Xylem Inc. (XYL) Earnings Call Transcript & Summary

Very pleased to have Mark Rajkowski, CFO; and Matt Latino from Investor Relations with us today. [Operator Instructions] So welcome, Mark, welcome, Matt. I'll jump straight into questions here.

Many economies around the globe are beginning to reopen, albeit slowly and well below full production levels. What is Xylem seeing in terms of increased activity from customers in May versus April?

Well, thanks, Nate. And we -- I want to thank everybody for participating and also extend my best wishes to all of you and your families and hopefully, you remain safe in these challenging times. With that, as you'll recall, Nate, from our earnings call back in beginning of May, we did see mid-teen declines in revenue -- in orders in the month of April. And at this point, through May, we've closed through May, we really haven't seen any change in that trajectory. So the mid-teens decline -- I'll remind everyone that for us, June is a big month. And so we continue to focus on taking care of our employees and our -- servicing our customers, but still a big month ahead of us. But no real change in trajectory in May from what we talked about in April.

Okay. China came out of the pandemic early and operated really very well in March and April, but there have been questions about whether some of that was pent-up demand and whether it was sustainable. Have you seen demand in China sustain or back off after working through what might have been some pent-up demand?

Yes. We -- Nate, we feel very good about the long-term health of the utilities market in China. And for those investors who don't know us that well, that is a substantial portion of our business in China, at least 2/3. It was certainly strong before COVID, and we're hearing and also seeing some reassuring signs about the continued investment by the government into water infrastructure over the coming years. So very positive on the utility side. Industrial and commercial, they've been a little bit slower to recover. So we haven't seen that immediate bump or sharp bounce-back in those 2 verticals as we've seen in utilities. So clearly, in those end markets, it's lagging behind our utilities business.

I mean, as we're getting in here to Europe and the U.S. open up, I know you said June is a big month for you guys just seasonally. Are you expecting to see June pick up from April and May? I guess this is more a Europe and U.S. question. Do you expect to see any pent-up demand coming through as the European and U.S. economies continue to open up?

Yes. I would say in Europe and the U.S., where -- the dynamic and the trajectory in terms of order rates, daily sales rates have been pretty consistent through May. And what we're seeing is a pretty resilient wastewater side of our business, particularly the OpEx as utilities continue to maintain and operate their wastewater collection networks and treatment plants. We are seeing some CapEx delays with utilities really focused on just firefighting and dealing with some of their most urgent needs, particularly with how some of their workforces have been impacted. So there's also impacts that we've been seeing on the clean water side in the U.S., in particular, relative to some of the pushout in the large AMI deployments. No cancellations. But OpEx very, very resilient. CapEx, a little bit of a pushout. In our industrial and commercial end markets, we're not really -- at this point and I think it's still a little bit early, but we're not seeing any signs of pent-up demand just yet. And quite frankly, we'd expect those businesses to recover more as the overall economy recovers and probably a little bit of a slower start-stop pattern.

Okay. Any insights you've learned over the last few weeks in any parts of the business that would give you kind of any better idea on the slope of the recovery coming out of this recession?

Nate, nothing really that would give us a clear view on demand trends over the next couple of quarters. However, I would say that restrictions are lifting. Certainly, that's a positive. We've seen that in Europe. We're seeing that now in different parts of the U.S. But having said that, I mean, this is a very personal thing. It's all about human behavior. And the question is, even as things open up, are people -- employees going to feel safe going back as robustly as we might like. I mean, I would say maybe the biggest area of learning for us has been how our own internal operations have had to change over the last few months and how our customers really -- they're going through the same challenges we are. We've had to learn new ways to interface to support our customers. And we've been -- our team has been fantastic, our frontline folks on providing service, working in our factories have done a great job and -- but we're learning new things and -- from our customers in terms of how they want to interact with us. And it's happening, but it's all virtually. It's -- frankly, it's more efficient than the way we used to do things with lots of people in meetings and travel. So there is an element of both speed and efficiency there that certainly, these learnings are shaping the cost actions and the investment reprioritization in our own business.

Okay. One of the things we're starting to get more and more questions on from investors is the outlook for utility budgets in the wake of COVID-19. With the focus on the depletion of state and local governments to fight the pandemic and the resulting unemployment in the short term and with questions about how long it takes to return all or most of those unemployed people back to work so that they're paying their water rates, how are you guys thinking about the outlook for utility budgets as we go into 2021 and beyond? And what impact we could see on utility budgets over the next few years from this?

