Xylem Inc.

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 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, 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 Rakowski. 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'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 investor 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 866-9179. 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 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 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, and 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 disciplined 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 remained 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 slowdown 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 impacts 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 contended 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 contended 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-digit orders growth in the quarter, giving it 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 details 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 a creative desilum, all of which is to say that our growth thesis for the business has not changed. That said, the revenue ramp we're now seeing has taken longer to accelerate than we originally anticipated. And as we've continued to invest in the business, orders to sales conversion has been slower than expected, moving cash returns to 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 pace of revenue growth lagged expectations, The orders, sales, and backlog growth we're now seeing is strong evidence of a utilities market embracing digital transformation at an increasing pace. We're now beginning to see customers adopt 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're 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're 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 it to Mark, who will review our results by segment on slide six.

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 and was also up 12% year-over-year. The strength in orders and backlog was driven by project wins 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 served the oil and gas mining and construction markets. These declines were partially offset by mid-single-digit growth in our rental services 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. And 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 and margins. Our water infrastructure business in U.S. utilities continued to perform well, growing 4 percent 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 percent 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 19.6%, driven by our team's continued good work on price realization and productivity. This more than offset the impact of inflation, lower volumes, and a weaker mix of higher margin dewatering revenues. Please turn to slide seven. The applied water system segment delivered 1% organic revenue and orders growth in the quarter. This was below our expectations 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% 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 segments industrial and markets. Also, commercial building services revenues declined mid-single digits against a tough comparison of 12 percent 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 percent growth overall, led by 8 percent growth in the U.S. Western European revenues declined 6 percent 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 percent. Execution of productivity programs and continued price realization more than offset inflation in a weaker revenue mix due to lower U.S. commercial and industrial volumes. Now, please turn to slide eight. The measurement and control solution segment delivered 8 percent organic revenue growth in the quarter. Organic orders growth declined 11 percent, but that's against a tough comparison to last year's third quarter when we had 31 percent organic orders growth driven by a few large project wins. Total MNCS segment backlog grew 10 percent giving us continued confidence in the segment's outlook through next year and beyond. The MNCS water business continued 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. Census, in particular, had a strong quarter, growing organic revenue 10%, led by double-digit growth in its water business. Census delivered 5 percent growth in the U.S., led by 9 percent growth in water, partially moderated by lower growth in energy applications as we lap the large electric meter deployment. Our teams have done excellent work expanding our metrology business internationally, where the water business grew roughly 30 percent in the quarter. We are clearly seeing the benefits of leveraging the Global Asylum 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 percent, 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 percent, which is in line with our expectations. Volume and price gains plus 340 basis points in productivity more than offset moderating inflation in growth investments. Please turn to slide nine. 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 to $240 million. Our working capital in the third quarter increased 80 basis points year-over-year to 20.6 percent, 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 collection. 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 plan. We remain fully committed to meeting our target of 105 percent free cash flow conversion for the full year. Please turn to slide 10, and Patrick will cover our 2019 end market outlook. Patrick Higgins- 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 the 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 in 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 translations. 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, we'll take a moment to walk through the changes in our revenue expectation from our last earnings goal 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 percent organic revenue growth, roughly 180 basis points of 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 the 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 percent. 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 AIS businesses. This mixed 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 percent. 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 88 to 90 cents 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 percent, and we are adjusting our full-year Euro rate slightly downward to 111. Our FX sensitivity table is located in the appendix. Finally, we're increasing the full-year estimate for restructuring and realignment costs to a range of $75 to $85 million. This reflects the cost of additional actions we took during the third quarter to optimize the Census 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'll 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 census 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 gives confidence 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 an 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 31st 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.

The floor is now open for questions. At this time, if you have a question or comment, please press star 1 on your touch-tone phone. If at any point your question is answered, you may remove yourself from the queue by pressing the pound key. Again, we do ask that while you pose your question, you pick up your handset to provide optimal sound quality. Thank you. Our first question is coming from the line of Dean Dray with RBC Capital Markets.

Thank you. Good morning, everyone. Good morning, Dean. Hey, maybe we'll start with making sure we've calibrated which businesses are feeling most of the slowdown. And 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 are the right numbers? And then what kinds of end markets and activities are you seeing reduced in terms of demand here?

