Xylem Inc. (XYL) Q3 2019 Earnings Report, Transcript and Summary

Welcome to the Xylem Third Quarter 2019 Earnings Conference Call. At this time, all participants have been placed on a listen-only mode and the floor will be open for your questions following the presentation. [Operator Instructions] I would now like to turn the call over to Matt Latino, Senior Director of Investor Relations.

Thank you, Nicole. Good morning everyone, and welcome to Xylem's Third Quarter Earnings Conference Call. With me today are Chief Executive Officer, Patrick Decker and Chief Financial Officer, Mark Rajkowski. They will provide their perspective on Xylem's Third Quarter 2019 Results. Following our prepared remarks, we will address questions related to the information covered on the call. I will ask that you please keep to one question and a follow-up and then return to the queue. As a reminder, this call and our webcast are accompanied by a slide presentation available in the “Investors” section of our website at www.xylem.com. A replay of today's call will be available until midnight on November 30, 2019. Please note the replay number is 800-585-8367, and the confirmation code is 8669179. Additionally, the call will be available for playback via the “Investors” section of our website under the heading “Investor Events”. Please turn to slide two. We will make some forward-looking statements on today's call, including references to future events or developments that we anticipate will or may occur in the future. These statements are subject to future risks and uncertainties, such as those factors described in Xylem's most recent annual report on Form 10-K and in subsequent reports filed with the SEC. Please note that the company undertakes no obligation to update any forward-looking statements publicly to reflect subsequent events or circumstances, and actual events or results could differ materially from those anticipated. Please turn to slide three. We have provided you with a summary of our key performance metrics, including both GAAP and non-GAAP metrics. For the purposes of today's call, all references will be on an adjusted basis unless otherwise indicated, and non-GAAP financials have been reconciled for you and are included in the appendix section of the presentation. Now, please turn to slide four, and I will turn the call over to our CEO, Patrick Decker.

Thanks Matt. Good morning everyone. Thank you for joining us today to discuss our third quarter results. As you will have seen from our release this morning, we delivered a solid quarter of earnings performance and continued margin expansion. Year-over-year earnings-per-share growth, excluding FX impact, was in line with our expectation and represented an attractive year-on-year increase. Margin expansion was quite strong at the top-end of our guidance – reflecting discipline cost management, productivity gains and pricing, and free cash flow conversion was particularly strong in the quarter. However, in our end markets, we saw softer conditions than anticipated, and that's clearly reflected in the quarter's revenue performance – which came in below expectations. Utilities demand remains solid globally, and we saw good performance across the portfolio which delivered organic revenue growth in the mid-single-digits, as expected. However, we also saw a quicker-than-expected softening in our industrial and commercial demand, reflecting some uncertainties in these markets. In particular, there was a deceleration in the short-cycle part of our U.S. business. That slowed-down was both more sudden and deeper than expected pulling overall revenue growth below our expectations for the quarter. We expect this softness will persist through Q4 as a tight labor market continues to push back project timings and uncertainty around some industrial markets impact CapEx spend. Therefore, weaker near-term market outlooks have caused us to lower our full year guidance. Despite that moderation in industrial and commercial demand, we have nevertheless continued to make progress on both productivity and price. And that operational discipline enabled us to deliver on earnings and bring in margins at the higher end of our guidance. Exiting Q3, we had strong bidding pipelines and shippable backlogs beyond 2019. So, we continued to see solid growth and margin expansion potential through 2020 and into the long-term. Looking at our regional mix, we saw strong North American utilities performance and robust emerging market growth. In the U.S., the short-cycle softness I just mentioned held back our growth here overall, but growth in utilities was steady at 5%. Our investments in emerging markets continue to bear fruit. India, one of our fastest growing markets, delivered 28% organic revenue growth year-to-date. China also turned in a performance of double-digits orders growth in the quarter, giving a year-to-date orders and revenue growth in the double-digits. And Europe grew slightly better than expectations in the quarter in the low-single-digits. Mark will take us into the segment detail shortly, but I want to take a moment to provide an update on our AIA business, where we took a non-cash impairment charge in the quarter. AIA's recent commercial momentum has been quite robust. Orders grew more than 80% in the quarter, and organic revenue grew by double-digits. The size and incremental margin profile of this business continues to be extremely attractive and accretive to Xylem. All of which is a say that our growth thesis to the business has not changed. That said, the revenue ramp we are now seeing has taken longer to accelerate than we originally anticipated. As we continue to invest in the business, orders to sales conversion has been slower than expected, moving cash returns at the right – something we discussed in detail last quarter. That extended timing of cash returns required an impairment charge against goodwill, in accordance with the accounting guidelines. However, while the early phase of revenue growth lagged expectations, the orders, sales and backlog growth we are now seeing is strong evidence of a utilities market embracing digital transformation at an increasing pace. We are now beginning to see customers adapt several disruptive technologies at once, in order to get the full benefit of transformation, which creates pull-through across our entire portfolio. In India for example, we are deploying AIA's applications together with pumping solutions, sensor and measurement technologies, and other Xylem services, working across the portfolio to deliver our largest digital transformation project in India to-date. Increasingly, we are also seeing the benefit of integrating our AIA expertise with our commercial teams to take these solutions into customers. In Kansas, for example, AIA collaborated with our dewatering sales team to win a large robotic condition assessment project, which will provide data driven insights to reduce our customers' capital investment requirements. These are just two of many examples of the kinds of deals we're seeing as the market embraces digital transformation. Now with that, I'll turn over to Mark who will review our results by segment on slide 6.

