Xylem Inc.

Stand by, your program is about to begin. Welcome to the Xylem second quarter 2022 earnings conference call. At this time, all participants have been placed in a listen-only mode, and the floor will be open for your questions following the presentation. If you would like to ask a question at that time, please press star 1 on your telephone keypad. 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 Andrea Vanderberg, Vice President, Investor Relations.

Good morning, everyone, and welcome to Xylem's second quarter 2022 earnings conference call. With me today are Chief Executive Officer Patrick Decker and Chief Financial Officer Sandy Rowland. They will provide their perspective on Xylem's second quarter 2022 2022 results and discuss the third quarter and full year outlook. Following our prepared remarks, we'll 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, www.xylem.com. A replay of today's call will be available until midnight on August 9th. Please note the replay number is plus one 800-839-5676 or plus 1-402-220-2565. Additionally, the call will be available for playback via the investor section of our website under the heading investor events. Please turn to slide two. We will make some forward-looking statements on today's call, including references to future events or developments that we anticipate will or may occur in the future. These statements are subject to future risks and uncertainties, such as those factors described in Zion's most recent annual report on Form 10-K and 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. We've provided you with a summary of our key performance metrics, including both GAAP and non-GAAP metrics in the appendix. 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 also included in the appendix section of the presentation. Now, please turn to slide three, and we'll turn the call over to our CEO, Patrick Decker.

Thanks, Andrea, and good morning, everyone. We're pleased to report that the team delivered a very strong second quarter performance on all key metrics and well ahead of our guidance. The result builds on the momentum and underlying demand we saw in the first quarter, with disciplined operational execution on strong fundamentals and a moderate easing in chip supply constraints. Revenues grew 6% organically, surpassing our guide. The team's commercial performance was outstanding in all segments, and supply improvements in MNCS and water infrastructure enabled increased conversion of orders into revenue. Geographically, the growth was broad-based. Western Europe was up 9%, North America 6%, and emerging markets, excluding China, was up double digits. While China was down due to COVID lockdowns, backlogs continued to grow on underlying demand. In addition to organic revenue growth, the team posted 6% orders growth, That order's momentum reflects strong performance across each segment. Water infrastructure set the strongest pace, growing orders 21% in the quarter. Our backlogs were up sharply versus last year, with digital solutions comprising more than half the total backlog. EBITDA margin also came in well ahead of our guidance. We delivered strong quarter-on-quarter expansion driven by disciplined execution. All of that good work delivered earnings per share of 66 cents, which soundly beat our expectations. As you can see, some incremental improvement in chip supply came earlier than anticipated, and it had a strong positive impact on the quarter. To be clear, we don't believe chip supply will improve much more quickly than previously expected. What we are seeing is a gradual improvement in supply, which provides further confidence in our second half outlook. The team also delivered pricing actions to mitigate inflation across all segments. And I want to give a big shout out to the entire team, including our distribution and channel partners, for managing through a dynamic market environment. We combined those discipline actions with productivity savings from simplifying the way we work and entirely offset inflation in the quarter. We expect demand to remain resilient due to the essential nature of the services our customers need from us. So as you've seen in this morning's release, we are raising our organic revenue guidance to 8% to 10% growth for the full year. And we're raising the bottom end of our EPS range by $0.10. We'll come back and discuss our full review of the macro environment in a few minutes. But let me hand it over now to Sandy for some additional color on the second quarter.

Thanks, Patrick. Please turn to slide four. The team did a tremendous job over delivering on our commitments with disciplined execution on strong fundamentals and continuing demand. As a result, revenues grew globally, high single digits in Western Europe and mid single digits in the US. In emerging markets, revenue grew low double digits, excluding China, which was slowed by ongoing COVID restrictions. In a moment, I'll detail performance by segment, but in short, utilities was up 2% led by strength in Western Europe and the U.S. Industrial grew 12% on increasing activity in all geographies, particularly the U.S., Western Europe, and Latin America. Commercial was down 1%. Strength in Western Europe was offset by continued U.S. supply chain challenges. and residential was up 13%, led by commercial execution and backlog conversion in the U.S. Organic orders were up 6% in the quarter, with water infrastructure up 21%, and AWS up 2%, partially offset by MNCS. Global demand continues to be strong, and our book-to-bill ratio was a healthy 1.2 in the quarter. EBITDA margin was 16.6%, well above our guided range, and that reflects a 240 basis point rise sequentially on strong commercial execution and discipline on discretionary costs. Price contributed two points of incremental revenue growth sequentially. As Patrick mentioned, pricing and productivity benefits combined more than offset inflation, and our EPS in the quarter was 66 cents, coming in above expectations. Please turn to slide five, and I'll review the quarter segment performance in a bit more detail. Water infrastructure revenues exceeded expectations, growing 9% organically in the quarter. Industrial remained strong, driven by continued backlog conversion, and our U.S. wastewater utility business grew double digits as supply chain constraints improved throughout the quarter. Geographically, the U.S. and Western Europe were also up double digits, driven by robust transport demand in the U.S. and treatment applications in Western Europe, alongside strong dewatering growth. Emerging markets, excluding China, was up high single digits, driven by strength across Latin America and Africa. These markets were down mid-single digits, including China, due to COVID site access restrictions there. Borders in the second quarter were up 21% organically versus last year, with growth underpinned by strong underlying demand supported by large infrastructure projects in the U.S. and Canada. We also saw sustained demand in our wastewater utility business in North America and Western Europe. EBITDA margin for this segment was up 240 basis points, as strong price realization, volume, and productivity benefits more than offset inflation and investments. Please turn to page six. In the applied water segment, second quarter organic revenues grew 7%, modestly exceeding our expectations. Geographically, the U.S. was up high single digits with strength across industrial and residential, partially offset by supply chain constraints in the commercial business. Western Europe delivered low double digit growth with healthy gains across all end markets, led by benefits from new energy efficient product introductions. Emerging markets was up low single digits driven by strong industrial demand. Orders were up 2% organically and continued to outpace revenue with a book-to-bill ratio of 1.1 for the quarter. Segments EBITDA margin declined 130 basis points compared to the prior year. And while price realization more than offset inflation, volume and mix for the quarter were negative. Despite lower volumes, demand remains robust as seen in our book-to-bill ratio. However, we expect to continue to deliver sequential EBITDA improvement as the benefit of pricing actions comes through our backlog. And now let's turn to slide seven, and I'll cover our measurement and control solutions business. MNPS exceeded expectations on strong demand and modestly better chip supply, with revenue declining 2% organically. We also saw strong growth in our test and pipeline assessment services product lines. Geographically, the U.S. and Western Europe were down mid-single digits and emerging markets was up high single digits. MNCS orders declined 9% organically in the quarter due to lapping from large deals in North America and the U.K. Underlying demand for our AMI offering remained strong and orders continued to outpace revenue. We recorded a book-to-bill ratio of 1.4 and have built a backlog of over $2 billion. Segment EBITDA margin in the quarter was ahead of expectations, expanding 120 basis points sequentially on improved volumes. As supply chain stability improves and we convert our backlog, we will see strong margin accretion on higher volumes as we have previously discussed. And now let's turn to slide eight for an overview of cash flows and our balance sheet. In the second quarter, we generated a free cash flow of $67 million, driven by income conversion, partially offset by higher working capital. Our financial position remains strong, with $1.1 billion in cash and $1.9 billion of available liquidity. Net debt to EBITDA leverage is 1.5 times. I'm going to turn to slide 9, and I'll hand the call back to Patrick to look forward at the rest of the year.

