Xylem Inc. (XYL) Earnings Call Transcript & Summary

Hi. Good morning. My name is Saree Boroditsky. I cover multi-industrials here at Jefferies. We're very excited to have Xylem with us today, including Sandy Rowland, the current CFO; and Kristina Lee. We're going to start by doing a fireside chat. If you do have any questions, just please raise your hand and you're welcome to interrupt our flow of conversation at any time. So with that, we'll get into questions.

I think before we start kind of diving into the company stuff, you obviously had a major leadership management announcement. Could you just walk us through the planning process, the timing of that? And just how you guys have thought about it?

Yes. I think, Saree, that's a great question and probably top of mind. I think yesterday was an exciting day for Xylem. Patrick Decker has served as our Chief Executive Officer for nearly a decade, which is a really long run. And I think he has done a terrific job positioning the company for future growth. He has been planning for his retirement for some time. I think last year, in January, when we announced the appointment of Matthew Pine as our Chief Operating Officer, that all was done in the spirit of succession planning. And I think our Board of Directors, Patrick and other stakeholders think Matthew is the right person and he's ready to take the reins effective in January. And so he has the support of our customers. He has the support of our organization. And I think he's going to do a terrific job building on the foundation that Patrick has established. And for me, it's the right time for me to step away. Matthew, with making this change, I wanted to make sure that Matthew had a partner that was going to be with him for potentially the next decade. I think we've identified a great successor in Bill Grogan. Some of you that follow industrials very closely probably already know him well. I think I'm going to work very closely with him to make sure it's an absolutely seamless transition. And he's very excited to join the company, and I think Matthew and Bill are going to make a terrific combination and take the company forward for the next decade.

Thank you. So diving into the company and kind of your growth algorithm. So you provided an outlook for mid-single-digit revenue CAGR through 2025 at your Investor Day. You're currently averaging high single digits since 2021. Like has this changed how you think about your growth algorithm? And how does the addition of Evoqua change? Just given some of the synergy opportunities there?

Yes. Great question. I think when you look at the past 4 to 6 quarters, we've obviously been in a highly inflationary environment. Impacting not only material costs, but labor and overhead. And so when you break down our growth, we've gotten more pricing, a much larger tailwind from pricing than we historically do. And that was -- that's a different dimension that didn't exist when we set our longer-term growth targets. And so when you kind of push pricing more aside, we do think that our organic business grows at a rate of somewhere between 4% to 6% on average over the longer term. Within the portfolio, we have different product lines that have different growth rates. Our metrology business that sits within our Measurement & Controls division. We think, on a longer-term basis, can grow high single digits. We're going through a period of higher growth because we're catching up on some past due deliveries that have been constrained because of supply chain constraints, primarily chips. And as that normalizes over the next couple of years, we'll continue to have a tailwind to catch up on that past due backlog, but longer term, it grows high single digits. Our Water Infrastructure business grows even more mid-single digits. It's benefiting from some tailwinds around jurisdictions all over the globe, allocating more capital to firming up the resiliency of its Water Infrastructure. And then we have an applied water business that kind of grows as a GDP-like grower which generates really solid returns for the company but is a lower grower in our portfolio. We did -- you touched on what does Evoqua do to change the growth characteristics. And certainly, while we thought about the economics of the transaction and underwrote the deal based on the cost synergies, the strategic rationale for the transaction was very much along the growth lines. And we believe that it gives us a stronger platform to build on for growth. We're able to attack both the industrial end market and the industrial end market. We now have a sharper services skill set in the organization. And so -- and on a longer-term basis, we think that is a tailwind for growth and it should allow us to grow at a faster rate than we had previously talked about. We're going to have an Investor Day in the first part of 2024 and at that session, we'll have owned Evoqua since the May time frame. Our teams are collaborating really effectively and identifying what the growth opportunities look like. And I think by the time we get into 2024, we'll be in a much better position to provide a longer-term growth framework for the combined entity.

One of the things that people have been very curious about is kind of on the revenue synergy side. And I think you guys talked about in recent weeks having kind of an example of a time when you were able to kind of use products from both companies and services from both companies. So maybe kind of share like the early stages of that revenue synergies and how you're seeing it from a customer standpoint?

