Xylem Inc.

Welcome to the Xylem Q4 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 this 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 Mr. Matt Latino, Senior Director of Investor Relations.

Thank you, Lisa. Good morning, everyone, and welcome to Xylem's fourth quarter and full year 2019 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 fourth quarter and full year 2019 results and discuss the full year outlook for 2020. 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 March 7th. Please note the replay number is 800-585-8367, and the confirmation code is 4880738. 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've 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. Let me start with some reflections on 2019's full-year results and our progress as a company. Then I'll turn it over to Mark for additional detail on the fourth quarter, and we'll round back to offer our 2020 outlook before taking questions. Focusing first on 2019, in the first half, we delivered solid growth, mid-single digits or better across our segments and end markets. But the year presented a dynamic market environment, and second-half conditions were clearly more challenging. I was pleased with the agility of our teams in adapting to those changing conditions, and we were able to deliver full-year organic revenue growth of almost 4%. Solid performances in utilities and in our U.S. and emerging markets offset some of the second-half softness in industrial and commercial end markets. Our full-year margin expansion was 20 basis points, and we closed 2019 with an operating margin of 13.9%. Earnings per share were up 5% year-over-year and up 9%, excluding the effects of foreign exchange. The fourth quarter unfolded much as we foresaw in our October earnings call, and the team's agility and discipline delivered overperformance on cash, with free cash flow conversion of 124% against a target of 105%, driven by significant working capital improvements. That kind of solid operational execution was also essential to delivering our earnings commitment in the quarter. Because we focused on managing the things we can control while also maintaining our investment for growth, we are well positioned for 2020 and beyond. We have good visibility of our pipeline of business, and we've built strong fundamentals over the last few years that give us confidence about continuing to deliver significant value creation from near-term and long-term growth margin expansion, and cash generation. So let's focus on those fundamentals for a moment. We're a very different company today than we were just a few years ago. We laid out our key initiatives to lift the growth profile of the company back at our original investor day in 2015. At the time, the company was delivering low single-digit growth. Our emerging markets contributed roughly $750 million of total revenue. Our vitality index, which is the proportion of sales comprised of new products launched in the last five years, stood at just 18%. And we weren't yet in the metrology or digital solutions businesses at all. So now five years on, emerging markets are now well over a billion dollars, with China growing more than 50% and India more than doubling over that time frame. We've also placed Dialum at the cutting edge of innovation. Our investments have brought many of the industry's leading technologies into our portfolio, and the MNCS business exposes us to market segments with higher growth rates. Our vitality index has risen from 18% to 25%. The digital transformation of water networks, which was until recently a fragmented proposition, is now an executable reality for our customers. AIA's double-digit orders growth in 2019 shows the customer enthusiasm and demand. Our job in 2020 is now to deliver on that reality and lead the sector in helping customers catch the latent value in their networks. Our annual revenue is now $5.25 billion, and we have set a consistent pace of mid-single-digit organic growth over the last three years. Of course, our emphasis on growth would be a double-edged sword if we had diluted margins along the way, but we've done the work to become more profitable as we invested to ensure sustainable growth and margin expansion. We clearly have more work to do here. Margin expansion continues to be one of our top priorities, but we have so far delivered approximately 250 basis points of EBITDA expansion in the last five years, even as we invested to reach in the new geographies and new product segments. And we've been able to deliver an average 13% compound annual growth in EPS over the last five years, significantly improved versus the previous four years. EBITDA has increased by 65% over the same period. As we digest the large deals at the front end of new growth, and as CapEx shifts to aftermarket and recurring revenue streams in the next several years, we do expect the margin profile of our growth to become even more attractive. At the same time, we brought focus and rigor to operational execution, developing the capability I mentioned a moment ago to deliver favorable bottom line outcomes even in unfavorable market conditions. Just one example of that is our increased discipline in cash generation. We've delivered average pre-cash flow conversion of 108 percent over the last five years, largely by driving down working capital from 23 percent to 17.5 percent. I expect focused operational execution to continue being a key capability for us. Any reflection on what we've been building over the last few years would be incomplete without considering sustainability. which is at the center of Xylon's business strategy. Not that long ago, our sustainability goals were sincere and ambitious, but they were largely about reducing our own environmental footprint. Today, we're equally focused on the sustainability outcomes we create with our customers and in the communities in which they operate. Because of the positive impact of our products and solutions, this is a much bigger opportunity. So we built aggressive, industry-leading commitments into our sustainability strategy, targeting the downstream impact of the solutions we provide. This is a far more meaningful approach to sustainability and one we believe is a clear differentiator. The fundamentals we've built and the trajectory we've established give us a balanced view towards 2020 and beyond. We're cautious in the face of near-term uncertainty, but we're also well-grounded and able to deliver sustained growth. We do see continued softness in some of our short-cycle revenues in the first half, In the second half, we expect that to moderate and parallel with an increasingly solid position in our backlog. We expect to be delivering mid-single-digit growth in the back half of the year and into 2021. We'll talk about that full review shortly, including some more detailed guidance on 2020. A review of the drivers of our 2019 four-year results is on slide five. I'm happy to address any of that in more detail in the latter part of the call during Q&A. But now, I want to turn it over to Mark to provide a deeper level of detail on how our segments ended the quarter.

