Diebold Nixdorf (NYSE:DBD) Q4 2018 Earnings Conference Call February 13, 2019 8:30 AM ET
Steve Virostek - Vice President, Investor Relations.
Gerrard Schmid - President & Chief Executive Officer
Jeff Rutherford - Chief Financial Officer
Conference Call Participants
Matt Summerville - D.A. Davidson
Paul Coster – JPMorgan
Kartik Mehta - Northcoast Research
Justin Bergner - Gabelli & Company
Rob Jost - Invesco
Good day, and welcome to the Diebold Incorporated Hosted Fourth Quarter and Full Year 2018 Earnings Call.
At this time, I'd like to turn the conference over to Steve Virostek. Please go ahead, sir.
Thank you, Brandon. Welcome to Diebold Nixdorf's Fourth Quarter Earnings Call for 2018. Joining me today are Gerrard Schmid, President and Chief Executive Officer; and Jeff Rutherford, Chief Financial Officer.
For your benefit, we have posted slides to accompany our discussion and these slides are available on the Investor Relations page of dieboldnixdorf.com. Later today we will post a replay of our webcast to this IR website.
On slide 2 of the presentation, we have a reminder that our comments today will include non-GAAP financial information, which we believe is helpful in assessing the company's performance. In the supplemental schedules of our slides, we've reconciled each non-GAAP metric to its most directly comparable GAAP metric.
On slide 3, we remind everyone that certain comments may be characterized as forward-looking statements and that there are a number of factors that could cause actual results to differ materially from these statements. You may find additional information on these factors in the company's SEC filings. I'd like to remind our listeners that this forward-looking information is current as of today and subsequent events may render this information out of date.
And with that, I will turn the call over to Gerrard.
Good morning, everyone. I'm pleased to join you today for a discussion of our solid fourth quarter results as I mark my third full quarter as CEO. I'll also discuss the company's improved financial outlook, which is underpinned by our value-creating DN Now program.
The company's fourth quarter performance is summarized on slide 3 and it demonstrates both the ability of our team to execute on our priorities as well as the stickiness of our offerings with customers. Total orders increased 10% in constant currency during the quarter versus one year ago, led by strong growth in Americas Banking and solid growth in Retail.
More specifically, our success in Americas Banking was underpinned by orders for more than $100 million of Windows 10 capable machines during the quarter. Contributing to the success was a $21 million contract from a large U.S. regional bank for integrated hardware and software and a new five-year managed services contract.
In Latin America, we signed an agreement with Banco do Brasil, the largest bank in Brazil, to deliver nearly 6,000 cash recyclers and maintenance services. In Mexico, we displaced an incumbent hardware provider with a $16 million contract win at Banco Azteca which extends DN's market leadership in that country.
On the service front, we achieved a very strong renewal rate, including a three-year maintenance service contract with BBVA Bancomer in Mexico, covering more than 7,600 ATMs. In Eurasia Banking, orders in Asia Pacific moderated, as we continued our bidding discipline and focus on profitable opportunities. Orders in Europe, the Middle East and Africa grew modestly.
Important wins in the quarter included an $11 million contract from a top South African retail bank for cash recyclers and software, an order for 2,000 Windows 10 ATM upgrades at one of the largest banks in France and a $6 million agreement with Banco de Oro in the Philippines, to deploy the first cash recyclers in that country, along with terminal and incident management software and a three-year maintenance service contract.
We are also pleased to secure an order for Windows 10 terminals and a multi-year managed service contract renewal at Sparkasse Hannover one of the largest savings banks in Germany.
On a global basis, the strength in banking orders reflects a number of recent customer conversations I've had, namely that the ATM will continue to serve as a critical customer touch point at financial institutions for several years. This reflects a more stable outlook for the industry going forward.
With respect to Retail orders, we delivered year-over-year constant currency growth in all regions. We won multiple contracts for point-of-sale systems, including a $9 million order to a large U.K. grocer and a $7 million win for hardware and peripherals at the largest food retailer in Germany.
In addition, we were pleased to sign a multi-year $24 million service contract renewal with a major discount supermarket franchise based in Germany. The strength in orders as we closed out 2018 illustrates that customer sentiment toward Diebold Nixdorf remains positive as we explore new opportunities and renew existing relationships.
Revenue trends for the quarter was similar to our order growth. We delivered 7% revenue growth in constant currency comprised of 19% growth from Retail and 10% growth in Americas Banking, while Eurasia Banking declined modestly. Based on market intelligence for ATM shipments DN is maintaining a solid share in Europe and North America growing our share in Latin America and the Middle East and we are intentionally focusing our efforts on more profitable business in Asia.
