Xylem Inc. (XYL) Earnings Call Transcript & Summary

All right. Good afternoon, everybody. Hope you're enjoying the day. Welcome to Xylem. We're very happy to have Matthew Pine, Chief Operating Officer; and Andrea van der Berg, who's Vice President of Investor Relations and FP&A, with us today. Now the Evoqua deal is we can talk about that. So that should be interesting.

So I'm going to present 3 bear cases on the stock, and Matthew and Andrea are going to tell me why I'm stupid for presenting those. And then I'm going to present 3 bull cases, and they're going to tell me why I'm brilliant for presenting those. So we're going to start off with the bear cases, so I feel better at the end after the bull cases. So first one here is Xylem's track record with acquisitions has not been overly impressive. Sensus is still earning margins well below peers, 6-plus years after its acquisition, and almost the entire pure technologies price was written off. The acquisition of Evoqua creates additional execution risk.

All right. Good question. We strongly believe in the acquisitions that we brought on over the past few years. One thing I would probably just highlight is those acquisitions were largely digital. And they really help the broader Xylem portfolio when we brought them on. I think that gets lost in translation is we brought those companies on over the past 5 to 6 years. They've made the broader Xylem more resilient with digital. We think about our Applied Water business and our Water Infrastructure business, and really are helping architect this journey from 35% of our revenues to 50% of our revenues being smarter connected products. So I would probably start there. I think most industrial companies that are on this journey moving from a digital -- from a kind of an industrial product company to a digital solutions company, look, there's not a straight line. There's going to be bumps and starts and fits and starts. And we've learned a lot of lessons along the way. Some of it was, I would say, our internal readiness for digital, and we've obviously corrected that over the years. And some of it is the timing of our customers' readiness for digital. And I would say that specifically in utilities, they have tended to be slow to adopt technology. What I would say is, really, since the pandemic, we have seen a change in our utilities in terms of their adoption of digital technology. And we're making good progress there. I think specifically to Sensus, we were largely on track up until the pandemic with that business that we acquired back in 2017. When the pandemic hit, we had site access restrictions, we created a lot of challenges for us in terms of being able to convert backlog. And then as we came out of that, we got hit by the chip shortage. And so I'd say largely, the chip shortage was very painful for us in that business, and like I said, largely up until the pandemic was on track. I think what I would point to as a proof point where we have done well with these businesses is the backlog at Sensus. It's $2.1 billion. It's pretty significant. We were up 8% in Q1 in our backlog, which was already at records. And so I think people are seeing the value proposition within that business, and we continue to see good order momentum. And we also haven't seen order cancellation; our backlog cancellation during the pandemic as well. So I would say that, yes, we've had some challenges along the way, but I think if you point to the backlog of Sensus specifically and what the broader digital portfolio that we brought on, it's really helped us in the enterprise and build momentum around the shift to digital.

You must be reading some of my follow-up questions down here. Do you think that Xylem, when they acquired Sensus and when they acquired Pure Technologies, overestimated the pace of adoption of water utilities at that time? I mean they are historically a very risk-averse customer base, and do you think some of the targets that were laid out there were a little too aggressive and maybe overestimated the pace of adoption?

I don't -- I don't think so. I think Sensus was obviously a mature business when we brought that on and that continued to be on track, like I said up until the pandemic. So I'd say no there. I do think that on some of the more -- some of the smaller, what I would call technology acquisitions that had very little revenue that were technology, I think that's probably where we had some lessons learned on being able to quickly pivot technology and commercialize that. And probably more internally, our readiness to convert, to go commercialize that technology. So I think it's a little bit of a mixed bag. I'd say Sensus not so much, but maybe some of the technology that we brought on probably underestimated the opportunity to commercialize that.

Okay. I'm going to go on to the second one, which when I was looking back through these, I probably should have put last because I might not get anywhere after this slowed. So bear case number 2, which I hear from investors will say that I personally don't agree with this, but anyway. Xylem overpaid for Evoqua. Effectively, all of the cost synergies were transferred to Evoqua shareholders in the purchase price. To make this deal worthwhile for Xylem shareholders, the combined business is going to have to grow significantly faster together than they would separately. Where are those revenue synergies coming from?