Thanks, Patrick. Revenue growth was flat in the fourth quarter as the market softness we began to experience in the third quarter persisted, and slightly worse than we expected. Top-line growth continued to be affected by weakness in the shorter cycle industrial market, as well as some softness related to timing of sales in the commercial end market. Organic orders in the quarter also came in soft, down 6 percent versus the prior year. We did see some deceleration of order rates in the quarter, although it is worth noting that we were lapping a 10 percent organic orders growth rate in the fourth quarter of 2018. The soft orders intake at the end of the year certainly influences our view on top-line growth for the first half of 2020. As we look at revenue performance across the end markets, we saw strength in utilities continue, up 4 percent in the quarter, with growth reflected across most major geographies. Industrial end markets were down 3 percent, weaker than expected and primarily impacted by the same short cycle dynamics we experienced at the end of the third quarter. Our commercial end market was down 5 percent, with declines across most major geographies, and the residential end market was down 2 percent, which was slightly better than expected. I'll cover end market dynamics in more detail as we move through the segment discussion. Operating margin was 15 percent, down 10 basis points versus the prior year. I'll also review operating margin performance by segment in a moment. But as we look across the businesses, Weaker-than-expected volumes and unfavorable mix, particularly from the double-digit declines in our high-margin dewatering business, negatively impacted the quarter's margin performance compared to our expectations. While I'm disappointed in our revenue growth and margin performance in the quarter, I am pleased with the team's operational execution and cost discipline to deliver strong cash flow and meet our commitment on earnings per share of 89 cents. Please turn to slide seven, and I'll review our segment performance for the quarter. Water infrastructure orders in the fourth quarter were down 8% versus last year, driven by declines in our dewatering business as well as timing on large project winds. Total shippable backlog in the segment exiting 2019 is up 7%. Backlog shippable within 2020 is down 1 percent, while shippable backlog in 2021 and beyond is up double digits, reflecting the near-term softness expected in the first half of 2020, along with a strong backlog of large projects in hand to be delivered beginning in 2021. Water infrastructure revenue grew 1 percent organically in the quarter, as the 11% decline in our North American dewatering business largely offset mid-single-digit growth in the rest of the segment. While we had expected the dewatering business to be down in the quarter, rental revenues in North America declined 17%. This was softer than expected due to a sharp decline in rentals to oil and gas customers, as well as lower year-over-year rentals related to storm events. We expect this cycle to persist at least through the first half of the year. Operating margin for the segment remained flat versus last year at 20.7 percent in the quarter. Significant savings from net productivity and cost reductions were offset by volume declines and the negative mix impact from our North American dewatering business. The segment delivered 70 basis points of margin expansion for the full year, ending at 18.2 percent. This reflects continued gains across the year in price realization and productivity, more than offsetting the second-half volume declines in weaker revenue. Next. Please turn to slide eight. Applied water revenue declined 2 percent in the quarter, driven by lower sales in commercial building services, as well as modest declines in residential. Segment orders and backlog were each down 1 percent in the fourth quarter. Shippable backlog within 2020 is down 4 percent versus last year. Both of these indicators are pointing to what we expect to be a softer first half of 2020 for segment revenues. From an end market perspective, commercial decline 5 percent in the quarter with tough compares driven by the timing of prior year shipments related to price increases for tariffs in the U.S., as well as some slowing demand in Western Europe. Residential was down low single digits in the quarter, driven by economic softness in Europe. The U.S. residential market was a bright spot, up 6 percent in the fourth quarter and up 10 percent for the full year. driven by modest share gains and some improvement in housing market activity. Operating margin declined 60 basis points in the quarter to 16.6 percent. Volume declines in the commercial business, geographic mix, and overall inflation were not fully offset by strong productivity and price realization in the quarter. Despite the challenging fourth quarter, for the year, The team was able to deliver 50 basis points of margin expansion mid-market headwinds and tariff impacts by driving 250 basis points of price realization and 400 basis points of productivity across the business. Now, let's turn to slide nine, and I'll cover MNCS. Measurement and control solutions orders declined 7 percent organically in the quarter, which primarily reflected a tough compare to 18 percent orders growth in the prior year, which included a large Middle East metrology order and the timing of large North American energy orders. Revenue increased 2 percent, driven by mid-single-digit growth in census and partially offset by modest weakness in the analytics business and project timing in AIA. Segment backlog exiting 2019 is up 8 percent. Shippable backlogs in 2020 are down 4 percent, reflecting the impact of the timing of large project deployments, with most of the decline in the first half of the year. However, shippable backlogs for 2021 and beyond are up double digits, providing confidence on revenue growth momentum in the back half of 2020 and into 2021. Census revenues in the quarter grew 4%, driven by growth in water and energy metrology deployments in emerging markets, while lapping a tough compare of 13% revenue growth last year. Advanced infrastructure analytics revenues declined 3% in the quarter with several project push-outs. Orders were also down in the quarter, although it's worth noting that this is coming off a third quarter with nearly 85% organic orders growth. Full-year orders, revenue, and backlog were up double digits. We expect to continue to see relatively lumpy revenue and orders growth on a quarterly basis as we scale this project-driven business. Segment EBITDA margins in the quarter were up 80 basis points to 18.1%, and segment operating margin increased 20 basis points to 7.7%. Net productivity benefits and price realization were partially offset by weaker revenue mix. From a full-year perspective, EBITDA margins declined 100 basis points to 18.2 percent, and operating margins declined 90 basis points to 8.5 percent. Unfavorable mix in the impact of strategic investments ahead of a slower-than-expected ramp of digital solutions revenues were partially offset by 390 basis points of productivity, volume leverage, and 80 basis points of price realization. Now, let's turn to slide 10 for an overview of cash flows and the company's financial position. We closed the quarter with a cash balance of $724 million. We invested $51 million in CapEx in the quarter. and returned $43 million to shareholders through dividends. Working capital also improved significantly versus 2018, ending at 17.5 percent of sales. This is 150 basis point improvement from last year, driven by the team's focus on operational efficiency, significant reduction in inventories, and solid improvements in accounts receivable collections and payable. Our cash conversion cycle improved by five days in 2019, with a strong second-half push, which enabled us to grow free cash flow 75% for the full year and deliver free cash flow conversion of 124%. Lastly, we also announced an annual dividend increase of 8%, representing our ninth consecutive annual dividend increase. Please turn to slide 11, and Patrick will cover our 2020 outlook.

