Xylem Inc. (XYL) Earnings Call Transcript & Summary

Hello, everyone. I'm Connor Lynagh. I cover industrials and energy here at Morgan Stanley. Pleased to welcome Sandy Rowland, Chief Financial Officer of Xylem, as well as Andrea van der Berg, VP of IR at Xylem.

So I think many people are familiar with the story, but Sandy, maybe you could just give us a brief elevator pitch on what Xylem is and what you focus on?

Yes, sure. Sure, Connor. And first of all, thanks for having us. We're happy to be here. So for those of you who aren't familiar with our story, I think Xylem is a really interesting company. We are a leading player in the water technology space. And we're focused on solving the world's most challenging water issues whether it's the affordability of water, scarcity of water and the resiliency of the infrastructure of water around the globe. We've got a very broad portfolio. We play in virtually all parts of the water sector. We have differentiated solutions for clean water and wastewater utilities with our transport and treatment and metering solutions as well as solutions for commercial, industrial and residential customers, a portfolio of really strong brands. For example, our Flygt brand is over 100 years old. And our Sensus brand is another really well-recognized brand in the water space. And a lot of our strategy hinges upon leveraging our heritage and foundational products. And then wrapping around digital technologies and digital solutions to make them more sophisticated and more economical for our customers. I'll pause there because I'm sure we'll dig into different elements as we move along.

Exactly. Let's keep high level to start with, though. It doesn't take long of researching the supply-demand picture or the investment regmies that play in the water industry to come across the data point that effectively by the end of the decade, demand is expected to outstrip supply substantially. In other words, current investment is not enough. How do you see this evolving? Are there changes in various regions or in various customer bases that are going to help mitigate this problem?

Yes. I mean, I think it's a really interesting question that you posed. And I think we all are sort of witnessing the convergence of 2 very powerful mega trends. #1, there's been decades of underinvestment in infrastructure in all parts of the world. And when you marry that with the impacts that are becoming very real related to climate change. We're seeing extreme flooding in Pakistan and Kentucky. And on the other extreme, droughts, whether it's in this region of the country, in parts of Europe this summer. And so I think this is becoming a more frequent storyline in the news and we're starting to see some of the governments on a global basis start to recognize this powerful trend. And as we're thinking about infrastructure investment, you're seeing pockets of investment that are now getting specifically targeted towards the water sector. And so the infrastructure bill in the U.S. is a great example. It's the first time you're seeing water specifically called out in funds, specifically earmarked for some of the water challenges.

Yes. So what do you guys think of -- just looking at your portfolio, what are the biggest opportunities or areas where Xylem can help?

Yes. I think there are a number of areas. Maybe I'll just call out a few. When you look at our portfolio and what we think may be the -- will be the fastest grower in our portfolio, it's our metrology offering that sits within our M&CS segment. And this is where we bring a digital metering solution to our customers where they can monitor remotely the usage of water and make sure that they bill for all that water that's being delivered to their customers. So with mechanical meters, the reliability of the meter starts to diminish over time. And with a digital or static meter, you get very, very reliable measurements. And collecting for all the revenue of the water that's being delivered will help give the utilities more assets that they can make investments for some of the other areas. So I think we have a really interesting example in South Bend, Indiana, whereby we worked with the city of South Bend and they had a project that they thought was going to cost them in excess of $800 million. And we were able to bring down the cost of the project through our like wastewater network optimization solutions by half. And so what was happening in South Bend is every time you had a heavy water event, the wastewater network wasn't equipped to deal with those surges and you saw a lot of flooding and you saw polluted water making its way into the sir Saint Joseph River. And so by using that wastewater network optimization, you can better optimize the flow and then they're able to reduce the amount of actual infrastructure that needed to actually be repaired. So there are numerous, numerous opportunities.

Yes. So one of the things that I think is sort of top of mind for people is the catalyst. So I think you're pointing to basically these, for lack of a better word, crisis points as catalysts for people to invest more. Do you think there's anything policymakers are going to do over the next few years to head off some of this? Or is this just a sort of structural break/fix type system?