Thanks, Andy. As you've seen, the team is delivering strong results in a very dynamic environment. Given the prominence of discussions about macro uncertainty in the economy, it's worth spending a few minutes talking about our confidence and the resilience of underlying demand for Xylem's offerings. The aspect of our sector and our business model that gets most discussed in this context, and for good reason, is that our offering is at the core of essential services through the ups and downs of economic cycles. Cities and towns must provide essential water and wastewater services, so the demand associated with water management tends to be quite resilient. It's also important to understand the dynamics between OPEX versus CAPEX across economic cycles, particularly for water utilities. OPEX spending is very stable given the basic need for day-to-day water services. CapEx, which represents roughly a third of spending on Xylem's offerings, is focused on infrastructure expansion or refurbishment. And it comes with longer regulatory and funding approvals. So spending against these projects once approved historically has not wavered to a material extent. And this is not just a U.S. dynamic, but it applies globally. You see it in Europe, both at the regional level. For example, with the EU's recovery and resilience funding, and at the country level as seen in the UK's AMP process. Similarly, infrastructure funding is embedded in China's five-year planning cycle. And, of course, you're all familiar with the recent U.S. federal infrastructure funding and the timelines on which the state revolving funds have worked. Those structural advantages of the sector, however, are only a benefit if our portfolio delivers distinctive value to our customers through the cycle. For many of our customers, value is defined in terms of becoming more efficient, and that means modernizing their infrastructure with digital technologies to make their networks more affordable. Our AMI metrology backlogs offer a proof point about the resilience of that demand. Despite the ongoing chip supply challenges that have dogged the tech sector for the last year, our backlogs have continued to grow. Our distinctive data and communications-driven AMI solutions deliver a step change in both efficiency and resilience for utilities. AMI represents now roughly a third of all water meters in the US, which shows the progress of adoption, but also the potential for future growth. Given the budgetary pressures that utilities face, both to generate revenue and reduce water loss, smart meters will remain a top imperative. One other demand trend that will persist through the cycle, and in fact is set to increase, is the growing response to climate change. Cities around the world are committing to net zero emissions. At the same time, they are investing in mitigating the impacts of climate change that are already here, like those we've seen this summer in the form of historic and tragic flooding in the U.S. and Asia. These are generational challenges. Innovations and new approaches are absolutely essential to solving them because water management is a significant carbon contributor, accounting for up to 10% of greenhouse gas emissions globally. In commercial and residential markets, cities have begun introducing building regulations to reduce emissions, including efficient water management standards for both greenfield construction and retrofits. And the utility market, which produces greenhouse gas emissions equal to the entire global shipping industry, it's going to be required to reduce its carbon intensity in line with the commitments of their cities, municipalities, and countries. And we at Xylem are an outright leader in this space and are in a unique position to support our customers and their sustainability commitments. You may have seen that we released our annual sustainability report in May. Among all the progress made against our 2025 goals, I'd highlight that we enabled our customers to reduce their carbon footprint by 730,000 metric tons in 2021 alone using our technology. That is the equivalent of taking 160,000 cars off the road. And we're on track to help them reduce their emissions by 2.8 million metric tons by 2025. So stepping back, we're very confident that the macro force is driving our underlying demand will continue. We're also confident that Xylem is better positioned than ever to create value by helping our customers respond to them. So now I'll turn it back over to Sandy for more detail and color on our outlook and guide.

