Xylem Inc. (XYL) Earnings Call Transcript & Summary

Great. So next up, we have Xylem. Xylem is a leading global water technology company with a broad portfolio of products, services and solutions that address customer needs across the water cycle, from the delivery, measurement and use of drinking water to the collection, testing, analysis and treatment of wastewater to the return of water to the environment. Joining us today in person from Xylem is segment CFO for Applied Water Systems and Americas Commercial Team and Vice President of Investor Relations, Matt Latino. Matt was promoted to his current role last month after first joining Xylem in 2012 and leading Investor Relations since 2017. He previously served in Audit Practice at Deloitte. Xylem has 180.3 million shares outstanding. The stock trades around $89, $16.1 billion market cap, $1.1 billion of net debt, $17.2 billion total enterprise value. Matt, thanks so much for being here. You have a couple of introductory slides, and then we can fireside chat.

Thanks for having me. Good to see everybody in person. So for those not as familiar with Xylem, here is just a quick snapshot of us. We've got -- about 50% of our revenue that serves the utility market, about 30% that's in industrials and then the balance in commercial and residential. Mostly North America based. We have a healthy amount of revenue that's in Europe and some fairly significant operations there as well. And the balance in emerging markets, which has been growing fairly strong for us over the last several years, we'll touch on that in a bit here. I think one of the important parts of what we do, what's unique about us is also on the sustainability side and the impact that we have both from an environmental and social side, but also with the nature of our products and what that brings to customers. So one of the things that we added in 2019 was customer impact goals and so tracking to what that -- what those are in terms of water reuse that customers reuse the wastewater that is generated and also reducing non-revenue water or something that can be leaks that are lost along the way from clean water that you put into a network. And in the course of getting it to our homes or commercial buildings like this, you lose about 30% of that on average globally. And so that's been -- those have been areas that we've added both inorganically, but also growing some of our organic investments to address some of those key areas. So you think about what's unique about Xylem. We see the entire water cycle. And so I think you've got several other peer companies of ours that have been here today. And we see them in different parts of that water cycle, maybe just on the clean water side, maybe just in metering or maybe just in pumping. But we really see it from start to finish. So as you bring water in from watersheds, rivers, lakes, you treat that, you pump it, you put it into the clean water network, we get it to people to use at the end users, agriculture applications, residential homes or in a commercial building. Here, you generate wastewater, you move that into the wastewater sewer network, that's pumped, treated, tested and then discharged ultimately at the end of the cycle. And so we play in just about each part of that cycle. So it gives us really a holistic view of a utilities operation or all customers, right, at different parts of that cycle. Three segments that address that, and so the Water Infrastructure segment is primarily addressing that on the wastewater side. The Applied Water business, which has products for the end users of water and so applications that you would need for each one of us to use during our daily life. And then Measurement & Control Solutions, which would be how we monitor it. So more on the clean water side as well, but how utilities ultimately charge their customers. We tend to think about this in terms of 3 pillars or drivers, right, that are the secular trends here. And so that -- for us, that kind of centers around scarcity, resilience and affordability. You see some pretty staggering stats in terms of what scarcity could look like for all of us, right, that we're going to deal with over the next several years. You're already seeing it today. Things that are happening out West, where we're reaching levels of scarcity and drought that are unprecedented level. You probably saw some of that in the news in terms of -- in California and in Nevada, where levels of reservoirs have gotten to levels that really haven't been seen before and quicker than we thought we would get there. The other part is infrastructure resiliency. We've seen more storm impacts that have hit us over the last several years, things that were -- 100-year storms are happening more frequently or happening multiple times a year. And so that's another area that we've seen where communities are looking for technologies and applications that can help them address those aspects. And then underpinning all of that is the idea of affordability, right, that budgets and communities are constrained by how much they can do. And so how do you go about that in a more affordable manner? How do we pass the -- what we can on to customers, to rate payers. But at the same time, we're able to do things more efficiently, and so that also has been an area that we've been partnering with our utility customers to help them do that. We had a Investor Day in late September. And one of the key aspects, I think, what we laid out there was this move of the digitization of the water sector. And so we sized up. Today, our portfolio is about 35%, what we call digital. So meaning, it's got connectivity. It may be sensors within pumps or sensors in water quality instruments, but they're connected to an application. They're connected