Thanks, Patrick. Water Infrastructure organic revenue grew 1% in the quarter, and was below our expectations due to a sudden and sharp decline in our short-cycle dewatering business. The decline in this business impacted segment growth by more than 200 basis points in the quarter. Organic orders grew 12%, and our total segment backlog continued to grow. It was also up 12% year-over-year. The strength in orders and backlog was driven by project winds in our utilities business. Q4 shippable backlogs are up 3% year-over-year despite the order declines in our industrial markets. Geographically, the U.S. Water Infrastructure business was up 1%. This was below expectations, with solid utilities growth being largely offset by the unexpected mid-single-digit declines we saw in our dewatering business. The Dewatering business was most significantly impacted by a double-digit decline in equipment sales to our distributors, who largely serve the oil and gas, mining and construction markets. These declines were partially offset by mid-single-digit growth in our rental services business. Based on feedback we're getting from our distributors and direct customers, we expect the softness in equipment sales into these industrial verticals to continue into the fourth quarter. In this month, we've seen some slowing in our higher-margin rental business serving these industrial verticals, as well. These recent trends are having a significant impact on the segment’s outlook for fourth quarter revenue growth in margins. Our Water Infrastructure business in U.S. utilities continues to perform well, growing 4% in the quarter. However, we are seeing some delays in projects due to labor shortages and inflation in some markets. While emerging markets growth in Water Infrastructure was flat in Q3, it was lapping 23% organic revenue growth in last year's third quarter. The segment’s emerging markets business continues to perform very well overall, and grew orders by double-digits. Western Europe was up 2% overall and slightly better than our expectations. We continue to experience mixed performance across Europe with utilities fairly stable, but with some softness in industrial markets. Segment operating margins grew 40 basis points to 19.6%, driven by our team's continued good work on price realization in productivity. This more than offset the impact of inflation, lower volumes and a weaker mix of higher margin dewatering revenues. Please turn to Slide 7. The Applied Water Systems segment delivered 1% organic revenue and orders growth in the quarter. This was below our expectations due to softer demand leading to volume declines in both the industrial and commercial building services markets. Higher price realization more than offset lower volumes in these markets. This also reduced the segment’s total backlog which declined 3% percent year-over-year. Growth in the segment was led by continuing strength in emerging markets, with double-digit growth in China, India and Eastern Europe. This was largely driven by strong growth in the commercial building services market. The U.S. was flat with softening demand in the short-cycle portions of the segment’s industrial end-markets. Also, commercial building services revenues declined mid-single-digits against a tough comparison of 12% growth in 2018. And while we continue to see good pace in quoting activity in our commercial business, we experienced a number of project delays in the quarter largely due to construction labor shortages in several markets – which we see as a sign of improving demand over the medium term. Residential had a good quarter, with 4% growth overall, led by 8% growth in the U.S. Western European revenues declined 6% in the quarter as demand further softened in the commercial and residential markets. Our teams did a nice job of managing through tougher-than-anticipated market conditions, and were able to expand margins 90 basis points in the quarter to 17%. Execution and productivity programs and continued price realization more than offset inflation and a weaker revenue mix due to lower U.S. commercial and industrial volumes. Now please turn to slide 8. The Measurement and Control Solutions segment delivered 8% organic revenue growth in the quarter. Organic orders growth declined 11%, but that's against a tough comparison to last year's third quarter when we had 31% organic orders growth driven by a few large project wins. Total M&CS segment backlog grew 10% giving us continued confidence in the segments outlook from next year and beyond. The M&CS water business continue to be the primary growth driver for the segment up 15% in the quarter, energy grew 3% and the test business grew low-single-digits. Sensus in particular had a strong quarter growing organic revenue 10% led by double-digit growth in its water business. Sensus delivered 5% growth in the U.S., led by 9% growth in water, partially moderated by lower growth in energy applications as we lap the large Alliant electric meter deployment. Our teams have done excellent work expanding our metrology business internationally, where the water business grew roughly 30% in the quarter. We are clearly seeing the benefits of leveraging the global Xylem network, and this will be an increasing source of revenue growth in the fourth quarter and beyond. We're also pleased with the strong commercial momentum we saw during the quarter across our AIA platform. In addition to double-digit revenue growth, we had a meaningful acceleration in the conversion of pipeline opportunities, resulting in year-over-year orders growth of more than 80%, while also replenishing the pipeline, which continued to grow strong double-digits in the quarter. For the segment overall, operating margins expanded 50 basis points to 10%, which is in line with our expectations. Volume and price gains plus 340 basis points in productivity more than offset moderating inflation and growth investments. Please turn to Slide 9. Our cash balance grew to over $450 million in Q3. During the quarter, we returned $44 million to our shareholders through dividends. We invested $46 million in CapEx, reflecting the expected moderating spend in the second half of the year, and tracking to our full year CapEx forecast of $235 million to $240 million. Our working capital in the third quarter increased 80 basis points year-over-year to 20.6%, reflecting both the impact of last year's fourth quarter inventory build, which we will burn off in this year's fourth quarter as well as timing of receivables collections. Free cash flow increased almost 60% year-over-year and free cash flow conversion in the quarter was 162% improving substantially over the prior year and quarter sequentially. This was primarily driven by an improvement in working capital levels due to better inventory management, lower CapEx spend and lower contributions to our pension plans. We remain fully committed to meeting our target of 105% free cash flow conversion for the full year. Please turn to Slide 10 and Patrick will cover our 2019 and market outlook.

