Xylem Inc. (XYL) Q2 2013 Earnings Report, Transcript and Summary

Good morning, my name is Jackie, and I will be your conference operator today. At this time, I would like to welcome everyone to the Xylem Second Quarter 2013 Earnings Conference Call. [Operator Instructions] I would now like to turn the call over to Phil De Sousa, Head of Investor Relations. Please go ahead.

Thank you, Jackie. Good morning, everyone, and welcome to Xylem's Second Quarter 2013 Earnings Conference Call. With me today are Chief Executive Officer, Gretchen McClain; and Chief Financial Officer, Michael Speetzen. We will provide our perspective on Xylem's second quarter results and discuss the full year outlook for 2013. Following their prepared remarks, they will address questions related to information covered on the call. [Operator Instructions] We anticipate that the call will last approximately 1 hour. As a reminder, this call and our webcast are accompanied by a slide presentation available in the Investors section of our website at www.xyleminc.com. All references today will be on an adjusted basis unless otherwise indicated. The non-GAAP financials are reconciled for you in the Appendix section of the presentation. A replay of today's call will be available until Tuesday, August 13 at 6:00 p.m. Please note the replay number is (404) 537-3406, and the confirmation code is 11620868. 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 reports as 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 will turn the call over to our CEO, Gretchen McClain.

Thank you, Phil. Good morning, everyone and thank you for joining us today. Most of you have seen the news release with our disappointing second quarter results. Today, we'd like to walk you through the numbers and of course, respond to your questions and feedback at the conclusion of the call. As outlined in our earnings release, we experienced a 3% organic decline in revenue in the second quarter. This lower-than-expected revenue, along with investments of growth and productivity, resulted in lower operating profit and led to adjusted earnings per share that were below our expectations. During today's call, we'll summarize the dynamics impacting our top line, show how they affected our financial performance and give you our outlook for the remainder of the year. Also, I'll tell you about some of the things we accomplished in the second quarter and outline the strategic and tactical actions we are taking to enhance our performance for both the short and the long term. So let's start the quarterly summary with the key driver, our revenue performance. Before jumping into the details, let's take a look at what we assumed going into the quarter. You may recall at the beginning of 2013, we were bearish on the macroeconomic conditions across Europe, and we planned accordingly. Even with this precaution, conditions have proven to be more challenging than we had anticipated. A significant portion of our business is short cycle in nature with 50% of our sales going through distribution. These dynamics coupled with customers requiring shorter lead time and distributors minimizing inventories, have led to more frequent and smaller transactions, thus limiting our short-term visibility and resulting in increased variability from month-to-month. Let me also remind you of our seasonality of our business with the fourth quarter being the largest, followed by…

Thanks, Gretchen. Please go to Slide 6. Given our second quarter results, we feel it's important to walk you through our performance relative to our expectations. Organic revenue was unfavorable by 2 percentage points. Strong performance across all end markets in the U.S. was more than offset by weaker conditions in Europe, in the emerging markets, lower price realization and unfavorable foreign exchange impacts. Let me cover the market dynamics in more detail. First, we saw better-than-expected market conditions in our U.S. residential and commercial building service business, and our Ag business continued to benefit from drought conditions in the Southwest. Europe was generally weaker than expected, but most significantly down in the public utility and industrial markets. We also encountered greater-than-anticipated pricing pressure, as continued market demands challenged our ability to gain more significant price increases. Foreign exchange was a significant headwind, as we saw the U.S. dollar and Swedish krona appreciate against other currencies. The most significant impact was from the noneconomic translation of financial statements into U.S. dollars. The impact to Xylem's revenue was $14 million and the impact to earnings was $3 million. Acquisitions in our restructuring and realignment activities tracked expectations. During the quarter, we realized restructuring savings of $4 million, reflecting our 2012 actions in the initial savings from actions initiated in 2013. Lastly, our adjusted tax rate of 22% was in line with our previous guidance and expectations. As you can see from the bottom of the chart, our EPS shortfall was primarily driven by the volume miss of $0.05. In addition, price and foreign exchange were each $0.01 unfavorable during the quarter. Please turn to Slide 7. Xylem revenues were $960 million, down 1% from the prior year driven by a 3% organic decline and partially offset by acquisitions. Let me provide…

This is not easy news to deliver and we're not pleased to deliver it. We know we must take tough decisions and accelerate our actions given the market conditions we face. But remember, we're seeing a number of positive signs across the business: our order rates are improving, we have a good backlog, we are launching compelling new products and the commercial efforts we are making are all starting to yield positive results. Building the Xylem business is a journey. We're taking the necessary steps to position this great company to achieve higher performance in both the short and the long term. Operator, we're ready for questions now.

