Xylem Inc. (XYL) Earnings Call Transcript & Summary

Good day, everyone. It's Deane Dray with RBC. We're delighted to have the Xylem to present at our Industrials Conference today. If you -- there's nothing wrong, you don't have to adjust your monitor. The empty seat right now will be filled, we hope, by Patrick Decker who happens to be running into some unforeseen traffic issues. And by the way, I've done this long enough where this is not the first time this has happened to me in a conference. Luckily, we have the Head of Investor Relations with Xylem, Matt Latino, here.

Hey, Deane. Don't worry, I'm here.

Okay. All right. So we are disappointed not to see Patrick's smiling face. But Patrick, I love having you connect, even if it's on video or if it's not on audio-only.

No worries. As you said many times before, I've got a great face for radio.

Yes, I've been told that, and then the radio guys tell me I have a great voice for print. So it kind of all goes in full circle.

All right. Let's just jump right into it. Patrick, COVID has been such an upheaval event that continues to play out across the water sector, the water utilities. Where do things stand in terms of like permanent changes? How has the -- has COVID maybe accelerated some trends? Actually that would be favorable for Xylem, and I'm talking specifically about faster adoption in digital and smart water systems. Let's start there.

Yes. And again, Deane, I literally am one minute away from the office, so close, but yet so far away. Traffic was terrible. So anyway, the -- I want to make sure you can hear me.

I hear you perfect. Go right ahead.

Okay. Yes. So it's a great question, Deane. Definitely, we've seen increased digital adoption, mainly amongst utilities, but also even in the industrial space. And that really has been driven by kind of work site restrictions, reduced workforce. I think we all see the challenges going on right now in terms of labor demands, and that's definitely hitting utilities in a meaningful way. So they are -- we are seeing a faster pick up and adoption of kind of remote monitoring of assets, is one area. I would say, two, they are definitely facing the challenges of the expectations placed on them around energy consumption, reduction of that, their own commitments to sustainability. I mean all these things are converging forces on them at one time. And that's where they are definitely -- it's not just the U.S. I mean, we're seeing it in Europe as well as across Asia, a much faster pick up in digital adoption.

That's great to hear. If I had to put a number on it, I'd say, somewhere around a 30-year portfolio today is in some way digital.

Yes.

Maybe take us through where you think the evolution of -- and the mix shift is happening at Xylem.

Sure. So you get it right, Deane. So we as -- and we're going to be talking about this at our Investor Day on September 30, which is, again, unpaid commercial adversement here. So September 30 Investor Day, for those that are listening in, we're going to lay out those specific metrics in terms of how we define what digital means for us. But we look back a few years ago, we'd say we were probably around 12% or so of our revenue was tied to digital. We'd say today, we're kind of in that 36%, 38% give or take range on what digital means for us. The way we define digital is not just Software as a Service or Network as a Service, but also how we bring a digital solution to creating an opportunity for our customers. So an example of that is a number of our large, advanced metering deals right now, we win those deals because there is a heavy digital component that is enabling those meters to be smart to provide the customer solution. We expect that revenue to be north of 50% over the next few years. And so, it is a meaningful transformation in the portfolio. The margins on that part of our business are definitely accretive and more attractive than our traditional pieces of the portfolio.

It is. Can you put a number on that? I know attractive, I would think it could be as high as 1,000 basis points higher. Sorry to shock you. I can't see your face right now, but...

That's okay.

Is that reasonable?

I won't comment on a specific number yet. I mean, we'll walk you through that at Investor Day, Deane. But it definitely is meaningfully accretive to the portfolio.

Good. All right. How about pricing model? Because you and I have gone through this. You're offering, in many ways, such a disruptive an advantageous service. You're making the utilities more efficient. You're avoiding downtime. You're detecting leaks. You're enhancing revenue. You're avoiding big storm water events. How does this get priced? And maybe it's priced to value, but let's start there.

Yes. So the -- we are dealing with traditional pricing models in the utility space. I would say, industrial is a little bit easier to bring in disruptive pricing models. On the utility side, we are in the pilots that we've been doing in some of the projects we've put in place. We are testing and experimenting kind of a shared value proposition with customers, where we take on -- and I hate to use the word risk because it's manageable risk. But we take on some of the sharing of risk, meaning can we deliver the proposition that we're putting in front of them, which, of course, we are confident we can? And we're getting more and more utilities to go that path. But I wouldn't want to leave those that are listening in with the impression that this is going to change tomorrow. It is an effort that we are trying to lead in the industry. And that is helping utilities understand that you've got to take on some more risk, you got to lean in, and in doing so, you got to share value. We are not -- we're moving beyond being a traditional component supplier to utilities, and I feel good about the progress we're making. Again, we'll have more to share on that at Investor Day as we got -- a couple of our key leaders are going to be talking specifically about how innovation is positively disrupting the utility sector. And we're going to have -- Matt, you can speak more on this. We plan on -- I don't want to get ahead of ourselves here, but we're going to have, I believe, a handful of utility leaders from around the world. They're going to be part of our Investor Day experience. And they're going to be speaking specifically to how digital has changed their day-to-day experience.