Thanks, Mark. So, based on some of the market dynamics we discussed earlier, we've updated our full-year end-market guidance. In the Utilities market, we're tightening our outlook to mid-single-digit growth. Our backlogs are healthy, indicating steady underlying demand growth, but that is offset somewhat by project timing effects. In Industrial, we now expect flattish growth versus last year, down slightly from our previous low-single-digit expectations. We foresee the acceleration we experienced in the third quarter persisting into the fourth. We're also still seeing mixed economic conditions across geographies, including areas of Western Europe and parts of Emerging Markets. Our outlook for the Commercial market is low- to mid-single-digit growth. The U.S. Commercial market in particular is likely to continue showing moderation to the fourth quarter due to project delays caused by a tight labor market. Our Residential outlook remains at flat to low-single-digit growth. Please turn to Slide 11 and we'll provide guidance for the remainder of 2019. Despite steady top-line growth in utility sector, we are lowering our overall organic revenue guidance to between 3% and 4% for the full year. And we're adjusting our operating margin expectations downward. Two factors are driving this change in outlook. First, the impact of lower-than-expected volumes in our high-margin short cycle businesses, particularly in industrial and commercial. And second, the impact of project timing and our high margin AIA digital solutions business. For these reasons, we are adjusting our operating margin expectations to a range of between 13.8% and 14%. This represents an operating margin expansion of 10 to 30 basis points and EBITDA margin expansion of 10 to 20 basis points for the year. Moving on to earnings-per-share, we're adjusting our outlook to a range of $3.01 to $3.03 representing year-over-year growth of between 7% and 8% excluding FX translation. Let me now turn it back over to Mark to walk through some of the detail on that guidance.

Thanks, Patrick. Slide 12, typically includes a seasonal profile of revenues and earnings by quarter. However, given the expected slowdown in our Q4 revenue growth outlook, we've seen a meaningful change this year in the historical profile of our quarterly revenue and earnings. So, I'll take a moment to walk through the changes in our revenue expectation from our last earnings call to our current outlook and the impact on our fourth quarter implied margins in EPS. At the end of last quarter, we expected approximately 5% organic revenue growth roughly 180 basis points margin expansion and earnings-per-share of approximately $1.02. Given significant changes in the market dynamic we saw in Q3 and continuing into Q4, we've moderated our expectations for revenue growth. And therefore, margin expansion in EPS as well. There are two factors impacting our new guidance. First, the softer-than-expected demand in our short-cycle businesses in the U.S. has significantly impacted our volume growth. And while we're entering the fourth quarter with healthy shippable backlog, based on current order trends, we expect to book and ship revenues for our short cycle businesses in the U.S. to decline in the quarter. Overall, we expect this will have a 300 basis point impact on organic revenue growth and a 90 basis point impact on margin, applying our typical fourth quarter incremental margin rate of 35%. Second, we're being impacted by weaker margin mix as we expect to have lower revenues from our highest margin businesses, which deliver well above our average Xylem incremental margins, particularly our dewatering rental and AIA businesses. This mix effect further impacts margins by about 60 basis points. Together, these changes have lowered our margin expectations to a range of 15.3% to 15.5% representing a 20 to 40 basis point expansion versus the prior year. While there is modest negative impact expected from foreign exchange headwind, this is largely offset by lower interest expense bringing our updated earnings per share expectations to a range of $0.88 to $0.90 for the fourth quarter. These changes in our full year revenue outlook for the company are also broken down by segment as shown on the slide. Just a couple of other items to note, we're maintaining our full year estimated effective tax rate at 19%. And we are adjusting our full-year Euro rate slightly downward to $1.11. Our FX sensitivity table is located in the appendix. Finally, we're increasing the full-year estimate for restructuring and realignment cost to a range of $75 million to $85 million. This reflects the cost of additional actions we took during the third quarter to optimize the Sensus European manufacturing and commercial operations to better support our customers and improve profitability. Savings from these actions will begin to materialize in 2020, with a long-term run rate benefit of $13 million. Now please turn to Slide 13, and I will turn the call back over to Patrick for closing comments.

So, to wrap-up, clearly the sudden and pronounced slowing in our industrial and commercial end-markets has presented some near-term challenges putting pressure on margins in our short-cycle businesses. And based on our current assessment, we expect some of that market uncertainty to continue through the balance of this year. But, our teams have responded to those challenges with disciplined operational execution, enabling us to deliver both earnings and margin expansion. Their actions in the face of evolving market conditions enabled us to meet some of our most important commitments. We have the advantage of an extremely strong portfolio of market-leading products. And we built on that foundation with genuinely disruptive digital technologies – giving us momentum as the sector embraces digital transformation. That strong market position is particularly reflected in our utilities growth, which continues at a steady pace across both Water Infrastructure and Measurement and Control Solutions. Notably, our Sensus business is delivering very healthy growth and our AIA portfolio is ramping quickly, creating a leadership position for Xylem as digital adoption accelerates across both the clean water and wastewater sides of our utility customers. And our investments in emerging markets are also delivering impressive growth in both orders and revenues, all of which gets competence in the medium and longer term growth profile of our business despite near term headwind. We have a resilient business that will continue to expand margins at attractive rate and will deliver strong cash generation alongside sustainable mid-single-digit growth over the long-term. We look forward to you joining us at our 2020 Investor Day to hear more about our strategy, our long-term targets and growth profile. And I'm pleased to announce the date of our Investor Day will be in the spring on March 31, when we’ll gather in Atlanta, Georgia at our Data Analytics Center of Excellence. And I look forward to hosting as many of you there as possible then. With that operator, we're now happy to take questions.