Nate, that is a great question. It's an important question and certainly one that we've been spending a fair amount of time in assessing and better understanding. And we're really framing it up in a couple of different areas as we learn from our clients and continue to have dialogues with them. One is just around operational resiliency of utility. And even prior to COVID-19, the grain, if you will, of the workforce was one of the key challenges that many of our utility clients had as they look at planning for their operations in the future, and COVID-19 has only really increased that concern as utilities are trying to figure out how to work remotely, dealing with reduced workforce. The -- and the other is really -- and this is certainly as important to them is just the financial resiliency for the next several years. And it's going to be a real challenge for many utilities as they maintain day-to-day operations, but also face aging infrastructure that's going to require upgrades and investments. So their key problems and challenges and pain points have not gone away. And the problem is it's just going to be tougher to afford those. And frankly, from our perspective, and we've spent a lot more time because we've had a lot more time with customers over the last few months. We think those 2 areas, operational resiliency, financial resiliency are really creating opportunities to look at new ways of operating. And importantly, certainly from our perspective, is innovative technology, using smart connected system intelligence solutions in their operations or technology to make some of these infrastructure upgrades more affordable.

Okay. Just on Applied Water, it's more exposed to the industrial and commercial sides of the business, which clearly have challenges related to both COVID-19, but also lower oil prices, which tends to mute overall industrial activity. While Xylem's direct oil exposure is low, oil money does tend to lubricate large parts of the general industrial economy. Oil price shocks historically tend to take 1 to 2 years to be absorbed into the industrial economy. How are you guys thinking about your exposure to lower oil prices in the industrial business and the potential top line impact to the business from lower oil prices? And have lower oil prices -- how have lower oil prices impact you in previous cycles?

Yes. I mean, it's a good question. And just as a reminder, overall, our exposure to oil and gas is relatively low, about 2% of revenues for Xylem wide, for the entire company. And that said, where we see the most significant impact from oil and gas pricing and the impacts to that vertical is in our dewatering business, which is within our water infrastructure segment. So this business primarily serves the upstream oil and gas market and is -- it's probably a little bit more than $60 million in revenue or about half our total exposure. So here, we provide pumps, equipment and a lot of that in North America for the fracking market, which has been extremely hard hit given the cost profile of that technology. But overall, while it's a relatively small amount of revenue, it is disproportionately profitable for us due to the rental side having such high incremental margins. So we saw softness in the second half of last year, and certainly, in the first quarter this year. You'll also remember that the downturn in -- the market downturn in 2015 and '16 impacted us meaningfully. So then we saw our business down over 30%, and our Q2 revenue guidance reflects what we expect to be ongoing softness in our dewatering business, both oil and gas, but also mining and particularly construction in the second quarter. And so we're expecting that part of our business, certainly, a chunk of it attributable to impacts to oil and gas segment, but also construction segment. But we'd expect roughly 35% decline year-over-year in the second quarter in that business.

Okay. I think we've had some sound problems here. So I just want to hit on the 8-K you guys filed last week on the structural cost reductions here. Can you talk about -- any color you can give on how much of that's going to be realized in 2020 versus how much is going to be realized in 2021? And then talk really about what these cost reduction initiatives are targeted on? What they're focused on? How you came to the decision to make these kind of cuts?

Sure. The -- and we've laid some of this out in the 8-K. There is more detail to come, and we'll be providing more commentary in our second quarter earnings call. But some of the questions that we've gotten, made from investors post that filing is, was it -- was this reactive to the pandemic? What is that -- is there something untoward relative to what you see as longer-term demand and [ buying ] trends? And certainly, a meaningful part of this program -- there's really 2 aspects of it. One, we have been talking about the opportunity to simplify the organization, become leaner, more nimble, move faster, be more responsive to customers. This was work that certainly we've been focused on, and the pandemic really accelerated the need to really get after that, okay? So this is -- these are not reactive programs. This is work that we had been looking at, and we've just accelerated. We're also -- we're being informed by what we're learning from our customers in terms of how they want to work. We've had over 2 to 3 months now to test drive how we're working internally, and we see significant opportunities, both within our own back office and operations and also how we deal with customers that are informing some of these actions as well. And it's not just all about cost, it's reprioritizing investment. And there are some things, I mentioned earlier, the need for digital solutions and remote monitoring, capabilities that are really important to our customers that we want to double down and bring to our customers in an accelerated way. And there's other things that we're dialing back on. But this is -- it's really focused on streamlining the organization, making sure we're more nimble, we can move more quickly. We can service our customers better in the way they want to be serviced, and to emerge from this pandemic a more sustainable, financially strong company.