That's a great tease. Just one last question on this. There are 55,000 U.S. drinking water utilities, 15,000 wastewater utilities. Not all of them are going to be able to afford the equipment necessarily in deploying the sensors themselves.

Yes.

It sounds to me like you have a different angle in way to either do like a Network as a Service for these that may not necessarily be the deep-pocketed utilities.

Yes, that's absolutely right, Deane. I'd say a couple of things. One, you do see more and more utilities kind of coming together and combining their kind of efforts. And so, we do offer a Network as a Service opportunity. We've done that a number of times within, predominantly, smart metering, where we leverage our FlexNet capability. And we make the investments, which is de minimis, honestly, to put up that network, and then we lease it back to them collectively over a period of time. The other thing is, as we think about whether it be leaks, broader kind of, as we say, non-revenue water. So it's where the utilities are not collecting the revenue that is owed to them because of leaks or ineffective metering, people hijacking water, utilities, especially those that are in challenged areas financially, in their own minds, aren't able to afford, in their view, kind of new technology. And so, we also have flexible models where we are -- again, it's de minimis from an investment standpoint, but where we go ahead and provide it to them. But then again, we share in the value that we're helping them save along the way. And then, once they realize that value, they're able to invest those savings into further productivity, further opportunities. So a lot of this is education, and making sure that we're doing it, again, in a very responsible way financially, but in a way that is very accretive from a growth and margin perspective.

That's really helpful. Let's pivot over to the storm events that have been constantly in the headlines in people's backyards. And that really brings up one of the truisms of water. It's either scarce where you need it most or it's flooded where you don't want it.

Right.

And you have a significant dewatering business as well as this plays into cities, resiliency and climate change to be able to have the dewatering setup to avoid or at least minimize these storm events. Just capsulize for us what the business is, how it's fairing in these events? And longer term, you're seeing cities needing to prepare as this becomes more of a regular occurrence, sadly.

Yes. I would say, Deane -- let me start with the -- I wouldn't say longer term, but beyond this quarter or next quarter. I think anyone listening in now, if you did a word count on news over the last few months, water has probably popped up more frequently than ever in the context of infrastructure challenges. So I think before the last couple of superstorms, water was popping up in the infrastructure bill discussion. I think because of the storms of late, between Henri and Ida, water has become even more prominent. I think some would say, well, that's episodic. Is it going to stick? The reality is, yes, it is going to stick. And I think you and I both know that the realities of infrastructure are that we've got a lot of work to do. And it's not just in the U.S., it's around the world. So we are seeing that playing into the overall sentiment around resilience. So we talk about accessibility to water. We talk about resilience of infrastructure against climate change, but also water infrastructure. But then we talk about affordability, how do you pay for all this. And that's where digital plays such an important role in making it affordable. So we are definitely seeing very attractive trends in our bidding pipeline, in our overall dialogue, especially with utility customers, but also on the industrial and commercial side of things. In the immediate term, to your point, we've got a business, we call it dewatering, which is effectively, in many cases, emergency pump rental where we've got fleets out there, either we do it directly or we have distributors that have our fleet. And we are well positioned in these storm events well in advance to be able to help them deal with the flooding and other immediate needs. So we certainly are seeing a lot of activity there. It's unfortunate for the communities, but we're well positioned there. I wouldn't say it's not -- it doesn't change our investment thesis in the immediate term. So I wouldn't want anybody thinking that there's some huge boost to revenue in the immediate term. These storms, they come and they go, but it is, as you know, an attractive and meaningful part of our business.

Yes. That's great to hear. We'll be watching that closely. And then you mentioned the infrastructure build. Just broad strokes, how does Xylem expect to benefit from that type of spending?

Yes. I -- again, I wouldn't suggest to investors to necessarily think that's going to be an immediate big bang to us. I mean, we believe that what it does is it takes pressure off of otherwise pressured municipal budgets where city leaders or community leaders are making choices between one part of infrastructure versus another. And historically, water has taken a back seat on these kind of investment needs. So we believe, this is going to be very positive in terms of their ability to, again, focus on investing in water infrastructure for the medium and long term. So it is definitely a positive for us. I'd say, right now, it's still too early to put a number on what that means in terms of top line growth, but it definitely is a very healthy tailwind for us.