I think people are -- I think in some like the pandemic changed so many things and it's changing the way people are thinking about everything. And so 50% of our client base and our customer base is utilities, historically a slower industry to adopt new technologies. There's a way that the utilities approached all their work, and it worked very effectively for them for a number of years. And so replicating that model was kind of standard operating procedure, but things like the pandemic, how effective remote monitoring of your assets could be when people weren't able to turn up for work? I think the conversations are -- we feel like the conversations are different now, and there's more openness to at least becoming more knowledgeable about some of the digital technologies and digital solutions that are out there. I think one of the things you see nontraditional players starting to become even interested in the water space. And these problems that we're trying to solve are really complex. And so we're never under the view that one company can solve everything. And so we're open and flexible to working with partners. The way we approach R&D as an example, is we do have internal teams that are working on things but we're also building an ecosystem of the venture capital partners and other technology partners in the space.

So let's say, on the digital technology, what is the ultimate value add that you're selling to customers with your solutions? And can you just sort of identify some of the actual pieces of product or software that you're offering in the sales process?

Yes. I mean I think the largest digital asset that we have in our portfolio is our metrology solution. And by enabling customers to remotely monitor and meter the water. They no longer have to send an individual out into somebody's home to read the meter or those that were a little more sophisticated they no longer have to send a truck out to read the meter. And they're able to get constant measurements that are not only more reliable, but they can also help them to identify leaks on a much more contemporaneous basis. And the utilities really love this. They're buying into the AMI value proposition because they're also facing labor shortages. They no longer require labor to collect that data. It's a more environmentally sustainable solution, not to send out a fleet of vehicles to take those measurements. And one of the things that Xylem brings to the table is -- and that's unique and differentiates our strategy from the competition is that we have a proprietary communications protocol and that allows for a better capture of the readings. And we've seen that we are a really robust solution first for the largest utilities in the space, but we're starting to see that also really resonate with midsize utilities. And as I look at our funnel, right now, it's a really nice mix of larger and midsized utilities. And you know Connor it's important to -- like we're still in the relatively early innings of this conversion. When we look in North America, our data suggested about 1/3 of the utilities have converted to AMI solutions. And so there's still a long runway there. And when we look at the top 100 of the utilities who have adopted AMI solutions, 50% of those have chosen Xylem. So we have a good leading market share position in that part of the market as well.

And who are you competing against in this space? Are you seeing players like tech companies that wouldn't participate in meters, but participate in the software? Or is this a situation where you can really own a lot of that growth?

Yes. I think when you look at the competitive offering, they tend to bring a cellular solution to the equation and certainly to our partners in that ecosystem. There are players like Microsoft that would participate in the cloud aspect of that delivery. So I think our competitors as well are embracing partners as they compete with us and try to bring a robust solution to the market as well. Let me pause here, -- Andrea, what do you think I...

I think you covered it. It's just -- but mainly on the water side, it's the traditional and smart metering, but we differentiate with the private network versus a cellular network or mesh network and a smart meter.

Right. Right. Let's just hone in on that point for one second. So basically, this is an area of some debate in the industry is if there's a winning technology or fit-for-purpose. Can you just help the audience understand what the distinction is between these and your position on that?

Yes. So as we mentioned, we have a private network, where we basically have our own spectrum that allows a utility to read a meter versus other competitors may use cellular technology where you utilize a partner like AT&T where you pay a monthly subscription fee. What we think is the benefit of a private network is you have reliability and redundancy. So we guarantee security and reliability that if there is a cellular outage or there is severe weather events, which is when you want to communicate through meter the most, we have redundancy that you can always communicate and identify leaks to remote even remote shut off a meter, if there is a leak happening. And the benefit also of a private network versus cellular is you can control when you can speak to the meter. Often, meter's old-relying battery is power. So you want to optimize the battery life of your meter. And for the private network, we warranty up to a 15-year old life just because we can control how often you are paying the meter versus cellular you're going to pay more often. So we have a much lower cost of ownership because we warranty 50% longer versus a cellular network.

Got it. So that's some of the high level, let's zoom in on what you're seeing in the business today. Recession is top of everyone's mind. Can you help us think through historically what the cyclicality of your business looks like? But I suppose more importantly, what do you think today? Are there signs of weakening in Europe in particular or any sort of other data points you're monitoring?