to could be a SCADA network, could be cloud network. But ultimately, that connectivity is pretty key. We see that moving to about 50% of our revenue by 2025. And so what will come with that, right, is higher margins and also increased growth, we think an acceleration in growth as well. I touched a little bit on the sustainability side earlier, but these were some of our key signature goals from that 2019 release that we had around kind of shifting towards the customer side. You would have seen before that, and I think where a lot of companies have been on that ESG journey had been having goals that were primarily around their footprint, primarily around how do we reduce our own water usage or reduce our own greenhouse gas emissions and other things. And we said, that's still core to what we're going to be focused on doing, but we're also going to track our impact to customers as well. That was a pretty key move for us and especially with the ESG community I think seeing that impact, and what that can do for our customers, but also our communities was a pretty important move. We also doubled down on that with a net-zero commitment at Investor Day as well, and we'll look to achieve that before 2050 and science-based targets by 2030. Think about the long-term framework that we laid out there in terms of financial framework, right, we put mid-single-digit organic growth CAGR to 2025 with healthy margin expansion, about 50 to 75 bps of margin expansion per year, 100% free cash flow. We size up about $4 billion in terms of capital deployment capacity. 2022 -- finishing 2021 and then heading into 2022, some challenges, right, that we are facing on the supply chain side, in particular. And that was especially impacting one of our segments of Measurement & Control Solutions, where we are pretty reliant on chips for those smart meters. And so that's an area that is certainly impacting the growth of that business. This year, it's also impacting some of our margin expansion outlook, but it hasn't really changed the fundamental outlook for the business. Those contracts that we've won have all gone into backlog, and we expect that. We'll start to deploy on those contracts later this year and then certainly ramps up even more in 2023 and 2024. They haven't been canceled. Customers are still committed to moving forward with that technology. But it's just a matter of getting this chip supply. Few couple of the other businesses are also battling inflation. We're battling supply chain headwinds like a lot of companies are. We're moving through with price increases. We've done a number of price increases in the other 2 segments to help offset inflation. And so that's working its way through the backlog, and we'll look -- we look to get price cost positive by the time we get to Q2 and then that spread ramps through the balance of the year. All the meantime, we control what we can control on the cost side. And so you try to mitigate any of those other inflation headwinds that we're seeing. The last piece has been a little bit quieter on M&A over the last couple of years. And it's not for lack of appetite or being not finding the right assets or not having a healthy pipeline. We continue to pursue some of the deals, getting comfortable with some of the valuations and also finding the right strategic fit for some of the companies at those valuations have been something that we're still disciplined around. But we expect that, that will be something that we have a lever this year to pull. In the meantime, if -- we have a share repurchase authorization. And so that's an area where we can lean in if we like or other areas where we can -- we might be able to deploy capital into partnerships and other things. So last piece was just on the -- this was our outlook from -- for the '22 year, some of the key assumptions that we've got there. So as you can see, it's mid-single-digit growth in 2 of our segments, in the Water Infrastructure and Applied Water businesses. Measurement & Control Solutions, we think will be about flattish. There it's going to be a story of the first half being impacted by the chip supply issues, they'll be down about double digits, and then they come back in the second half and will be up low double digits. So we expect kind of finish the year kind of flattish. That still sets up for a decent year on the top line and one that we look to be prudent around the margin guide, and we think there's room for upside there if the supply chain challenges ease in the -- during the course of the year and also the -- we start to see the allocation of the chips. Maybe just leaving with the investment pieces here. I think nothing has changed really from our standpoint in terms of where the business is. There's some timing of when we're going to see some of the attractiveness of that Measurement & Control Solutions segment play out and the accelerated growth and margin expansion that we expect to see there, but you still have a really strong company with a great installed base of products and customers. We're going to build on top of that. We're going to continue to see that digital part of the portfolio increase. And ultimately, you're going to see that drive above-market growth for us. The last piece, I think we're excited by the opportunities to add to this portfolio by using M&A, and so that's certainly a strong area of opportunity for us. And we think that's something that can happen here in the near term this year.

All right. Thanks so much, Matt. [Operator Instructions] I wanted to start on the Xylem Smart Water Solutions, your digital offerings and the environmental as well as economic impact those provide for customers and then the road map for getting half of your total revenue from digital products and services.

