Xylem Inc. (XYL) Q3 2012 Earnings Report, Transcript and Summary

Welcome to the Xylem Third Quarter 2012 Earnings Conference Call. Hosting the call today from Xylem's headquarters in White Plains, New York is Gretchen McClain, Xylem's President and Chief Executive Officer. She is joined by Michael Speetzen, Xylem's SVP and Chief Financial Officer. Today's call is being recorded and will be available for replay beginning at 12 p.m. Eastern Standard Time. [Operator Instructions] It is now my pleasure to turn the floor over to Phil De Sousa, Investor Relations Officer. You may begin.

Thank you, Brandy. Good morning, everyone, and welcome to Xylem's third quarter 2012 earnings conference call. With me today are Chief Executive Officer, Gretchen McClain; and Chief Financial Officer, Michael Speetzen. They'll provide their perspective on Xylem's third quarter results and full year outlook. Following their prepared remarks, we will address questions related to information covered on the call. [Operator Instructions] We anticipate that today's call will last approximately 1 hour. As a reminder, this call and our webcast are accompanied by a slide presentation available on the Investors section of our website at www.xyleminc.com. All references today will be on an adjusted basis, unless otherwise indicated. And non-GAAP financials are reconciled for you in the appendix section of the presentation. A replay of today's call will be available until Thursday, November 15 at 6 p.m. Please note the replay number is (404) 537-3406 and the confirmation code is 34764853. Additionally, the call will be available for playback via the Investors section of our website, under the heading Presentations. With that said, please turn to Slide 2. We will make some forward-looking statements on today's call, including references to future events or developments that we anticipate will or may occur in the future. These statements are subject to future risks and uncertainties, such as those outlined in Xylem's annual report on Form 10-K and those described in subsequent report that's filed with the SEC. These remarks constitute forward-looking statements for purposes of the Safe Harbor provision. Please note that the company undertakes no obligation to update such statements publicly to reflect subsequent events or circumstances, and actual results could differ materially from those anticipated. Now please turn to Slide 3, and I'll turn the call over to our CEO, Gretchen McClain.

Thank you, Phil. Good morning, everyone, and thank you for joining the call. We appreciate your interest in Xylem. Today is a special day for us as it marks our 1-year anniversary as a separately traded public company. As we were getting ready to celebrate this week, Hurricane Sandy hit the East Coast, leaving a path of devastation behind. I'm sure many of you and your families have been affected as many of our Xylem employees have been, so please know that our thoughts are with you. I'm always reminded in the aftermath of crisis situations such as this of the importance of the work we do. In many of the areas where flooding is a huge issue, Xylem is there with our equipment and with our expertise, helping to bring things back to normal as quickly as possible. As I reflect back over the past year and on our accomplishments, I'm proud of our team and how we've come together, staying focused on our customers, advancing our strategic initiatives, all while standing up a new company and in the face of some very difficult economic headwinds. This has been a challenging year by any standard, but a satisfying one as well. The team has sharpened its execution, tightened spending and continues to drive cost reductions to navigate through these challenging times, and as a result, our business operations continue to improve even with lower-than-anticipated revenues. But our journey has just begun. We are laying the path for growth with investments to provide customers with new products, services and solutions they're looking for. We're investing to expand geographically so we can reach our entire servable market and realize our full market share potential. And we continue to expand our portfolio with our disciplined acquisition process. And today, I'll highlight our…

