Xylem Inc.

welcome to the Xylem first 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 if you would like to ask a question at that time please press star 1 on your touchtone phone if at any point your question has been answered you may remove yourself from the queue by pressing the pound key We ask that you please pick up your handset to allow optimal sound quality. Lastly, if you should require operator assistance, please press star zero. I would now like to turn the call over to Matt Latino, Senior Director of Investor Relations.

Thank you, Bridget. Good morning, everyone, and welcome to Xylem's first quarter earnings conference call. With me today are Chief Executive Officer Patrick Denker and Chief Financial Officer Mark Rakowski. They will provide their perspective on Xylem's first quarter 2019 results. Following our prepared remarks, we will address questions related to the information covered on the call. I'll 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 June 2nd. Please note the replay number is 800-585-8367, and the confirmation code is 298-7515. Additionally, the call will be available for playback via the investor 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 Zion'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 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. Thanks for joining us to discuss our first quarter results. We continue to see strong top line growth and healthy demand in the first quarter, but frankly, we were disappointed with missing our guidance for margin and earnings. Lower margin performance was driven by the mix of products that we sold and operational factors that we should have identified and planned for, most notably in our sales and operations planning process. We take our commitments very seriously, and we care deeply about doing what we say we're going to do, as our track record has shown over the past five-plus years. And we've taken corrective actions to address these shortfalls. We are pleased with our continued growth momentum, remain very excited about our ongoing growth prospects, and an achieving healthy margin expansion for the remainder of this year and well beyond. Now, let me review some of the other key details. We once again delivered solid organic revenue growth of 6% in the quarter. We saw gains across all of our end markets, highlighted by the continued mid-single-digit growth in our largest sector, utilities. This continues to represent above-market growth in a healthy market. From a geographical standpoint, the U.S. market produced strong revenue growth with an 11% increase year-over-year. This included double-digit growth in utilities and at least mid-single-digit growth in our other end markets. The emerging markets continue to be healthy and build momentum as well, up 12% overall, with particularly strong performance in Asia and Latin America. India and China saw strong gains once again. India increased 58% with growth in transport and treatment, as well as the beginning of our deployment of a large census metrology project. China was up 14%. And looking forward, we remain very confident about long-term growth opportunities in these markets. Turning to orders, we saw a 4% increase in the quarter. This is on top of 10% orders growth in the first quarter of last year, and there are clear signs of contended strength with a 10% growth in backlog. Another important achievement, which is reflected in our backlog growth, is our recent deal with Philadelphia Water, announced in early February. This project focuses on smart metering infrastructure that incorporates our FlexNet communications technology. It's an example of the kind of synergistic deals since the acquisition of Census that we are now uniquely positioned to secure and execute by leveraging strengths from across our portfolio. It's also a key milestone because with this award, we have now won contracts that represent nearly $200 million of revenue synergies, which exceeds our previously stated revenue synergy goal from the 2017 Investor Day of between $150 to $175 million. It further highlights the power and sustainable long-term growth profile of our portfolio. Based on the strategy we've executed and acquisitions made, we are now positioned to offer solutions that target the most crucial issues facing our customers. Challenges like water affordability, water scarcity, and resilience. This is accelerating demand for our solutions. Our advanced infrastructure analytics, or AIA platform, is a clear example of this. That platform saw accelerated market momentum in the quarter with orders growth of over 30%. we are building a robust pipeline with increasing interest in utilities in the U.S. and a growing presence in Europe and Asia. Now let me turn now to our margin performance, which was impacted by two primary factors. The first was unfavorable revenue mix over the expected test and European aftermarket and service revenues. The second was unfavorable overhead absorption in a couple of our key factories due to some demand planning decisions we made to optimize our inventory levels. Simply put, we should have had a better process in place to align forecasted demand with production. We've taken steps to address our sales and operating planning process, and we are confident that these margin effects are largely behind us. I'm now going to hand it over to Mark, who's going to give additional detail on the quarter. Mark? Thanks, Patrick. Please turn to slide five, and I'll begin with our first quarter results. I'm pleased with the continued market momentum we saw throughout the first quarter. Organic orders growth of 4% was in line with our expectations, very solid considering the tough comparison for last year's 10% growth. Revenues were up 6% in the quarter and at the high end of our revenue guidance. We had strong revenue growth across the majority of our geographic regions led by the 12% growth in emerging markets and 11% growth in the U.S. China continued its strong growth trend with revenues up 14%, with growth across each segment. Western Europe declined 2%, which was in line with our forecast and driven by a tough comparison to last year's first quarter, where we had a significant software sale and several large treatment project deliveries. Each of our end markets grew in the quarter, with continued strength in the utilities market up 6%, and 12% growth in commercial building services, which benefited from strong price realization, better-than-expected market conditions, and new products. The industrial and residential end markets both delivered solid growth of 4%. Adjusted operating margin for the quarter was 10.8%, down 30 basis points from the prior year. Cost reductions from our productivity programs and accelerating price realization of 170 basis points were