Yes. So I think this has been a key part of the strategy over the last few years for us. Really, when we did the Sensus acquisition in late 2016, that was kind of our -- well, our biggest transaction to date, but also brought us into the tech side in a much more profound way. And so previously, strong set of products and equipment, right, on the pumping side and treatment technology and the kind of core businesses that we have been serving for decades. This was now an opportunity for us to get -- not only get into the clean water sector but also to bring a different set of capabilities to customers. And so then we've continued to build on that, both organically and inorganically, to round out a really compelling offering, we think, for our customers. And so as you think about their biggest challenges, what we mentioned on non-revenue water or that leak -- the leaks that take place in all utilities across the world, having an offering for that, that ties in very well to having a communication network with the Sensus side, being able to identify and monitor where things are going to happen within what's a very old pipe network, pretty much across the -- especially the developed markets. This is an area where we continue to see a lot of interest in terms of addressing those challenges. And that's both -- that's going to drive value, both on the economic side for your customers, but also it drives environmental impact, right? And so you're having to go maybe do less truck rolls if you're a utility to go and fix pipes, right? Or you can proactively go and address where the pipe integrity is failing rather than just doing wholesale changes of the pipeline, which is what utilities largely have done so far. This -- today is they just come up with streets that they're going to replace the pipeline, and it's a very inefficient use of both time and capital. And so there's a lot of areas like that where we're finding we can help partner with customers pretty close.

I was wondering if we could talk more about Xylem's unique approach to new product development in terms of forging industry partnerships and collaborations as well as the new innovation hub you opened in Singapore recently, and what -- how that ties into innovation strategy?

Yes. So I think innovation has been a key part of the strategy for us as well over the last few years. It's really since Patrick got here and challenged the team, I think a little bit differently about innovation, right, think it about R&D a little bit differently. We don't necessarily need to do everything organically. And that's where we've pulled in a bigger network of partners to go and work on projects together. So think about universities. We've done partnerships with some other companies that maybe have really unique expertise in an area. For instance, we had -- we partnered -- we announced a partnership with a company called Esri earlier this year. And there are experts in their field in geospatial information systems, so think mapping of a utility. So for us serving the utilities customers, seeing how water flows through a network, seeing where your labor gets deployed in the most efficient manner, knowing where your problem areas are, those are areas that you can partner really well with somebody that can do the mapping side of it. And then we have a core expertise in the water side. And so it's a really good marriage. Another one we did was on the cybersecurity front, big issue that increasingly important to water utilities. And so we partnered with a company called Dragos that does cybersecurity for industrial -- primarily industrial customers, but another area where you can further -- what we know really well in our domain expertise, and then they can bring their value there as well. And so what that does is it brings maybe unique offerings. It also brings commercial opportunities for us with our customer base. But really a unique set with what we're able to bring to the table, maybe versus what they traditionally would have seen from competitors.

And you also touched on it a bit in opening remarks, but can you discuss the selling process for advanced metering infrastructure business, how that leads to stickiness of the backlog? And then expectations for delivering against a very strong backlog?

Sure. Yes, so the process with the smart meter, so automated meter infrastructure, that's AMI, that is the newer technology that utilities will use now versus what had been previously used as what they call automated meter reading or if you're in a neighborhood, you would see trucks from a utility roll through and get readings very close to homes or businesses. The AMI side takes that labor part and the truck roll part out of the equation. And so it's a remote reading capability. And so it can be over -- could be over a cellular network that some providers offer. We have a communication platform that we call FlexNet, which is a proprietary network that came with Sensus. And so really, when you're going through the bidding process with a utility that's up for -- when the meters start to fail at the end of their life, they'll start maybe 2 or 3 years ahead of that time frame when their contract would be up from the previous provider, and they would look for, okay, what are we going to go forward with next? And so most utilities are going with an AMI solution. And so when they decide to do that, they take a couple of providers, typically 2 or 3, they'll down-select ultimately, but they're piloting over the course of that period to try to decide, hey, which way do I want to go? Which technology do I want to go with? And so that's where -- ultimately, when they award it, it's going to be a 15- to 20-year contract. So it's a big deal when you win it, and they can be of a larger variety. We've won several that have been upwards of about $100 million or $150 million in terms of revenue. But you get very close to the customer over the course of that period. You have -- not only putting the meter and the endpoints out on homes, right, that you were -- ultimately, your -- that's how you're charging your customers, but they're also getting comfortable with the communication side of that. And so that remote monitoring capability, right, that goes back to -- could be out of data center for the utility, they may have the capability and how some don't, and so we can manage that for them remotely, but it provides a cost benefit ultimately for them. And so it's a big deal. It's something they go through every decade or so. But ultimately, it's really hard to displace someone out of that -- like an incumbent out of that market unless you have a really compelling technology. And that's where we've seen this shift for us with the Sensus business to win some of these large, large meter deals has come because customers have found that's a really unique selling capability or unique value proposition that we're going to get from having this contract.