Profitability and cash flow were both strong in the fourth quarter. A healthy top line coupled with lower selling general and administrative expenses enabled the company to increase adjusted EBITDA by 21% to $127 million, while posting a margin of nearly 10%. Strong profits, improving inventory management and solid collections enabled the company to generate $250 million of free cash flow. We exceeded our guidance by delivering the best quarterly performance for adjusted EBITDA and cash flow since the combination of Diebold and Wincor Nixdorf.
Our improved financial performance was made possible by the hard work and dedication of our employees as they execute our value-creating DN Now initiatives designed to simplify our operations, reduce costs and relentlessly focus on our customers.
Slide 4 provides a visual representation of these initiatives as well as the expected timing of the associated cost savings. During prior investor calls, we have spoken about our transition to a new streamlined operating model. This project focused on streamlining management layers and other non-customer facing roles.
As of year-end, approximately 1,200 employees had exited the company and we have reached agreements with several European works councils that ensure this program will be completed on schedule. As a reminder, we expect this initiative will deliver about $100 million in gross savings during 2019 and $130 million of savings by 2020. Second we have streamlined the number of ATM models by 30% and are optimizing our manufacturing footprint. We closed our assembly facility in India during the third quarter and we will ship production of certain products to lower-cost facilities and take additional actions to optimize our manufacturing cost structure.
Next, we have launched a Services Modernization Plan, which includes upgrading all the hardware and software, automating incident identification response, and standardizing internal processes to better leverage our scale. The management team's ability to drive positive changes will benefit from globally consistent KPIs and standard reports across our footprint.
We are seeing early signs of success, which include sequential gross service margin expansion in the third and fourth quarters. We achieved a 27% gross service margin for both Americas Banking and Eurasia Banking in the fourth quarter driven by meaningful year-over-year improvements in France, Germany and the United States.
As we discussed last quarter, following the momentum of our cost actions in 2018, we kicked off additional initiatives in the fourth quarter, focused on transforming our workforce, enhancing our go-to-market approach and reducing our cost structure. For example, we've launched a number of work streams aimed at reducing our G&A costs, specifically in finance, IT and real estate.
A key enabler of this plan is to make greater use of shared services, streamline internal technology platforms, and implement consistent processes across the company. Another key initiative is to improve our net working capital.
Jeff will report our activities in a moment, but let me simply say that I am encouraged to report that net working capital as a percent of revenue improved to 18.3% in the fourth quarter, down from 21.3% in the year-ago period.
Based on the detailed work we have completed thus far, we are increasing the expected financial benefit of our DN Now initiatives from approximately $250 million to approximately $400 million of gross savings through the year 2021. We expect to realize about $160 million of these savings in 2019 with progressively greater benefits in 2020 and 2021.
The timing of savings will vary by initiative and will be partially offset by typical business factors, such as wage inflation and product deflation. While our DN Now transformation requires rigorous work and extensive contributions from virtually all functions of the business, our early success is creating good energy within the leadership team.
I find that a number of DN associates are invigorated by the opportunity to remake this 160-year-old company into a more profitable and customer-centric enterprise. It's also why DN has been able to attract seasoned leaders. We have brought on Hermann Wimmer, to lead our Retail business; Julian Sparkes, to transform internal IT as our Chief Digital Officer; and we confirmed Jeff as our CFO.
In addition, we have strengthened our software product management and product development functions with new talent.
Our progress with portfolio optimization is taking a bit longer than I anticipated. We exited some smaller loss-making businesses and we anticipate closing two transactions later this quarter with other noncore divestitures expected in the coming quarters.
Moving to slide 5, we are introducing four DN Now success metrics, which should help investors track our progress. Starting at the upper left, you can see the number of ATMs currently under services contract has held steady during 2018 at about 630,000 machines.
The geographic composition of ATMs has modestly shifted towards EMEA and the Americas.
Looking to the future, we are targeting modest growth in the installed base of ATMs under contract as we further differentiate DN through our All-Connect Services engine and our Services Modernization program.
On the upper right, you can see that we have delivered strong service contract renewal rates from our banking and retail customers. This metric is calculated as the total contract value of our renewals, divided by the total contract value of the renewal opportunity during each period. By improving overall service levels and working with our customers, we expect renewal rate to remain north of 95%.
At the bottom left, you can see the improved trajectory of our non-GAAP services gross margin, following the launch of our Services Modernization Plan in the second quarter. By following through on these activities, we are targeting service margins in excess of 27% recognizing that we do experience some seasonal fluctuations with Q1 typically being the low watermark of the year.