Thanks, Patrick. Consistent with our previous presentations, we've provided key facts for each end market in the appendix. The outlook across our end markets has broadly improved. We expect healthy underlying demand will continue through the remainder of the year with improved price-cost mix and modest improvements in supply chain. We now expect our utility business to grow mid-single digits up from low single digits. On the wastewater side, we now expect mid-single digit growth up from low to mid-single digit growth on improved backlog conversion and resilient global demand. The outlook for longer term capital project spending and bid activity remains solid globally. For clean water utilities, we now expect mid-single digit growth up from flat. The main driver is earlier than expected easing of chip supply constraints. Although supply has improved, lead times continue to remain elevated, We also expect momentum in our test and pipeline assessment services business to continue, due to increasing focus in our end markets on infrastructure and climate challenges, as evidenced by our strong backlog. Please turn to slide 11. Looking at the industrial end market, we now expect high single-digit to low double-digit growth, up from mid-single-digit growth, on increased activity in the US and Europe, and strong global demand for our solutions. We continue to expect the commercial end market to deliver mid-single to high single-digit growth on solid replacement activity and new product introductions in the U.S. and Europe. In residential, our smallest end market, we now expect healthy demand to drive double-digit growth up from mid-single digits. As a reminder, the majority of our commercial and residential end market exposure is replacement-driven versus new construction. Now, let's turn to slide 12, and I'll walk you through our updated guidance. Our outperformance in the second quarter gives us confidence to increase our full-year guidance for organic revenue growth and to raise the low end of the adjusted EPS range. We now expect full-year organic revenue growth of 8 to 10 percent, up from 4 to 6 percent, and we have raised the bottom end of our EPS range by 10 cents. The increase in the reported revenue guidance is more modest, as the strength in the dollar offsets roughly half of our operational improvements. We have modified our assumptions on our basket of currency exposure, which is included in the appendix. These changes result in an incremental $0.05 headwind to the full-year EPS guide. And this is on top of the $0.10 EPS FX headwind that we discussed last quarter. On slide 13, we've shown how our guidance breaks down by segment. We now expect high single-digit growth in water infrastructure, up from mid-single digits, and low double-digit growth in applied water, up from high single digits. Driven by disciplined commercial execution and backlog conversion on continuing strong demand in both segments. We now expect measurement and control solutions to be up mid-single digits, up from flat. This reflects the outperformance in the first half from chip supply improving sooner than expected. For 2022, we are raising the bottom end of our adjusted EBITDA margin range, which is now 16.5% to 17%. And this yields the adjusted EPS range of $2.50 to $2.70 that I just mentioned. We now expect free cash flow conversion to be approximately 90% of net income. We're carrying about a month of extra inventory to mitigate the risk of supply chain disruptions and provide continuity of service to our customers. We expect to bring conversion back to historical levels as supply chains stabilize, enabling us to return to free cash flow conversion of at least 100%. We have provided you with a number of other full-year assumptions on the slide to supplement your models. And now, drilling down on the third quarter, we anticipate total company organic revenues will be up 10 to 12 percent. This includes mid-single-digit growth in water infrastructure and mid-double-digit growth in applied water and MNCS. We expect third quarter adjusted EBITDA margin to be in the range of 16.5 to 17 percent, a sequential improvement over the prior quarter. And with that, please turn to slide 14, and I'll turn the call back over to Patrick for closing comments.

Thanks, Sandy. We saw the power of some short-term swings this past quarter. A small improvement in chip supply had a big impact. Currency movements have been offering what you could call a challenging forecasting environment. And the unexpected duration of COVID shutdowns held China back. Just a quick note on China. Our team and our customers there have been continuing to serve their communities under very tough conditions, given the extensive restrictions in place to manage COVID. I'm incredibly proud of the team. We expect to see progressive improvements in the market for the second half and have full confidence China will continue to be a source of innovation and growth to the long run. In the context of short-term uncertainty, our job is to manage through the unexpected. Meeting those challenges is what being a good operator is all about, and the team has certainly been doing that. The team's strong operational execution is built on the same foundation as our 2025 growth and strategic milestones, a consistent story at the heart of our investment thesis. We're building on our leadership position as a technology company with a durable business model. We're benefiting from long-term secular trends of rising demand driven by water and climate-related challenges. We're driving above-market growth and margin expansion as we digitize our portfolio to serve our customers' imperative to be more efficient. We're successfully putting sustainability at the center of everything we do across our company, our customers, and our communities. And we'll create additional stakeholder value with disciplined capital allocation as opportunities warrant. Strong contingent demand and the kind of performance we're seeing from the Xylem team show our ability to deliver on that thesis. And with that operator, let's open it up for Q&A.

Our floor is now open for questions. At this time, if you have a question or a comment, please press star 1 on your telephone keypad. 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 poise your question, you pick up your handset to allow optimal sound quality. Thank you. Our first question is coming from Dean DeRay with RBC Capital Markets. Your line is open.

Thank you. Good morning, everyone. Good morning, Dean. Good morning, Dean. Hey, maybe we can start with the better news on the chip supply. And we've been hearing that from other manufacturers that it's starting to improve gradually, and your commentary is pretty consistent with that. But just some additional color. What did you see in the quarter? And what's that outlook for the second half? How much of – you know, the backlog in digital, might you be able to ship?

Yes. Good morning, Dean. Thanks for the question. You know, we certainly were, you know, pleased to see definitely slightly better chip supply throughout the quarter. And I think if you go back to where we were from a low point from a revenue perspective last year in Q4, we're under $300 million of revenue. We've clawed that back and we're approaching $350 million in the second quarter. So it was definitely a bigger step up than we had anticipated. As we look at the second half of the year, Dean, we see a more modest increase from Q2 to Q3, and then another step up into Q4. We think we're going to exit the year really in line with what we had modeled. We've just been benefiting from some better supply earlier in the year. And I give credit to the team that has been in really close contact with all of our key suppliers leaning in and also being opportunistic in the spot market so that we can take care of our customers.