Yeah, so, Godwin, it'd be, you know, a little bit more, a little bit higher percentage, you know, maybe 10 percent. And to your point, Dean, you know, oil and gas, is, you know, it's not a big piece of it, maybe, you know, four or five percent. 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, you know, mining, construction, So that was really where we felt it the most. Rental was still, you know, pretty solid up, you know, mid-single digits. But as we, you know, worked through the, you know, the first part here of October, we have seen downward trends in our rental business as well. And 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, Dean, in speaking with the distributors is it's less of a destocking and it's really more just holding back on further investment just given the uncertainty in the CapEx budgets 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 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 lasts through Q4. We'll know more about how far it goes into 2020, I'd say, over the next couple of months.

But, you know, 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, those new orders at more than 80%, that's impressive. And it just seems so, you know, 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, you know, just give us a sense that it was the timing to cash was the factor, but some more color there would be helpful.

Yeah, 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 revenue synergy benefits of that integration. It is also some of the other digital solutions that we brought on board because the goodwill had to be looked at across the entire platform. And the reality is even though 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, you know, we talked about 60% increase in the bidding pipeline last quarter. We saw continued growth in the bidding pipeline this past quarter, and then it really is punctuated with the, you know, nearly 85% orders growth in the quarter and double-digit revenue growth. So, you know, look, we, you know, 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, you know, 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 aren't 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 trade show, and if you could give us some color around that. as well. Thanks. Yeah.

Sure, Dean. 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. You know, we still do pilots, you know, many times the 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 of what we're doing. And so, you know, the reality is, you know, 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, you know, 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 it 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 and determine where are the losses coming from, and therefore how do we optimize that deployment. So this was, you know, the one specifically in China was driven predominantly by our Vicente 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, you know, we're very encouraged by that because the more we get of these, Dean, 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 Millis Research.

Morning, guys. Good morning, Scott. I imagine you guys and Dean would be a lot of fun at a cocktail party talking about it. We would. God love you both. Yeah, it's fun. Anyways, I had to pick on him. I love Dean.

He's looking to get back online.

He's probably going to come down to my office and kick my ass. He's a pretty tall guy. Anyways, I wanted 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, you know, the five-year planning cycles, do they give you pretty good visibility on that kind of stuff, or are you walking into each, you know, quarter just kind of, you know, waiting for the phone to ring? How does that work?

Yeah, 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 the 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 rates. 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, et cetera, 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, you know, as the Fed's cutting rates and everybody is starting to worry about the macro in such an extreme. But is it skilled labor, non-skilled labor? Is there some sort of dynamic that's changed meaningfully in the last year? Is it related to people that can actually execute on these projects?

Yeah, we're seeing it largely as non-skilled labor, you know, particularly in the construction areas and kind of, you know, 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, you know, even yesterday, I think the Fed chair talked about tightening labor markets, you know, 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 U.S.-specific issue that we're seeing. And what we're also seeing at Shell, Scott, to a lesser extent, but we talk about project delays in 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 re-engineer the quote. The projects will still go through. We still see them in the 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 costs.

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

Thank you. Thank you.

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

Good morning, everyone.

Good morning, Nate.

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, you know, whatever has 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, very good question and an appropriate one, obviously. Our view over the long term, and I would even say now over the near or 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 aspects of AIA broadly, because we really are looking now at It's 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, you know, 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, you know, what we've learned and what I certainly have personally learned is that the conversion cycle for the utilities has simply been longer than we had originally anticipated. You know, in some cases, the sell cycle has been up to a year on the digital solutions because of the need to run pilots. you know, the procurement process that I talked about earlier, and just the fact that, you know, this is, you know, we're bringing disruptive solutions to a sector. And, you know, what I've certainly learned as well is that this was not going to be a straight line. You know, 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 is 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 Vicente that won that project. Vicente has been a pretty small business. And you talked there about the ability to pull through technologies from the other parts of the business. Maybe you can talk about whether it's just this specific project or more general, kind of what other content, you know, a non-revenue water project won by Vicente can pull through for the rest of Xylem?