Thanks, Mark. Given the slow revenue growth and mixed outcomes in the second half of 2019, we took an extremely close look at the forward profile of our business based on what we saw as we exited the year. One of the lessons of 2019 is a reminder of how much the short cycle business still impacts our revenues and margins. So we're being appropriately attentive to uncertainty in short cycle market conditions as we guide for 2020. We are also taking into account the revenue profile of our highest growth businesses, including treatment, census, and AIA, and our two fastest-growing emerging markets, India and China. Because these businesses deliver a higher proportion of large CapEx-intensive projects, we've been careful to account for timing effects in our guidance. Several of you have heard me say that growth rarely happens in a straight line. This year is going to provide good evidence of that. It's very much a story of two halves. In the first half, we see flat to down organic growth in utilities. This is primarily due to tough year-over-year comparisons. You may recall U.S. utilities was up mid-teens in the same half last year, and we're also lapping several large projects in the same period. In industrial end markets, the muted conditions experienced in the second half of 2019 are expected to constrain our short-cycle book-and-ship business at least through the second quarter. Although we anticipated this continued softness as we exited the year, Since then, events in China have further tempered our short-term outlook. The impact of the coronavirus has, for the time being, essentially halted deliveries within China, which is our second largest and fastest growing market, and it's slowing trade in Asia more generally. As of today, our best view is that the first quarter impact of the coronavirus to the company is likely to be approximately one to two points of revenue in the quarter and three to four cents of EPS. It's obviously a dynamic situation, and we are monitoring it very closely. In light of those first half challenges, we are being cautious in further managing costs down in 2020 on top of realizing savings from the restructuring actions we took in 2019. Those actions, combined with the operational discipline we demonstrated in the second half, will enable us to maintain our investments for growth through this period of market headwinds. We see a return momentum in the second half and into 2021. In utilities, we have clear visibility of significant growth from deals in hand in the second half of the year, including a half-dozen large census AMI deployments. We also expect double-digit growth in the second half of the year in both China and India, driven by project deployments. And based on the information we're receiving from our customers and distributors, we foresee a moderate recovery in industrial and commercial end markets and a return to modest revenue growth in the second half. For good measure, The third and fourth quarters will also be lapping the soft second half we've just experienced, giving both quarters the opportunity to build on favorable year-on-year comparisons. In short, in the second half of 2020, we anticipate returning to mid-single-digit growth overall. Now please turn to slide 12. For the full year, we anticipate utilities will end 2020 with low single-digit organic growth benefiting from a recovery in the second half of the year as U.S. OPEC spending normalizes to healthy levels and smart meter deployments continue to ramp up. Industrial is expected to come in flattish despite modest recovery in the second half, and we anticipate the first half softness in commercial will be largely offset in the second half and the market to be up low single digits for the year. For Xylem overall, we foresee a combined picture of full-year 2020 organic revenue growth in the low single digits. And we expect to exit 2020 with momentum and increased visibility of committed revenues, given the strong backlog position heading into 2021. It's a dynamic environment, so we will continue to manage through elements of uncertainty by focusing on the things we can influence, effectively controlling our costs and driving productivity so we can continue to invest to ensure sustainable growth over the long term. we are fortunate to be well positioned with a balanced global portfolio that we expect to continue delivering healthy cash generation through the year. By the end of the year, we foresee having approximately $1 billion in cash on hand. Given the growth in our cash balance, there has been understandable interest in our stance on capital allocation. Alongside organic investment, M&A remains a top priority, and we do see opportunity for some investments this year. Having said that, We are considering all options for capital deployment, including additional returns to shareholders in 2020 under existing share repurchase authorizations, which have a remaining capacity of more than $300 million. Now I'll turn it over to Mark for a bit more detail on both the first quarter and the full year.