Thanks, Gretchen. Please go to Slide 8. In the third quarter, Xylem revenues were $931 million, reflecting 3% growth on a constant currency basis. Organic revenue growth contributed 1 point to the total and acquisitions added another 2 points of growth. Foreign exchange translation was a headwind of 4 points. Let me provide you with some perspective of our third quarter revenue performance and how we see the remainder of the year by end market and by region. First, in our largest end market segment, industrial, organic revenue was down slightly year-over-year versus expectations of low-single digit growth. The North American region continues to be negatively impacted by dry weather conditions versus the prior-year period, which had seen double-digit growth in dewatering activities. European industrial market weakness continues for the second consecutive quarter. These results were partially offset by strength in mining, particularly in Latin America and South Africa. On a sequential basis, industrial declined low-single digits in the third quarter, driven by weakness in North America and Europe versus our previous expectation that these regions would be relatively flat. We now expect full year organic revenues for industrial to be flat to up low-single digits year-over-year. This range assumes fourth quarter revenues will be down low-single digits. We continue to see and expect resiliency out of the public utility market. Third quarter revenue was up high-single digits with growth coming across most regions, but generally in line with expectations and flat on a sequential basis. We expect second half 2012 revenue to be up low- to mid-single digits over the prior year. The timing of deliveries favorably impacted our third quarter performance and we expect fourth quarter revenue results to be down as a result of project deliveries in 2011. While bidding activity continues to improve, we continue to…

In summary, we had another strong quarter of operating performance. We are and will continue to position ourselves for long-term growth. By investing in our growth platforms, executing a disciplined acquisition strategy and advancing our geographic growth initiatives, I am confident we will deliver long-term growth and higher returns for our shareholders. We continue to launch new products and have the financial ability to continue to invest for future growth. And for our customer and operational excellence initiatives, we will continue to expand operating margins. And as I mentioned at the beginning of the call, we have a series of restructuring and realignment actions under way and are developing plans should the market deteriorate further. By making these difficult decisions today, we're preserving investment capabilities and defending and improving our competitive advantages. This will lead ultimately to higher levels of profitability. My last point, we're entering the fourth quarter and shortly thereafter, 2013, with a strong financial position and the flexibility to continue to execute our long-term strategy. With that, we'll be happy take your questions. Brandy?

[Operator Instructions] Your first question comes from the line of Deane Dray with Citi Research.

Just first question is regarding the impact of Hurricane Sandy. And of course, we're still early in the process, we understand, but from a disaster recovery standpoint, can you comment on any business interruptions that Xylem has had and then balance that with what are the opportunities for the company on the recovery process. Every time I heard you say low dewatering rentals in the quarter, I'm thinking that obviously you see the big reversal this quarter and even Heartland should participate as well. But if you just talk about what the opportunities are in residential, commercial, industrial and maybe comment on -- I heard on the radio that you all were shipping pumps on an emergency basis and you got a shout out, so maybe comment on that as well.

Sure, Dean. Let me talk about Sandy. In terms of your first question, interruptions to the business, I can't really comment right now. What we've been mostly focused on is making sure that we're deploying our equipment and we're trying to get expertise to those who obviously are in need at this time. We've shipped over 200 pumps into this whole North East region. And we have, I understand, another 100-some pumps and we also made sure that some pumps and if we're low on pumps, water system pumps are available to our channel and trying to help them as quickly as we can. So it's a horrible situation, but it's an opportunity for us to be able to engage with our expertise and our equipment. In terms of where we are with fourth quarter, as we're going into the fourth quarter, our orders are not where we want them to be, so this is an opportunity to backfill that. There will be some things that will be offset because things will be pushed to the right because of the disaster. So we'll kind of have to look at it through this quarter and into next -- and first of 2013 to see what the overall impact will be.

And then just as a follow-up, on your point about some of these order pushouts, maybe you can take us through the different markets, what types of pushouts are you seeing, on the muni side both in and on the industrial side? Are these pushouts as a result of funding issues or a lack of confidence in the outlook, the fiscal cliff and so forth, but a color on the motivation behind the pushouts and potential timing?

Yes, let me first start with industrial. I mean industrial, what we're seeing now is the capital expenditure being challenged. A lot of that's driven by the uncertainty in the economy, people holding back to see what happens here, so where we're seeing a significant part of project delays within the industrial side. As we've been talking about on the capital expenditure side on the public utilities, we saw nice orders in the second quarter. We've seen our bid activity in the third quarter increase. But again, we're not seeing the orders being released at the level that we would have anticipated. So that's the result of the CapEx in the public utilities being down. I don't think it's down any further. I think, right now, they're trying to determine which projects to let go out since they've got a backlog of activities. Commercial area, we saw the same thing in terms of capital expenditures pulling back, people pulling back because of the confidence in the region.