And our fourth success metric is selling, general and administrative expenses as a percent of revenue. We've plotted our progress to-date on the bottom right of the slide along with our target of driving this ratio to about 13% to 14% of revenue. To achieve this, we have started to execute clearly defined plans to reduced finance, IT, real estate and other general and administrative expenses.
The company's recent progress gives us the confidence in our improved financial outlook for 2019 which is shown on slide 6. We expect modest revenue growth in Americas Banking and growth in retail where normalized for divestitures to be offset by modest declines in Eurasia Banking, largely due to the continuation of the trends which we experienced in 2018.
Total revenue is expected to be within the range of $4.4 billion to $4.5 billion and is underpinned by our backlog and strong service renewals. With respect to our profitability, we expect double-digit growth of adjusted EBITDA to a range of $380 million to $420 million.
Key expectations include about $160 million in DN Now savings a $60 million headwind from inflation, normal compensation as well as benefits from near-term divestitures and about $20 million of benefits which occurred in 2018, but are now expected to recur.
On the cash flow front, we're expecting breakeven results for 2019 as we benefit from significant year-on-year improvements in adjusted EBITDA, lower integration costs and improved net working capital. The offsets to our outlook include higher cash interest, capital expenditures and restructuring costs when compared with 2018 results.
And now I'll hand the call to Jeff for his comments.
Thank you, Gerrard, and good morning, everyone. Based on my experience over the last few months, I'm very confident about our plans to deliver significant value to investors and customers. As I discuss our financial results of the fourth quarter and 2018, please keep in mind that comments will focus on non-GAAP metrics, unless otherwise noted.
On slide 7, you will see total revenue for the quarter increased 7% in constant currency, led by 19% growth in Retail and 10% growth in Americas Banking. Our focus on winning profitable business is impacting revenue in the Eurasia Banking segment, as lower volumes in Asia more than offsets the modest growth we are delivering in Europe, the Middle East and Africa.
Looking at the business lines: Product revenue growth was strong in the quarter at 18%, software was 6%, and services declined modestly.
Moving to slide 8: Revenue for the full year declined by 3% in constant currency. Modest growth in Retail and Americas Banking was offset by declines in Eurasia Banking, which again reflects our pursuit of more profitable business. Software revenue grew 5%, while product revenue declined by 5% on lower volume, and services declined by approximately 2%.
The next three slides provide segment level information. Starting with slide 9, total revenue from Eurasia Banking declined 3% in constant currency to $493 million during the fourth quarter, as revenue declines in Asia-Pacific masked modest revenue growth in EMEA.
Operating profit for the quarter increased from $36 million last year to $67 million this year, primarily due to higher product gross margin -- margins from a better solution mix and the initial DN Now savings from our new streamlined operating model. We highlight the full year variances on the bottom half of this slide.
Segment revenue declined 8% in constant currency to $1.8 billion primarily driven by declines in product and services revenue. Operating profit increased from $127 million to $147 million, primarily due to improved gross product margins, due to a more favorable customer and solution mix of hardware and the initial DN Now savings.
On the top of slide 10, we highlight 10% revenue growth in constant currency to $429 million from our Americas Banking segment, led by products and software growth in both North and Latin America. Operating profit increased from $9 million to $17 million in the quarter, primarily due to headcount-related savings from our DN Now initiatives.
For the full year, Americas Banking revenue increased 1% in constant currency to $1.5 billion driven by higher product volumes and software revenue growth. Operating profit decreased to $28 million, primarily due to higher service delivery costs, higher freight costs and an unfavorable geographic product mix, which impacted segment gross margin versus the prior year.
Moving to slide 11: You will see quarterly Retail revenue increased 19% in constant currency to $368 million with all business lines contributing to the growth. Operating profit decreased to $14 million due to a less profitable solution mix and continued underperformance in non-core businesses, which we are addressing through our portfolio-shaping activities. In addition, we incurred a one-off bad debt expense related to a contract dispute, which offsets savings from our DN Now initiative.
For the full year, Retail revenue increased 3% in constant currency to approximately $1.3 billion due to modest growth in EMEA and Asia and strong growth in the Americas, albeit off of a smaller base. Operating profit declined to $50 million, primarily due to the same factors which impacted the fourth quarter plus incremental software R&D and sales costs in North America which support our market expansion.
On slide 12, we have provided a year-over-year comparison of key profit metrics for the fourth quarter. Non-GAAP gross margin declined approximately 30 basis points to 23.1%, primarily due to the unfavorable solution mix in our retail segment.