Fair enough. You guys had guided to 50% decremental margins in the second quarter and expected those to maybe get down to closer to a historical 35% level as we approach the end of the year? Can you talk about if that changes the outlook for the decrementals in the back half, maybe they should be a bit lower? Or how you're thinking about what an incremental margin profile could look like as growth returns, meaning 2021? And just any color you can give us on how you're thinking about incrementals in the recovery as a result of these more structural kind of improvements to the business?

Yes. Sure. So first on the decremental margins, a couple of points there to provide some context and what we've laid out or guided to in the second quarter. So some of that -- just so we are -- as part of supporting our front-line workers, and we do have essential services pay and other payments that we're making to support employees who are impacted from the pandemic. And where we have to temporarily shut down facilities, where our employees have been infected and they're not able to work, but also for the folks who are out there on the front lines providing service and continuing to manufacture product for our customers. So we would expect -- and that's going to be a little bit over $20 million, and a big chunk of that is going to hit in the second quarter. So that has an impact of about 7 points of margin. So we'd be closer to the low 40s as opposed to 50% decremental margin. So just a little bit of perspective on that. Clearly, the -- we do expect both through some volume recovery in the second half of the year. And certainly, on top of that, the impact of the benefits from some of these structural actions will certainly favorably be reflected in our -- in the margin profile in the back half of the year. And I guess the last point, the question you were raising relative to, so what does the recovery look like? And will you see the same incremental margin in the recovery period as we did in -- as we're expecting to see in the decline in the second quarter. And that's all about the math, Nate. And the answer is yes. We -- as demand and volumes normalize, there's -- a lot of that's going to drop to the bottom line, for sure.

Okay. Just want to make a comment here. I know for people on the line, there was some dead air here for about the first 10 minutes, while Mark and I were just talking to each other. Wall Street webcasting have let me know that, that was being recorded and when the webcast is posted, you will be able to hear the first 10 minutes. So if you want to check back in later, you can get the whole thing. One question off the line here, Mark. Somebody wants you to talk about AIA and how that business is progressing.

Sure. Yes. The -- and let me break that down into a couple of pieces. One is the assessment services piece that is largely the pure acquisition. And then there's a whole host of digital solutions that largely have been acquired through bolt-on acquisitions over the last 2 to 3 years. And the -- we're seeing increasing interest, particularly through the pandemic relative to customers looking to leverage some of these digital solutions. I would say in the short run, particularly on some of the assessment services because of the requirement to be out in the field and to get workers there, including utility workers. We're seeing some pushout of project works as you -- project work, as you'd expect. But the interest, whether it's assessment services or these -- the broader digital solutions is -- it's increased. And the -- and even more so as we've -- we work through the pandemic. The one thing I'd highlight, too, is we have now really -- we've gotten our assessment services part of AIA, very focused operationally. And we're really -- we've spent a fair amount of time getting our go-to-market approach on the digital services better enabled and staffed. And the benefit of that is really looking at digital as the tip of the spear and a key enabler of revenues not just within the digital space, and that's meaningful because the margin profile is really important. So great continued strength in terms of pipeline development orders. But the real opportunity there is connecting these with other parts of the portfolio, including the equipment side and the significant pull-through, if you will, using digital as an enabler as we're having these broader strategic discussions with our customers as a significant -- what we believe will be a significant source of revenue growth in the years ahead.

Yes. Maybe one small piece to just add to what Mark said there. I think, Nate, obviously, the financial resilience questions are ones that are probably the most frequent that we're getting asked about utilities. And this is obviously one of those ways that we can help to alleviate some of the pressure there and some of these technologies help get at revenue sources, help finding opportunities for utilities to think about reducing OpEx spend or reducing large CapEx projects that would otherwise be the way they would go about solving some of these challenges. This is our -- this is a way you can get a bit more constructive with them at the table in terms of how they're thinking about things going forward. And this is certainly one of those ways that we can help them alleviate some of that pressure.