And I would just add, Jean, Sorry for my voice. In addition to that, the team has done terrific work not just on landing ships in the spot market, but a lot of the redesign work that we talked about in past quarters is nearing completion. There was an added cost in the quarter for that, but it was there to really make sure we secured supply for our customers. We also shipped out more mechanical meters in the interim for in order to bridge that gap while we're waiting on the chip to come through. So there were multiple dynamics, but as Sandy laid out, things certainly got better, and we feel more confident now about the second half than we did before.

That's real helpful.

And just the context of this, and I'm not sure if you can give specific numbers, but our expectation is that the profitability of these digitally enhanced products and services is They're roughly 50% more profitable than the legacy, I don't want to say dumb, but not digitally enabled products and services. Is it still that magnitude of difference in margins on the digital side?

Yeah, you know, Dean, the margins are clearly richer on the digital side. And, you know, we saw that in our mix at MNCS in the quarter. You know, we were about 5% less digital this year compared to last year. And I think, you know, that was with a purpose of taking care of our customers and putting, you know, product into the hands of our customers where to keep them up and going. And so that took, you know, a more mechanical approach. leaning this time around. I think as we look at longer term where we expect to land from a margin perspective, nothing has changed structurally from what we laid out in our investor day last year in September.

If anything, Dean, the backlog has gotten stronger, especially with some of the large deals that we brought in over the last few quarters, and the bidding pipeline remains very robust just given how Early we still are in terms of conversion AMI across especially the US on the water side of things. So we expect that runway to be there for quite some time. Got it. And then just last question for Sandy on the free cash flow. We've seen most of the companies this earnings season trimming free cash flow guidance all because of higher working capital commitments. both supply chain inefficiencies and big demand. The expectation for returning to 100% free cash flow, is that really dependent on the supply chain? What would be the time frame?

Yeah, I think great question, Dean. When we built our plan for 2022, we expected that supply chains would be meaningfully improved in the second half of the year. And we're not seeing big changes yet. and therefore we think it's prudent to carry some extra inventory with the meaning of delivering on revenue and delivering on our backlog. So there's a couple of things that are going on. Lead times are still elongated. We're still having problems where we're missing one or two key components, and then we're not able to get the entire solution out the door. And, of course, you know, inflation is bringing up the overall balances in our inventory. But, you know, we will bring that down. We'd expect that is certainly in 2023 at the latest. And it will be a key focus item for our teams. This is not something that we plan to do for a long period of time.

And from a segment perspective, Dean, it was most notable in applied water. where, again, we've had continued knock-on effects, whether it be supply chain castings coming out of China due to COVID. Obviously, we expect those to continue somewhat in the second half. And that's why, to Sandy's point, we brought in an extra month of inventory into that business. So it's very visible. We know exactly what it is. It's totally under control. It's simply a matter of needing to do that in order to supply customers and maintain that demand. All right. That was great, caller. Thank you. Thank you.

Thank you. We'll take our next question from Nathan Jones with Stifel. Your line is open.

Good morning, everyone. Good morning, Nate.

Morning, Nate. Going back to MNCS, I think Dean asked enough questions on the chip supply and how that's progressing. Maybe you could talk a little bit about the expected profitability of that business as we see revenue pick up in the third quarter, and then you've talked about a bigger step up in the fourth quarter, assuming that it's probably gonna continue to improve going into next year. Can you talk about the path to getting back to those profitability targets that you laid out in the investor day? Where might we be able to get to in 2023? How quickly can you get to that kind of expected margin level in the business?

Yeah, I think, you know, obviously really important question, Nate. You know, I think one thing I want to call out is, you know, we've already seen from the low point in Q4, you know, 300 basis points of margin expansion from, you know, Q4 to Q2. And, you know, that's evolving because of the, you know, higher volumes. You know, partially constrained by some of the things that we referenced earlier in the call, the mechanical mix. the redesign costs on optimal manufacturing flows. But as we look out into the back half of the year, there's not as much of a pickup from a revenue perspective, but we would expect margins to kind of continue along the same trajectory that we've recognized from Q4Q to Q2. I'm not going to give guidance on 23 on this call, but as we look out to 24, 25, we don't see anything structurally different about where margins should land in that time period.

My follow-up is Europe and industrial. One of the biggest concerns we hear from investors is Europe and industrial. Not only are you not seeing that, I think that was one of the stronger areas in terms of growth in the quarter and solid orders there. Maybe you can talk about the trends that you're seeing there. And then if you can talk about the resilience of the industrial business in general, particularly the light industrial side of the business, and how you would expect that to react in the potential for a recession in Europe.

Yeah, I think, you know, for us, Europe has been a real bright spot. And it's not just in one segment. It's really across the entire portfolio. We've seen good revenues in Europe. We've seen good orders. You know, I know there's a lot of concern about, you know, potential recession in Europe and the industrial market in particular. I think one thing I would call out is that if you look at our dewatering business, for example, which is more industrial, we've done a lot to diversify the end markets there, much less exposure to oil and gas than we did in the prior recession. I think we're down to about 1% revenue in that end market. And then, of course, we've also been diversifying from a geographic perspective.