Thanks, Patrick. On slide 13, we've provided our 2020 planning assumptions, as well as a profile of the first and second half market dynamics, which Patrick just reviewed. In the first half of 2020, we expect revenues to be down low single digits and then return to mid-single-digit growth in the second half. We're guiding to 1 to 3 percent organic revenue growth for 2020. This breaks down by segment as follows. We expect flat to 2 percent growth in water infrastructure, with solid growth in utilities being partially offset by continued weakness in our North American dewatering business, which will be lapping double-digit growth compares through the first half of the year. In applied water, we expect flat to 2 percent growth through the full year as the segment enters 2020 with weak water trends and lower shippable backlogs. In measurement and control solutions, we expect 4 to 6 percent growth with strong second-half revenues related to project deployments, offsetting lower first-half growth against tough prior-year compares of 15 percent growth in North America, driven by double-digit growth in water, as well as large energy project deployments. We're assuming a Euro rate of 111, which was the average for the month of January. Our FX sensitivity table is included in the appendix. Our estimated tax rate for 2020 is 19.5%. Non-cash pension income is expected to decline by $15 million, or 7 cents per share, due to the planned buyout of our UK pension plan. Expected 2020 EPS of $2.96 to $3.16 is an increase of 1 to 8%, excluding the impact of foreign exchange translation and the reduction in non-cash pension income. Moving to the first quarter, with shippable backlogs down 3% and at least one to two points of revenue growth impact from the coronavirus in the quarter, we anticipate total company organic revenues will decline in the range of 3% to 5%. We expect first quarter adjusted operating margins to be in the range of 8% to 9%, representing 180 to 280 basis points of contraction versus the prior year. At the Xylem level, this will be driven by unfavorable mix in lower volumes, largely in our North American dewatering business, the Census North American metering business, and in China. EBITDA margins are expected to be in the range of 14.1 to 15 percent. We see EBITDA margins breaking down by segment as follows. We expect water infrastructure to be in the range of 13 to 13.9 percent, applied water to be in the range of 16.2 to 17.1 percent, and MNCS to be in the range of 14.8 to 15.5 percent. With that, please turn to slide 14, and I'll turn the call back over to Patrick for some closing comments. Thanks, Mark.

The transition from 2019 to 2020 sees us emerging from one year of two-halves and entering another year of two-halves. Despite near-term uncertainty, 2020 presents a balanced picture. There are still some muted market conditions in the short term, but as we look toward the second half of the year, our backlog and our line of sight to the timing of major projects provide a high degree of confidence both about our guidance for 2020 and about the momentum to which we will return as we exit this year. And both now and over the longer term, we remain grounded in the tenets of our investment thesis. We expect to continue to deliver attractive top-line growth from our investments in the capabilities and solutions that enable our customers to transform their businesses. We remain committed to ongoing margin expansion while maintaining our investments in future growth by pursuing the productivity, cost, and simplification initiatives that will make those margin gains sustainable. And we will continue driving disciplined cash generation and to enhance our capacity for attractive capital deployment, including investment in organic and inorganic growth and increased returns to shareholders. We'll provide an update on our strategic priorities and our long-term plans at our upcoming Investor and Analyst Day on March 31st. We'll look forward to sharing more detail on our technology and solution capabilities, discussing our growth plans, and hearing directly from some of our business leaders and customers. I'm hoping to host as many of you as possible then at our Data Analytics Center of Excellence in Atlanta, Georgia. Now operator, we'll turn the call over to you for questions.

The floor is now open for questions. At this time, if you have any questions or comments, please press star one 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 while you pose your question that you pick up your handset to provide optimal sound quality. Your first question comes from Ryan Connors with Loaning Scattergood. Ryan Connors Great.

Thanks for taking my questions. I think you covered a lot of the details pretty well. I had a couple of bigger picture questions actually. The first one is just strategically, obviously you're transitioning here to a bit of a different period. Headwinds may in fact be transitory, but cost control and restructuring is becoming a more important part of the story right now, especially in the near term. So obviously you've said in the past you don't want to cut into bone, but can you just talk about how you look at the things you're doing in cost control and restructuring relative to R&D investments and other things? You talk about the vitality index and how you ensure that you don't lose that momentum on innovation and R&D and product development as you kind of rationalize things. Go ahead.

Yeah. Hey, Ryan. Morning. Yeah, it's Mark. I mean, it's a great point, and it's certainly something that we pay close attention to. At the end of the day, we're going to create the most value by, you know, growing. We need to continue to maintain our investments in R&D. You know, we are continuing to invest to grow out our digital solutions platform. So we're really focused on, you know, those areas of spend where, you know, we've got too much complexity, where we've got redundancy in the organization. And last year, you know, we launched, you know, a series of restructuring efforts to get after that very thing. And, you know, the savings coming from those programs, you know, all in are going to be, you know, roughly $40 million. We're continuing to look at opportunities. We continue to drive costs out through great work that all of the teams are doing through Tony Malondo's leadership and are under continuous improvement. You know, there's savings that, while a little bit delayed in GBS this past year, will provide opportunities to reduce complexity and take out cost as well. So we're not looking at cutting back on investment at all.

Yeah, Ryan, it's a great point. And I think that, first of all, we still see there to be a high level of continuous improvement opportunities across the company as we've deployed Lean Six Sigma starting a handful of years ago. But we're still in the early stages, quite frankly, from my perspective on where the opportunities are, especially beyond the four walls of the factory but across the rest of our P&L. But, you know, we are definitely going to be investing through this near-term noise. We adopted a handful of years ago what we called a productivity for growth mindset, where a meaningful portion of our productivity has been invested for growth because we believe this is a long-term game, to your point.

Okay. And then my follow-on was related in that if you look across the industrial landscape the last few years, it seems that this sort of portfolio pruning kind of targeted divestitures have become a popular strategy for companies when they're facing tougher times. Lots of peer companies going that route, whether they call it realignment or pruning. Is that something that's on your radar, or are there any lower-margin brands or businesses that you would consider or is everything you have considered kind of core?