Okay. I want to follow-up with some questions of my own on MCS. I think the construction of that segment over the last several years, looks to me, to be -- and strategically one of the most important, if not the most important area for utilities, which is nonrevenue water. It's always at or near the top of the list for utilities' pain points when we talk to them. But the performance of the business and of that segment overall has so far been a bit underwhelming and certainly a sore point for investors. Did you underestimate how risk-averse the customer base is and therefore, overestimate the pace of adoption in that business?

Yes. Nate, I mean, I think that's a fair -- it's a fair question, certainly one that we've heard before, right? And I just -- I think it's important to remind everybody the structure of that segment. The biggest piece of the business is census, which is our metering networking software business. The -- all about large portion of that business, AMI deployments, and that's over $1 billion. We have the test or the analytics business, which is about a $300 million piece. And then we've got AIA, which, as I said, includes assessment services and the digital portfolio, and that's about $125 million. As we look at census and the adoption of AMI and the technology provided through our metrology business, we've been very pleased with the performance of that portion and are definitely seeing increased interest from our customers to adopt the higher-end technology metrology solutions. That said, I would also say that 2019 and 2020, it's been a period of heavier investment. We've got 3 important new product launches that we need to support customers and project wins, and a lot of that investment is hitting in 2019 and this year. And we're continuing that investment because we still see this segment, to your point, as being one that's going to be an outside source of revenue growth and margin expansion. I think as it relates to the assessment services and digital solutions, it's absolutely fair to say that we overestimated the pace of adoption and, frankly, some of the hurdles that our customers have faced with the procurement process of some of these technologies that are completely new to the market. We are looking to create this new market. And -- so the conversion to revenue has been slower than we expected. I can tell you, as I mentioned just a moment ago, the underlying demand and interest remains incredibly robust and has picked up during the pandemic. As you guys recognize, as Matt said, the -- while the revenue profiles are challenged, their problems aren't going away. And whether it's nonrevenue water, whether it's combined sewer overflows and resilience, whether it's the ability to operate more efficiently and actually afford some of these large capital projects that they do need to implement, it's the solutions that we're bringing to them that are going to enable that. So yes, I think we were a little bit overly optimistic in terms of how quickly the adoption rate would accelerate, but I do believe we are at a tipping point, and we're seeing this through the pandemic and through the needs of our customers.

Yes. In my view, this is going to be a driver for years and decades, so a little slower on the front end doesn't really make a lot of difference to the value proposition. What, in your view, is the biggest impediment to getting more rapid adoption of those technologies in the market?

I think there have been a couple. One is that it's just -- and certainly -- and let me -- I'll segment. I'll talk about the developed markets. It's a little bit different in terms of what we're seeing versus the emerging markets. But I think one of the biggest lessons for us is just the challenges that utilities face with the procurement processes. And for good reasons, they've got restrictions to bid work in a competitive public forum. And that is the reality of the world we live in. And just one of the other parts to that is that we're bringing solutions to bear that frankly don't have really many, if any, competitors. And it's really challenging for utilities to simply put a bid to the street. So we've had to work alongside our customers to trial different pricing models, procurement methods, to deploy these solutions in a way that our clients can be confident that they are receiving the most value-creating solution for their operations. The -- I think it's a little bit different in emerging markets, and they're less encumbered. And it's all about solving their fundamental problems. And we're seeing in, particularly in China and India, that they're not moving up the same technology curve that we are in the developed markets. They're leapfrogging and going to the best technology that's available. So I talked about bringing the full breadth of Xylem's capabilities and solutions to bear. And it's, to some extent, ironic that the -- one of the biggest contracts that we've won and the best examples of where we led with digital solutions is in India and in Montara, but we went in with what was going to be a digital solution for pressure monitoring. And as the Indian team, who is outstanding by the way, outstanding commercial team, they're not encumbered by anything other than wanting to understand what the customers' needs and problems are. And after a relatively short period of time, what was going to be a $4 million or $5 million digital solutions contract turned into a $50 million win with lots of equipment and pumps attached to it. And that's really the power of when customers can see and are enabled to just act and go do it and see the value that we can bring, there's great opportunity. And we've seen it in emerging markets much more quickly than we've seen in the developing -- or the developed markets. But that -- as I said earlier, I do think we're at a tipping point there.

Very interesting. We're definitely out of time here, about 5 minutes over. So I'll cut it off there. Mark, Matt, thanks very much for your time today. And again. If anybody is interested, the first 10, 15 minutes that wasn't broadcast over the webcast will be available on the replay. Thanks guys. Have a good rest of your day.

Thank you.

Thanks, Nate.

Stay well.