Sure. Yeah, it's a great question. So, 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, you know, Vicente just happens 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 this but other examples as well, India, Australia, we've got an example here in the U.S., where they were able to go in and start off. They were the ones that opened the doors. 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 can be a range of things that happen. It's no different than whenever, you know, our MNET team goes in and our team applies that MNET technology around, you know, stormwater overflow or combined sewer overflows. There's the project around getting the data and doing the analysis, and that might be an ongoing SAS contract. But there are just as many opportunities to then go in and say, hey, there's a problem in the treatment plant. There's a problem in the wastewater pumping network. That can then pull through our flight 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 that other revenue is not showing up in AIAs. It's showing up in our other segments.

One quick one on industrial. We talked a lot about the drop in industrial demand here, related a lot to dewatering, 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, you're right with that observation. Nevertheless, you know, we did see decelerating water growth in our lighter industrial applications, a lot of that being in our applied water segment. So, you know, just like, you know, we're seeing in general capex spend, you know, OEMs are just, you know, a little bit more cautious in some of their spend. And we're, you know, our order trends are down. You know, we expect it to be flattish, maybe down low single digit, you know, going into the fourth quarter. And I think some of it's just general, you know, just general concerns and then managing their, you know, their operating budget.

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

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

Okay.

Thank you. Thanks, Nate.

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

Hi. Good morning. 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 look going forward. You know, this sounds cyclical, right, of some of these pressures that you're feeling, so they'll be transitory, and, you know, I think, as Dean alluded to, most companies are feeling this. But, you know, 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, you know, this kind of short cycle pressure you're feeling and the backlog, you know, what kind of visibility do you have to actually put a potential range out there for next year?

Sure, John. To 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 You know, 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 bidding activity and backlog we see there. And we are seeing, you know, our AMI metering project deployments ramping up in 2020. And then lastly, you know, 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, you know, 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 how long that's going to roll. You know, we'll have a better feel for that, I'm sure, as we get through the end of Q4. But that uncertainty, 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 laughing. I mean, again, First half of this year, industrial was up 3%. You know, 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 a tough comp in the first half. The last thing I would say is, but, you know, 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.

We have the next question, please.

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

Hey, guys. Good morning. Thanks for taking the question.

Hey, good morning.

Morning. Maybe to jump off of that topic, Patrick, since you bring up the productivity, at 400 basis points or so, I think it was the best you've seen here to date. And then on the flip side, 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? If this is the near-term trend, we should be expecting going forward for these margin drivers. And then Second question, just, you know, given the additional reset in operating margins here for fiscal 2019, I'm wondering if the, you know, the 100 basis point expansion view that you outlined earlier in the year for 2020, is that still intact, or should BBB be anticipating an update to that as well?

Thanks, Ryan. Let me take the first part of that question relative to, you know, some of what we saw in third quarter. I mentioned in my prepared remarks that The teams really did a nice job continuing to drive productivity. We continue to find places to take out 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 really started to ramp up in Q3. We'd expect that to continue into Q4 as well. And, you know, we've seen, as we expected, some moderating inflation in the third quarter as well. Certainly in our MNCS segment, as expected, as we lapped some of those component shortages and some of the higher costs we had to deal with some of the moves that we made on the, you know, to address tariffs. And also, we saw a lower inflation in applied water for the third quarter as well. And we'd expect that to continue into the fourth quarter also.

And on your question around, you know, kind of looking at 2020 and the 100 basis point of margin expansion, I would say Brian, our view on that as we stand here today is that the productivity, the pricing piece, you know, 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 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, you know, that will be the one factor that we'll make sure we get comfortable with as we give a guide for 2020. Okay, great.

I appreciate the call. Thanks, guys.

Thank you.

Your next question comes from Linus Suri Borodetsky with Jefferies.

Good morning. Good morning.

Good morning.

