Xylem Inc. (XYL) Earnings Call Transcript & Summary

Good afternoon, everyone. Welcome to our last but not least, or at least last but not least within my coverage, session of the Laguna Conference. I've got the Xylem team with me here. I've got Patrick Decker, President and CEO; and Matt Latino, Vice President of IR. Before we get started here, I do want to remind you that you can view our disclaimers at morganstanley.com/researchdisclosures. And if you have any questions about this session, please do feel free to reach out to your Morgan Stanley sales representative. So without much further ado, I think you know me, but if you haven't tuned into the conference session thus far, I'm Connor Lynagh. I cover industrial equipment and technology here. And we're going to be talking about the water industry with the team here.

So Patrick, I think a lot of people on the line are familiar, but if you could just give us the 30,000-foot view, the elevator pitch on Xylem, maybe that would be a good place to start here.

Yes. Thanks, Connor. I mean, it's -- again, thanks, everybody, for joining, and thanks for having us. I'll try to keep it brief. When you think about kind of why water matters, and I'm going to say some things that are probably intuitively obvious. But I think it will be even more obvious after the last few months here is the big challenges facing our world are accessibility to water, not just at a household level, but in terms of whether it be industrial users or commercial building, getting access to water is becoming increasingly challenging. Secondly, building infrastructure that is resilient to things like climate change and the water challenges is becoming more and more real. But most importantly is how do we do all that? How do we deal with all that, Connor, in a way that is affordable? Who's going to pay for it? And that really is where our solutions, both from a digital standpoint, but also from just an overall sustainability standpoint where it really matters. Beyond that -- I mean, that really is the growth story for the company. And I'll talk more about that. I'll let you have follow-up questions. But in terms of the overall investment thesis, it's growth beyond market rates. We have a great margin expansion story that is driven by the mix of our businesses. It's also driven by the role of digital technology. And when you're deploying that, you're going to get better margins. And then lastly, it's our cash conversion. We've got a great track record of cash conversion. And what that allows us to do is to build a balance sheet and an arsenal to go out and be a compounder, to go out and do M&A, put capital to work. And so those are the things that excite me the most.

Yes, good starting point here. And I guess the -- we could get into many, many different niches of the business in many different markets. But at a high level, it seems to me there are sort of 2 problems. There's -- one is insufficient access to water, and that certainly exists everywhere, but particularly a developing world problem. And then there's excessive use of water or inefficient use of water, and that seems to be more of a developed world problem. Do you agree with that view? And do you -- are you of the view that one drives one portion of your business and one drives the other? Like how should we think about what that means for Xylem?

No, it's a great question, Connor. I wouldn't simplify it that much because there are a few hundred watersheds around the world, and every watershed has its own challenges. And whether that be in developed markets or developing markets, I mean there are as many challenges that are facing communities here in the U.S. around affordability and access to water than there are in India or Africa. At the same time, there are communities in those countries that are overwhelmed with issues of flooding and not knowing what to do with the water that they have. So I think that right now, I'll keep it brief. I think right now, Connor, it's more just an awareness of what the water challenges are and not taking things for granted, and realizing that technology is the solution because it comes down to how we do that in an affordable way.

Yes. So I think we could focus on a lot of areas, but let's maybe start with the CapEx story for the industry. Obviously, we need to build more. We need to do more in terms of delivery and wastewater treatment. I mean where do you view that as the most critical need? And what do you see as sort of the big areas of growth within that?

So I would say, Connor, the -- so 70% of the world's investment in water, again, I'm throwing out big numbers. But directionally, 70% of the future investment in water infrastructure is going to be in developing markets. Having said that, that still means there's a lot to be spent in developed markets. 70% our business is OpEx. We serve existing infrastructure. But at the same time, we're also there to invest in CapEx, that 30% that is new infrastructure. Again, the big angle that we really are focused on is affordability. So helping whether it be utilities, which is 50% of our business today, or the third that is industrial or whether it be commercial buildings, resi or ag, it's helping those customers understand we can do a whole lot more with a whole lot less. We can do it affordably. And the way to do that is through using technology and digital solutions.

Yes. I guess -- so at least from the investment community's perspective, there's been increasing focus on broad ESG themes, but certainly energy transition, and I'd say increasingly, water scarcity or water management, sort of in the broader context of resource management, is more and more topical. I guess the question that we get pushed back on a lot is given the point that you made, which is half of the business is utilities, we can sit here and we can look at public companies and say they're going to be spending more, but it's a smaller portion of the business. So the question is, is capital being made more available to the industry do you think over the next few years? And I imagine that answer will differ somewhat depending on the region of the world. But ultimately, to fund this growth and this development, you're going to need the capital. So where do you think the capital is coming from?