But no pullback on what would be the break-and-check side of your media business, which is about 70%? Is that still the aftermarket percentage?

Yes, I think our business in terms of operations, maintenance, repair, services has been robust, continues to be resilient in Europe, and our large installed base in those relationships we have with the customers continue to be strong.

Dean, I'll add our aftermarket services are up 4.5% through the first 3 quarters of the year as evidence of that.

Your next question comes from the line of Matt Summerville with KeyBanc.

This is Joe Radigan on for Matt. Just in terms of the bidding activity that you talked about, Gretchen, what are you seeing in terms of the pricing dynamic on that project side? Is it -- do you see folks chasing that business so it's getting more competitive pricewise? Or just given the pent-up demand now and as you project capacity out as some of these orders theoretically let in the future, is it actually firming up and getting better?

So I wouldn't say the competitive nature has gotten any worse. I really think there's a lot of activity. Of course, our customers are making sure they are looking at choices and getting options. But they're looking specifically on how to resolve the issues. And the bidding activities there, our funnel is as rich as it's been in quite some time. Now the question is a matter of getting those released and getting them actually turned into firm orders.

Okay. And then, if I could just -- a quick follow-up on Deane's first question around Sandy, how much do you typically bake into your guidance for severe weather cleanup? I mean, I know it's impossible to predict the number of storms and where they are geographically, but there is a hurricane season, so there's some regularity there. Can you just give some color on maybe more broadly your thought process on how much -- when you think about guidance and how you bake in that kind of unpredictability?

Yes, so in the third quarter, when you think of the dewatering business, third quarter is typically a large time for seasonal effects. You've got the storms, the hurricanes coming in. And we only saw Isaac this third quarter, part of the reason why our orders and sales are down in our dewatering business. Typically, you'll see 3 or 4 different types of storms and we would react appropriately. So you'll see that typically more so in the third quarter. Going into fourth quarter, you typically don't see that type of seasonality. So we try to factor in an average amount of storms. So in some cases, you'll be down; other cases, you can actually benefit from it like we saw the year before.

Your next question comes from the line of Kevin Maczka with BB&T Capital Markets. Kevin R. Maczka - BB&T Capital Markets, Research Division: A question on gross margin, obviously, very strong here at 40%, matching your long-term goal. It sounds like, Gretchen, from what you're describing in terms of your order cadence and initiating new restructuring, maybe the top line gets a bit more challenging here before it gets better. I'm just wondering on that gross margin line, can we sustain this type of level in that environment? Or was there anything unusual in terms of mix or one-offs that really helped profit up this quarter?

So I would comment just in general on how we're driving the growth margin. I mean, it's coming from several different things. One, we've been driving our commercial excellence activities, which is driving price and we're seeing nice price. We're also seeing the shift in our portfolio through the acquisitions that we've done. The other benefit is we're seeing the sales that we are getting from our new product launches and our new product launches have higher margins. And we're also, of course, doing a lot of the things I talked about in my opening statements, is a lot of activities and there are many of them around continued productivity in our factories, in our supply chain, sourcing and so forth that are giving us benefit. When I look forward and say what's in front of us, we still have a lot of work to do around product rationalization, which will continue to propel us in the future. But volume does have an impact and we're living right now in a low-growth environment and I don't see that changing anytime soon.

Your next question comes from the line of David Rose with Wedbush Securities.

A couple of questions. One is going back to an earlier question on sort of the read in terms of why are projects being delayed. Is there any commentary, as I understand part is fiscal cliff, any potentially election-related?

I can't comment on that. I just think it's the uncertainty in the market in general. I think in most of our customers, they've got constrained budgets, they're trying to make the choices in the public utilities. What they're trying to determine is which project do they let loose first before the other ones and so, they're going through that now, I think, on a daily basis.

Okay. So there's really not a sense in terms of does this go live in December or January or February? So there's no sense of timing?

No.