more than offset by inflation, growth investments, and weaker sales mix. Part of the weaker mix of revenue was driven by lower-than-expected sales in our high-margin test and service and aftermarket businesses in Europe. We also had lower-than-expected overhead cost absorption in our applied water and water infrastructure segments. This was driven by lower production levels during the quarter to better align inventory with market demand to optimize working capital. As Patrick mentioned, we've taken actions to better align our sales and operating planning processes and have put this operational issue behind us. Earnings per share in the corn were 52 cents, up 12% over the prior year, excluding foreign currency translation. Please turn to slide seven, and I'll review our segment results. Water infrastructure, organic orders grew 2% in the quarter. This growth is on top of a tough comparison of 13% orders growth last year, where treatment orders grew 27% from several large project links. Segment backlog was $700 million at the end of the quarter. with $525 million shippable in 2019. This is up 5% over last year. Our treatment bidding pipeline, which we view as a bellwether of the health of the underlying utilities market, grew mid-single digits this quarter, driven by growing project work in India and new opportunities in North America. Water infrastructure revenues grew 7% in the quarter, Transport application revenues were up 7%, benefiting from high single-digit growth in both the utility and industrial end markets. The strength in utilities was fueled by strong aftermarket sales and stormwater resilience work in the U.S., and mid-teens growth in China from wastewater project deliveries. Industrial revenues were driven by our dewatering business, which was up 12% in the quarter with good growth in the mining and construction markets. Treatment application revenues grew 4% in the quarter from project deliveries in the U.S. in emerging markets, where momentum remains strong. Emerging market revenue growth was 10% driven by India, which grew 19% in China, which grew 21% in the quarter. With many of the major utilities in China now completing projects to comply with water regulations, we're turning our focus to smaller and medium-sized utilities to build or upgrade their treatment facilities to meet these regulations. We see a significant opportunity for growth in this segment of the China market and our pipeline for these projects is expanding. In Western Europe, Revenues were down as expected from lapping large treatment project deliveries last year. However, sales from our aftermarket and service business were softer than expected, which negatively impacted our mix of revenues and margin. Operating margin for the segment increased 110 basis points to 12.4% compared to last year. Cost reduction, strong price realization, volume leverage, more than offset inflation, a weaker sales mix, investments to grow our business and lower overhead absorption. Please turn to slide seven. The applied water systems segment delivered 6% organic orders growth over the prior year. Segment backlog was $222 million at the end of the quarter, with $194 million due to ship in 2019. This is up 12% over last year. Segment revenues in the quarter grew 7% versus the prior year, and we saw solid growth across each end market led by commercial building services. Geographically, we saw broad-based organic growth with the U.S. up 7%, Western Europe growing 4%, and we had very strong growth of 16% in the emerging markets led by China, which grew more than 30% driven by new project activity. Segment operating margin for the quarter was 15.6%, which reflects 110 basis points of improvement compared to last year. Cost reductions and 300 basis points of price realization more than offset higher inflation, lower overhead absorption, and foreign exchange headwinds. Now please turn to slide eight. Measurement and control solutions had 5%, organic orders growth in the quarter, which is on top of 12% orders growth in last year's first quarter. Total backlog for the segment was $980 million at the end of the quarter, up 16%, with $400 million shippable in 2019, which is up 19% year-over-year. We continue to gain momentum in the segment with new contract wins. We expect growth and margins to ramp throughout the year as previously announced contract wins, including our recent win with Philadelphia Water, will begin to deploy later in the second half of this year. Segment revenues grew 5% organically in the quarter. The water business grew 15% driven by strength in the North American market from continued demand for our eye pearl meters and AMI deployments for smaller and mid-sized utility customers. SAS and other service revenues were down 3% as expected as the segment lapsed the large software sales in Europe during the first half of last year. Energy, which is a combination of our electric and gas offerings, saw revenues decline 7% due to the lapping of the Alliant project deployment from last year. Test application revenues were flat in the quarter and below our expectations as the shipment of a large project was delayed by a customer into the second quarter. AIA organic revenues grew 10% in the quarter with growth across multiple regions. Strong customer interest continues for these new solutions, and we're penetrating new markets as we leverage existing Xylem channels in customer relationships. Segment operating margins contracted 420 basis points to 7.4%. Benefits from volume growth and cost reductions were more than offset by inflation. The unfavorable mixed impact from last year's high-margin software sale and investments to accelerate the growth of our AIA platform. We were also impacted by lower-than-expected revenues in our high-margin test business. The good news is that we saw some improvement in the availability of components and expect that challenge to be largely behind us by the end of the second quarter. We continue to outlook strong margin expansion for the second half of 2019, driven by improving mix, the scaling of our AIA platform, and volume levels. One new challenge we're working through are border crossing delays that we're experiencing in getting product from our Mexican supplier into the U.S. The team is managing this well to minimize impacts to our customers. Now let's turn to slide nine for an overview of cash flow and the company's financial position. We closed the quarter with a cash balance of $275 million. We returned $83 million of cash to our shareholders in the quarter through share repurchases and dividends. We invested $69 million in CapEx during the quarter, which is modestly higher than our full-year run rate and primarily related to timing. Investing in the business remains an important driver of growth for