Yeah, Ryan, so, you know, we take at least an annual review, if not even more frequent than that, of the growth profile, but also the returns on capital, you know, economic value creation is the criteria that we apply across, you know, each of our business lines. You know, as we sit here today, there really are, while there are some businesses that might be diluted at times in cycles to growth, There's nothing right now that is anywhere close to not delivering its return on capital above the cost of capital. So everything clears the hurdle at this point in time. But it is something that we look at on an annual basis at a minimum.

Okay, great. Thanks for your time. Thank you. Thanks, Ryan.

Your next question comes from the line of Dane Drake with RBC Capital Markets.

Thank you. Good morning, everyone.

Good morning, Dane.

Good morning.

Patrick, I was hoping you'd give us some high-level thoughts on guidance here. I think you've done a good job explaining the dynamics, first half, second half. But I'd be interested in hearing if you've taken any different approach this year to setting guidance, maybe along the lines of embedding some more conservativism, maybe some implied contingency, because there is variability there. to your earning stream, especially with a short cycle dewatering business. But has there been any change in terms of how you're approaching guidance?

Yeah, I think that, Dean, as I look back and reflect on kind of what we learned in 2019, as I mentioned before, you just reiterated, a meaningful portion of our business is still short cycle. Heading into 2019, we were still feeling pretty bullish based on what we were seeing in the marketplace. But quite frankly, we should have built in more contingency into that view. We think this guide is a balanced view. We clearly see near-term headwinds that we laid out, you know, order soft MP2-4, lower survival backlogs coming into the year, clearly the uncertainty with China, coronavirus, and some tough comps. But what gives us confidence about the second half of the year is the projects and backlog that we have already in hand for second half, and just assuming a modest return to growth in the short cycle. Again, not a miracle is required in the second half here. So we do feel it's achievable, but it's appropriately risk-adjusted.

Got it. And then you all are one of the only companies in the industrials and certainly ones that we follow that have actually embedded a revenue and EPS impact from the coronavirus. We appreciate the fact that you've taken this approach and Maybe just give us some real-time color in terms of how your businesses are being impacted. You know, you've got three or four cents negative impact, but is there any other lasting effects that you see in terms of relationships or the types of demand fallout that you're seeing today?

Sure. Great question, Dan. Appreciate that you appreciate that we've tried to be transparent here. You know, we felt it would be disingenuous not to lay out, you know, real time as of what we see right now impacts on the business given that it is our second largest business outside of the U.S. So first, as you all appreciate, the safety of our people is absolutely paramount. Secondly, we are, although we're not advertising it, we are heavily involved in the humanitarian response in Wuhan. We've been delivering pumps and offering to build water towers there at some of the pop-up hospitals. So that's been very important. As you said, this is very fluid. And so what we do know right now is that there would be impact on the shutdown of our factories because right now we have halted deliveries. Again, we don't know how much of that is simply delays versus it would get recovered either in the quarter or in Q2. So we're monitoring that very closely. There clearly is an impact on our supply chain. in terms of our suppliers being down as well. And so there's that kind of knock-on effect that, again, we think would be recovered over the course of the year, but we're trying to keep a handle on what that is for certainly Q1. And that's really the basis on which we laid out the impact on revenue and earnings per share. Again, we're going to keep monitoring this very closely and certainly in a position to give you all updates no later than investor day.

Appreciate that. And then can I also ask some questions on the free cash flow guide? So first of all, great work this year. So that was a vindication year, if you will, Mark, for the team on cash flow performance. So we appreciate that. Is there any other color you can give us on the guide of 95%? Is that also a conservative cut? We look at, I see CapEx is up, so that explains some of it. But I'm concerned there might be some give back in the working capital improvements that you did, especially in the fourth quarter. So give us some context there, please.

Yeah, Dean, and thanks for that note. We were certainly looking to vindicate ourselves after last year. But, you know, a chunk of that was timing, as we discussed. You know, we had built up inventories. We had a big ramp up in sales at the end of the year, you know, high single-digit growth. And, you know, to some extent, while, you know, the teams did a great job driving down inventories, there was a lot of inventory to drive down. We had softer volumes, and we maintained good discipline around our inventory build. We've done a better job on collecting cash, managing payables. And I would say that we're certainly expecting, as we took you through in prepared comments, you know, a ramping up of revenues in the second half. So there will be, instead of a, you know, working capital being a, you know, a source, it won't be as big a source of cash flow in 2020. However, we're still looking at improving our cash conversion cycle and reducing days both in inventories, receivables, and payables.

And I would just add, Dean, we think it's a very balanced view on working capital. There's really no major movement built into our guide here on working capital. Obviously, we'll have some of the pressure that Mark alluded to here, but there's still opportunities to try to mitigate that as well. We feel much better about the spot that we're in with working capital now than we were a few years ago. I think to your question also on conversion, you picked up on the CapEx, the modest increase there. And that really is driven predominantly by some expansion plans that we've laid out for India to support the, you know, really breakout growth there, as well as continued investment in some of the software in the MNCS, but also our other segments where much of that gets capitalized. And so those are really the two big drivers for CapEx increase in 2020. Thank you. Thank you. Thanks, Tim.

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

Good morning, everyone. Good morning. I'd like to go back to some of the guidance, specifically the mid single digit expectation in the second half. I mean, clearly you're going to have easier comps. It sounds like you have some shippable backlog there, primarily around the MCS kind of stuff. I think there clearly has to be an expectation here that you're going to see short cycle improvement. You probably need to see the orders start rolling in about the second quarter to ship those in the back half. Can you talk about for that mid single digit growth rate in the back half, what you have in hand, what's in backlog in terms of these projects versus what kind of improvement you need to see in the underlying environment, what kind of growth you need to see in order rates over the next couple of quarters to support that outlook in the back half?