Okay. Secondly, if we could, going back to the notion of dewatering, clearly, you've benefited in the past by -- in the oil and gas shale plays as we've discussed, you're expanding into other markets. Can you discuss sort of the strategy in dewatering as it relates to both opportunities, risk management and working capital requirements? Clearly, you're going to have to step up inventories if you have a lot of storms. And as you go internationally, what sort of inventory will you have to have for emerging markets like China, et cetera?

Yes, so a great question. And just let me take a step back in terms of our dewatering strategy. The one thing we acquired when we acquired Godwin was a very good business model around 24/7, and -- in terms of being able rental and services with equipment not only for public utilities, but also in the industrial market being mining, whether it being shale, whether it be disaster-related activity, and most of that equipment can be deployed in multiple uses. So far, that's the positive part of it. Typically, in the U.S., you would typically see maybe the East Coast being a drought and the West Coast being wet or vice versa, and you typically wouldn't see the whole U.S. in a drought situation like we've seen this year. Typically, that will offset itself. One of the things we're trying to do with our dewatering strategy is to take that model and now take it geographically. And we've talked about expanding in Brazil. We've talked about expanding in other regions around the world. And we think that ultimately will allow us to better utilize our footprint, get maximum utilization in terms of our assets which, it is a costly model, but is a very profitable model when deployed appropriately.

Hey, David, the other thing I'd add is, we've mentioned before, we manage that business in a different manner just given the nature of the CapEx that's involved. And so for example, when we see lower volume rates, we dial back the investment because we're looking at utilization rates and return on assets. The other thing I'd point out is, given the nature of the equipment, it can be moved pretty easily between applications. So it can be moved from construction to municipal bypass relatively easily. So that allows us to get some efficiency, whether it's in the CapEx or the inventory that's used to support the equipment. So it's definitely an area that we watch very carefully. And as we go into new markets, we're very deliberate about how much investment we make and we monitor that closely against the utilization rates we have in the business.

So as the footprint expands, you'll probably see less volatility in top line in margins, I would take it?

That's one of the benefits from the global expansion, absolutely. That and the diverse end market exposure.

Your next question comes from the line of Chip Moore with Canaccord.

So back to Sandy, I guess once you get past sort of the immediate disaster recovery cleanup efforts, what does it look like longer term for you guys in terms of the infrastructure investments? What you see back with Katrina in New Orleans, is there any opportunity there for the rest of the portfolio?

The area that I'd say where we play is in building services, we will have a lot of businesses that we'll have to go back and retrofit some of their services, whether it be boilers, heating, ventilation, air conditioning and so forth, so there's opportunity in the future as that expands out. But that won't be the first need. Obviously, the first need will be the initial cleanup.

And then just as a follow-up, on the M&A side, clearly, the balance sheet is very strong. Can you just talk about the thought process, analytics, dewatering, where you're looking, what we should be looking for?

Yes, I'd just comment that we have a healthy pipeline. We have been continuing to work our -- the different candidates that we're cultivating. I feel very good about the process in which we are on. I'm very optimistic of what's in front of us. We continue to use the same process. First, start with our strategy. Our strategy has been to expand in these nice profitable growing areas like dewatering and analytics. We will see that continuing to play out. We'll continue to use our demonstrated process that we have and make sure that we're managing and integrating and getting the value out of the acquisitions that we've executed so far. So I see it as a ripe pipeline and an opportunity in front of us to continue to expand.

Your next question comes from the line of Ryan Connors with Janney Montgomery Scott.

I apologize if this has already been covered, we've been kind of shuttling between calls with Sandy-related conference call delays here. But pricing, I wonder if you could just talk a little bit about your strategic pricing initiative and the goals you've laid out for us there and how you believe the current environment and the book-to-bill kind of headwind you talked about, Gretchen, and how that impacts your short-term ability to meet the sort of guidance you've given us on pricing, annualized, through strategic pricing. And then just longer-term, update us on what kind of contribution you think pricing can make to the top line.