Lower operating expense from our DN Now initiatives enabled the company to increase operating profit to $83 million and the corresponding operating margin to approximately 6.4%. For the same reasons, adjusted EBITDA increased to $127 million or a margin of 9.8%.
The charts on the slide 13 compare DN Now profit metrics for the full year. As most of you are aware the company's financial results were below expectations in the first half but improved in the second half as the leadership team executed on our DN Now initiative.
In fact, we generated over 70% of the company's 2018 operating profit in the second half of the year. For the full year, gross profit declined approximately $100 million due to the segment level trends I have already described and while we reduced our operating expenses by $42 million, operating profit decreased by $58 million due to the change in gross profit.
Lower operating expenses reflects the initial impact of our DN Now initiatives as well as the $22 million benefit from lower variable incentive compensation expense which includes favorable mark-to-market impacts on a cash compensation program linked to our stock price.
We do not expect this benefit to recur in 2019. These factors also explain how the adjusted EBITDA decreased by approximately $37 million to $331 million and the margin declined by 80 basis points to 7.2%.
Moving to slide 14, the company generated significant net working capital improvements in the quarter, primarily due to the positive inventory management changes we made and the disciplined collections we are doing.
We've established target levels for spare parts, raw materials, and finished goods across every country and we have designated clear owners who are responsible for achieving these targets.
In the quarter we harvested $142 million of cash from inventory. We believe we can build on our progress going forward as a result of working with these leaders on better inventory management and streamlining their product portfolio. The company took a one-time non-cash inventory provision of $70.5 million. Our year end 2018 inventory balance of $610 million declined by more than $100 million year-over-year and is at its lowest point since our combination.
We also put in place more proactive policies for monitoring the management receivables and payables. Due to our collective efforts, the company reduced its net working capital as a percentage of revenue to 18.3% in the fourth quarter, which is down from 21.3% in the year ago period.
This working capital management coupled with strong profitability in the quarter enabled the company to generate $250 million of free cash flow. This is approximately $5 million higher than the prior year period and our annual free cash flow is approximately $37 million more favorable than our prior outlook.
On the last slide of slide 15, we illustrate our liquidity position at year-end 2018. With cash of $492 million and net debt of approximately $1.75 billion, our key leverage ratio of net debt to trailing 12 months adjusted EBITDA was 5.3 times. This compares with our bank facility covenant maximum of 7 times.
To the right side of the slide, you will see the time line for our debt maturities. While there are no meaningful maturities in 2019, our revolving credit facility and Term Loan A will mature in December 2020. We incorporated these debt maturities into our three year plans so that we maintain sufficient capital for meeting all of our operating and funding needs.
On slide 16, we provide our 2019 outlook and our three year targets. As Gerrard discussed, our outlook for 2019 includes a modest decline in revenue significant growth of adjusted EBITDA and breakeven free cash flow. While we do not provide quarterly guidance we do expect typical seasonal trends to play out in our 2019 results. Specifically, we expect first quarter revenue and adjusted EBITDA to be modestly below levels reported in 2018.
As our DN Now initiatives gain traction throughout the year both revenue and adjusted EBITDA are expected to improve sequentially for each quarter of 2019. Our seasonal trends coupled with the pace of restructuring cash outflows and working capital trends indicate the company will be using cash for the first three quarters and will generate significant positive free cash flow in fourth quarter.
Key expectations, which underpin our breakeven cash flow outlook for 2019 include strong growth in adjusted EBITDA, net working capital, cash flow, harvesting of working capital of about $100 million; net interest expense of approximately $190 million; restructuring payments of approximately $130 million; and approximately $80 million of capital expenditures, $60 million of cash taxes and $40 million of other cash uses.
Next I'll discuss our 2021 targets and key drivers of the model. We are targeting revenue growth of 2% to 4% annually led by our Americas Banking and Retail segments and our services and software business lines. The model includes stable product revenue supported by Win 10 refresh activity.
With respect to our operating profit and adjusted EBITDA, we are targeting strong improvements driven primarily by the DN Now $400 million cost savings program. Revenue growth from higher-margin services and software offerings should also benefit our profit margins.
Offsets in the model include inflation of approximately $40 million per year, post product deflation normal compensation expense and a few other minor items. These factors along with the continued working capital management yield a target 2021 operating profit margin of about 9% and an adjusted EBITDA margin of about 12%. Strong profit growth through 2021 and continued working capital management are the primary factor, which reduces our leverage ratio to less than three times net debt to trailing 12 months adjusted EBITDA with a modest reduction in debt. These profit increases along with continued harvesting in net working capital and the easing of restructuring payments will benefit free cash flow.