[Operator Instructions] Your first question comes from the line of Matt Summerville with KeyBanc.

A couple of questions. You mentioned heading into the second half of the year, you had about $960 million in backlog, $400 million ships in 3Q, $200 million in 4Q. In a more normal year, what would that dispersion look like? And what I'm trying to get a sense of is how much more you still have to go out and get in a tough year like this relative to a normal year? Does that make sense?

Sure, sure. I mean our backlog, when you look at it from a year-over-year prospective, we're up 7% year-over-year. So we're going in with a good backlog, solid backlog. We still have work to do because we do have a short cycle business. But I would say, we feel good about the rates in terms of what we need to achieve as well as the market conditions that we've looked at and adjusted based upon the first half of the year.

Matt, the other thing I'd add to that is when we look at that backlog shippable in the second half, we look at it as a percent of the revenue. If you look back at 2012 as an example, it represented about 30%. When you look at the backlog, we're entering our second half, it's up at about 30 [indiscernible] a little bit higher. That's not surprising given the fact that we've seen a decline in the project business. So that's a dynamic that we adjust for as we look at that. And I'd say the dispersion between the 2 quarters is pretty typical of what we've seen barring the projects.

And then based on what you're stepping up and doing from a cost standpoint now and what you've previously disclosed, how much in incremental savings should we be thinking about for 2014, assuming you complete everything you've discussed?

So, Matt, we're working on that today. I mean, we're laying out those actions to date. Most of the things that we're talking about are, it's $0.06 to the EPS, it's $15 million that's baked into our revised guidance. It's discretionary pullback, taking some costs that we need to out of the business. As we get a better projection of the '14, we'll obviously -- we'll share that with you.

Your next question comes from the line of Deane Dray with Citi Research.

The first question is for Mike. Take us through the free cash flow because if I've done my math right, you've done a 2% free cash flow conversion so far year-to-date. So how do you get to a 90% conversion in the second half if you're looking at longer collection periods, higher inventory and obviously higher working capital?

Yes. It's a good question, Deane. We've taken a hard look at this and I think from a cash standpoint, the one we have to keep in perspective is the cash cost structure is a little bit different than the P&L structure. For example, we pay out bonuses at the beginning of the year and then you're earning yourself back as you go through the year. So adjusting for those types of items, that's why we've revised our working capital projection down, which has had about a 5-point impact on our free cash flow conversion. When we look at the profitable -- profitability and the contribution to cash, we get pretty comfortable as we look into the back half of the guidance levels we have. We've factored in the longer collection cycles as well as the inventory levels that we've got on hand. And then, the thing you have to keep in mind is sort of at least that first half period, we're dealing with a little bit higher cash tax rate given some of the deferrals we had from last year. And then obviously, to Gretchen's point, we're looking at investments in the second half which in terms of the free cash flow conversion, the one area that will be impacted is our capital expenditures. We see that as being dialed way back from the guidance that we have originally given where we talked about it being at about 3.5x -- or 3.5% of revenue. I'd look at that number as being closer to 3% or lower in the back half.

Okay, and then, maybe you can talk about how the quarter progressed because you did say that June came in weaker and that was expected to be seasonally strongest. And the spirit of the question is, when you see the margin shortfall as severe as it did this quarter, I'd like to get a better sense of how proactively did you take out cost this quarter. I know you're trying to manage to a decremental margin because it sounds you're making some cost take outs here adding only about $10 million to the restructuring. I thought that maybe I would see more and maybe see more cost take out within the quarter. So maybe just take us through how the quarter progressed and what cost actions you were taking during the quarter?