I would just offer up, Nadia, you probably recall this, but if you go back over time and look at previous kind of industrial recessions back in kind of the 2015-16 timeframe, our European business still held up in terms of growth during that timeframe because the The results are, you know, much less cyclical there, given the in-market exposure that we've got. And also, you know, so, for example, I think the numbers in 2016, you know, Europe still grew 3%, despite being in the middle of an industrial recession. So we feel pretty good about that. We think it would be that resilient again. I think, as you well know, you know, if we were to first see any softening orders, which we've not seen to this point. It would be in our short cycle businesses, which would be more applied water and dewatering. Again, we've not seen that yet. Our back wall continues to grow, good book to bill. And, again, obviously there would be actions that we would take, you know, if we began to see those metrics coming through, as we've done in the past. You know, we can phase investments. We still have further productivity opportunities to go after across the organization, and we're sitting on record backlogs. And, you know, the fact that we've been able to weather the chip supply issue without losing any business in those deals and backlog is a pretty strong statement about the resilience of our pipeline and the markets that we serve.

Thanks for taking my questions, Pasadena. Thank you.

We will take our next question from Connor Benna with Morgan Stanley. Your line is open.

Yeah, thanks. I just wanted to talk a little bit about cash flow and capital allocation. So on the cash flow side, your full year free cash flow guidance does seem to anticipate some pretty good relief on working capital investment in the back half. I'm just thinking through. It looks like you have a CapEx acceleration. Obviously, we can sort of get to the EBITDA number. Is that because you think that you will be starting to work down inventories, or is that just sort of a seasonal release in working capital that you're anticipating?

No, great question. We do have a plan to start working down some of our inventory through the back half of the year. It's nothing dramatic. It's going to take place over the next six months on a very gradual basis. And I think our teams have been doing a good job on the elements around working capital. We are going to continue to lean in hard on collections and make sure we bring those in, and we've seen really good results through the pandemic on our collections front. And similarly, we're doing work around getting better terms from a payable perspective. I may have referenced it on another call. We have a supply chain financing program. That's quite active and it allows our supplier base to take advantage of our credit rating. We're getting more of our supplier base engaged on that program and that will give us some incremental days from a payables perspective. And, you know, I think it all ties into being prudent also around, you know, costs and discretionary spend and capex spend to make sure we start seeing a better cash conversion in the second half, which lines up with our historical seasonality as well.

Makes sense. And then I was noticing it looks like you slowed your cadence of buybacks in the quarter. Is that driven by, you know, any concern around the state of the business? Is it because you're starting to see more opportunities emerge on M&A? Just any color on what you're thinking there.

Yeah, so we haven't changed our strategy, our capital allocation strategy. We've typically bought stock back in the first quarter, which is when we have a vesting date in our equity compensation programs. And so this was nothing new. We bought back stock in Q1. We wrapped that up, you know, in the March timeframe. And, you know, as we look at our M&A funnel and pipeline, you know, we still see, you know, we're really encouraged by the funnel, the range of opportunities, and, you know, that remains a higher priority for us than buying back our stock.

Yeah, I would just add to that, you know, if you look at our balance sheet, we've got upwards of about $4 billion in dry powder stocks. And, you know, we are not hesitant to do a deal when it needs to be done. But, again, that would all be an advanced strategy that we've laid out. As Sandy said, the pipeline is very active, all different size of opportunities in that pipeline. But, again, we want to continue to be disciplined and selective with an eye towards significant value creation. And, again, as I always say, it takes two to tango.

Right. Makes sense. I'll leave that comment for somebody else to ask about, but thanks.

We will take our next question from Mike Halloran with Barrett. Your line is open.

Hey, good morning everyone. Good morning, Mike. Good morning, Mike.

Thanks for that. So obviously you guys seem pretty confident in the underlying trends of the end market. I know you spent a lot of time talking about your ability to react if things do so here or there. But obviously backlog's really strong. Maybe you could talk a little bit about how that visibility from the backlog stretches out here. How does that compare to what that normal visibility looks like in the any color you can around how booked out you are as we get to out years at this point?

Yeah, I think, Mike, really good question. You know, nothing has changed structurally about our backlog. If you look at our AWS business, it has a larger book-to-bill ratio than the other segments, and we're carrying record backlogs across really all three of our segments. And we did see really strong book-to-bill ratios across the portfolio and the quarter from an orders perspective. As we look at our water infrastructure and MNCS backlogs, they stretch out for longer periods of time. Water infrastructure is in the middle. We have our transport business, which turns fairly quickly, and a treatment business that has projects that stand out for multiple years. And then MNCS is the longest. You know, coupled with the supply chain constraints, which don't, you know, magically disappear at any one month, you know, we have a $2 billion backlog there. So that's going to take, you know, a couple of years to – a couple years plus to work through.

Appreciate that. And then the price-cost cadence, sequential improvement. catching up on the price side relative to the inflation pressures. How does that work in the back half of the year on an even dollar basis when you think your whole, when you think margins start reflecting the positive pricing you're putting through?

Yeah, I mean, we are really pleased with what we saw from a price perspective. You know, we've leaned in harder on price because inflation is also coming in higher throughout the year. A big milestone, we did get price cost positive in the quarter from a dollar perspective. Given the magnitude, it's slightly dilutive to the rate in Q2. Q3 is a little bit lower on the revenue side compared to Q2 just because of the typical seasonality in our water infrastructure business. And so in Q3, we expect to continue to be price-cost positive on a dollar basis, probably still in the same order of magnitude, about 30 basis points this quarter, in that order of magnitude diluted from a rate perspective. And then we think in Q4, we should be positive again from a dollar perspective and neutral from a rate perspective. So really good progress across the portfolio to reach this important milestone.