Sure, yeah. Hey, Nate, it's Mark. You know, I think it starts with the confidence that we've got, certainly in the utility space, broadly, but, you know, accentuated in our MNCS business. There are, you know, the way the projects work in terms of deliveries year over year, they, you know, the backlogs are much stronger. in the second half of the year. We also, you know, we're not looking, as Patrick said, for a miracle in terms of, you know, recovery in the short cycle businesses, but they are going up against much tougher compares. Or easier compares. I mean, easier compares. So I would say what really gives us confidence is more in terms of you know, projects in hand in the back half of the year versus, you know, a strong recovery in our short cycle business.

And we've been hearing as we stay close to our channel partners as well, Nate, especially here in the U.S., that they feel quite good right now about bidding and quoting activity that they're involved in. And part of the softness they saw in the second half was working down some of their inventory that they bought in ahead of the price increases that we had done. So, There's a bit of that. So more of the pressure that will linger in the second half would be in the industrial business. And that's the one that we're staying closest to in terms of seeing what that order rate looks like in Q2.

Okay, fair enough. I'd like to then talk a little bit about mix, both here in 2020 and longer term. I mean, clearly you've got some headwinds from stuff like dewatering. It's very high margins. you're going to have some mix headwinds on these MCS projects as you roll out the hardware initially. Can you talk about what you anticipate the impact of mix to be, whether it's basis points of margin or however you want to catch it in 2020? And then if you look forward, I would think, let's say dewatering recovers and these MCS projects get the hardware installed and move to software, you should see an improving mix as we go forward over the next few years. Can you talk a little bit more about, you know, what kinds of impacts we should expect to see that have on margins as you go forward, you know, qualitatively or quantitatively?

Yeah, hey, Nate, it's Mark. You know, we're going to lay out a lot more of this, you know, when we get together in March. But clearly, you know, it gets back to the story. It is a story of two halves, right? And, you know, our mix, it's really tough given compares in our dewatering business in the first half of the year, and also certainly in the first quarter plus, the compares with our census North American water growth. But that does turn around in the second half, given the project deployments that we see in MNCS, just an easier set of compares in you know, in our short cycle businesses, a little bit more robust growth, as Patrick mentioned, given some of the timing in commercial business services. And, you know, we are expecting to see a better ramp in, you know, in our digital solutions business. So it'll, you know, first half tough, second half better, but all in, it's probably not a big contributor to overall margin expansion.

So, Nate, this is Patrick. You've raised a very important point here, I think, for investors to look at and understand, and we will go into much more detail on this at Investor Day, is the impact that we see from the shifting growth profile of the company to the higher margin. We will see a recovery in dewatering. It is very high incremental margins, but on top of that, we will see the adoption of AIA and MTS overall which will have very nice and creative margins, higher growth profiles. So that mix is going to be part of our story of yesterday, but that does not remove us from focusing on what we control, and that is productivity, cost, and our investments.

Okay, thanks very much. I'll pause it on.

Thank you.

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

Lisa, maybe we'll come back to them and we'll go to the next one.

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

Hi. Good morning.

Good morning, John.

Hi. Yeah, thanks for all that detail and the prepared remarks. I guess following on the last question, just wondering if we could have a conversation about how some of the restructuring and realignment savings flow through. I'm just trying to put everything together and looking at what your implied Q1 decrementals are and then how we get positive. Obviously, you highlighted a lot of stuff already around volume, et cetera, but Maybe you can talk about how the savings flow through into 2020, and I'm assuming some of that stuff has a tail into 2021 as well.

Yeah, yeah. So the 2020 restructuring and realignment is, you know, primarily around business simplification. You know, it's GBS related, so we are seeing benefits coming from our procurement tower. Finance, as we've talked about, is going to be delayed into later into 2020. But we did initiate some programs last year in terms of simplification in Europe, additional actions in North America. And, you know, as we look at those benefits, you know, we're certainly expecting them to ramp up through, you know, through the year. particularly those actions in Europe, which were, you know, just take longer to work through the Works Council.

I mean, any way to kind of quantify an H-1 versus an H-2 benefit, just so we can kind of help for the modeling purposes?

There's about $6 million of restructuring savings in Q-1, John. Okay.

And then, you know, obviously appreciate, you know, you gave the details around the backlog shippable into 2020 and also visibility into 2021. Can you just remind us how firm those orders are? Like once a customer decides to place an order, are there, you know, either progress payments or cancellation fees? Just wanted to understand that a little bit better.

Yeah, John, they are, you know, these are commitments. Now, in some cases, particularly in some of our larger infrastructure projects, particularly in emerging markets, but not limited to emerging markets, we do look to get advance payments. The, you know, while the orders are in hand, as long as there's a commitment, some of these, you know, the timing of them can move out from quarter to quarter. So that's always something that we need to pay close attention to. But these are certainly things that there are commitments for, but timing can shift in any given quarter.

Yes. Very rarely, Patrick, very rarely would they be canceled. And when you think about even our metrology deals that we do, especially in the AMI side. You know, the economics on these things, the returns on capital for utility, once they've gotten these things approved in their rate case by the regulator, are so attractive for them that it would be rare for them to ever cancel one of these. And that's a big part of what we see in the shippable backlog beyond 2020.