Yes. So, Deane, let me address so. As we went through the quarter, as I mentioned, June is a big month for us and it's solid. So we didn't see that fall out. We were working our restructuring actions to $60 million to $70 million that we had in our plan. If you remember, we had set our plan assuming we're going to be a flat growth rate and we would size our cost base accordingly. And so we are focused on those areas. Still advancing some of our investments around productivity, which was tied to repositioning ourselves in Europe, and also some new product launches. So that didn't come through. This was our high growth margin business and we saw a big drop to the bottom. Now going forward, we are going to be resizing the business and taking steps. I've talked about what's embedded in the revised guidance. There's more work we need to do and we are looking at all opportunities to see how we can bring our cost base down. Our end markets are challenged right now. The underlying fundamentals of our market are going to be -- have an overshadow of the economy and we've got to make sure we've got cushion in our business to be able to still allow us to invest into growth initiatives that we need because this is a strong market in the long term. And right now, we need to get be able to get our cost base further down. And so there will be more actions. As I mentioned, we put in the $15 million in the revised guidance, actions we will be taking for the rest the year. And while we are 7 months into the year, we've got 5 months yet. Most of those will be savings that will probably play out into 2014 and beyond.

And, Deane, I think on the decremental question, roughly we're managing to about a 50% decremental and there's a couple dynamics that play in. While we are taking the cost actions which helped us in the second half, one, we're dealing with a revenue decline in our highest margin business where we have a higher cost structure that we're contending with. So you've got very little erosion in gross margin, but you can see the impact at the up line and that's really around that cost structure. The second dynamic we're contending with is much lower price realization. And as you know, that drops at 100%. We're obviously not just accepting that. We're pushing the teams. But in light of the current environment, that certainly places additional pressure on that decremental margin. So at this point, it wants to be close to 60% and we're fighting to get it down closer to about 50%.

And then, just one last question for me. If I heard it correctly, it sounded, Gretchen, like you still had some M&A lined up for the second half. And are you locked into these acquisitions? Are they the right ones to be doing at this time? And I know there's a sense that you want to be playing offense here for the long run, and just how you're weighing that against some of the shorter-term challenges of getting the P&L in order?

Deane, it's a great question. And clearly, as I mentioned, we're dialing back a little from what we have originally said. There are some key bolt-on strategies that we'd like to continue to progress. But our #1 priority is to make sure that we get the business in order. We get our performance higher. And making sure that we address, taking the cost out that we need to deposition this company and bring it forward. But there are some acquisitions that strategically are nicely positioned to help us ultimately grow. So again, that balanced equation is essential. Take the cost out, position us for a cushion, but then be able to invest in those strategic initiatives.

Your next question comes from the line of Brian Konigsberg with Vertical Research.

I just want to touch on the incrementals again but more sequentially, meaning, the second half of the year versus the first half of the year. So you're looking at a $42 million increase at the midpoint on revenue between H1 and H2 and a $46 million increase in the operating profit. It sounds like maybe $25 million, $26 million or so that it's from incremental restructuring, but it still suggests a fairly significant incremental from the core business. I think there are some other items, but I was hoping if you could help bridge that gap for us.

Sure. Yes, there's a little bit of noise in there. So let me give you a few of the pieces that I think will help provide that. If you look at our core volume, organically, we're up about $67 million versus the first half. Foreign exchange is about a $34 million headwind in the second half and then we've got an additional $10 million of acquisitions. You have to remember the acquisitions are not contributing at a high drop rate at this point in time and foreign exchange are obviously has its set of impacts. So when you look at the core volume increase, less the savings from restructuring, we're looking at about a 50% incremental drop rate, which given where we're at in the business specifically around Water Infrastructure where we see that sequential improvement, we expect to see that drop rate. The drop rate then gets enhanced by the incremental $12 million worth of restructuring benefit that we pick up in the back half. So in my prepared comment, I talked about our restructuring in the second quarter, was it $4 million? $3 million of that came from the actions we initiated in '12. One of that came from the actions we started earlier this year. We pick up incrementally in the back half another $12 million of restructuring benefit.

Okay, but the core business dropping at 50%, I mean, have you ever had that type of experience before? Why is that changed now?