Key inputs to our free cash flow target of more than $200 million by 2021 are; annual and net interest expense of $200 million; capital expenditures of $80 million; cash taxes of $60 million; and ample cash flow from net working capital, which will fund our restructuring.
Perhaps the most compelling target is the return on invested capital, which we define as tax affected operating profit divided by invested capital. Our model yields an ROIC in the mid-teens, which would be a significant improvement over the mid single-digit return, which we delivered in 2018. At those levels, we will be creating sustainable value for all of our stakeholders.
And now I'll hand the call back to Gerrard for a few closing remarks.
Thank you, Jeff. And before opening the call to questions, I'd like to echo Jeff's comments that DN Now is a clearly defined path of value creation for investors. We are fundamentally remaking Diebold Nixdorf using best practices, which are designed to leverage our market leadership position and our global scale.
I see tremendous energy and commitment from our leadership team to achieve the long-term goals, which we have discussed today. The vast majority of these actions are within our control and we have demonstrated strong success in the initial stages. We are also encouraged by our product competitiveness, strong market share and stabilizing end market demand, which will provide additional confidence in our future.
And now I'll ask the operator to provide instructions for our Q&A session. Thank you.
Thank you. [Operator Instructions] The first question will come from Matt Summerville with D. A. Davidson. Please go ahead with your question.
Thanks. Good morning. A couple of questions. First on the $400 million of cost save target, it looks like the $160 million growth you'll realize in 2019, $80 million fall through to operating profit. Is it fair to assume 50% or $200 million on the $400 million is what you're targeting to drop through to OP? Can you walk through that please?
We're talking specifically about the three-year model here, Matt. Or are you talking about 2019?
If the flow through rate is 15% in 2019, I'm curious as to what the flow through rate is for the three-year model that you guys are laying out please.
Yeah. And the $400 million is the accumulation of the benefits over time. And again as Gerrard spoke, it's the combination of few projects. And you can put it in perspective that it's modernization of G&A, support and then taking advantage of the operating profits adjustments we have.
The flow-through is offset by mainly inflation and other adjustments. So it increases as we go through the model, right? So in 2019, our guidance is $331 million to $400 million and then the target is $600 million. So it sequentially increase every year over the next two years. And it's pretty linear as far as that increase from $400 million to $600 million.
And, Matt, what makes that ratio 50% in 2019 is the $20 million headwind we have from non-recurring benefits. So that would be a unique to 2019.
Okay. Understood. And then, Gerrard, you mentioned that the monetization of certain assets that you've identified, or certain business lines, is taking a little bit longer than what you would have otherwise expected. Can you talk about what's happened with that process and sort of update? Are we still looking at 5% to 10% of the company's total revenue to be monetized at this point? And I guess what underlying that would be a reasonable level of proceeds that we can anticipate from that?
Yes. So nothing has fundamentally changed to the overall time lines, nor to the underlying integrity of the processes, other than the normal activities you would find in any specific transaction, which is why we remain confident that we will close on two transactions this quarter.
In terms of the overall program, yes, we are still targeting divestitures in the range of 5% to 10%, probably a little bit closer towards the bottom end of that range. And in terms of net proceeds, obviously, it varies based on market conditions. And, yes, I'd say that, it will be probably a little bit lower than one times multiple of revenues, give or take, depending on the different transactions. So I think we'll hold on that until we see -- until we've got a few of these under our belt.
Thanks. I'll go back in queue.
Thank you for the question. The next question will come from Paul Coster with JPMorgan. Please go ahead.
Yes. Thanks for taking the question. First up, on the services front. Obviously, a little bit of -- you should -- it looks like you're expecting some kind of positive inflection in terms of growth. And you must have some visibility into that. So perhaps you can talk us through what's about to happen there?
Yes. So there's a few things that have been happening. I mean, you would have seen some revenue declines in our services business in 2018. When you take a look at what's actually been driving that, the biggest drivers of that have been a decent-sized contract in Asia that was extremely low margin. The second big driver was foreign exchange. And the third driver was volume declines in China specifically.
So when we take a look at our core business and you take a look at the trends in 2018, 2019 rather, we're expecting a lot of those items to really be in the rear-view mirror. And when we couple that with the momentum that we're seeing in new product sales, plus our all-connect engine, plus the benefits of our services modernization program, it points towards us continuing to see some emerging strength in that business especially on the bottom line.
Got it. And Jeff we should assume I believe that the $100 million in restricted cash is reserved for the buyback of the German shares, is that correct? And is that the full obligation that's outstanding?
It is for that use and it's materially all the remaining obligation.