Great. Thank you for the color. Appreciate it. You're welcome.

Your next question comes from Pavel Molchanov with Raymond James.

Thanks for taking the question. You guys alluded to the hefty cash balance that you're expecting by the end of the year and in that context. Let me ask about the M&A landscape. You guys are seeing the headwinds, presumably many smaller players in the water tech space are seeing as much if not more. Is the valuation opportunity becoming more interesting from a consolidation angle?

You know, I would say we've not seen, you know, any meaningful change in valuations to date. Obviously, you know, that could change based upon the, you know, the volatility you alluded to. And so, you know, we are always evaluating. We think we have a very attractive pipeline of opportunities. We will always remain disciplined on valuations and, again, make sure that these things are critical to really enabling the strategic growth of the portfolio. So again, as we mentioned earlier, we think there are some opportunities out there this year. But again, we'll have more of an update on that at Investor Day in terms of what that pipeline looks like, at least directionally.

Okay. Your next question comes from the line of Joseph Giordano with Cowen.

Good morning, guys. This is Francisco Amadorian for Joe. Could you expand on why you expect MCS margins to be so low to the start of the year and just what your longer-term margin target is for MCS and how you get there?

Yeah, Francisco, it's Mark. There's a couple of things. One, your volumes are down, and we'll see some impact on that relative to leverage. But also mix, as I mentioned in our prepared remarks, you know, our North American water business had a really tough compare year over year, very high margins. And also, you know, just given some of the timing we see in our high margin digital solutions business, there's some mixed impact there as well. And the last point, and Patrick mentioned this, you know, despite the, you know, the soft patch in terms of volumes and mix in Q1. We are continuing to invest. We've got customer commitments we need to meet. We also, you know, we're excited about, you know, the opportunities in the digital side. So we're actually increasing our investment year over year.

And I would say just to punctuate the investment comment, the couple of areas that are really our priority to invest in that segment right now are predominantly Again, meeting some of the customer commitments on some product modification for some of the large deals. We do have some new products that we're looking to roll out this year in the metrology space that we think are going to be very exciting. And then lastly, continuing to invest in building out the go-to-market infrastructure for the digital solutions capabilities that we've got. And that's not just in the U.S. That's on a global scale.

Okay, great. Thank you. And then just as a follow-up, are you seeing any aggressive pricing by competitors in the dewatering market having an impact on margins? And do you have any color just on the competitive landscape here?

Yeah, I think, you know, the dewatering space has always been quite competitive from a pricing standpoint, although obviously the margins are very attractive. You know, I'd probably rather not comment too much on competitive pricing, you know, at this stage. But I would say we don't really – I don't think we see a major sea change in that area, but it's always been a competitive market that we, you know, and what really helps lift margins in that business is just the emergency nature of it and how critical the services are to customers when they are in need.

And obviously, as volumes are softer, it's, you know, it's even more competitive.

Great. Appreciate it. Thank you. Yep.

Your next question comes from the line of Brett Lindsey with Vertical Research Partners.

Hi, good morning.

Good morning.

I just wanted to come back to the second half guide. Could you just put a finer point on the size of those specific MCS deployments that you expect? And then thinking about the delivery timetables there, is it pretty balanced between Q3 and Q4, or is it pretty loaded up in the tail end of the year?

No, it's fairly balanced. And, you know, it is certainly a component. But, you know, we have a global business, and we see continued improvement in, you know, in just, you know, recurring revenue and replacement of meters as well. But the thing that really makes the difference is a little bit a little bit easier to compare and more robust backlogs that are pretty much evenly expected to deploy across Q3 and Q4.

Is there any way you could quantify the size of the projects and call it points to the year or absolute dollars?

The growth in the deployment

of these these larger projects is you know it's mid single digit plus impact okay got it thanks um and then just shifting back to the restructuring question uh go ahead go ahead yes okay yeah shifting back to the restructuring question i am a bit surprised you know given the softness and some catch up on the simplification efforts here and doing more from a restructuring standpoint this year um maybe just the thought process there and then you know, how you're thinking about the drop-through on savings and payback timing.

Yeah, you know, the savings, you know, we discussed have always been phased. It doesn't happen all at once. The programs that we undertook from a simplification perspective last year in Europe and North America, were really rolled out as we saw things moving in the back half of the year. So we start to see that ramp up throughout this year. We saw some benefits at the end of last year, but we'll see more this year.

This is Patrick. Again, you think about any time you've got restructuring programs, you've got some that are rolling off as you're lapping. And so we had taken restructuring in the first half of last year that we had announced that really began to benefit second half of the year and trails a little bit into this year. That phase was done. That was kind of phase one in Europe. We had a phase two in Europe that we launched in the second half of last year. And just given the lead times involved in getting things like, you know, works council approval, you know, there's some factory implications, so these things have to be managed. We expect those to happen in the second half of the year. So, you know, there's always a bit of phasing here in terms of when a program gets launched versus when it gets rolled out and delivers savings.

Got it. No, I appreciate the color. Thanks a lot. All right.

You're welcome.