Well, there's a couple of things. I think when you look at the Water Infrastructure business, one, we're going to be levering off that cost base. Two, when you look at the mix that we're anticipating in the second half, specifically on the industrial market as it relates to dewatering, even though we're down on a year-over-year basis, the trends we've seen in terms of some of the frac-ing that's driving increased volume to support the rig count increase, that activity comes at a very high drop rate and it's helping us from a mix perspective.

Okay. And then just moving on to the comments about the municipal trends, I think, Gretchen, you said you anticipate the spending to remain weak into 2014. The orders from the quarter actually maybe showed a little bit of an improvement. Maybe can you just elaborate on that comment, I mean, is this just a small aberration in orders that you see in the quarter and it had to drop off again? Maybe you can give us some color on that market, it would be helpful.

Yes. So if I step back and I just look at some of the market dynamics that are going on, first of all, in the U.S., you have wastewater spending which is down substantially. And that doesn't look like it's changing anytime soon. Now, we all understand the need of water and the demand that is pending up. And we're seeing that in terms of the bid activity. There's a lot of work in terms of bidding. But the confidence level to actually make that bidding into an order is just not happening. It's not converting. And we anticipate going forward in 2014, right now, nothing that indicates a significant change there. Now if there's public-private partnership that may move that more aggressively, but when I look at the general dynamics in the market, not only in the U.S. but even globally, the confidence level in the funding streams haven't changed. And when you think about 2014, you need to start getting those orders now versus next year because they typically are 12- to 18-month type of orders.

And Brian, I guess, what I'd add to that is when you look at the 1% order increase that we had in the quarter, a significant portion of that was driven by Applied Water. The Water Infrastructure business was up about 0.6%. And when you look at that business on a year-to-date basis, because it was down close to 10% in the first quarter, orders were down about 5%. So back to Gretchen's point, the order funnel really hasn't filled at the level that would support significant growth in 2014.

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

Can you talk a little bit about the signs of bottoming you're seeing to support the outlook in the back half. It sounds like you're not factoring further deterioration in Europe, mining's obviously been quite challenged. Can you just sort of walk us through what you're seeing in some of those markets?

Yes. So mining as you mentioned is challenged globally. We're clearly seeing the mining industry being challenged and that hit us, as we talked about in terms of the emerging markets. But let me talk about a little bit from the regional perspective. In the U.S., we're seeing positive signs but the industrial market still has not had the confidence level to give us the confidence that's going to pick up in the second half of the year. In Europe, we're still seeing Europe down. We saw substantially a decline in southern Europe more than we anticipated. While we thought it was down substantially, we didn't think it could go down much further and we've seen that continue. In the Nordics, positive -- still positive growth there but not enough to offset what we're seeing in Europe. And where we're seeing Europe as well as in the public utilities and industrial markets, we anticipate will be weaker as we go into the second half of the year. Emerging markets, China and Russia, we're doing extremely well. We're double-digit growth in both of those regions. But with the global economy pulling back and confidence level still being questioned around the growth in China, that has had impact in the mining industry and our emerging markets globally, specifically, the Middle East and Australia when I look at the Asia Pacific region.

Okay. And I guess as you look out if you couple sort of visibility staying challenged in '14, it sounds like with dialing back the M&A a little bit, maybe you can talk about some of those longer-term assumptions, how we should think about those?

Yes. I think I would say a couple things. What we think is the markets is pulling back some. We're still feeling confident about the product launches that we are launching this year and into next year. I feel good about some signs of the market picking up. We're seeing residential, commercial picking up. So what we want to do in terms of given the overhang that we've got in some of our markets, being industrial and public utility, still stay strong with our customers, work with them as they're challenged in terms of their funding with services and aftermarket. But we're going to have to adjust ourselves to pull our cost base down. We're still committed in terms of our long term in our business. We're taking the right short-term actions to position the cost base, but still being able to position ourselves with the growth initiatives to hold on to our long-term objectives.

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

Would you please quantify the impact that you think the decline in the dewatering business had on margins and revenues as well?