Okay. And then my last question is you're talking about product deflation which I think is actually very realistic. So thank you for that realism, but it's also a little unusual. Could you just talk us through what you are referring to there?
Yes, sure. So I think in prior calls I have commented on the fact that in some markets we have seen pricing be very, very competitive and very challenging. You have seen in some of those markets in Asia we have very consciously pulled back from wanting to participate in those sorts of deals, because we are very much focused on doing profitable business.
But there are some markets where we do want to participate, where we do want to either expand or maintain market share, where pricing competition is still something of note. And we're simply being pragmatic to say in some markets, we would see some pricing compression. And that pricing compression is really most notable on the hardware side a lot less so on software and services. So it's really more on the hardware side in specific countries.
All right. Thank you very much.
Thank you for your question. The next question will come from Kartik Mehta with Northcoast Research. Please go ahead with your question.
Good morning, Gerrard and Jeff. I wanted to ask Gerrard a little bit on Windows 10 and the environment you're seeing maybe the U.S. and then outside of the U.S. Are you seeing more in terms of displacements or more in terms of just upgrading current machines?
Kartik would you mind just repeating your question? Your phone line just staggered up, so I just wanted to make sure I heard what you are saying. So you talked about Windows 10 then just repeat that.
Yes, I apologize. Yes I apologize, I'm in an airport so I'm sorry for the background noise. Now my question was on Windows 10 the demand you are seeing, are you seeing more in terms of displacement of machines or upgrade of existing machines?
Yes. So I think we're universally seeing a combination of both. So for example, you would have seen the most recent quarter very large new hardware up -- new buying cycle from some of the Brazilian banks where they are increasingly moving towards cash-recycling technologies. We're seeing something similar in the Philippines with the shift towards cash recycling and obviously Windows 10 capabilities go along with those. In the case of the U.S. market, it's more of a mixed bag where we're seeing both hardware upgrades plus just software upgrades. So I think it varies by market with the U.S. being more of a split whereas some of the other markets shifting towards hardware transactions.
And then in the North America you talked a little bit about why margins were lower than you anticipated. As you look at your three-year plan, how do you envision the North American market in terms of operating margins? Do you think they'll be close to what you've looked at in terms of long-term growth that you've laid out? Or is this market going to be a little bit different in terms of operating income?
Yes. When I take a look at our different product lines, at the moment we clearly have some meaningful actions underway from a services perspective. And when you take a look at the performance in Q4 there is no reason for us to believe that our services business in the Americas shouldn't be performing consistently in line with the performance that we're seeing in Eurasia as an example. The same holds true in software. And if anything I would anticipate modestly higher software margins coming out of the Americas than other parts of the globe, just given the mix of the customer base in the U.S. in particular.
Right now, we are seeing some diversions in margins on the hardware front between Europe and the Americas. We certainly have a number of actions underway in terms of our product platform evolution that, we believe will normalize that. So, that all points towards us having stronger confidence in our hardware margins, more consistently across the globe. The other thing I would say is from a G&A perspective given that we’re a U.S. domiciled entity a lot of our G&A is embedded in the U.S. So when we think about all the way – or the drop through to OP and we talk about the programs that are just being laid out we anticipate the improvements on that front too.
Thank you very much. Appreciate it.
Thank you for your question. The next question will come from Justin Bergner with Gabelli & Company. Please go ahead with your question.
Hi. Thank you for taking my questions. And thank you for the midterm plan this morning.
You're welcome Justin.
My first question relates to the services gross margin target of 27%. Maybe you could help us understand or given the seasonality of gross margin what the second half service gross margin means? Or sort of, how you view the run rate exiting 2018 versus the 2021 target? And sort of what are the biggest sources of improvement to bridging that gap?
Yeah. So I think it’s – as you pointed out Justin we operate in a seasonal business where Q4 historically and on a go-forward basis is generally the strongest quarter in the year with Q1 being the weakest. And when you look at the gross margins between Q1 and Q4 there's typically a 500-plus basis point difference between those quarters. And a lot of that is the seasonality of when a hardware gets bought and implemented. So we don't anticipate that seasonality necessarily changing going forward which is why we just want to remind investors that Q1 is likely to be coming-off the strong Q4 that we just exited.
But as we look at the walk-up quarter-over-quarter on an annual basis, we anticipate moving from 2018 having gross margins of around 23% to an excess of 27%. And it's all underpinned by the Services Modernization Plan that we've talked about in the past couple of quarters.