And you've also touched on it a bit already, but can you talk about the actions and programs your engineering teams have put in place in order to kind of work around some of the industry constraints and navigate the challenges in that area?

Yes. So it's tough, right? With the chip challenge, there's a couple of different pieces to that, right? So if you have a microprocessor, which would think about kind of memory, right, within a device, you can alternative source that. And so you can get others onboarded, maybe it's going to take a few months or weeks, right, depending on your process, you can do that. Where we found the challenge here is with microcontrollers. And so if you think about a microcontroller, it's like the brain of the operation. Everything in that product has been designed around it. It ties into the firmware, it ties into your software. And so you can't just switch out maybe a chip from Texas Instruments for NXP because you just -- you can get a microcontroller here, it won't work, right? And so if you're going to go change that chip, it's a pretty lengthy -- it's going to require a whole product redesign. And so where it's made sense, we've started that process with some of our R&D teams to think about, okay, and they're partnering with the chip provider, the suppliers that we have to try to identify, hey, what are the components that we don't think are going to be to lead to some scarcity that we're going to see here, how can we protect against that as best we can going forward. So we've tried to start that process now. In the meantime, you're trying to make sure you're getting the allocation that you deserve from the chip suppliers and from our contract -- partnering with our contract manufacturing partner there. And we're closely monitoring the committal rates. So one of the challenges we had this year was right before Investor Day, we got a major de-commit from that chip supplier saying, "Look, we're not going to be able to commit to our fourth quarter -- we're going to pull on our fourth quarter commitment to you." Terrible timing, right, right before Investor Day. And so that started to change, and you don't get a lot of notice, unfortunately, with these things. But closely monitoring their committal rates after that, right, month in, month out, week to week, these guys, it's a daily fight, trying to make sure we're getting that proper allocation. And so far, since that point in September, we've seen that consistently consistent performance. It doesn't mean you're -- it's IronCloud, and we're out of the woods yet, but we've just, I think, taken a probably prudent approach on the guidance of what we assume is going to -- we're going to be able to get in. And then we're working to make sure we get everything else underway with these large contracts, stand up the communication network, do everything you can. So once the supply comes back online, you're able to move forward with these deployments. But it's been a challenging thing, and you've had to re-divert some of the resources over to mitigating this fire that you've got over here, and they're moving away from some of the normal product development that they would otherwise be focused on.

I want to move over to another part of the portfolio, dewatering business at Xylem. And any investments you're making both in the U.S. and internationally support the growth ahead for that part of the business?

Yes, yes. So dewatering is about a $600 million platform for us. About half of it is in the North America region. We do both rental and non-rental, so sale of pumps and equipment here. We've seen a big rebate. This is probably one of the more cyclical parts of the business that we have. It's also got some of the nicest incremental margins when it is growing. And so over the last couple of years when we've seen energy impacts on the oil and gas side or other, even mining not being that attractive, it had been a bit of a challenged business for us. That sort of changed this year, we saw a bit of a bounce back. Certainly, construction picking -- starting to pick up and general industrial picking up, but mining, especially outside of the U.S., where we don't have so much mining here in North America, but in places like Australia, in Africa, Latin America, the Nordics, you saw mining pickup, and you still see that with the metal prices clearly supporting that. So we had seen that, that was a nice uplift for the Water Infrastructure business where dewatering sits. We have started to replenish the fleet a bit. We had pulled back a little bit on investment there over the last couple of years where there have been just challenges in that, that the market's there. We felt like we needed to allocate our capital into a couple of other areas for more growth. And so when you don't invest in that fleet, right, and the fleet's a little bit tired, right, and it's been in use for a while, you start to lose some of the opportunities to other competitors, particularly in the rental market where it's pretty competitive with the likes of United Rentals, Sunbelt and some other players, especially in North America, they do a lot of CapEx in that part of their business. And so there's an area where really to still continue to be competitive, you do need to start to replenish the fleet. And so that's been an area where we've done that, and you're starting to see the early signs of positive results coming.

All right. And with that, we're bumping up against time. Matt, I want to thank you very much for being here. Really terrific, and I really appreciate your participation.

Yes. Thank you.