Yes. Maybe I'll just elevate a bit here and take a step back and say that while the deal is not based on cost synergies alone, if you look at -- and you capitalize the cost synergies, which is $140 million, it's $3 billion. And the kind of premium was $1.5 billion. So that's kind of the math as I think about it. And quite frankly, we built the largest pure play water platform in the world. And I think that's going to give us a lot of a lot of leverage, a lot of opportunity to really get after growth, which is what the deal's all about. Specific to revenue synergies, and maybe Andrea can weigh in here in a minute, too, on this topic, I'm not -- we're not going to come out and give a discrete list of the different revenue synergies and the number. We'll get to that later and talk about what this means in terms of when you bring the 2 companies together and you look at the long-range plans, what does this mean from an additive point of view on growth. But maybe just to give you some color on how I think about the revenue synergies, there's a couple of areas. One is what I would call penetration, both in municipality and utilities, and then penetration in industrials. Obviously, the legacy's Xylem business has a strong presence in municipalities and utilities and then bringing through Evoqua products in that domain, and then vice versa through industrials. And maybe I'll dive down a little further. When you think about a treatment plant, it's got multiple processes. They call it kind of the -- really the drivetrain, if you will, through the utility and the treatment process. So that could be 4, 5, 6, 7 processes along the way. Well, the Xylem business probably plays in maybe 3 or 4 of those. And Evoqua plays in another 2 or 3, and they're very complementary. And so when we go into a utility, I'd say, through the front door on maybe a bid-type situation allows us to bundle our solutions together and be more optimized as we bring not only just products to bear, but a now solution to bear over time. And then the other way I think about that, too, is kind of coming up the pipe, as I would say, where if, for example, in Evoqua, a technician is on a site in a municipality and they always get asked questions about, hey, I've got this problem, I got that problem. Now they've got a portfolio that they can pull from and say, okay, what can fix that problem? That's really kind of the synergy side of it. And maybe an example of that would be where we may be doing UV disinfection on a site and maybe Evoqua is doing microfiltration. Today, we're not talking to 1 another. Now we can bundle those solutions together. I think on the industrial front, a good example would be, for example, in a power plant. We recently won some large jobs where we're bringing water into a power facility to use in their production process. Well, Evoqua does a lot of the treatment of that water, and we are the delivery mechanism through pumping. We never talk to 1 another. And now we can bundle that solution to the customer from a water transport point of view, and the treatment of that water, of that process water. So that's another one. I think 1 that's, maybe the last 1 I'll say here on this, is in our business in water infrastructure, specifically our Flygt brand, we're in municipalities all over the world and specifically lift stations, pump stations. Well, today, Evoqua has odor control technology that we don't have, so you can bundle our Flygt pumps with odor control and other opportunities down the road as as-a-service in utilities and then bring that to market. So those are some examples of this tip of the iceberg or things that we're thinking about in terms of driving revenue synergy. Maybe just a couple more. I'd say internationally, I think there's a real opportunity there. Now that's not something that out of the gate we're going to jump into. I think the treatment piece of our business will be where we see the synergies on the revenue side happen first. But internationally, on the services business, the services business for Evoqua is largely North America. But their customers in the U.S. want them to do work outside of the U.S. Well, we have, obviously, a global company at Xylem. We have legal entity structure back office. And so it will make that jump into expanding services internationally a lot easier through the combination. And then lastly, I would say digital is another element that I think is really important, where Evoqua uses digital to enable services to be more productive specifically on their build-own-operate model where they can win and they do the turnkey water for customers. Well, we have a lot of connected assets, connected products, and we can come in into that environment and help them connect other pieces of their outsourced water portfolio that can even help them be more proactive with their customers beyond just knowing when the filter needs to be changed, but what's the disposition of the pump and other aspects on heat temperature vibration in the broader ecosystem. So making servicing and really understanding kind of the -- making sure time on wrench is easier when you get to the job is a big benefit. So those are things I would point to that are kind of tip of the iceberg that would help us move the needle on synergies to start.

I'm going to ask you a couple of questions about this because I cover both companies. So I have some idea what's going on a little bit. The jewel in Evoqua's portfolio is the servicing work, and they have done an extremely good job disrupting the market into an outsourced kind of water model. Xylem's a very product-focused company. Do you see opportunities to experiment with some new business models in Xylem's legacy portfolio, leveraging Evoqua's service network to look to maybe some more service-based business models? The 1 that sticks out as potential for me is dewatering. And how you guys are thinking about that, whether there's any potential to kind of play around with some different business models...