[Operator Instructions] Thank you. Our first question is coming from the line of Deane Dray with RBC Capital Markets.

Thank you. Good morning everyone. Hey. Maybe we start with the making sure we've calibrated which businesses are feeling most of the slowdown, and then -- frankly, we're just seeing this everywhere across the industrials – with industrial, commercial short-cycle weakness including oil and gas. So, Godwin, by our calculations, that's about 8% of total revenues and last calibrated their total Xylem oil and gas was about 5%. So, what else within Godwin – maybe it's the construction markets are soft there. So just – are those the right numbers, and then what kinds of end markets and activities are you seeing reduced in terms of demand here?

Yeah. So, Godwin would be a little bit more – a little bit higher percentage, maybe 10%. And, to your point, Deane, oil and gas is – it's not a big piece of it, maybe 4%, 5%. But what we saw in the quarter was a big slowdown in sales into our distributors, and they are heavily oriented towards oil and gas, but also mining, construction. So, that was really where we felt it the most. Rental was still pretty solid, up mid-single-digits. But as we work through the first part here of October, we have seen downward trends in our rental business as well. And it's – a lot of it is – we believe just a function of what is some slowing CapEx spend in the broader industrial space.

On the distributors -- and this is again common with other industrial levered companies -- are your distributors destocking as near as you can tell? Do you have a sense of the sell-in versus sell-through?

Yeah. Our sense, Deane, in speaking with the distributors is it's less of a destocking, and it's really more of just holding back on further investment. Just given the uncertainty and the CapEx budget they're selling into. They're still somewhat confident around bidding activity and things that are out there, but it's such a short-cycle business for them that there has been… They're being conservative right now. It's hard to tell how long that lasts through the quarter. Right now, we're saying we assume it last that Q4. We'll know more about how far it goes into 2020 I'd say over the next couple months.

Early results in October are fairly consistent with what we saw in the third quarter as well on the distributor side.

Got it. That's really helpful. And then on the AIA, does new orders at more than 80%, that's impressive. And it just seems so, yeah, the timing of this seems a little inconsistent that you're also taking an impairment -- and I know the impairment is more backward looking-- but the idea here, is that on the impairment… is that related to the pure technologies? And just give us a sense is it – was it the timing, cash was the factor but some more color there would be helpful.

Yes. So Dean, this is Patrick. So, it is largely Pure, and it is largely a function of us having had more aggressive assumptions around how quickly: one, we would get some of the synergy benefits of that integration. It is also some of the other digital solutions that we brought onboard because the goodwill had to be looked at across the entire platform. And the reality is even though we are seeing good momentum here, it was short of what our original assumptions were. Even though we're now gaining the momentum that we had originally expected, the timing was delayed of what was originally assumed in the deal financials. And so, following accounting guidelines, we were required to take an impairment in the quarter, but I think it's important for people to read through and pick up on the comment you're making, and that is what we're seeing in terms of the bidding activity at this point in time. We talked about 60% increase in the bidding pipeline last quarter. We saw continued growth in the pipeline this past quarter. And then it really is punctuated with the nearly 85% orders growth in the quarter and double-digit revenue growth. So, look, we… disappointing, it took longer to get ramped up than we expected, but we feel we're in a much stronger position now than we were even a quarter ago.

Great. Just last question for me, just if we could get some more context or color within that 85% order growth. I just want to make sure those are just like pilot programs, but is there some real substance around them? And then related, there was news that you all had a successful non-revenue water project in China – in Shanghai. We learned about that at the WEFTEC Program Trade Show, and can you give us some color around that as well? Thanks.

Yeah. Sure, Deane. So, yeah, the orders in Q3 of north of 80% are not just a whole bunch of pilots. I mean this is substantive business that we're getting. We still do pilots. Many times, utilities in order to get through their procurement processes which is three bids and a buy, and oftentimes there aren't two other bids to be had. Given the newness of the technology, they need to go through a pilot to be able to demonstrate proprietary nature of what we're doing. And so, the reality is we do see some of that pilot activity, but the large majority of the orders that we had here were actually in the Pure piece of AIA. The second part of your question -- which was the non-revenue water win in China. We're now seeing a number of these tenders coming out where the utilities are -- especially the more thought-leading utilities -- are not looking at this as: Well, let's do a leak detection project, or Let's do a metering project. They're looking at and saying: We don't necessarily know which of these levers are going to improve our non-revenue water issue the most. And so, the reality is, they're going out now and saying: Let's do a tender to bring someone in to look at our pipeline overall and determine where are the losses coming from. And, therefore, how do we optimize that deployment. So, this was… the one specifically in China was driven, predominantly, by our Visenti leak detection capabilities, but it pulls through other parts of the business. And it was a non-revenue water project that we're doing across several districts in Shanghai. And so, we're very encouraged by that because the more we get these, Deane -- as you can appreciate -- the more reference wins we have for other utilities around the world, and that's what we're seeing happening right now. It just takes momentum.

Thank you.

Thank you.

The next question comes from the line of Scott Davis with Melius Research.