So you remain 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 pretty good visibility into the MCNS segment based upon our shippable backlog in 2020 and beyond. The shippable backlog in 2020 and beyond is quite healthy. I think we're looking at, like, you know, 7% growth, you know, versus last year, which is, you know, that was coming out of the quarter. We've got, you know, there is a portion of that business that is day-to-day replacement meters. And so I wouldn't want anybody to think that, you know, everything's locked in the bag based, you know, it's not all large projects. But there is a meaningful piece of that business that definitely is. You know, 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 upon what the broader economy was to do, If we were to go into a recessionary environment, then of course, you know, there's always some risk there that projects can move to the right. But that's not historically been the case based upon the diligence that we've done. Lastly, although, you know, again, it's only a – right now it's only $120 million or so of business. Again, we're seeing good ramp-up now in AIA, which is very helpful in terms of, you know, helping spike that growth rate for the segment. And then, you know, the lastly I would say is we've integrated the AIA business and the census business now into our commercial teams in Europe and emerging markets, and that's given the team already a bump up in increasing 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 it seemed like your growth in Western Europe picked up slightly from last quarter, just a little difference in some of the macro trends. So could you provide some color 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 relative strength. you know, low single digits plus in some parts of Europe, but 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, you know, the good surprises we had. And we expect, you know, we are expecting that to, you know, to continue into Q4.

I appreciate the color. Thank you.

Thank you.

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

Thanks for taking that question. 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, you know, 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. You know, 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 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 continued tuck-ins and bolt-ons of digital solutions. And then the second, not even second, but our other biggest priority is building out a more robust industrial franchise. And so we continue to look at those opportunities, and hopefully some things will come along here, but we're going to be disciplined

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

Yeah, we are. I mean, we're, you know, we had post the pure acquisition gotten a little bit of, 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, you know, we're now moving it into, you know, our targeted range, which is two and a half to three times Moody's.

Got it. Okay. Understood. Appreciate it, guys.

Thank you.

The next question comes from the line of George Giordano with Cohen.

Hey, guys. George. Hey, Joe. Hey, Joe. George here. Hey, George. Hey, George. So, look, it's hard to give guidance. I think we all appreciate that. So we've seen a couple cuts in a row. You know, 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 running 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?

Yeah, I think so, Joe. It's a good and fair point to make. I mean, 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, there are things obviously that we look at. 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 – If we had 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 its high end of our margin guidance and arrange for the quarter. Obviously, as 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, it's important that everyone note that we have been focused also on preserving investments and the key elements of our portfolio, and we'll 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, you know, the cycle will turn. We need to be prepared for that. And, you know, 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 here near the end of this last quarter and through Q4 is, again, really just getting as much visibility as possible into is this an air pocket for commercial and industrial in the U.S.? ? how long does that pocket run before you see some return to normalization? Because, you know, 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, you know, 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, 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 some heft to them? Do you have to recalibrate what what the appropriate multiple on some of those businesses are as you go forward?

I think it's, you know, 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 Zion, 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 had, Only had, you know, the non-peer 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 time frame. 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 customers. as we look at any future bolt-on acquisitions, both from a valuation standpoint. But, you know, you're never going to be able to perfectly time an acquisition and perfectly layer the price on what you're paying. You know, you don't want to overpay, of course, and we'll always be disciplined in that regard. So those are our learnings. But, no, we're not gun-shy about going on and continuing to build out this portfolio. Not at all.

That's fair. And just last, I just want to sneak one last one in here. As we get into a slower pocket in some of your cyclical businesses, your infrastructure segment has done a really nice job on margins. It's been 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 a slower growth market, how much more potential is in that segment?

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

Yeah, I think the, you know, 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 positions 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. It's the new product development pipeline. By definition, as we continue to grow that pipeline, I think right now as a company, you know, we're up to 25% in our vitality index. It's up from 22% in the first quarter. And so there's a continued ramp there that we're seeing. And that pipeline draws through it. In our experience, you know, 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. Good. Thanks, guys. Thank you. Thanks, Joe.

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

Thanks for taking my question.

Sure.

Good morning. Good morning. So my question is pretty quick and easy. I just wanted to drill into the MNCS business. You mentioned that the visibility is good. You've got 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.

Yeah, we had... Well, we had some, you know, big wins, you know, a year, year and a half ago that were electric, gas, and, you know, they're starting to roll off in where we've seen good success recently, both domestically and internationally, is in our water business. So, you know, 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, you know, 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 it higher margins.

Okay, got it. All right, thank you very much.

Thank you.

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. I know we ran a little bit long here. Thanks for your continued support and interest, and I 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 asylum third quarter earnings conference call. Please disconnect your lines at this time and have a wonderful day.