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

Hey, guys. Good morning. Thanks for taking the questions. Good morning, Brian. Good morning. I guess just first off on the margin front, I know this has been something you guys have obviously been highly focused on, a couple moving parts here. But if you could just help us, you know, you had been talking about I believe 100 basis points of EBIT margin expansion in 2020 originally. Now the target midpoint is more like 30 to 40 basis points year on year. I appreciate there's a lot of moving parts here, but to the extent that you can, any sense that you can provide of kind of the bridge between the old and new views, you know, how much is lower volume, how much is mix, operational savings maybe falling short, and then any other items as we think about how you can – again, kind of bridge back to the faster margin expansion trajectory you had been targeting before?

Yeah, this is Patrick. I mean, I would say, first of all, clearly we plan to spend a fair amount of time on this at Investor Day to really kind of lay out how we're thinking about margin expansion. Clearly, we are still deeply committed to margin expansion through productivity. shifting mix in our revenue portfolio and still some other cost takeout opportunities. So we'll walk through that certainly at Investor Day in a bit more depth. I think the biggest drivers here thematically are the challenges in our two highest margin businesses, that being dewatering and simply the slower ramp up of conversion of orders to revenue on digital solutions. We believe those are simply transitory, but we'll walk you through that at Investor Day. You know, Mark talked about some execution delays that we talked about last year as it related to the finance tower. We're still deeply committed to that. We're moving that forward, but it had been a shift to the right, and that's certainly impacting part of 2020. We've also continued to invest for growth, so we've not pulled back on R&D or other investments to grow these faster investments. growing businesses. But again, we'll walk you through in more depth on that in terms of how we're thinking about longer-term margin expansion and how we're going to guide to that each year.

Okay, fair enough. I'll look forward to that. And then maybe just a housekeeping question for Mark. I noticed the interest expense assumption for 2020, it's coming down about close to $10 million year-on-year. Any assumptions there embedded on refinancing or paying down debt through the year or what else might be driving that year on your change outside of just additional cash on the balance sheet?

Yeah, well, part of it is we've managed our interest rate risk through swaps and other programs that are certainly benefiting us a little bit this year in the back back part of the year, as well as a full-year benefit into 2020. So that's just the effects of that interest rate risk management program.

All right. I got it. Thank you.

Your next question comes from the line of Andrew Kaplowitz with Citi. Hey, good morning, guys.

Good morning. Patrick, your rental business was starting to weaken when you reported last October. I think you said it was down 17% in Q4. You mentioned tough storm comparisons, weakness in oil and gas. Have you seen the rate of decline in rental stabilize at all yet? And what are your rental teams telling you about the incremental weakness in that market and when it might subside?

Yes. So if I follow your question correctly, You have to really break the watering out between the rental piece of the business and our equipment sale. And actually, we did see growth in our rental business by mid-single digits. It was really the equipment sales that we saw the big drop there. And that was largely driven by reaction on the part of our distributors. They were seeing what they saw, CapEx uncertainty, they run to cash, they're small distributors typically, and so they got skittish understandably and pulled back. Our rental piece continued to grow modestly during that time frame. Now we have again seen that weakness continue in that part of the watering for heading into this year. That's why we're trying to be cautious in terms of how we guide that business. I think the At this point in time, we are still seeing broad-based industrial weakness, and so that does temper our view on how we view this. And because it has such a large decremental impact when it goes the wrong way, we want to be cautious in terms of how we guide here.

Yeah, and just to add a little more color in terms of what changed in the fourth quarter, we expected some rental weakness. just based upon what we were seeing in our distributor channels and on the sales side. In the fourth quarter, it was weaker than we expected, and really for two reasons. One, our shipments into customers in the oil and gas space were down more than we expected, and some of that had to do with bankruptcies and oil refinery explosions. And then there was a big year-over-year decline in rentals related to storm events. So both of those were more than we expected. But to Patrick's point, we do expect some of the weakness in rental to persist, particularly as we sell into the oil and gas and other heavy industry in the first half of 2020. but some normalization as we get out of that period, particularly when you look at the tough compares that we had to the first half of 2019.

Great. Thanks for that, guys. And then just I wanted to ask you about NCS in the context of timing. You know, revenue growth in Q4 was up two. I think you said shippable backlog in 2020 was down 4%, but up double digits for 2021. So, you know, you mentioned difficult comparisons, but has something been happening either in the quarter or the last couple quarters to sort of further slow down decision-making? Are customers just more hesitant to take on these digital projects given they're worried about the economy? Is that what it is? Is it labor availability? What is it that's slowing it down?

Yeah, well, I think we have to break it down between, you know, it's hard to talk about MNCS as one. It's not one business line. So the projects, you know, they're very different kind of projects. So, you know, the digital solutions piece where we're talking about those kind of projects, these are things that typically start off in a pilot phase. Then they move into orders. And then, you know, they're always subject to weather events. You know, it's not a reflection of there being a lack of funding or a lack of interest or they're pulling off on those. It's simply a matter of time in that regard based upon the orders that we had on hand coming out of Q3 and Q4. And then for the census or metrology piece of MNCS, you know, we've not really seen any change in dynamics in terms of decision making, length of time it takes. You know, that's not really been a driver here in terms of why we see that backlog. It's just, you know, these are large, you know, several large implementations that it takes a while for those utilities to get their case approved and get the specs finalized and get the RFPs out and finalized. And so there's always going to be a level of lumpiness there, and that's why it's important in our view that we look at these things over a longer timeframe than a couple of quarters or even from one year to the next.

Appreciate it, guys. Thank you.

Thank you. This does conclude today's Xylem Q4 2019 earnings conference call. Please disconnect your lines at this time and have a wonderful day.