Good morning guys. I imagine you guys and Deane would be a lot of fun at a cocktail party talking about…

…we would.

Yeah. I love you both. But yes, it's fun. Anyways, I had to pick on him. I love Deane. Anyways, I want to take a step backwards because I'm not really in the nitty-gritty here, but the… how much visibility do you guys have when you look out to like 2020 on the China infrastructure spend? I mean given the five-year planning cycles -- did they give you pretty good visibility on that kind of stuff, or you walking into each quarter just kind of waiting for the phone to ring. How does that work?

Yes. It's a great question, Scott. I think let me start from the top and say roughly two-thirds… a little more than two-thirds of our business in China is in the utility sector, and the remainder is in commercial buildings and industrial for the most part. I would say on the commercial and industrial piece: that is a short cycle business, not very much different from what we see in the rest of world. But for that little north of two-thirds of our business in China, it is very much long visibility... It's long lead time… It's heavy CapEx. It's very heavily oriented towards treatment. And so we have good visibility into that bidding pipeline and our conversion and win rate so… and that very much is tied to the fact that this is a central government led kind of mandate around clean water and environmental pickup and it is part of a kind of rolling five-year plan. So, that part, I would say, of our business, we've got some of the greatest visibility going into 2020. And of course, we're also now seeing the increased appetite to implement some of these digital solutions that we're talking about around non-revenue water, etcetera, which gives us greater confidence.

Okay. That's really helpful. And I'm fascinated by this whole labor shortage thing and it just seems so strange… the Fed’s cutting rates and everybody is starting to worry about the macro in such an extreme, but is it skilled labor or non-skilled labor? Is there some sort of dynamic that's changed meaningfully in the last years as it relates to people that can actually execute on these projects?

Yeah. We're seeing it largely as non-skilled labor, particularly in the construction areas and kind of short project businesses, where a lot of this, also, is where they oftentimes rely on temporary labor. And the temporary labor market has really tightened up at this point in time. And I know even yesterday, I think the Fed chair talked about tightening labor markets despite the discussion around softening or lessening interest rates. So, we saw that on the commercial side of the business. We think it's transitory because we still see strong quoting activity. And this is feedback we're getting from our channel partners where we rely heavily on our indirect channel for this market in the U.S. It is a US-specific issue that we're seeing. And what we're also seeing is show up, Scott, to a lesser extent, but we talk about project delays and utilities even though we've got strong growth there. We are seeing some projects being delayed through our engineering consulting firms whereby their initial budgetary quotes are coming in well above what the utilities have been expecting. So, they're pushing back on them to go back and reengineer the quote. The projects will still go through. We still see them as bidding pipeline, but we're also seeing that little bit of an air pocket as people go back and have to kind of redo their budget assumptions on some of these projects due to higher labor cost.

That's amazing. Okay. Thanks for color guys. Good luck to you.

The next question comes from the line of Nathan Jones with Stifel.

Good morning, everyone. I'd like to follow up on the goodwill write-down first in Pure. I think you've explained pretty thoroughly that things haven't ramped up here as fast as you'd anticipated. You've had Pure for about a year-and-a-half now. Maybe you could comment on the changes in your view of where you end up in the long term rather than whatever happened here in the short term. After a year-and-a-half of having that and putting together this AIA platform, have your expectations for the long-term revenue potential out of this platform increased, decreased, stayed the same?

Yeah. I would say, Nate, a very good question and appropriate one obviously. Our view over the long term -- and I would even say now over the near and medium term, as we stand here today -- things remain unchanged from our original assumption. It just took us longer to get the ramp going than what was originally assumed. And so, if I look at what parts or what aspects of AIA broadly -- because we really are looking now at its AIA broadly rather than just Pure, and quite frankly, we're now looking at it in terms of the broader impact and pull-through potential for Xylem in terms of really deploying these digital solutions and new technologies, hence, the reference to the win in China, the win in India, the win in Kansas, these are pull-through opportunities for also the rest of the company. I would say we feel as good if not better about that potential and opportunity than we did at the time that we built this platform. I would say… what have we learned? I think what we've learned -- and what I certainly personally learned -- is that the conversion cycle for the utilities has simply been longer than we had originally anticipated. In some cases, the sale cycle has been up to a year on the digital solutions because of the need to run pilots, the procurement process that I talked about earlier. And just the fact that this is… we're bringing disruptive solutions to a sector, and what I've certainly learned, as well, is that this is not going to be a straight line. Disruption is never a straight line. So, it's taken longer than we had originally anticipated. But we feel very good about where we are now, and I'm very proud of what the team's doing.

Water utilities are well known for their pace of adoption of new technologies. Maybe just talking a little bit more about this China project. You said it was largely Visenti that won that project. Visenti has been a pretty small business, and you talked there about the ability to pull through technologies from the other parts of the business. So, maybe you could talk about whether it's just this specific project or a more general… kind of what are the content non-revenue water project won by Visenti can pull through for the rest of Xylem?