Yes, maybe there's a couple of ways to answer that. One is I would say utilization is an opportunity where Evoqua has done a great job with branding their technicians AQUA pros. And they have a career pathing process for their technicians. We do not have that. I'd say we're not as mature with our service business as they are. So I think there's a real opportunity with our branch networks, especially in the U.S., to leverage the know-how of Evoqua with their technician kind of journey, and helping us with utilization. So for example, doing cross training, where we may be short technicians and if you're watering the legacy dewatering business at Xylem, we can cross train and bring technicians over and vice versa. So I think there's a real utilization opportunity and a broader career pathing for our technicians, which, as everybody knows, are hard to find nowadays. So building that competency will be important. I think on the business model side, there's a lot to learn from Evoqua with build own operate in the industrial vertical. We are doing some. We have done some pilots within the Xylem business as a service for utilities. They're not as advanced, obviously, as the industrial space. But we're seeing more and more with brain drain at utilities. Labor challenges utilities that there can be opportunities to do outsourced work, and I think Evoqua can really help us ramp up in that area.

Would that be sort of -- I mean, is it -- I mean I don't think you could really do metering as a service, but maybe lift pump business...

Well I think that lift business -- like lift stations-as-a-service, or pump stations-as-a-service where you go in, you put the asset in, you manage it, you monitor it, you maintain it.

Yes, I do think that could be a big opportunity. On the international expansion side, it's definitely something that investors speculate about, right, is taking that Evoqua business model out of the U.S. I think there is excited about the opportunity as nervous about the risk, right? I mean building out that kind of network takes a long time, costs a lot of money. One of the things that struck me that you were talking about there is their customers want them to do this internationally. So would this be the kind of thing where you would expand that service network internationally but only with customers in your pocket as you're doing it?

Well, I mean I think in the beginning, I think that's the right approach. I mean, this is a journey we're talking about, not just in the next couple of years.

Oh, yes, I think this will take decades.

Yes. But I think over the next years ahead, the smart approach is to follow the customer because we do have a base of customers today that are international, and they want that same water quality that Evoqua's been able to give the customers in the U.S. internationally. And I think it also helps us be very focused as we expand internationally to certain countries we will go to in the beginning. And then from there, we can begin to build beyond just the customers that carry us into the international space.

Yes, I could spend all afternoon talking about this, but I'll move on. Execution, so this is the third one. Execution over the last several years has been spotted. The company has missed guidance a load number of several times before COVID as well as around the electronic supply chain over the last 18 months and didn't deliver the long-term margin targets that it set many years ago. It's hard for investors to have confidence that Xylem is going to deliver on its commitments.

Yes. We still are very committed to our long-term framework that we laid out in our Investor Day in 2021 of September. We're on track to that. Obviously, that was pre-Evoqua, and we'll kind of reset what that long-range plan looks like shortly. But largely, we're on track there. No doubt, we've had some bumps along the way with the pandemic that I talked about, especially with the impact to our NCS segment that was severely impacted by chip shortage. But when you kind of -- maybe I'll just step back and look at our recent performance. Really '22 is a very strong year. The exit rate was strong. Coming into Q1 '21, we had great results across all of our segments, both on revenue and margin. Our book-to-bill was plus 1 across all segments in Q1. So there's a lot of momentum, I would say, in the business. And we've been on track really the past 5 quarters delivering results coming out of the pandemic. So that's, I'd say, really sound momentum that we have. And again, M&CS, we're back to delivering sequential growth. You've seen the improvements there. The thing that I was excited about from a margin point of view, in Q1, we saw our M&CS segment get back to 40% incrementals. So really starting to see that volume come through, help with the absorption, driving productivity in the business. Price cost has turned positive in that business, which was really the last 1 within Xylem to face inflation and kind of get over the price/cost hump. So a lot of reasons to believe we have good momentum there. I think the last thing I would say, too, and really M&CS has been the 1 to watch in the segments, is our backlog and the order pace of what we're seeing. And we're still in early innings of utilities adopting AMI technology. Only 1/3 of utilities in the U.S. have adopted AMI technology. So I think we've got a long runway ahead of us. And what's even more fascinating is the rest of the world is about a decade behind the U.S. And so there's tremendous opportunities internationally too as we move forward.

Well, while we're talking about the backlog in M&CS, let's go to bull case number 1. Over the last few years, Xylem has built a very large backlog, which increased 138% over the last 5 years and in 2022 driven primarily by those M&CS projects. This should give investors confidence that demand is very strong, and revenue growth should be strong over the next several years supported by that backlog.