Again, great question. And you're right. It differs by geography. I mean the short answer to your question would be, yes. We definitely are seeing it in our bidding pipeline. We're seeing it in the sentiment of conversations that we have with whether it be utilities, whether it be industrial, users of water commercial building, I think we're all seeing that the pressure points continue to build. This issue of sustainability from a water standpoint, it's not going away. It's not. And whether it be federal infrastructure bills here in the U.S., whether it be mandates in China or India, where accessibility to water or safe hygiene has been part of their mandates for the last 5 years, that's what's driven our growth in China and India. And we're now seeing it coming here to the U.S. Europe has always been pretty steady. My friends in Europe always say, hey -- I don't mean to be cute here, Connor, but "You guys, the Americans, you always go from guardrail to guardrail. Why don't you just like to stay right down the middle of the highway." Europe is focused on water infrastructure for a long time. So it's not sexy. It's kind of low mid-single digits, but it's sustainable growth. But I think here in the U.S., water is becoming a big deal. And I would encourage investors to get out in front of it.

Yes. So let's tie this back to the business then. So which -- what solutions do you feel are most differentiated within your business? Where do you see the greatest tailwind from these trends we're talking about here?

I would say, if I gave you, again, kind of percentages as parameters, I know that we talk a lot about digital. We talk a lot about technology and disruption. It's important, I think, for investors to understand that, again, the bedrock of what we do is the equipment, the hardware, the proven solutions that we provide to customers, whether it be utilities or industrial or commercial every day, that's still the large majority of our business. And that's going to continue to be the case. There is this growing component, which is digital, which is technology. And there, what it's really about -- and again, I know it's boring, it's how we use the power of the data capture with our customers to help them have greater insights about how they can actually optimize the investments they've already made around hardware and equipment.

Yes. So let's zoom in on that digital side for a minute. So certainly, I think we understand the need to have more information. It feels at least someone relatively newer to the story that there was a bit of hype cycle around it, maybe 3 years ago, and investors have grown a little bit tired of hearing about it, if I'm being candid or maybe snarky about it, so the growth profile...

Things never move as quickly as industry want to.

Yes. So I guess the question is basically, is there a reason to believe that this is going to be moving faster going forward? Are you seeing an evolution in customer behavior that would lead you to believe that the market is trending significantly higher?

Yes. And we will -- in the purpose of brevity, we will give you those proof points at our Investor Day on September 30.

Thought maybe we would get a teaser, so thank you.

We're seeing a big increase in adoption of pilots of projects that we're working on. Again, we see -- we saw rapid adoption in China, India, Australia, parts of Europe. It was slower in the U.S. We've seen that really tick up here during the pandemic, and we've got some proof points that we'll share with you on September 30.

Yes, absolutely. I'm curious mostly on the software side of that business. I guess the question that we get a lot is why are you the right company to provide that solution? There's always a concern when you start talking about software and talking about tech that the tech giants are just going to come in and do the whole thing and take all of the economic profits from everyone. So what's your thinking about that?

That's probably the best question I've heard of all week. No, that's a great question. I mean -- and it's one of the things that I think really it enlightens me and the team. I remember having a conversation with one of our customers in Australia. And I asked her -- and this is in no disrespect to any one of the big tech firms or our engineering consulting colleagues and customers. And I asked her, I said you went out and did a request for proposal on nonrevenue water. Nonrevenue water for those that are listening in for the first time is all the revenue loss by utility between the time that they actually treat and deliver water to the time they actually bill it and collect revenue. It's called nonrevenue water. We didn't come up with the name, the industry did. They went out for the first time, we never seen, with a nonrevenue water proposal, and we won the bid. And I -- and we won it against big tech companies. And I said, why did we win the bid? And she said because it's important to get data. So Connor, data matters, but she said, what we really need is somebody needs to take the data and tell us what to go do with it. What are the insights? In other words, we have hardware and equipment that you've already invested in, we've already bought it from you. And whether you were the ones who provided it or one of your competitors did, I just need somebody to come tell me what valve to go turn, what hydrant to go replace, what meter to replace. Give me insights. And so we're not going to do it all on our own. We will partner with big tech companies, no doubt. But where we really bring -- in my view, where we really bring the special sauce is the insight and the knowledge about what to go do with data.