Yes. I mean, of course, we're monitoring a lot of data points right now. I think what I would share is we are fortunate that we have a pretty resilient portfolio. That's not to say there are parts of our business that have more cyclicity during the ups and downs of the economic cycle. But when you start from an end market perspective and look that 50% -- over 50% of our revenue comes from utilities. And we have established customers and a high percentage of that revenue comes from what we call OpEx rather than the CapEx of new products, you have to go out and you have to keep your wastewater plant up and running. And so you have to make those OpEx replacement purchases to keep things going. So the utilities part of our business has historically been very resilient to the ups and downs of the economic cycles. And I think a big part of our growth story is around the deployment of our AMI solutions that are sitting today in our backlog. And so we've been -- as some of you know, maybe new to others, we've been constrained in converting our backlog on -- as timely as we would like to because we've been constrained by the chip shortages. And so I believe that those AMI deployments are going to proceed, whether or not we're in a recession or not. The customers that have awarded us those business have gone through a very robust research process, a very robust RFP process. And they're very anxious to get the solution deployed because of the economic and social benefits that the solution brings. Let me just point out if there are a few parts of our business that are more susceptible to recession impacts. So we have about 5% of our business comes from our -- the residential end market, and that residential end market tends to be -- to see bigger swings. The one thing that makes our portfolio a little bit unique is we do have a heavy concentration of that business that is replacement business and not as much tied to new builds. In resi, it's about 90% tied to replacement business versus new build-outs. Another 10% to 15% of our revenue comes from commercial buildings and not -- we don't -- it's the concentration on replacement is not quite as high, but it's still heavy there. Another 30% of our business comes from the industrial end market and we play with -- partner with a lot of light manufacturing, some of the pharmaceutical end markets. Some of those end markets are very, very resilient and other parts of industrials is a little bit of a mixed bag. But I think when you benchmark Xylem versus maybe some of the other companies that are here today, we do enjoy greater resiliency throughout the economic cycles. But let me just pivot, we're -- we have our antenna up, we're monitoring demand very, very closely. I think the sentiment for most of our conversations is people are most concerned about Europe. And to date, our order momentum and demand generation in Europe remains strong. Actually, it was probably our fastest grower in the prior quarter. Our Water Infrastructure business, which has the most exposure to Europe. We saw orders growth of 20%. Now some of that ties into our private -- prior conversation, there were a couple of big order awards for large infrastructure projects, one in Canada and one in the U.S. But if you like if you strip those out, we still saw close to double-digit growth in that part of the business. So I think others are struggling with us as well. Some of the year-over-year comps around orders can get a little bit tricky because we saw unusual ordering patterns last year. And so we continue to monitor what is our backlog? Are we starting to eat into our backlog. You know book-and-bill ratios, which continue to -- up to now have been well above 1:1. And so there's still a lot of signs of strength in the -- on the demand side of the portfolio. And having said that, just reinforcing to our team that we need to be prepared if things turn and things can turn quickly and just make sure we're focused on discretionary costs, prioritizing our investments into the most -- deploying our capital into the most impactful projects and staying really focused on the needs and requirements of our customers.

Yes. I like a good overview there. There's 2 areas that you sort of brought up, I want to dive in a little more. The first is supply chain. So that's been a problem for the metering business. How should investors think about the path forward on that business? And I guess a related question is, if your supply chain on the semiconductor freeze up, are there more bottlenecks down the road, for example, labor for installs, that are going to further hinder the ability to convert? Or do you feel good once you've got the supply you're going to be able to ship?

Yes. I mean -- I think Connor, I mean as you know [indiscernible] been the #1 challenge, in some ways, a frustration point because the demand is there. We've seen some encouraging signs around semiconductors. We knew our revenue was going to be constrained in 2022 because we were not going to be able to get all the chips we needed to deliver to our customers. I'm encouraged that if I look at where we were in Q4 and where we finished Q2, we saw about $50 million higher revenue in our M&CS segment. And -- not all of that was attributable to better supply of chips. We saw some strength in other parts of our portfolio, but a bigger part was. And when we went into the year, we had a big ramp in the back half of the year as we thought supply would improve throughout the year. And because we saw a bigger uptick in the first half of the year, now that ramp is much more gradual, which gives us confidence about delivering the back half of the year. We've been doing a lot of work around this challenge. We've done a lot of redesign work. We -- unfortunately, we had to pull some of our engineering talent off new product introduction work and productivity work and allocate their time to redesign chips. We're making really good progress. We're kind of through the design part of that work, and we're moving more into the test and certification part of the process. And I think it's really -- what we're expecting is sort of another bigger step up when that comes online, end of the second quarter next year, sort of May, June time frame is where you'll start to see -- so we think we'll start to see some of that work really help us in getting more out the door. In M&CS, we have a record backlog. We've been continuing to win awards even while we battle the supply chain challenges, which we feel really good about. The backlog has been really resilient. We haven't seen customers walk away from a large AMI deployment. And specially with our semiconductor suppliers to be as transparent as possible, so we can message accordingly to our customers.