Yes. So the backlog is roughly $3.7 billion for the enterprise, like we've talked about. M&CS is $2.1 billion of that. But I would point to maybe the other segments here where Applied Water and Water Infrastructure have had pretty resilient backlogs as well, especially Applied Water really coming off a strong Q1 and the backlog there. Typically, that's a book-to-bill business. And we've seen that backlog over a quarter's worth of revenue, which is not typical. It's typically probably 1/3 or 1/2. And so there's -- with more cyclicality in that segment, that's nice to have that backlog to handle some of the potential headwinds in the second half of the year with some of the more cyclical businesses. Again, we talked about M&CS. So I think the other thing I would point to in addition to M&CS is really our utility strength. Half of our revenues come from utilities globally. And so half of it comes from utilities and half of that revenue is outside the U.S. So pretty resilient in terms of the utilities, which roughly about 75% of our volume comes from OpEx, 25%, CapEx. And the OpEx, obviously, depending on the time of the year and the years in the cycle tends to be pretty resilient. Obviously, CapEx is the watch item that we'll have to look for, and just make sure that, that stays on track. But largely pretty resilient and has been resilient over the years. I think the last thing I would leave you with in addition to kind of the utility exposure that we have that provides resiliency is 1 of the kind of thesis is for Evoqua is bringing on a business that has a very stable backlog. It has -- it's resilient, it's got reoccurring revenue. And it's in some -- it's in mission-critical water applications with some very nice growth verticals. When you think about microelectronics, pharma, in these different verticals, and the need for these folks to be able to manage their water, especially with a lot of regulation and compliance. There's this tremendous opportunity for growth there, as well as just the resiliency of that reoccurring revenue. So I think there's a lot to be happy about with where we are.

Yes. I mean, I think, certainly, the backlog there should give people a lot of confidence in the revenue growth. One of the questions we get is how much of that is due to secular growth in things like conversion to AMI and how much of it is due to supply chain constraints that mean you can't deliver it? So maybe you could give us some color on things like past due backlog metrics. If those have peaked and are starting to come down as supply chains are starting to loosen up.

Yes, I would say, in general, the supply chain is getting healthier within the business. I'd say the last kind of hold out is a couple of areas, one is chip supply, although sequentially improving, it's still not out of the woods. I talk a lot about the industrial and automotive chip supply. The book-to-bill is over 1. So it's still going to be a little bumpy for a while. But we're still seeing that nice modest improvement. That will continue to improve. The backlog, to your point, is roughly 30% past due. We're working to build a model to see how quick that can move through, but it's really dependent on how fast we can get chips to recover. We've got good momentum there. And so that's what we're really focused on is getting the backlog out at M&CS, getting the past due out the door. And I think from a supply chain, the broader supply chain, I think probably the other business is the most impacted would be Applied Water, and that's why the backlog is over 1 month or 1 quarter of revenue. It's largely probably castings is 1 of our main challenges there. And we're not as vertically integrated in that business as we are in our Water Infrastructure business. So it's a little bit about some of the backlog.

Do you see the backlog declining as the supply chain loosen up? Or do you think that there will be enough orders to replace that? And this is kind of a backlog that's sustainable at this level?

I think it's a mixed bag. I think across Xylem holistically, probably it will continue to replace, but I think stronger in M&CS because of just our value proposition and the penetration of that business. Obviously, Applied Water is a bit more cyclical, and we've kind of talked about that and some of the potential headwinds on the horizon from an end market point of view. And then I think water infrastructure is a very steady business. We just talked about the resiliency of utilities which were largely focused on OpEx, and we have a nice geographic mix.

I think that makes a lot of sense. I'll go to the second 1 here. Xylem's strategy around making products smarter and connected has positioned it ahead of strong sustainability trends as customers look to reduce emissions and conserve/recycle and reuse water and reduce costs. As a leader and early mover in this area, Xylem is likely to gain market share in markets that show above average growth, and the addition of Evoqua will be additive to that strategy.

