look at Mountain Valley, we have been progressing. I would say, it wouldn't be as high as that but could be around $5-plus million, that sounds about right.
Your next question comes from Mark Petrie with CIBC World Markets.
I just wanted to touch on the pricing dynamics in the water business. And I know you had talked about that as a potential offset to some of the labor pressures that you've been seeing. But it sounds like maybe you have addressed those even better than you had expected. So could you just sort of summarize where you're at in terms of the impact on pricing in the water business in Q2 and then also the outlook for that through the balance of the year?
Yes, so our current pricing is in line with our expectations and we see 1% to 2%, and we frankly see that not changing as we go through the balance of the year in the pricing environment. We are experiencing good price elasticity and the ability to continue to execute pricing with our customer base. It's certainly supported by our efforts on things like customer experience and customer satisfaction and service levels that our teams are executing. So when a customer is serviced flawlessly, it gives us greater power in terms of pricing elasticity.
And then if I could just ask about the filtration launch, just to confirm the timing of that and then your expectations in terms of how that would roll out.
So we would expect the new device to land sometime in Q3 and this will be a slow rollout. It will frankly start in the Western United States because you have the pipeline of the asset hitting the U.S. and then we'll refine our skills in terms of how we do the sales pitch and we'll implement the app so that customers can see water quality in real time and then roll it out over the coming years. So this is not a roll it out across the entire RBS footprint or filtration footprint in one quarter. It will be over time over the course of a couple of years.
And that will go through your existing -- at least in the test or the initial launch, in the Western U.S., through your existing sales force?
Yes. We have a dedicated team of people today, but we would look to expand that once we have that asset in place because there is really 2 parts to the execution, Mark. There is the installed base, which we want to convert for retention purposes and an upgrade and that's 160,000 or 170,000 filtration customer locations. And then use the expanded sales force then to build on that base of 160,000 to some other larger number in the future.
Your next question is from Bryan Hunt with Wells Fargo.
I was wondering if you could discuss a little bit more on your efforts to cross-sell and add cases in sparkling. The basket opportunity seems like a great opportunity because there is no initial -- additional stock, but it definitely adds additional dollars and gross profit to each stock. So when you look at what you reported for the quarter, I believe you said you're up 4% ex acquisitions and pricing is up 1% to 2%. Do we assume the rest of that is basket and could you just explore maybe those comments?
Yes. Our current focus is first on cased water, which is traditional cased water that you might buy a 24 pack at some retail location. And we really are using our direct sales force to get to the consumer to fill that consumption occasion. And we're quite pleased because we're in -- the historical penetration was roughly 8% to 10% in the U.S., and we're seeing double-digit increase in that penetration, which is really increasing the size of the basket. Now in addition to that, we began a slow rollout this year of sparkling ice across the business and we've also focused on sparkling water and sell 2 different brands, one essentially in the West and one in the Northeast corridor and they're producing some good results. This is a ongoing execution contact with the customer. So our CX is actually, we believe, going to be the key enabler as we begin to not rely on the route sales person to interact directly with the customer. They're doing a good job, but our investments in CX will enable us to enhance the communication via mobile, via text, via our app, and we think that that will help us build that base of penetration over time. It's largely a U.S. execution today. So we'll -- over time, we have to find the appropriate solutions in Europe and extend that to Europe and frankly into Canada.
It sounds like an exciting opportunity. Next, looking at this online retailer that you're expanding across Georgia and Florida, where -- can you talk about what their pricing strategy is relative to your core pricing strategy as well as -- because you're expanding potentially so rapidly with them geographically, does that new customer kind of skew your acquisition targets geographically?
Yes. Look, in terms of pricing, there is really no conflict between what they market online for and what we market online for. And we've been very cautious about the economics of that customer so that we don't self-inflict mix issues or pricing pressure, right? So we like our current price elasticity, and we're going to stay very focused on how that contributes to our revenue growth in the next couple of quarters and well into the future. So we've been rather judicious in our approach to that. We look at it in terms of customer acquisition tactics. If we have 6 tactics, this would be tactic #7, and then we would always look to balance those customer acquisitions by channel, right? So if you will -- we love all of our customers, but we're particularly focused on small commercial because it has the highest profitability, largely driven by higher pricing and the length of the customer, right? So we'll always look to balance. And our local teams are accountable for ensuring that the balance in any market, any region is appropriate to maximize top line and the bottom line along the way, and I think the teams are doing a pretty good job of that today.
And then my last question, if you can squeeze in one more. Just talk about maybe balance sheet goals. Where is your target leverage? I know there's seasonality in the business today and you're kind of peaked for the year, but where do you see yourself longer-term? And that's it from me.
Leverage. Our leverage, if you disregard the new lease accounting rules where everybody are starting to put leases on their books and everybody will slowly catch up, our leverage is around [ 3.75 ] right now. And we really expect that number to continue to decline as we pay down our ABL and grow our EBITDA during the year and we continue to do so over the remainder of this year and for several years to come. So no specific targets, but that's where our focus. Cash flow deployment is after the dividend after the tuck-ins and investing in growth. But we'll continue to focus on reducing our leverage.
Our last question is from Amit Sharma with BMO Capital Markets.
Tom, just wanted to make sure that I heard this right. So as you were talking about your filtration business, did you say 3% of your HOD customers tend to convert to filtration? A clarification -- sorry, go ahead.
No, that's a good question. So clarity is helpful. Of our total quit, 3% of that.
Okay. Got it.
A very small number, right?
Right, okay.
As Tom talked about…
So we don't see -- what's important is, we don't see a big exodus of my HOD Water base converting to filtration. If they do, we expect them to stay with us and frankly we think that will only be enhanced with the pending execution and rollout of our new patented technology. So we think it really -- we'll get more of those 3% that come to us and then obviously expand our market share over time.
Got it. And just one more on that. When you think about the revenue structure of the filtration business, can you talk about that a little bit? You did say that you entered into a longer-term contract. Like how should we think about that? It's less revenue, but better gross profit, is that the way to think about filtration business?
Yes. It's not necessarily less revenue. It, frankly, depends on the customer, right? So you have some that are less, some that are more. Higher revenue comes with larger customers where we would typically enter into a longer-term agreement. When you think about the free cash flow from the customer -- and look, this is an average of an average for our customer base. It's about the same as an HOD customer after you factor out capital.
Got it. Okay. So even if people move to filtration, it's not dilutive to your free cash flow profile…
Yes. I'll use the word agnostic. We like customers who are happy to have them in either solution. And look, our investments are about enhancing our footprint in the filtration side of our business. So at the end of the day, we benefit from the best of both worlds in healthy hydration, growing category…
In some of our larger customers, we do both.
Correct.
Where their offices are and they have an easy access to water, there we do filtration units. In the plants, where there is no easy access to water, we do water coolers. So our goal is to generate similar dollar profits and be agnostic to which our customer want. We just provide them the service that fits their needs.
Ladies and gentlemen, this concludes the Q&A period, and I'll turn it back to Jarrod for any closing remarks.
This ends our Q2 2019 earnings results. Thank you all for joining. Goodbye.
This concludes today's conference call. You may now disconnect.