Mike, if I could just go back to your question on visibility and backlog. I think the other dimension that we feel much better about now than we even did in the last industrial downturn is the visibility and the closeness we have to our channel partners, our distribution channel partners, both here in the U.S. as well as in Europe. where we have meaningful, you know, indirect channel business. And we've got much better visibility and coordination with them now than we did back then. So, you know, we got hit with a couple surprises last time around in a quarter or two. We feel much better about that not happening, you know, going forward. So they're also our eyes and ears of what's going on in the marketplace at a local level.

Thanks for that, Patrick. Thanks, Andy.

Thanks, Mike.

We'll take our next question from Scott Davis with Millers Research. Your line is open.

Hey, good morning, everybody. Hey, good morning, Scott. Good morning, Scott. A couple little things here. I mean, the supply chain issues, I mean, chips we've been talking about for quite some time. Have the other supply chain challenges gotten a lot better, the non-chip related stuff, getting materials faster, easier?

Yeah, so it's... Scott, another great question. It's a mixed bag. I'd say supply chain in the aggregate has modestly improved versus Q1, but it really does vary across the three segments. As we mentioned, ship supply is getting a bit better within MNCS, but lead times are still long, but they're not worse. They're getting better. In water infrastructure, We have seen improvement in lead times from our European factories into the U.S., and certainly what our infrastructure has benefited over the last year by offering more competitive lead times due to better vertical integration that we did within the company. But then I would say, as we mentioned earlier, you know, one of the reasons we're carrying an extra month of inventory is because of applied water. It's not limited to applied water, but that's the main driver. And that's really, again, just knock on effects from China, mainly castings. But also, you know, we see continued delays in shipping and logistics that we're just having to work through. So I'd say it's getting marginally better across the board, but it really varies by segment.

And we talked a little bit about China. How does it work? You know, when you think about they're in a controlled economy like that and their capex budgets and how they think about cadencing projects and stuff, when you have the lockdowns like you've had this year, does it push the projects to 2023, but then the existing 23 plan remains and then they try to catch up? Does everything push, right? And how does China kind of work?

Sure, yeah. Obviously, it's a big market, so it does vary depending upon the vertical, the end market that we're talking about. What we find is that the utility side is much more stable. Right now, The issue for us has not been so much for our plants not to be up and running. We return back to normal levels in terms of staffing and presence back in May, I believe it was. It really, though, is logistics and transportation have been at a standstill because customers and colleagues are required to get home. These impact all kinds of projects, Scott, but mainly the government-funded projects But that's not a bad thing because those projects don't go away. They simply shift to the right. And we would see from the past that there would be an accelerated catch-up as the restrictions are lifted. So we've got plenty of capacity in our factories and as do the distribution partners to get this stuff out. It's simply a matter of sites not being open, I mean customer job sites, utilities not being open, that's what we're waiting to see recovery. We're not assuming that we're going to get much, if any, recovery in the second half of this year, but we do expect that to recover to come back quite strongly in 2023. But no structural changes in our view on the attractiveness of China. This is simply things moving to the right.

Okay. That's really helpful. Best of luck. Thank you. Thank you.

We'll take our next question from Brian Lee with Goldman Sachs.

Your line is now open.

Brian, your line is now open.

Yeah. Hey, hello. This is Miguel for Brian. Just a quick question on the supply chain on the chips. I know a lot has been talked about there, but it sounds like on chip supply it's definitely – The commentary sounds, it's improving, but, you know, some of your peers have still been kind of been more cautious on the chip supply. Is there anything on the supply side or what you're doing specifically that maybe is helping you, you know, out a bit more recently versus Pearson?

You know, can't speak for all of our peers. I think we have been working very, as we said earlier, working very closely with our suppliers. The trajectory on where we exit the year is very consistent with what we expected. It's been good work to get some better chip supply earlier. And also within MNCS, there have been some other product lines that have been strong as well. It's not only the chips that drove the upside in MNCS. So we're seeing good results from our test business, some traction with our pipeline assessment services business. And so that broader portfolio is also helping us get out ahead of what we had modeled for the year.

The only other thing I would add, which I am cautious to share too much on this because we've got good visibility, but it's not perfect because things can change. But I do think, depending upon who you're including in that peer group that talks about digital, we've got somewhat higher concentrations. Therefore, we get a bit more leverage with suppliers, and we've got some really strong relationships with our partners, whether it be the direct suppliers from the chips and wafers or whether it be our partnership with Flex. We aggregate our demand, and I think it gives us a stronger platform, at least stronger than what it would be if we were doing it all on our own. So some of these things, it's also just been a number of calls that I and others have been on with the leaders of these companies saying, And, you know, the team has been working it. And we've had to be more patient than we wanted to. But I think those relationships and those investments in relationships are beginning to pay off.

Understood. Thanks a lot. I'll pass it on. Appreciate the call. Thank you.

We will take our next question from Sari Brodetsky with Jeffries. Your line is open.

Good morning. Good morning. So you highlighted strong growth in dewatering applications across most geographies. Could you talk about the benefit that had on March in the quarter, and should that continue to be a margin tail end for the remainder of the year?

Yeah. So, you know, if you look at water infrastructure for business, we saw a really good margin performance. You know, that business has been the most resilient when we look over the past couple of years. And certainly the recovery and dewatering is a contributing factor. And so a lot of hard work has gone into our dewatering business, both to diversify it from an end market perspective, from a geographic perspective. We've made some purposeful investments in our fleet. to make it more modern and current. And we're seeing that upside on the rental side as well. So certainly dewatering positive, seeing good orders momentum there continue in the quarter on a global basis. So certainly helpful to the margin expansion story within water infrastructure.