Sure, yeah, it's a great question. And China is just one example, we've got a number of these examples around the world. And what we're really talking about here is… Visenti just happened to be one of our number of digital solutions whereby, in this case, it happens to be a specific type of leak detection capability. They were able to go in and -- in this but other examples as well… India, Australia, we've got an example here in the US -- where they were able to go in and start off. They were the ones that opened the door… where the customer looks at this as my non-revenue water issue is: I’ve got to solve leaks. But as the team goes in and assesses the situation, they see a bigger opportunity than just doing a leak detection opportunity. It can flow into the fact that there may be a metering need… a metering opportunity. There may be a metering replacement opportunity that we pull through one of our other capabilities. It could be… it can be of a range of things that happen. It's no different than whenever, our EmNet team goes in and our team applies that EmNet technology around storm water overflow or combined sewer overflows. There's the project around doing… getting the data and doing the analysis. And that might be an ongoing SaaS contract. But there are just as many opportunities to then go in and say: Hey, there's a problem in the treatment plan.There's a problem in the wastewater pumping network. That can then pull through our Flygt submersible wastewater pumps into that. So, there are a number of examples where one of our digital solutions are applied. They get the signature win, but they pull through the rest of the business. And then other revenues not showing up in AIA. It's showing up in our other… at our other segments.

Yeah. One quick one on industrial. We talked a lot about the drop in industrial demand here related a lot to de- watering, related to heavy industry oil and gas that kind of stuff. The light industrial business is supposed to be a lot more stable and a lot less subject to these kinds of rapid fluctuations. Can you talk about light industrial during 3Q and your outlook for light industrial in 4Q?

Yeah. Nate, we… you're right with that observation. Nevertheless, we did see decelerating order growth in our lighter industrial applications. A lot of that being in our Applied Water segment. So just like we're seeing in general CapEx spend, OEMs are just a little bit more cautious in some of their spend, and we're… our order trends are down and we expect it to be flattish, maybe down low-single digit, going into the fourth quarter. It's… and I think some of it is just general… just general concerns and then managing their operating budgets.

Yeah. I mean I think Nate the… our comments in the past, I wouldn't want them to be interpreted as a “every single quarter”. I think our view is over the course of any given year. That whole sector of light industrial typically is in that low single digit. That's what we're seeing. Certainly when the year said and done as we look ahead to next year, we still expect that to be generally in line with GDP growth. But there can't be a quarter here or there where you get some skittishness on the part of our distributors to hold back a little bit. We also… in the quarter and even to the second half we had a pretty tough comp versus last year. I mean we were up I think close to 9% last year in the quarter so that we didn't kind of call that out and our comments but that's an important point to make here.

Okay. Thanks very much for taking my questions. I'll pass it on.

The next question comes from line of John Walsh with Credit Suisse.

Hi. Good morning. Just wanted to kind of go back to thinking about calibrating the forward look here and obviously, you remain very confident in your mid-single-digit organic growth going forward. This sounds cyclical on some of these pressures that you're feeling. So, there'll be transitory and I think, as Deane alluded to, most companies are feeling this, but consensus does have 5%. I know it's early to kind of be putting point estimates down for next year, but how would you think given this kind of short cycle pressure feeling in the backlog, what kind of visibility do you have to actually put a potential range out there for next year?

Sure, John. So, yeah, I'm into your point. Obviously, it's early for us to really be giving any specific guide -- and we will give a full guide with our Q4 earnings report early next year. I would say we look at it really in a few different dimensions. First of all, and I think to your point most importantly here, we feel good about the steady growth in utilities, most notably within our MC&S segment as well as that part of the Water Infrastructure business where shippable backlog in 2020 is up high-single-digits in both of those segments. We think China and India still have a lot of runway based upon building activity of backlog we see there, and we are seeing our AMI metering project deployments ramping up in 2020. And then, lastly, the conversion of the AIA funnel we expect to be ramping up in 2020 and beyond as well. Having said all that to your point, we do have a somewhat of a cyclical downturn here right now in our commercial and industrial businesses, and we're not going to try to prognosticate here in terms of what… how long that's going to roll. We'll have a better feel for that, I'm sure, as we get through the end of Q4. But that uncertainly in my view probably will linger through certainly the first half of the year and the fact that we had some tough comps that we're going to be lapping. I mean again first half of this year, Industrial was up 3%. Not a lot to write home about, but… about where it normally is, but Commercial was up 9% in the first half. So, we're going to have a little bit of tough comp in the first half. The last thing I would say is… but we continue to be confident in our margin expansion, and we still have meaningful productivity opportunities out there. We've talked before about the mix of MC&S coming to our favor now given the heavy water project rollout there, and also the continued strong performance in Water Infrastructure from a margin standpoint.

Can we have the next question please?

Next question comes from the line of Brian Lee with Goldman Sachs.

Hey guys. Good morning. Maybe to jump off of that topic, Patrick, since you bring up the productivity, 400 basis points, or so, I think it was the best you've seen year-to-date. And then on the flipside, volume mix was maybe a bit worse than you've been tracking at. So, two questions here. Can you maybe talk to the puts and takes here you know this is the near-term trend we should be expecting going forward for these margin drivers. And then second question, just given the additional reset in operating margins here for fiscal 2019. I'm wondering if the 100 basis point expansion view that you outlined earlier in the year for 2020. Is that still intact or should we be anticipating an update to that as well? Thanks, guys.

Let me let me take the first part of that question relative to some of what we saw on third quarter. I mentioned in my prepared remarks the teams really did a nice job continuing to drive productivity. We continue to find places to take out our costs in our manufacturing supply chain operations. And as you'll recall, we did take some restructuring actions as well in the first part of this year that's really starting to ramp up in Q3. We expect that to continue into Q4 as well. And we've seen, as we expected, some moderating inflation in the third quarter as well, certainly in our M&CS segment as expected as we lap some of those component shortages and some of the higher costs. We have to deal with some of the moves that we've made on addressed tariffs and also we saw a lower inflation in Applied Water for the third quarter as well, and we expect that to continue into the fourth quarter also.