Got it. The other element is price, and you guys have been pretty transparent about the fact that you've taken a lot of price, I think particularly in your water infrastructure business, but correct me if I'm wrong there. How should we think about the flow-through of that? Where do you turn -- how far do you have to run to fully realize that in results?

Yes. So we've been seeing a continuous step up in price realization really starting in Q4 last year as we sort of worked through some of the elevated backlogs that didn't carry as attractive prices. And at the enterprise level, we got the price cost positive in Q2. There are still certain parts of our portfolio that we have further opportunity to refine. And we think that's going to carry good momentum with us into the back half of the year, which is why from a margin perspective, our outlook calls for a higher margin exit rate than our first half -- first half exit rate.

And how has -- how do you frame the pricing to customers? Basically, if we do get deflation, do you have to give some of that back? Is it just fixed price or it's material pass-through or a freight pass-through, like how is it designed?

Yes. So I think initially, we saw -- we are seeing basically inflation in all categories of spend, whether it's materials, commodities, freight, labor, energy, basically, everything was inflationary, and we were pushing our teams to go out and get as much price as possible. There's been some discussion around commodities moderating and even becoming deflationary, but the other pockets are still inflationary. There's still labor inflation, we're still seeing energy inflation. We're seeing inflation in the other categories. And so we're evaluating our strategies around pricing. And I think any -- I think the analysis has to be a bit more nuanced at this phase in the game because we have to better -- make sure we're understating the delta between our pricing and our competition's pricing. Are there any places in the portfolio that we're seeing some impacts around demand? And so I'd say we've learned our teams have learned a lot and built a more nimble response around pricing, and we're continuing to refine that and make the analysis sharper and more nuanced.

I have got a couple minutes left. I do want to take a little time for audience Q&A. Does anybody in the crowd have a question? I almost always know the answer to that. One day I'm going to get there.

Talk more about what's happening with municipal water customers, like how does the dynamic change there when the -- I'll say, publicly traded, but private water companies that are doing roll-ups on traditional municipals as that progresses for AWK? How does that change the demand for your product? Is it much greater because they're totally focused on getting to the optimal construct with limited -- they want to reduce work for all the thing that they want to do to take costs out. So does that drive a lot of the game for you or are you seeing those gains regardless of even if the municipal water company stays, held by the city or the state or whatever?

I think maybe -- the prior one is maybe a little more openness to discussions around some of the newer technologies. But fundamentally, I don't think we're having dramatically different conversations with those both sets of customers...

I think it's still a dynamic conversation. It goes to Sandy's point, we always kind of also talk about the change in guard to as some of these facilities have been operated by individuals have been there for a while not as open to technology, so that can help spark those conversations. But I think the demand is regardless of whether it's public or private, there's demand there.

Two questions from my side. The first one is around your solution on the network, the private network that you have. How do you monetize that to your customer in terms of -- because you said it was a better value proposition from a total cost of ownership. So how do you use that as a differentiator, monetizing it and potentially also creating either a base for more service revenues or recurring revenues? So that's my first question. The second one on your industrial business, 30%. How much of, I would say, the new requirements that a lot of companies, and I'm thinking particularly companies in Europe are having in terms of the environmental consideration, wastewater, all of that. How much of that do you think could become a driver for yourself or generally speaking for your industry?

Yes. So 2 really good questions. I see I'm a little bit short on time, so I'm going to try to answer as quickly as possible. The question about our communications protocol. So we have really different revenue streams over the duration of the relationship with the utility. And that usually spans up to 20 years. And so the first phase is really the rollout of the meters. And then we have ongoing replacement business over the duration of the contract. And then you're absolutely right, we have what we call network as a service, or SaaS revenue that we monetize with our customers throughout the duration of the contract period. And so there's a big surge in the first couple of years of deployment, but then there's an ongoing revenue stream throughout the duration of the relationship. And then your second question, Connor was asking about sort of catalysts for greater investment around water infrastructure and resiliency. And I think these [ crisises ] and extreme weather events that we're all experiencing is one catalyst. And then our -- a lot of our customers have their -- have sustainability goals. And so a number of our solutions are actually enablers to helping those customers achieve their sustainability goals. So we see that as sort of a secondary tailwind.

Good job on the timing though.

Well thanks for having us. Thank you.

Thank you guys.