Yes. Dewatering globally had been significantly impacted in the industrial market and very specifically, in the U.S. we've seen some decline there, about $4 million in the U.S., in Europe, $7 million, and in Latin America, about another $1 million. So it's down over $10 million in terms of dewatering. Now let me just talk a little bit about our dewatering strategy. That is not just our Godwin business but it is our Flygt business that support some of the mining industry. So it's a combination of the 2.

Okay. And I'm sorry, I wasn't clear. That's the -- what's the operating impact on the business?

Well, David, it's a high drop rate business. I mean the majority of where we've seen the pullback is around the rental market. As you know, that's a high margin business. And that's played into, frankly, where we're dialing back from a capital expenditure standpoint as we size that fleet accordingly. We don't typically get into the specific breakouts, but there is obviously within the water infrastructure business, dewatering being a relatively large component of that and impact from the pullback in the rental revenue.

Okay. And then lastly, I think when we last spoke, your sense was that your assumptions basically been would hold, this is back in June, provided that you didn't see deterioration in Europe. Most indications is Europe is not deteriorating. Is there some element in your business that you see different than your competitors where you're more vulnerable than your competitors?

Yes. So, David, it's a great question. It's obviously something we sit back and we look at the data and analyze it. But I still feel very confident about the issue that we're facing is the market dynamics. And it's the underlying market overhang that we're seeing specifically in the public utilities, very specifically around CapEx, and then also the pullback very specifically in the mining and the industrial market, just the confidence of not being able to go spend. When I look at our win-loss data, we look at data in the industry trade. Our share, we think we're holding our share. We feel very good about where we're going. Now of course, what's important to that is to make sure we continue to launch new products and we stay close to our customers. But I do not believe this is a share issue, it's a market dynamic.

And David, I guess, I'd just -- I'd point out a couple of things. If you look at our peers specifically around the wastewater side of our pumping business, where we're down about 6% in the public utilities, I think you'll see pretty similar characteristics in those results. And then in the commercial and resi side where we're up 9% and 18%, respectively, that's very strong relative to the peer group, although it's a small part of our business. Those 2 components make up just under 20% of our revenue.

Okay. And then, lastly, general commentary was MRO is up, is that the same for you or not?

Our repair and overhaul or our service revenue was up in the quarter when you exclude the effect of our PIMS acquisition. We were up just over 1%. So that's pretty consistent with what we've seen coming out of the operational side of the public utilities and even the industrial market where folks are still continuing to spend on repairing and maintaining the existing equipment.

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

I had a question on -- I wanted to continue on this topic of competitive dynamics. And specifically, Mike, you mentioned price and the fact that they initiated pushing the teams to try that, maintain that, and so forth. Can you just give us a little more color around that side of things? How the market weakness that you're seeing is impacting your strategic pricing initiatives and then just probably price across the market. And then relatedly after my follow on here and relatedly, do you believe industry capacity overall is where it needs to be? Or are we at risk here of having an overcapacity situation and impact on price there that impact the end market weakness per se?

Yes. So, Ryan, let me talk about pricing. If the pricing dynamics that we're really seeing is in the industrial and public utility market, that's the market that we've seen down. And also across-the-board, it is a competitive market. The market is slow and so everyone is going after competitively to win the bids that out there. Now we have a good process in place and we've been driving price and have seen up and through last year, a positive price value gap. We want to continue to drive that, but we also do not want to lose share in our core positions. And that's what we've done is we pull back to make sure that we can get the position that we need. I'd say beyond just a price perspective though, our commercial excellence initiatives that we've been driving, drive more than just price. It's about talking to our customers about our value proposition, around really thinking about our key accounts and making sure that we're driving our growth with those accounts. So I feel good about our strategy. And we are continuing to drive for profitable growth. That is key to us. But we will make sure that we don't lose share in the marketplace.

Ryan, I made a comment in my prepared remarks in terms of we saw about 30 basis points of favorable margin impact in the second quarter, which was down pretty significantly from what we had in the first. We think that's indicative of where we'll be for the balance of the year. So we were anticipating when we originally gave guidance that we'd be around 1% pricing. We now see the effect of revenue is about 40 basis points positive pricing and that flows through the margin with about 30 basis points. So pretty similar in what you saw in the second quarter, holding for the balance of the year.