And on your question around kind of looking at 2020 and the 100 basis points of margin expansion, I would say, Brian, of our view on that, as we sit here today, is that the productivity, the pricing piece, all the levers that we have in our control remain intact. And I think the big question in terms of what any kind of delta might be versus that is it all going to come down to what we believe our volume growth profile is going to be in 2020 relative to what we said before in terms of a mid- single digit. I'm not signaling anything there. I'm simply saying that will be the one factor that will make sure we get comfortable with it as we give a guide for 2020.

Okay, great. I appreciate the color. Thanks guys.

Your next question comes from the line of Saree Boroditsky with Jefferies.

Good morning. So, you remained pretty positive on the outlook for 2020 for MCS. And I guess, could you just comment on the visibility that you have into the project timing, and is there any risk that some of these projects get pushed out?

Sure. So, we've got… we've got pretty good visibility into the MCS segment based on our shippable backlog in 2020 and beyond. The shippable backlog in 2020 and beyond is quite healthy. I think we're looking at like 7% growth versus last year which is that was coming out of the quarter. We've got… there is a portion of that business that is day-to-day replacement meters. And so, I wouldn't want anybody to think that everything is locked in the bag base. It's not all large projects, but there is a meaningful piece of that business that definitely is. It's probably about half of the revenue for the segment is sitting in backlog right now, and that's pretty solid for any one of our businesses going in. I think secondly, what we're seeing there is just again good, healthy conversion to AMI, and those projects have very good returns on them economically, not just for us but for the utilities. That's why they make the investment. I'd say there's always a risk that depending up on what the broader economy was to do. If we were to go into a recessionary environment, then, of course, there's always some risk there that project can move to the right. But that's not historically been the case based upon the diligence that we've done. Lastly, although again it's only… it's right now only $120 million of business. Again, we were seeing good ramp up now in AIA which is very helpful in terms of helping spike that growth rate for the segment. And then the… lastly, what I would say is: we've integrated the AIA business and the Sensus business now into our commercial teams in Europe and emerging markets. And that's given the team already a bump up in increase in bidding pipeline and visibility into the market in terms of opportunities. And so, I do expect there to be opportunity there as well.

That's helpful. And considering your growth in Western Europe picked up slightly from last quarter just a little different from some of the macro trends. So, could you provide some color like on what you're seeing in that market?

Yeah, it did actually. It was actually a little bit better than we had seen in the first part of the year. A lot of that was driven by utilities and it was… we saw a relative strength low-single-digits plus in some parts of Europe. But it was it was fairly broad based and where we… where it wasn't as strong was on the industrial side but that was in the quarter probably one of the good surprises we had. And we expect… we are expecting that to continue into Q4.

I appreciate the color. Thank you.

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

Thanks for taking the questions. Given the industrial headwinds that we've been talking about for the past hour, I'm curious if the smaller more focused private players in your value chain are presumably feeling this to a greater extent. And if so, does this perhaps create an opportunity for you guys to kind of reaccelerate the M&A trend from several years ago?

That's a good question. I mean I think you know we remain disciplined on our approach to M&A. We do have a healthy pipeline right now of targets that we look at all different shapes and sizes. We haven't seen a meaningful move as of yet in terms of valuation expectations. But I do believe that could certainly change depending upon how prolonged the industrial commercial thing could be. But we'll play that by ear, we'll remain disciplined and our priorities remain unchanged. We've talked about before we think we have a really good platform in utilities at this point in time. So anything we do there would be more likely to continue tuck-ins and bolt-ons of digital solutions. And then the second – not even our second – our other biggest priority is building out a more robust industrial franchise. And so, we continue to look those opportunities, and, hopefully, some things will come along here, but we're going to be disciplined.

And then a follow-up on the balance sheet, your net-debt-to-cap went below 40% this quarter, the lowest level since before the Sensus acquisition. Are you pretty happy with where the leverage is at the moment?

Yeah, we are. I mean we had, post the Pure acquisition, gotten a little bit ahead of our target, but we knew we'd be able to bring that down relatively quickly. We have. And it was just this quarter, really, where we've seen really strong cash flow that we were pleased with. So, we're now moving it into our targeted range which is 2.5 to 3 times Moody's.

Got. Okay. Understood. Appreciate it guys.

The next question comes from the line of Joe Giordano with Cowen.

Hey guys. So, look, it's hard to give guidance. I think we all appreciate that. So, we've seen a couple cuts in a row. If you're looking at it just optically, it could look like it's a bit reactionary rather than anticipatory. So, I was wondering if you can kind of reconcile that with how you're actually learning the business internally. Like getting ahead of slowdowns in terms of restructuring actions and looking at cost structures. And have you feel like you've been a little bit faster to react on that part rather than maybe the publicly discussed numbers that are out there?

Yes. I think so Joe. It's a good and fair point to make. I mean, we do have – we do still have a meaningful part of our business, which is roughly somewhere probably between 40%, 45% especially non-utility that is short cycle business. And so, to your point that there are things obviously that we will get, we don't just kind of wing it and take a guess on outlooks and forecasts. The point is things can change quickly within a quarter. And that's what we saw in this quarter was things really change late in the quarter. And it happened pretty suddenly and through distribution, et cetera. So, I would say, had we not been anticipatory around that being a possibility then we would not have been able to pull the levers that we did to deliver on our EPS and at high end of our margin guidance in range for the quarter. Obviously, we're looking into Q4, and now even in 2020, there are other actions that we've taken both from a cost out, but also just leaning in even harder on productivity than otherwise anticipated. Lastly, I would say though we are… it's important that everyone knows that we have been focused also on preserving investments and the key elements of our portfolio, and will do so both in Q4, as well as going into 2020. That's an area that we do not want to be seen as being purely reactive to the near-term.