I think it's 1 of our strong value propositions and really somewhat of an investment thesis for Xylem. When you think about our business, I think 1 of the advantages we have now being the largest pure-play water platform, is that we -- what I'd say is we play across the water value chain and we have a holistic view of everything going on from pumping wastewater to treating wastewater, to metering it, to pumping clean water to metering clean water. We've got analytical instrumentation that we have out in watersheds and look at surface water. So we see a lot of the utilities business holistically, and I think that gives us a real opportunity to advise them and help them move from products to solutions. And increasingly, a lot of the utilities are looking for digital solutions, especially coming out of the pandemic with some of the trends that I talked about. And I think that we have a unique position also to kind of meet the customer where they are in that journey. If you think about utilities, 400, 500 make up the bulk of the utilities, and there's just such a long tail of thousands of utilities. And so each 1 has a different need state in their journey. And so we can meet them where they are with our digital solutions. I think 1 of the things that I'm really excited about is this partnership with Idrica, the Spanish utility. So just to kind of ground everybody here if you haven't heard about this, we recently had a joint venture with a company called Idrica out of Spain, out of Valencia, Spain. They were born out of a utility operator called Global Omnium. And Global Omnium, who manages 300 utilities, saw a need back in 2008 and '09 to really build out a digital platform to connect all the data and workflows that a utility has that they're trying to manage day in and day out. And in Xylem, we have great point solutions and applications for utilities, but what we don't have is a platform to stitch everything together. And when we're out talking to these utilities, the biggest pain point they have is they have 17 log-ins, multiple applications, the data is siloed. It's not brought together. We can't "democratize the data," and they can't really get analytics around it. And so through this partnership with Idrica in this -- and they spun it off to commercialize this, we can bring this platform to bear. We have the channels, we have the utility partnerships. And we have the know-how from an OEM point of view, and then they understand the workflows. And this is not something that takes 2 years to implement. We're talking 90 days, 120 days to go in and help a utility stitch all this together so they can be more productive. The last thing I would say here is I really believe that we have the opportunity to be the aggregator of this data and analytics in the utility space. We're not going to do that in commercial buildings. We're not going to do that in resi. Industrial may be a piece of it. But we really have, through this view, this holistic view of that opportunity.

Yes. I mean I think Xylem would be the sensible aggregator of data and utility, but probably not a sensible aggregator of data in a lot of those other markets.

Correct, yes.

So it sounds like you're dating Idrica at the moment.

Yes.

Okay. I'll go into the last 1 here. Balance sheet was in very good shape prior to the Evoqua deal with net debt at 1.1. It's an all-stock deal. So the balance sheet's actually probably going to stay roughly the same, I think. Cash flow has been strong with an average 100% conversion of adjusted net income over the last 5 years despite all the disruptions around COVID and working capital investments that, that's required. Xylem would likely still have 5-plus billion of capital. It could deploy over the next 2.5, 3 years to advance strategic goals or repurchase shares. I guess, can you talk about how you're looking at that? Certainly through the M&A lens at the moment, right, I think probably investors would rather see you all focusing on integrating Evoqua and delivering on that rather than more acquisitions at the moment. So just how you guys are thinking about that deployment of capital, stocks pulled back a bit post the deal. Is there any thought to maybe some buyback in there over the next period of time while you're integrating that acquisition?

Yes, maybe I'll let Andrea weigh in here, too, but maybe just ground everybody in kind of one of our integration principles for Evoqua. It's, first of all, both companies make our 2023 plan. I mean, that's really important. They'll get distracted. The second is the value capture you talk about, getting the $140 million of cost synergies, as well as the revenue synergies that we're working on together as a team. Retaining the best talent and making sure we combine the companies that we're retaining and motivating that talent. And lastly is culture, a big focus on culture. So I just want to make sure I kind of frame that. This is important, but really getting after that integration and that value capture is kind of priority #1. We both have healthy M&A pipelines, and we'll continue to work those. I think digital is an area that we want to continue to invest in. Obviously, industrial was a piece that we have been talking about, and with Evoqua coming in, there's a lot of opportunity in industrial. But there could be some other things that we look at on the industrial front that helps continue to strengthen that part of the portfolio. But I think the last thing I would say, maybe have Andrea weigh in here, is I think Evoqua has done a really nice job of these small service tuck-ins. So we definitely want to continue to cultivate the small service tuck-ins because it's created a competitive advantage for them and giving them really speed to market with their customers, whether 2 hours away -- the longest trip is 2 hours to any customer. We want to continue that momentum and build that scale. So that's kind of how I'd see it, and maybe have you weigh in.

And I think what we'd like to is just the all-stock transaction that we have optionality for the future for inorganic growth opportunity.

Sure, I mean those kind of tuck-in acquisitions would be okay. I mean that was pretty small when you're talking about those service locations. Questions from the audience people? I'll wrap this up before we go. All right. Well, in that case, Matthew, Andrea, thank you very much for joining us today.

Thank you.

Thanks, everybody, for attending, and enjoy the rest of the day, what's left of it.

Great. Thank you.