That's great to hear. Let's pivot over to one of the big topics at our conference the past couple of days has been on all of the pressures on the supply chain, inflation, materials, disruptions, labor shortages. I know Xylem is not immune to this. Just give us the state of the company today.

Sure. I -- you said it well there, Deane. I -- we are not immune to what's going on that every other company is talking about. And that really is, in our case, demand remained very strong. Orders are very strong. Backlog, very strong. And again, it's driven by all of the things that you teed up here in the first part of this conversation. So I think people are going to be very -- feel very good and impressed by what they see in terms of demand strength. The challenge is delivery. And so we, like everybody else, we're competing for the same supply chain. And so we are seeing the impact of labor shortage. We're seeing, obviously, in our case, in a more meaningful way, the impact of electronic component shortages, especially for our M&CS business. And we're just seeing the impact of issues around basic shipping and -- whether it be truck drivers. I mean, just getting things delivered right now is a challenge. The good news for us is none of this is about losing demand. This is simply about things shifting to the right. And that's why we still remain very positive about what our medium- to long-term outlook is around top line growth. The margins, we are not -- we're doing all the things that we can to deliver in the immediate term, but we're not paying up for that significantly. So it's not going to be a meaningful impact from a margin standpoint. It really is timing.

Did we just lose him, Matt?

Can you hear me?

Yes, you're back.

Okay. I'm not sure if I -- if you caught the end of my comment there. So if you didn't, Matt can certainly -- he can handle this topic.

Good. How about just on price cost? Where does that stand? You said the expectation, you've got the whole cost side of it, you're persevering. But where does -- if you net this together, where does price cost stand?

Yes. So Matt, in case I drop off here, I'll make sure you jump in and cover it. As we've said before, Deane, we -- the cost escalation really hit hard, especially in Q2 for everyone. We saw it continuing here in Q3. We were already out with a couple of price increases. We've gone out now with 1/3. And we do believe that between pricing and productivity, we're going to be able to mitigate the cost inflation. But we had a lag, and that lag certainly goes through Q3. We feel much better about that in Q4. And certainly, if we get to equilibrium, but not net positive going into '22. But Matt, if you want to add something there in case I drop off here?

Yes. I mean, the only thing I'd add, Deane, I think, is the -- part of this was also the demand of that recovery, right? So when we saw that backlog -- the record orders and backlog from the early part of the year, as you go through those price increases, it takes a little bit of time for that to work its way through the P&L. So we're a little bit upside down from where we'd like to be in the third quarter just by sheer fact of that first part of the year with the demand being so high and you're fulfilling those orders that had come in first. And then you're ultimately starting to see that realization come in as we get -- work our way through the backlog in the back half of the year here.

That's real helpful. Patrick, you're still with us?

Yes, I'm still here.

All right. Good. Let's pivot over to M&A. You've got -- if you could just frame for us the balance sheet power that you could conceivably put to M&A. It did come up a couple of times on last quarter's call that you would be willing to use stock as a currency. Just frame for us capital allocation opportunities, what you're seeing in the marketplace? You've done a really good job on small bolt-on kind of start-up companies. When I think of them net, I think of Visenti. Those were just not big price points, but big impactful additions to your portfolio of digital.

Yes.

So I don't think you have to do anything big. But you tell me what -- where you see the landscape and opportunity today?

Sure. Again, another great question, Deane. So I -- we always start with M&A as an enabler of the strategy. And I know that sounds a bit -- of course, Patrick. But the point is we really are focused in on end markets. So if I think about utilities, you've said it well, Deane, there are not likely any big transformative transactions out there in the utility space. We're going to continue to do some bolt-on acquisitions, build out what our solution profile looks like for utilities, and we're getting smarter every day on what utilities need and what our gaps are. And so -- but those will be not big dollar amounts that we're talking about. We then look at industrial. We've talked before about industrial. I would say it's industrial, but it's also our broader services offering as a company. We -- I really want to enhance our services profile. It's not as big, in my view as it needs to be and the benefit there is recurring revenue, attractive margin, stable growth. And so there are different opportunities we're looking at that could enhance that services offering for us. In terms of capacity, we -- so we're going to maintain investment-grade rating, which we are now. And when you look at the cash generation profile of the company, when you look at what our current capacity is already, and then you look at our equity, our stock price as a currency, we've got a lot of firepower. And so if there are large transformative things to go do, we're well positioned to do them. But I want to be clear to all of the investors listening in that we've got a very robust portfolio of M&A opportunities that we're looking at. And we'll have more to say at Investor Day on that. But it's not one thing here or one thing there, it's broad-based. And I feel better than I ever have around the opportunities for us to put capital to work on the M&A side in a smart, disciplined way.