And we've talked about this as a team going into the beginning of this year relative to at some point the cycle will turn, we need to be prepared for that, and we... as every business has, there are opportunities for us to get more streamlined and leaner, and we've been doing that throughout the course of the year.

So, I think, Joe, the challenge that we've been facing near the end of this last quarter and through Q4, it's again really just getting as much visibility as possible into: Is this an air pocket commercial and industrial in the US?... for… and How long does that pocket run before you see some return to normalization? Because if it were not for this softness that we saw in this particular part of the business -- which does tend to be more cyclical, but it does rebound -- we saw very solid and strong growth in the rest of our portfolio in line with what we've been talking about both in the near-term and longer term.

Sure that makes sense. On AIA on the impairment, look, I get the… I think the portfolio that you're building there is interesting and it's unique and it's almost by definition going to take a long time to kind of figure this out with the market. But does this kind of development kind of change the way you think about how much to pay for smaller bolt-ons or maybe not real small bolt-ons but ones that have, like, some heft to them? Does it… do you have to like recalibrate what the appropriate multiple in some of those businesses are as you go forward?

I think it's… I think the most important thing, Joe, the way we look at it is I would say first of all I certainly wouldn't want to have any of these businesses in somebody else's hands. They need to be with Xylem. Okay. And as we… and I think that as we have integrated the ones that we now have over the course of the past number of months here – because, you know, we've only had the non-pure businesses, we've only had those over the course of the last year -- and so we've been integrating those as we speak. We've learned a lot during that timeframe. I've learned a lot by being out with a lot of customers and understanding even better kind of how they think now that we have C-suite level conversations because we have the credibility to go in and talk to customers at a broad enterprise level. That will certainly inform and educate as we look at any future bolt-on acquisitions both from evaluation standpoint. You're never going be able to perfectly time an acquisition and perfectly layer the price on what you're paying. It… you don't want to over pay, of course, and we'll always be discipline in that regard. So, those are our learning but no, we're not… we're not gun shy about going on and continue to build out this portfolio. Not at all.

That's fair. And just last one, I just want to sneak a last one here. As we get into like a slower kind of pocket in some of your cyclical businesses, your infrastructure segment has done a really nice job on margins. It's been a definitely a bright spot. What's the potential there? It's expanded a lot over the last couple of years. You've had good volume to help drive that. If you get into like a slower growth market, how much more potential is in that segment?

Yeah. Listen, the… there's always opportunity in it. It doesn't come just from cost cutting and more productivity. That's important and that we do that, and we'll continue to do that months in and months out. I think the other part of it is also continuing to innovate and bringing new leading edge products, solutions, into that form, to Patrick's point earlier. This whole notion of opening the door with our AIA platform and digital solutions in the pool and bringing new higher end pumps and equipment in aftermarket is… there's a lot of potential there relative to the margin profile.

Yeah. I think the.. I think the… beyond just normal volume-driven leverage and productivity that we get in any one of our businesses -- and certainly most notably in Water Infrastructure given our strong market position there in terms of leadership. That, by definition, draws through very strong incrementals when you've got growth even if it's slower growth. But I think the really big deal here is on the innovation side. The new product development pipeline, by definition, as we continue to grow that pipeline. I think right now, as a company, we're up to 25% in our vitality index. That's up from 22% in the first quarter. And so, there's a continued ramp there that we're seeing and that pipeline drove through it. In our experience, these products that not only grow faster or technology grow faster than the average but they bring with them higher margins than the average. And so, that's a very meaningful part here of the story across each one of the three segments including Water Infrastructure.

Great. Thanks guys.

The final question will come from the line of Walter Liptak with Seaport Global.

Good morning. So, my question is pretty quick and easy. I just wanted to drill into the M&CS business. You mentioned that the visibility is good. You've had nice backlogs, but I wonder if you could delineate that between water, gas and electric because it sounds like the water was strong this quarter and you've got some tough comps in some of the others. I wonder about the visibility for 2020 with that funnel for gas and electric.

Well, we had some big wins a year-and-a-half-ago that were electric, gas and they're starting to roll off and where we've seen good success recently both domestically and internationally is in our water business. So, most of that is on the water side.

Yeah. The good news is also we just launched a brand-new product in the energy side as well. So, we expect that to get momentum in the market. I think we just announced that a few days ago publicly. So, we still feel good about the electric-and-gas side of the market, but certainly we're very encouraged by the momentum we're seeing on the water side which brings with higher margins.

Okay. Got it. All right. Thank you very much. With no further questions, I'll hand the floor back to Patrick Decker for closing remarks.

Great. Thank you. So, thanks everybody for your time and attention this morning and patience – as we ran a little bit long here. Thanks for your continued support and interest and we look forward to seeing many of you out in the field. Otherwise, we'll be back in touch for our Q4 earnings call. Thank you all.

Thank you. This does conclude today's Xylem third quarter earnings conference call. Please disconnect your lines at this time and have a wonderful day.