Yes. Makes sense. So I guess let's maybe turn to the near term a little bit here. So your business, obviously, isn't hypercyclical but you had a bit of a cycle in 2020, and things have been recovering nicely and certainly site access restrictions and things like that seem to have continued a little bit. But I guess the question is how far along are we in the recovery? Where do you see potential further upside? Where do you see more normalization within the portfolio?

It's hard to know, to be honest. If we look at things right now, bidding pipeline -- I'll talk about a couple of areas. So bidding pipeline in terms of metrology, which is more of the clean water side of utilities is very robust. There is still a significant conversion happening in terms of moving to smart metering. So moving away from drive-by, read-by metering to remote metering. That's a very good trend line. And we see that continuing over many years. Wastewater infrastructure, it's critical. It's mid-single digits. It's been there. It's going to continue to go forward. And there, we look at our treatment pipeline, and our treatment bidding pipeline remains very robust around the world. The area that I've said before and I'm not trying to foreshadow anything is, I think in the part of our business that is more of a GDP-type business, which is Applied Water, it looks healthy. It looks robust. Don't keep counting on double-digit growth rates as an indicator for the business, but it looks good. So we feel good overall right now from a demand standpoint. The challenge is supply chain, and we're not alone.

Yes, might as well stay on that topic since it's -- you can't escape a meeting here without talking about it. So what are you guys seeing on that front? You guys have been pretty proactive on the price side of things. And I think you had sort of alluded in the last conference call that you're going to be doing more. But can you just provide an update on where you're seeing the biggest pinch points? And what you're doing to mitigate it?

Sure. So I mean biggest pinch points for us, electronic component supply is a big challenge for us, mainly within our M&CS segment. We continue to do all we can there. We've got a great partner in Flex that has really worked tremendously with us on mitigating that, but we still have challenges there. I would say, we also are dealing with labor shortages. We're dealing with the freight challenges right now. But again, the team is doing a terrific job working through that, Connor, and mitigating it. But again, we're not untarnished in terms of the challenges here in the quarter to deal with that. On the pricing side, cost hit us quick in Q2 coming into Q3. We've already gone out with 2 price increases. We've gone out with a third. We'll continue to be disciplined in how we manage that. And we expect the price cost dynamic to catch up to equilibrium as we go into Q4 and 2022. I know one of the questions we've gotten from a number of your clients today is how sticky is that? And -- no, we feel good about -- when we go out with price increases, nobody ever wants to do it. I mean nobody wants to do it. And we're not the only supplier going out with price increases to our customers. So they're dealing with all this from a lot of angles like we are. But they understand that we're doing it in a very responsible way. And therefore, when we do it, it sticks.

So as you look at sort of the trend here, do you feel like you've now gotten ahead of it or at least are sort of pacing it? In other words, if we're thinking about margins as we move through the next few quarters here, do you feel you're going to be flat to increasing? Or do you think we should be cautious around that point?

I would say we're pacing it. I mean, of course, we expect that we're ahead of it, but it's moving. And I wouldn't want to promise anything, but the team is very disciplined. We are definitely staying ahead of this and being appropriate as a market leader. But I -- Connor, I can't tell you what's going to happen next quarter or the one after that. But right now, based on where we are, I feel good about what the team has done.

Yes. Yes, absolutely. So I guess let's move to capital deployment. So you guys have been a little bit quieter on the acquisition front over the past couple of years here. But certainly, the balance sheet is at a place where you could be more aggressive if you wanted to. What's your thinking around what makes sense to do? Where do you want to build the portfolio more?

Sure. So as you laid out, Connor, we have the arsenal to go do pretty much whatever we'd like to do. And I know that on the last couple of earnings calls, I've been called out both during the call and afterwards on, are you prepared to use equity as a currency? Of course. Having said that, we're going to be responsible about how we use that equity. And so I come back to the basic premise, and that is, what are we solving for? What we're solving for is where do we see the biggest opportunities for growth. I think in the utility space, we pretty much have what we need. We've got some opportunities to go acquire some things, but they're probably going to be more bolt-on. Then I look at it and say, industrial. And in industrial, the biggest opportunity there is to build out a services platform. And we don't really have that channel to market right now. There are a number of ways to get access to that. Then we talk about digital in the industrial side. And there are a number of ways for us to go do that. So we've got a really rich pipeline right now. Very excited about what we see, a number of things that we're talking to the board about. And -- but it always takes 2 to tango. So whether it be one-on-one larger acquisition or something that's smaller tuck-in, it's robust right now. And I've never been more excited about the M&A pipeline than I am right now. But again, it takes...