Great. Let's pivot over to ESG. You all are recognized, and congratulations as the most popular industrial stock owned by active and passive ESG investors by a fairly wide margin. There's first-mover advantage, but there's a lot of savvy positioning, communication that has -- you've done throughout the organization. What can you tell us that can change from here? I mean, it's a continuous process, but maybe a quick victory lap on the recent success. But where does ESG go from here for Xylem?

I love that question, Deane, and I love your inference. This is my comment, not yours, but your inference around people getting more savvy about how they talk about ESG. I mean, we've been not talking about ESG, but we've been doing things not as a stand-alone project or objective, but it's integral to what we do as a business, not just water, but also how we behave as a company. We've been doing this now for a number of years. And I just give a huge statement of gratitude to not just all of our colleagues around the world, but our customers, our partners that are involved in this. But to your question, where we go from here? Again, I don't want to keep saying on Investor Day, but we've got a fair amount we want to cover on Investor Day. We are going to be talking about what the next stage is for us and in terms of commitments around, again, sustainability specifically, but also ESG, in general. I would say even right now, what differentiates us, I think, in many cases from other companies, and I'm not now talking about us versus competitors or peer companies, but other companies that are seen as being leaders in sustainability is that it's tied into our compensation model. So it's a meaningful part of my own bonus and calculation this year is how we make sure that we sustain our leadership rating and Sustainalytics. We also have -- we issued equity, a special equity grant this past year on motivating our top 100 or so leaders on our commitment to very specific deliverables around sustainability. It's not a feel-good metric. I mean, these are hardwired metrics that we're holding people accountable for. But I think when you see companies moving into the area of time compensation to this, that's when you know getting serious, and we're very serious about this. So we've got more to say on Investor Day. We've got some new more ambitious goals that we're going to be laying out, and more to come on September 30.

That's great. And look, it's a related question, but it just shows you how all of this is tied also into the P&L within Xylem. Talk about your issuance of $1 billion in senior unsecured green bonds. I mean, this is part of the sustainability angle. It really does translate into advantaged capital at lower interest rates for Xylem.

Yes. I mean, you covered it well. I was very pleased and impressed with the team's ability to go secure that. It is a real meaningful financing opportunity for us. To your point, the faster and the more able we are to deliver on our own sustainability commitments, the more attractive that bond issuance becomes. And so, again, whether it be compensation or just financial incentives on the P&L, it's real. I think the point I would add to what you've said, Deane, is you're not able to go do those things if you don't have a track record that's proven and legit in this space. You don't just show up and say, "Hey, we want to go do a green bond." You got to have a track record to do this. And that's where, again, I really applaud the team. Matt, I don't know if there's anything else you want to offer specifically on that element of financing or other aspects of P&L impact from an ESG perspective.

Yes, I'd just say, I think that's one other tool I think we built on. We did a credit revolver a year before that, where we linked the rate also to our sustainability performance than we did the green bond. And the green bond, for us, just about anything we would do, any projects we'd invest in, any R&D, any partnerships or prudential M&A, they're all going to fit into sustainability, right? It's going to -- by nature of what we do, it will qualify under that green financing framework. So again, it's just -- it more talks to just how deeply embedded sustainability is across the strategy, across the business for us.

Yes. And Deane, last thing I would say, again, not to get too philosophical here, but this is real and that is in today's world where there is a real battle for talent, and there's a battle for engagement of people and talent across the board, what we found is when you pull our colleagues across the company, if not the #1 thing, one of the #1 things that really drives them and motivates them is commitment to sustainability. Everybody has a choice as to where they're going to go spend their time and talent. And I've always said, everybody wants to believe in something larger than themselves. And we've said for a long time that we focus on doing well by doing good. So creating both economic value and social value. The two go hand in hand. And I know it's a bit overplayed these days, but we've been talking about that for a long time. And this is as much about engagement of our people because that's what makes the difference.

You know what? I could not think of a better note to end on in terms of how much you've positioned the company, we think, in a meaningful opportunities within the water sector. You're a thought leader in this space. You've got it. You're a technology. We like to say, your lead on the competition on these digital solutions is significant, and it will -- we think it will drive a whole step change in profitability. So I'm really looking forward to your September conference. The only disappointment of the day is we didn't get to see Patrick Decker's smiling face, but you've got all your messages here. We really appreciate it. We're out of time. Patrick, thank you for joining us. Matt, I appreciate for orchestrating all of this. This concludes the presentation by Xylem.

Thanks, Deane.

Well, thank you. Thank you so much, Deane, for your support. Appreciate it.

Great. Everyone can sign off now. Thank you.

Okay. Take care.