Yeah, and I would just add it's – I mean, certainly it's one of the shorter cycle businesses that we've got, and it's not immune to cyclical downturns just like it gets it up on the way up. I think the other area that we've benefited from is full-on integration within our commercial team, most notably in North America. where I think it's been upgrade in leadership. I think there have been investments that Sandy's talked about. And the diverse education has really been away from heavy oil and gas and mining and looking at more utility, muni opportunities, where there's visibility with some of our other businesses in the portfolio, so good lead generation by sharing leads with our field services teams. So we're in the early stages of that, but, you know, we've had some really good growth rates here. You know, we're maybe double digit here through the first half of the year on the order side, and, you know, we hope that continues.

Great. And then obviously you've talked a lot about MSCS and kind of the strong growth outlook there, but organic orders declined in the quarter. So just when would you expect to see orders turn positive again?

You know, I think, you know, when orders, you know, we've had a real surge in orders over the past several quarters. And so while, you know, the headline print on orders for MNCS may have been negative, when you look at the orders from a dollar perspective, we're still running well ahead of what we're able to convert from a revenue perspective. I think we had $475 million of orders in the quarter, which is so a really good number relative to our revenue. The pipeline continues to be robust. We're still in the early innings of the overall AMI conversion journey. About a third of the industry has converted to AMI in North America, so there's still a lot of runway. And we have a really differentiated product there that's gaining traction.

Yeah, and I think, as we said earlier, you know, I know none of us ever like to be talking about difficult year-over-year comps when you have big deals in a quarter last year, but there is some element of the nature of that in business. And, you know, we'll certainly, you know, be even more transparent going forward as to, you know, how big are those deals, what other big deals are coming, because, you know, it is a big, rich pipeline right now that we're bidding on. And so, you know, we have been running hot for, a better part of a year and a half or so on some big deals, big books. But we were very positive on that pipeline.

Great. Thanks for taking my questions.

Thank you.

We will take our next question from Andy Capowitz with Citigroup. Your line is open.

Good morning, everyone. Good morning. Good morning. Patrick or Sandy, maybe you could talk about what you're seeing on the municipal waterfront and how IAGA funding may be starting to flow in. Have you seen any of that funding yet, and how are you thinking about that moving forward into 2023?

Yeah, no, we've really, we've not seen, I mean, well, first of all, we've seen demand in utilities very robust, and especially here, I mean, stable in Europe. Good emerging markets, obviously, you know, ex-China and was really strong in the quarter here in North America. We really have not seen anything meaningful come through from the funding standpoint yet, so that would still be upside. And, you know, we talk a lot about the infrastructure bill here in the U.S., but as I mentioned in my prepared comments earlier, You've also got the recovery and resilience funding going on in the EU. You've got that at the country level in the UK's five-year process that we talk about. And then you've got the infrastructure funding that's embedded in China's five-year planning cycle, which remains unchanged. So all those together, we can really point to very strong funding infrastructure for utility spend globally.

That's helpful, Patrick. And I know, Sandy, you talked about price-cost improving. Obviously, you've mentioned productivity in the past. It seems like it's also improving, but maybe you can talk about that, how constrained labor is, and you're sort of pushing productivity as you go forward and how that impacts the overall price-cost dynamic.

Yeah, so I think we were price-cost positive, excluding productivity in the quarter, so that was really encouraging. We have a pipeline of continuous improvement projects that we're driving across the portfolio. Some of that has been a little bit constrained this year as we've moved engineers off of continuous improvement projects onto redesign work. As Patrick talked about earlier in the call, as that work matures and we move through the test and certification part of that process, we'll be able to bring some of our resources back and focus on continuous improvement projects. and continue to pick up momentum on the productivity front as well. But I think looking across the globe, our teams are doing a good job there, and it's contributing to our margin improvement story on a quarter sequential basis.

Appreciate it.

And we will take our next question from Joe Giudorio with Cowan. Your line is open.

Hey, guys. Good morning. Hey, Jill. Hey.

So you think when this all normalizes on supply chain, you look back at how it went and you think about MNCS, what do you think you're going to come out thinking, like, this is what we did really well, this is some things that we need to, like, structurally maybe alter going forward to kind of meet a new reality? It's a great question. I think Right now, Joe, certainly as I look at it, and Sandy can certainly comment here, I think what we're going to look back on and say we did quite well is navigating through the chip supply and holding a team together, holding morale, people spending days and nights and weekends over and over and over again on the phone with suppliers, customers working, or commercial teams working with customers, keeping them on board, nobody happy, but the team's fortitude really shone through and it continues to show through. I think, too, The fact that there have been no cancellations in a record backlog is a testimony to that, and no decline in the margins of that backlog due to chip supply. Our margins have been impacted by some of the near-term choices we've had to make on spending money on redesigns, on selling some mechanical meters in at lower margin than our other meters. Those, I think, are all going to be in the plus column. I think if there were things that we could have done differently, the one that comes to mind for me was I think we probably waited a little too long to get going on some of the redesign work. And I don't think we missed it by much, but I think we all learned that the sooner you get on that, the better you're going to be because it takes a while to sort through that. So that would be my high-level takes on this. But, you know, we're not out of it yet. So still have time to reserve the right to get smarter. That's a good call. Thank you, Patrick. And then maybe I'll ask on some of your more international products. We've been hearing this from some other companies. Have you seen, like, increased international competition from, like, maybe competitors who are selling in U.S. dollars but have, like, fully – local currency cost basis, so they don't really need to raise prices because their margins are benefiting, and you guys are in a comparably tougher situation. Are you seeing any of that?