Okay. Thank you for that. I'll try and work from that Q1 seasonal guidance to sort of come up with a run rate for current service gross margins. The second question I had is within your sort of 2021 free cash flow framework upgraded to $200 million I mean should I assume that the cash restructuring expenses are largest in 2019 and then step down materially in 2020 and are hopefully fairly negligible come 2021? Is that a reasonable way to think about cash restructuring expenses?
It's trending correctly that it will trend down into 2021. That's going to be substantial in 2019 as we talked about from a guidance perspective. It will be down in 2020 but it will still be a material number. It will be in the $80 million or more range and then it will drop-off in2021.
And that's all needed right to support our transformation from where we're at today to where we want to be. As Gerrard said, we want to take Diebold Nixdorf into a more modern era of things like G&A support.
Yes. Let me just comment on that and add to that briefly, Justin. At the end of the day I understand from investors that they've seen this sector go through wave upon wave of cost programs as the markets -- the companies have reacted to slowdowns in overall end market demand.
Now what we're talking about here is actually a much, much more structural transformational change of how we operate as an organization. So we're not looking at one-time changes. We're looking at structural changes to how we operate. And Jeff pointed obliquely to some of the programs that we have underway from a G&A perspective.
Now our expectation coming out of the back end of 2021 is a sustainable organization. And that's what we're focusing on. We're not trying to focus on one-time gains. And therefore, while I understand the preference to be minimizing restructuring we actually think it's the right long-term answer for the organization's health.
Okay, thank you for that detail. And then lastly as you think about the 2021, EBITDA margin could you sort of tell us where retail will fall out? And maybe how we should rank order the profitability of the three segments? It seems like you've kind of made some inferences there but just to gain any additional clarity would help?
In our models right, retail will have the highest level of profit of the three segments and has the potential for the greatest margin expansion of the three. We're not giving individual segment guidance at this point. But those trends should continue. And with the new leadership we have in retail that's the expectation we have.
Thank you, Jeff and Gerrard, for taking my questions.
The next question will come from Rob Jost with Invesco. Please go ahead.
Hi thanks. I just wanted to touch on, you're taking a lot of costs out of your supply chain, your working capital and I think your forecast is for another $100 million out. Is there -- as an investor, the concern I have is, you're potentially taking too much out it might impact your service levels. Can you speak to where you want to go versus historical levels? And how you get comfortable with that level of working capital?
Yes sure. So the first thing I'd say is that in particular on the net working capital side this is an extremely collaborative exercise with our leaders in our manufacturing plants, our leaders in our spare parts depots, as well as our leaders in dealing with finished goods.
And when you take a look at what we do -- what we've been doing? We've been consolidating increasingly our manufacturing footprint down to a fewer number of manufacturing entities. That allows us to more optimally leverage our raw materials. Secondly as we are simplifying our product line which we talked about earlier this year, it drives a much smaller simplified way to deal with our supply chain.
And thirdly, if you take a look at our balance sheet and look at the spare parts trajectory we've been optimizing that quite steadily over the past several quarters as we've been applying analytics to run our spare parts inventory on a more global basis rather than having spare parts sitting resident in any one given country trying to leverage our global centers more effectively.
So those are the real operational underpinnings around what allows us to get to the improved working capital. And we are very mindful that, what we don't want to be doing is introducing adverse risk where we will be slowing down deliveries to our customers. And I'm pleased to say that notwithstanding the very important progress that we saw in Q4, we actually had the best quarter in terms of our delivery cycles to our customers too.
So we're seeing the manufacturing teams and the spare part teams manage the interplay between those two appropriately. And it's really been driven by a bottoms-up view rather than a top-down view. So we're feeling quite confident that we can keep yielding these gains.
And then if I could just add, Gerrard. We've mentioned earlier in accounts payable that we have opportunity. That's blocking and tackling. And sometimes we don't do the blocking and tackling as well as we can. We've got that in order. We feel good about our opportunities to harvest capital out of accounts payable. And I wanted to say that the segment people do a tremendous job working with our receivables groups and -- on collections.
And the last thing, I would say just to augment what Gerrard said is, our sales and operational planning people do a really good job. And they have some really good automation that they brought into their process to help assure that we're always going to be able to meet to the best of our abilities our customers' demands.
Okay. I really appreciate that color. Thank you. My follow-up is on the pressure from Asia. We've heard about that for some time as some of these contracts roll-off. That's impacting the, I believe, on the services side. So can you talk about when we can expect to have that abate? Is that more in 2020?
Yes. I would have a difficult time answering that question at this stage, because it's largely driven by actions from our competitors where we're seeing pricing that quite frankly, we're not sure is sustainable in those markets.