We have a couple of questions in the queue here. And for those who are on the GlobalMeet platform, feel free to answer additional questions as they come in. But Patrick, we've got a few and a couple directly related to what we were just talking about. So one question here is, why are you inclined to use equity as a funding source? You have free cash flow, you have cash. What is the thinking around that? Are there targets that are large or transformational enough that you would use equity to fund them?

We're not -- I'm glad for the question, Connor. We are -- I'm not suggesting we are inclined to do it. My only comment was in response to questions in the last 2 earnings calls, would you ever be willing to? The answer was yes. I'm not suggesting we're inclined to. We will always do the right thing financially because you're right, and the person who asked the question. We've got a lot of kind of things here at our disposal from an M&A standpoint. All I'm saying is, I'm not going to be blind or deaf to the use of equity, but it's not our priority right now.

Yes. And then another one here, just putting together the components of supply chain pressures as well as your pricing actions, et cetera. Do you see any risk to revenue guides for your segments in the third quarter?

Well, I mean, obviously, I mean, we've -- I assume Matt's on. I mean we're in quiet period right now. So I'm not going to comment other than reaffirming kind of what we've laid out. So yes, I've got no comment on the revenue number for the quarter.

Worth a try.

I know. I got it.

But let's take a bigger picture to end out here. So in terms of thinking about your business, the capital allocation framework that you've laid out suggests a continued desire to invest in the business, your free cash flow conversion should be moving higher. Given the relative stability of your end markets, what is the right level of leverage? How much -- how do you think about investable capital within the business?

Yes. So great question, Connor. So we look at the balance sheet and say, pretty much where we are right now, kind of somewhere between 2.5x to 3x EBITDA leverage is the right space to be. That's where we've normally played. Some people ask me why that matters? I mean could we go higher? Of course, we could. We have to fund strategic moves, but we've always brought that back into play. And the reason it matters is because when we're going out and doing large deals in the pipeline where there is bonding and financing required, having an investable grade asset and a balance sheet matters. And so we're never going to get too far out of bounds on that. We are in a great spot right now, and we will be for a long time to go do the kind of deals or investment in capital we need to. Our organic CapEx requirements are very small, very small. This is not a CapEx-intensive business. And so for those of you that are relatively new to the story, again, growth, margin expansion in front of us, tremendously strong cash conversion history, and the ability to then take that cash and balance sheet and put it to work, it sounds generic, but that's pretty much the story, Connor.

Yes. Yes, understood. So maybe just one more that focuses a bit more on capital availability to the industry. And just the thing that I've wondered about, as you know, come from an energy background, the degree of private investment abroad in water infrastructure is really underwhelming compared to what you see in oil and gas. And I get it, you have big cycles, and there's less maybe sexy pricing or returns. But it does seem like there's an opportunity there, particularly with how much capital is available in the world and how much is now devoted towards impact investing. Are you seeing opportunities to partner with or provide incremental funding or connect funders to those in need of capital in some of the big international markets?

Yes, we do. It's a great question. You and I have talked about it before. Again, it differs by geography. I think if you were to talk to -- I won't mention company names, but those companies that are private owners of the utilities in the U.S. and around the world, they would say to you that if they could buy more assets tomorrow, they would do it in a heartbeat. The challenge is you got to go through a regulatory process for that change in control to occur. But they are working at it. And they're great customers of ours. Secondly, I would say, in developing markets, it's a little bit easier in terms of the private investment along the way on the utility side. And what we've said there is we are fully prepared to do partnerships. And these are not -- these are small dollar amounts. I don't want any investor to think we're leveraging our balance sheet. These are really small dollar amounts. To, again, help our customers that when they realize the value of minimizing revenue loss, reducing the energy consumption, connecting a higher percentage of their citizens to clean treating water, we're prepared to invest with them side by side. And the value creation around that is exponential compared to what you would normally just invoice somebody for in terms of selling a pump or a meter or a digital solution. But again, Connor, I want to make sure our investors hear me loud and clear. I'm not talking about leveraging balance sheet, okay? I mean these are simple, small solutions that we're able to provide that have immediate paybacks.

Great. It's a good spot to end it as we're about out of time, but Patrick, thank you again. Those on the line, thanks again. If you have any questions, please feel free to reach out to me, your Morgan Stanley sales representative, director of the Xylem team, but we'll happily put you in touch. So Patrick, Matt, thanks very much for joining us. Everyone, have a good rest of your day.

Thank you, Connor.

Thanks, Connor.