Yes. As we've talked about, we've said pricing, we'd like to be able to get 1 to 2 points from pricing each year. Our whole commercial excellence activity has really driven our whole strategy, our strategic pricing thought process and the actions that we're driving throughout the organization in a very positive way. As I mentioned, in third quarter, we've had 1.5% price after the first half of the year being 1.7%. Now we're going into the fourth quarter. It's going to trend downwards. We're wrapping around from some of the price actions we got from last year and we're also in a tough environment in terms of competitive nature with the low growth markets that we're living in. But that's not going to get -- make us step back. We believe we've got strong products, we've got a strong understanding of where we play. We've got a good discipline. We continue to look at our losses and our wins and readjust appropriately. So we think we've got the right position to go after price in the right strategic differentiated areas. In other areas where it make sense, we'll aggressively play so that we can make sure we don't lose market share.

Ryan, I'd add to what Gretchen said in the sense of the mechanics. One of the things we're doing is making sure that as we see price increases on the back end of the business, as I commented about the value gap, that those are being built into the pricing model. But I'd also point out, this pricing initiative is not a broad initiative in terms of the way we apply it. It's very targeted in terms of end markets and products. And it helps that we have such a healthy pipeline of new products, that gives us the ability to differentiate and get improved pricing in the marketplace. So I think Gretchen's absolutely right. We're going to continue to see headwinds given the economic environment, but we're pretty confident that we've got a good process in place to maximize our potential.

Great. And then just a kind of follow-on to that, I mean, one of the things we've been trying to figure out is whether there's been a change -- a sort of sea change in the public utility channel, in particular in terms of resistance to price increases and how hard utilities are sort of driving a bargain on pricing just given all that they've gone through from a financial standpoint the last couple of years. Any color you can provide on that would be helpful. I mean, do you sense any difference today versus 2 years ago? Even for your customers that are spending, do they have a more -- are they more sort of aggressive at the bargaining table than they used to be?

So let me address it from this perspective. I mean, we're seeing price in both our Water Infrastructure and our Applied Water. So we're seeing it both in the public utilities, as well as across our end markets. Your question around public utilities, and there's no question, they're challenged for -- to be able to do all the projects they want to do. Now the one thing is, their budget continues -- because tariffs still continue to go up, but they are -- the real strategy here in my mind is helping them understand how we can help them reduce their operating costs. That allows them to ultimately spend less in their maintenance and operations and be able to free up money to be able to put on their capital expenditures. So if you have the dialogue, you can demonstrate it in terms of the energy efficiency, cost of ownership. They're inclined to go after quality reliable parts because they're talking about water and wastewater that's critical for all of our health.

And then just a follow-up, lastly, to a prior question there on the M&A environment, there's been a lot of talk about the tax changes at the beginning of 2013 and how that's driving some smaller business owners to actually seek an exit prior to that. Is there any -- do you believe that could drive some deal activity for you all in the near term and then maybe a little bit of a fall-off in the first half of next year?

No, I wouldn't say that. I mean, when you look at our pipeline and what we're cultivating and working on, it's not driven by the need to tell a company because of tax reasons. It varies depending upon what the candidate is doing, if they need more investment in terms of their business, ultimately if they want, and they don't have something, a successor, to hand the business off to. Whether they'd like to be part of a bigger business that's focused around water, that has played to our advantage. So I wouldn't say it's the tax issue and things will fall off after next year.

Your next question comes from the line of Michael Halloran with Robert W. Baird. Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division: So orders were a little tougher in the quarter, but you talked encouragingly about bid activity improving sequentially here. Could you talk about the composition of that bid activity and if there's any inflection one way or another that's different from the broader trends you're seeing on the underlying order rates? In other words, any pockets where you're starting to see things get a little bit better from a quoting activity, but aren't seeing in your core numbers at this point?

Right now, I'd say the bidding activity across most of our end markets, both industrial and the public utilities, are probably the largest area. Industrial is encouraging to us. Again, we've not seen the release of it, but I'm encouraged when you think about where we played in our treatment business to be able to expand more in the industrial side. Our teams are going after a number of activities and I do believe they're going to break loose. It's just a matter of when. Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division: And then on the restructuring side of things, other than the ongoing initiatives you have in place to meet those long-term targets and just specifically focusing on some of the actions you're taking to respond to the shorter-term environment, any way to delineate, at least qualitatively, how much of that's more permanent in nature and how much of it is just the desire to flex up or to flex down to meet the demand levels?