I'll remind everyone that our Asia banking, which is the area that's primarily experiencing this, is now less than 10% of our overall revenues. So while we continue to anticipate some declines, our primary focus is on maintaining and winning profitable deals.
And I'd say, the good news is that when Asia is a complex market, it's a very broad market, and it starts to bifurcate into different markets where we continue to see pricing stability. And those are the markets where we're putting more of our attention and energy. But I'm not going to at this point guess when does pricing behavior change on our competitors' side.
All right. Thanks.
Thank you. The next question will come from Russell Higgens, Barings [ph]. Please go ahead.
Q – Unidentified Analyst
Hi, guys. Thanks for the call and taking my questions. I just have a couple more on restructuring. The 160 that you guided -- sorry the 150 that you guided to could you just break that out between the spend on FTE reduction and the product portfolio optimization? I had $160 million in my head.
And then following on to that, are you still intending to pay $50 million worth of pension contributions in the year? Or has that been paid? And then just final question is that the $20 million reversal that you mentioned was that occurring in Q4?
I think I caught most of that. And the first question was regarding the restructuring payments and whether they relate to the TAM reduction.
FTE versus other.
And here is what it is. It's primarily FTE, but there is also some costs in there related to third-party payments on restructuring-type assistance, but the majority of it is going to be FTE.
And the majority of that has also been due to actions that we have already taken, right? So, a lot of the cash payments associated with that restructuring are from actions undertaken in 2018 as we exit the individuals and the associated payment terms associated with their contracts.
And could you repeat the second question?
The second question was the pension contribution do we expect to make it this year. I think the answer is yes. Unequivocally, we don't see any change to that. And then there's a third question related to the timing of the $20 million benefit that won't reoccur in 2019. What -- when will it happen?
Yes, most of that will happen in the third quarter. We had mark-to-market adjustments in all quarters of the year, but the compensation reversal was a third quarter event.
And so that $50 million pension contribution that's not included in the $130 million guidance?
When you say pension contribution I'm -- you were breaking up. I didn't hear the question, if you could ask it again.
I think last year, sort of, mid-year, you guided to $50 million contribution to pay down the pension deficit. I was wondering if that was included in the $130 million one-off costs for 2019.
So, any sort of pension contributions would be captured in the EBITDA number and so they would be fully reflected in our free cash flow outlook.
Yes, our pension contributions were minimal in 2019. Now, we did have a benefit from a German shift plan which would have been -- more -- would have been a benefit not a contribution, would have been in the third quarter, but pension contributions are not significant.
All right. Thanks.
Thank you. The final question will come from Matt Summerville with D.A. Davidson. Please go ahead.
Just a couple of follow-ups. First can you talk a little bit about the ROIC framework that you're putting in to the company Jeff as well as how management maybe incentivized around not only ROIC and potentially free cash going forward? So, talk about the management incentives as well as the ROIC framework please.
Yes, it's not in management incentive as of this point in time. Cash flows are in the management incentive. We're using it more as an educational tool at this point to push down within our organization, within things like our capital committee and so forth that we give a tool to people to understand how that is created.
And the framework is simple, right? We're taking non-GAAP, so adjusted operating profit. We're taxing affected -- affecting it for probably a conservative rate 30% a statutory rate, which is high for the entities we're in or the countries we're in but we feel it's the right number to use.
And we're just dividing by our fully affected invested capital, which is just a little over $2 billion. So if you do that you're going to generate mid-single digits for 2018. And, obviously, we have a relatively high weighted average cost of capital, especially since our interest is not deductible in the U.S. at this point in time. So it helps us provide targets for where we need to get the model. And when we look out in that 2021 time period, we hit to a point where we're creating real value for shareholders. So it's more of a tool to help guide as to what we need to do from a value creation perspective.
And then just as a follow-up, Gerrard you've talked about Windows 10 order activity over the course of 2018. Maybe just to use a baseball analogy where do you think we're at right now innings-wise in Windows 10 in the U.S. as well as Western Europe please?
Yeah, sure. The difficulty with that baseball analogy is just that one person's version of where they're in the six innings might be somebody else's version of the fourth innings. But if you'd just work within the framework of some margin of error there from my frame of reference in the U.S. we're likely in the let's call it the fifth to sixth innings, and I think we're in the roughly second innings in Europe.
Got it. Thank you guys.
Thank you. Speakers, I'll turn the conference back over to you.
Great. I want to thank everybody for joining us for the earnings call today. And if you have a follow-up please send an e-mail to our e-mail address at Investor Relations. Have a great day.
Thank you, everyone.
Thank you, ladies and gentlemen. This concludes today's event. You may now disconnect your lines.