You know, Joe, we're really not seeing anything meaningful on that front. We're seeing across our end markets with our competitors that they are also taking price increases. I mean, nobody has been immune to inflation in this market, and so we have been the price leader where we have competitive advantage.

We have a structure, probably a somewhat different structure than some of our peers or other companies that you follow in that our competitive base for products that we, for example, sell out of Europe, Those product lines are also predominantly European competitors, so we've got great footprint, whether it be in Italy, whether it be in Sweden, whether it be in the UK. And we've reduced our lead times on still being able to ship those things into the U.S., In North America, the markets we serve, our competitors there are, for the most part, U.S.-based companies also. So there's just structurally not that big of a disadvantage vis-à-vis our competitors. We're kind of all in the same boat. We don't take that for granted. We're always looking for ways to further localize and take costs out and reduce lead times. Thanks.

We will take our next question from John Walsh with Credit Suisse. Your line is open.

Good morning and wanted to say nice quarter. Thank you.

Thank you.

Appreciate it. A lot of ground covered. Question around price cost. One, just wondering if you could talk about what you're seeing sequentially with some of the big cost buckets, be it materials, logistics, et cetera. And then I know you've done some structural pricing initiatives, just how much of the price you think is structural and how much might be tied to surcharges. Thank you.

Yeah, thanks for the question, John. Yeah, I'll take the last one first. And when you look at what we've done from a pricing perspective, we haven't taken the approach to tack on surcharges. What we've done is more permanent price increases. So that's been our roadmap there. Let me give a little bit of color from a price perspective. We saw a big step up in our price realization from Q1 to Q2. We'd expect that to moderate in the back half of the year because it was the second half of the year last year that we started turning on our price increases. So that will level out a bit in the second half. And, you know, I think the other thing I would just close with to remind people, you know, there's been some headlines on some moderation in commodity pricing. You know, we're still seeing inflation in many of the other categories, freight, labor, overhead, et cetera. And so, you know, we're still facing an inflationary environment. But, you know, net, net, all in, we're going to be in a better place in the second half of the year than we were in the first half.

Great. And then maybe just as a follow-on, any color you can provide kind of last time we saw commodity deflation and experienced that? I mean, obviously, as you just noted, it's more than commodities, but just curious historically, you know, the ability of the price.

Yeah, the, you know, if you... Take one example of when we were in the heavy tariff situation and then a number of those tariffs were rolled back. We did not give up those increases because of the value that we were selling to our customers and they understood the situation we were in. Historically, when there has been a rollback in material inflation, we've been pretty successful at hanging on to that. I think almost entirely successful in doing that. But I'm sure there's an exception or two here or there. But in the headline numbers, they don't roll back. Great.

Thanks for fitting me in and taking the questions. Appreciate it. You're welcome.

We will take our next question from Hoval Melikov with Raymond James. Your line is open.

Thanks for taking the question. Sure. Obviously supply chain problems affect everybody and I probably touched on this a quarter ago. Are you seeing any situations where some of the smaller middle market players that could be prospective acquisition targets for you are struggling disproportionately and perhaps creating kind of an opportunistic situation for you to look at M&A? It's an interesting question and I think it was perhaps raised earlier in the previous quarter when we were all even more needy into supply chain challenges. We haven't really looked at it that way. We haven't really seen – I mean, the companies that we look at are high quality, and they may not always be at big scale, but they are pretty good at managing their supply chains as well. I mean, they're much more focused on a product line or a couple of offerings. Having said that, I do believe – and this speaks to maybe the question that Joe asked earlier – I think all of us look at supply chain now as being one of the new most important competitive advantages that a company needs to have. Because whether it be chip supply this time, it'll be something else down the road. And the world is so interdependent at this point in time. And we've gotten a whole lot better ourselves. We still have ways to go. But I do think that it can be the form of a new synergy going forward. But it's not prominent in our thinking about the specific pipeline that we've got right now. Understood. Follow up about the UK specifically. There was a report from one of the government experts the other day saying that without the implementation of smart water metering, the UK would be experiencing outright water scarcity by the end of the decade. Pretty striking headline. Just thought I'd get your perspective on that. Yeah, so I won't prognosticate on the prediction, but what I can reinforce is the lead, so OFWAT, which is the Office of Water in the U.K., they regulate the 17 or so utilities that serve the U.K., and that five-year AMP cycle they go through, there is a pre-AMP, piece to that where they all have to come forward with their proposals in order to get their funding approvals, their rate cases approved. And all that is published very visibly as to what are the top three priorities that each utility is focusing on. They're mandated to have that. And we can confirm that in this last cycle, unlike any cycle before, virtually every one of the utilities, when you look at what they were trying to solve for, it was things around scarcity. It was things around water losses and how they do all that in an affordable, efficient way. So that common theme was a big deal. And then also, in some cases, climate change impact. in terms of flood prevention and building more resilient infrastructure. So there is a lot there. It makes it a very attractive market. So hopefully that was helpful. Thank you very much. Thank you.

We have reached our allotted time for questions. I would now like to turn the call back over to Patrick Decker for any additional or closing remarks.

Well, thanks, everyone, for your time today, for your continued support. I know we've run a bit long here. Appreciate the questions and the interest. Trust you'll all have a very safe and enjoyable remainder of your summer. I know you're in an even earning season, so we appreciate your time and your attention and look forward to hearing from you again.

Thank you. This does conclude today's ILEM second quarter 2022 earnings conference call. Please disconnect your line at this time and have a wonderful day.