Mike, I guess the way I'd answer that question is the restructuring, that $20 million that we're executing this year, the majority of that is permanent in nature. So we're taking the opportunity given the fact that we have a view that Europe's going to be a challenging market for the foreseeable future, that we'll be looking at restructure. You can see it in the payback, quite frankly, in terms of the payback being around 2 years, that we're taking some more difficult cuts that are going to position the business better for the long term and are more sustained in nature.

I would just add, when we think of Europe, and that's where the focus has been around, the restructuring, is really aligning ourselves as one Xylem team. I mean, we take -- we go to market in very different ways today. We have the opportunity to leverage our portfolio to position ourselves even more effectively with our customers. And so part of what we're doing is helping us get to our long-term strategies.

Your next question comes from the line of Brent Thielman and with D. A. Davidson. Brent Thielman - D.A. Davidson & Co., Research Division: It sounds like you've obviously talked about some continued order delays in treatment though the pipeline is getting larger. Are these projects in any specific region? And then it sounds like the private industrial treatment jobs are moving a little faster than the public utilities side. Did those jobs offer the same opportunities to leverage sort of other products in your portfolio as you'd see on the public utility side?

Yes, so let me just talk about the orders and so forth. I mean, geographically, U.S., there's a lot of bid activity. The emerging markets, there's significant activity. Europe's a little weaker from an activity base and that kind of plays with the economics we're seeing. I'd say a lot more of the projects are smaller in nature as they are compared to large in nature. And today, when we look at large projects, we look at the full capability of our portfolio and how we can bring that together where it makes sense.

Your final question comes from the line of Jim Krapfel with Morningstar.

What kind of returns on invested capital are you expecting out of your YSI and MJK acquisitions? And how have the acquisitions tracked relative to your original expectations?

Yes, Jim, we're actually going to spend some time in our Investor Day talking through the performance of the acquisitions, because it's an important part of the story that we have. But the criteria that we set out in clearly, YSI and the other acquisitions falling through, is we look for returns in the midteens. The way I would characterize the series of acquisitions that we've done, Godwin, Nova and a string of analytics deals, is they are outperforming our models despite the economic environment. And the reason that we do that is when we go through justifying the acquisition, we obviously don't load in all the expected synergies and then we obviously put more aggressive targets inside the business to ensure that we drive the growth. As we've talked in the past, we've got a pretty robust integration model where we're measuring the business against those original plans, meeting with a business in the initial 30, 60 and 90 days of the integration to make sure that gets integrated well and then doing periodic check-ins after that. So I would answer the question broadly, that they're performing better and we intend to get into that in a little bit more detail when we have our Investor Day next year.

And I'd say in both our dewatering and our analytics business, they're now becoming a large platform in which not only can we do -- continue to expand with acquisitions to expand them, but we also now have a core competence level to do organic growth. And so you've got the benefits of both.

Okay, and you mentioned that your acquisition pipeline is still pretty strong. Are you seeing anything to the size of what you did with the YSI?

Our approach has been a bolt-on strategy. But in our pipeline, we look at all sizes, all shapes and all regions. We'll continue to look at it from a strategic perspective and how that can help us accelerate our strategic vision. So again, mostly, a bolt-on strategy, but we don't preclude looking at larger acquisitions as well.

That was our final question and I'd now like to turn the floor back over to Gretchen for any closing remarks.

Yes, I'd just like to say thank you for your interest and your time this morning and really sharing our first year anniversary with us. As I mentioned, the business operations will continue to improve even with the lower anticipated revenues. We're aggressively positioning Xylem for the future with immediate [ph] actions that we've talked about this morning. And while we do that, we remain, of course, very focused on good earnings and solid cash flow. So again, thank you for your time. We appreciate your interest.

Thank you. This does conclude today's Xylem Third Quarter 2012 Earnings Conference Call. Please disconnect your lines at this time, and have a wonderful day.