us. That said, we will remain disciplined and continue to forecast full-year capital spending between 2030 and $240 million. Our working capital increased 15.9%. This is in line with our expectations and driven by the inventory bill during the second half of 2018 to address tariff and component issues. These inventories will be worked down over the next two quarters, and we expect our working capital and free cash flow conversion to continue to improve each quarter. Cash flow from operations improved over 30% from last year's first quarter and free cash flow conversion improved substantially. As a reminder, the first quarter is our seasonally weakest cash flow period as we build inventory for the back half of the year. We continue on track to meet our full year target of 105% free cash flow conversion. On a final note, Earlier this quarter, we announced a new credit revolver tied to our sustainability performance. This is the first of its kind in our sector, and we're pleased to be able to align the interest of our shareholders to more efficient financing with our focus on sustainability and social value creation. Please turn to slide 10, and Patrick will cover our 2019 in-market outlook. The view of our end markets for the full year remains largely unchanged from the guidance we provided on our last earnings call. While we will lapse some tough year-over-year comparisons, the growth that we saw in the first quarter, combined with healthy orders and backlog, reinforces our confidence and our growth momentum for 2019. I'll quickly run through some key points for each one of our end markets. In the utilities market, we still expect solid growth in the U.S., where we continue to see strong project backlog, and a very healthy aftermarket business. Even with top comparisons to the balance of the year, we still expect mid-single-digit growth in the U.S. We are moderating our outlook for Europe slightly, as we saw some softening from uncertainty in the U.K. In the emerging markets, China and India continue to lead the way. Regulation is expanding in both countries, and adoption of our advanced treatment technology and other core infrastructure work is accelerating. We therefore maintain mid-single-digit growth expectations for the overall utilities market. In industrial, we continue to expect low to mid-single-digit growth as we foresee moderation in the second half of the year. While mining and construction boosted first quarter growth, we do expect general slowing consistent with our last outlook. In commercial, we saw another quarter of strong growth driven primarily by activity in the U.S. and China. We do expect that the market will moderate in the back half of the year, and we will also face challenging comparisons. However, our performance in the first quarter and outlook based on order demand gives us confidence to raise the outlook for commercial for the full year slightly to mid-single digits. Our residential outlook remains at low single-digit growth. Signs of a flattening U.S. housing market, low single-digit growth in Europe, and a mixed outlook across emerging markets all remain unchanged from our guidance last quarter. Now, please turn to slide 11, and we'll provide an update on the rest of our guidance for 2019. As we just discussed, we started the year with solid top line growth and continue to expect to deliver organic revenue growth of 4% to 6%. We are adjusting our operating margin outlook to a range of 14.5% to 14.9%. This represents healthy expansion of 80 to 120 basis points. We expect similar improvement on an adjusted EBITDA basis, which will bring it to a range of 20.3% to 20.6%. This updated outlook takes into account our performance last quarter and stronger dollar for the remainder of the year. Let me pause for a moment and talk about other actions we're taking to improve our margin profile. We first talked at our 2017 Investor Day about our overall approach to business simplification, which included two primary components. First, the implementation of a global business services platform, which represents the simplification of a number of our back office functions. I'll come back to this in a moment. Second, broader organizational opportunities to do further management delaying and elimination of other duplicate support functions. Since that time, we've advanced this effort to reduce complexity within the organization, allowing us to be faster and more agile so we can serve our customers better. These actions are being taken as we speak, and we expect to see modest savings this year with the bulk of the savings being realized in 2020. Now, turning back to our four-year guidance, we are revising the adjusted EPS to a range of $3.12 to $3.32, which reflects a reduction of $0.04 for the stronger dollar and $0.04 for the shortfall in the first quarter. This represents solid growth year over year of between 8% and 15%. And finally, we continue to expect at least 105% free cash flow conversion and are on track to do so. Let me now turn it back over to Mark to walk you through some of the other full year and second quarter details. On slide 12, we're providing the seasonal profile of our business as well as highlights of our updated 2019 planning assumptions. We continue to expect 4 to 6% organic growth for 2019, which breaks down by segment as follows. We expect 5 to 7% growth in water infrastructure. 3 to 5% growth in applied water systems, and 4 to 6% growth in measurement and control solutions. We're now assuming a yield rate of 112, which was the average for the month of April, and we've included that in our FX sensitivity table in the appendix. We are increasing our forecast for restructuring and realignment costs for the year to $60 to $70 million. The increase relates to the actions Patrick covered earlier related to organization simplification. The increase in estimated restructuring charges will largely be recorded in the back half of this year, with the majority of savings being realized in 2020. Our estimated tax rate for 2019 remains at 19.5%. Now moving to the second quarter. We expect total company growth in the range of 4 to 6%, led by continuing strength in the U.S. municipal market, as well as broad-based growth in China and India. We expect second quarter adjusted operating margins to be in the range of 14.3 to 14.5%, representing 50 to 70 basis points of expansion over the prior year. We expect continued strong margin expansion in both our water infrastructure and applied water system segments driven by cost reductions, volume leverage, and improved price realization. We expect margin expansion of about 20 to 60 basis points from our MCS segment, which reflects moderating impact from the component supply and mix challenges

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