Okay. And on the issue of capacity, I mean, do you believe that from industry perspective, the situation is significant enough in terms of end market weakness, but it needs to be a curtailment of capacity industry-wide. And if so, is that happening or is that not the right way to frame it?

Well, I'd say from this perspective, the capacity issue, when you look at where our equipment, our technology is positioned in the marketplace, as long as the factories are up and running and so forth, our equipment is being utilized. I would say in the mines, they're not opening the mines. That industry has pulled back, but still we got a good position in the marketplace. As I mentioned earlier, though, some of the dynamics in the marketplace in terms of inventory in the markets, it's not there, pullback. So there's a growth cycle, that maybe an opportunity for us in terms of quick turnaround. But right now I don't think capacity is a big driver for us.

Ryan, I think we look at it in short and long-term views. I think in the short term, we all know that distribution channel has pretty well destocked to a level that when growth is restored, we think that will obviously serve as an opportunity. And I think as we look over the longer term, we don't see that as a capacity issue.

Your next question comes from the line of Brent Thielman with D. A. Davidson. Brent Thielman - D.A. Davidson & Co., Research Division: You talked about pressure from the sequestration on the test category, which I know provide some nice margins for you guys. But what percentage of that business is impacted by these sort of issues?

Yes. If you take our Analytics business, it's really the YSI business here in the U.S. They typically do work with the USGS and of course, with some universities and that typically get their funding coming from the government. It's probably 40% of that business, roughly. Now the one thing I would say is, while sequestration is having an impact, there's not been significant reductions in terms of budgets, but the pullback of funding and the confidence to go ahead with certain projects is clearly stalled in the market. And so we're watching that closely. We feel pretty confident about our position and our relationships with those end customers. And our hope is that will get released over time.

And I think it's also important to point out as we did in our remarks that Europe was up about 5%, which is a strong performance in light of the current environment.

And I even say even in the U.S. in our wastewater Analytics business, we feel positive signs as well. Brent Thielman - D.A. Davidson & Co., Research Division: Sure. And then on the commercial side of things, it looks like you saw some gains there. I know it's smaller. But any sense how much of that is market growth this quarter versus sort of market share gains or any repositioning you've done with that business?

I would say it's a little bit of both. I mean we had spent some time investing in new product launches and the team has done a great job in getting out and being able to show the value proposition announced. As a lot of company -- or businesses are upgrading their commercial buildings, our new products are nicely positioned to do retrofits and so forth. So I think it's a combination of growing with the market as well as taking some share.

Your next question comes from the line of Michael Gaugler with Brean Capital.

You had mentioned in earlier prepared remarks, Europe municipals and industrials as weak end markets. As you look to future acquisitions, are you looking to exclude these areas in the end markets?

So let me address it, in general, that's a tough question to answer. I mean, I'd prefer an acquisition that's going to give us a nice position to the emerging markets, which are the growing markets. But depending upon the technology and how that complements our position and being able to serve our customers more effectively, you've got to look at the technology and potentially the channel to the market as we go forward. So it's more of a strategic direction.

Okay. And then my apologies if you covered this previously. In your infrastructure segment, how's your after sales service business performing? And what percentage of the sales mix is it now?

Yes. So right now, in the second quarter, our aftermarket for Water Infrastructure was up about 8%, but that includes the effects of the PIMS acquisition. We're up about 2% organically. And that constitutes just under about 20% of our revenue coming out of that segment.

There appear to be no further questions at this time. I'd now like to turn the floor back over to Gretchen McClain for any closing remarks.

Well, let me just summarize with -- as we reported today, we are not happy with our performance. We know we have work to do. Our markets are challenged. However, we do have some very positive signs that are taking place on the business. And we're going to continue to push forward with our new products. We're going to make sure that we're staying close with our customers and make sure that we're driving the top line. At the same time, we're going to make sure that we're positioning this company with cushion for some challenging markets that we know are still there. And we are focused on our long-term objectives and making sure that we're putting the actions in place that we can assure the long-term still plays out. This is a strong market. The macro conditions are still there. And we have the right technologies and the right talent to be able to lead the market. Thank you.

Thank you. This concludes today's conference call. You may now disconnect.