Yes. Well, let me give you a little bit of a bigger picture framework of how we're thinking about the revenue synergies. And then I'll ask Kristina to share really what I think is an inspiring example of what the 2 companies can do together. So the way that we're thinking about synergies in the short term -- revenue synergies in the short term, and of course, we haven't had as much time to work on revenue synergies because the transaction just closed at the end of May. And we were constrained on how much interaction our 2 teams could have together before we were formally one organization. But I think what our business number one, our treatment portfolios are very complementary. And when you put them together, we have a broader set of solutions that we can offer to our customers. We have very deep relationships on the utility side. and they have very deep relationships with industrial customers. And so the ability to cross-sell a broader product set across our complementary challenges -- channels will give us an immediate opportunity for revenue synergies. And the teams are already preparing for that getting training materials organized, getting marketing collateral, all put together. And I think we're going to see some immediate wins. I think second order of business is when you look at Evoqua, their business is largely U.S.-centric. And they have a really great customer list of North American customers. And so there are places where they're providing services to a global customer in North America. And we have a footprint in -- outside of North America that can be leveraged. And so without trying to identify new customers, we can start meeting with our existing customer base and identify opportunities to take those services and deliver them on a more global nature. And so that is something that we're doing in a purposeful and targeted way and trying to remain disciplined around. And then longer term, I think there is a broader opportunity to expand the services businesses more broadly, on a global basis, but that's something that has to come in phases. And after we get certain jurisdictions built out a little bit stronger and take advantage of where there might be jurisdictions that we have pockets of opportunity. Kristina, why don't you talk about the customer example.

Yes. Just to share a very recent example, of a synergy opportunity. We had an Evoqua customer that needed an emergency response solution and needed access to critical and temporary water services. And our teams went in, we're very proactive on the Xylem side lead emergency piping to provide access to water. On the Evoqua side, provided mobile water treatment services and very quickly within 24 hours, had the customer up and running. And we like to share this story because it shows, one, the speed with which we were able to respond to the customers' needs. Now being a combined company, it was much quicker than if we had to coordinate across multiple parties. And then also the pro-activeness of the local teams. They immediately were able to make -- they already have the right contacts within both companies and didn't have to escalate it to more senior -- it was essentially all local response and so it really shows the momentum and excitement that's occurring.

So kind of going back to that long-term growth algorithm like kind of boiling down to the segments, I think you Pure Water Infrastructure expected to grow mid-single digits versus low single digits for the market. You've outperformed this target as well to date. So maybe talk about your growth versus the market over the last couple of years? And then how do you think about both as you get into 2025?

Yes. I think great question. Water infrastructure is our largest segment. It tends to be the part of the business that is most resilient. We saw that during COVID, we saw that -- we've seen that during different economic cycles. That part of our business has a lot of solutions for -- utility is focused on the wastewater side of the business, which is more recession resilient. We have some really powerful brands that are part of that portfolio. Our Flygt brand has been around for more than 100 years. We already have a large installed base that we can leverage. We're focusing more on the services side of that segment, and that's a significant growth pillar for us. We also, in that segment have the -- had the opportunity to immediately bring in one of the Evoqua's segments that offered treatment solutions to their customers more on -- not on a services basis, but more on a product basis. And so the combination of those portfolios, as we just talked about, will be another accelerator of growth for us. And I think one thing that you are seeing -- that we are seeing, not just in North America but around the world, is that governments are allocating resources and capital to building out their infrastructure and making their ecosystems more resilient. And you're starting to see that specifically embedded in legislation, water investments are getting called out. And so that should be a longer-term tailwind for the company and for the segment in particular. Now some of the allocation of those dollars takes time. We get a lot of questions about the stimulus program in North America. And when are we starting to see that come through either in RFQs or in orders or actually in revenue. And I think we're very much in the early innings of those rollouts.

And then moving to Applied Water. It's also been outperforming its target for low to mid-single-digit growth. It's kind of the area I think you're most cautious on currently. So maybe just talk about how you think about this growth outlook the recent double-digit organic growth performance in 2021 and 2022?

Yes. So I think, Saree, that this -- our Applied Water business is one that we think about as being a little bit more of a lower grower in the portfolio but has really strong returns. This business for us was the business that was impacted the most by inflationary pressures. And so we have taken a number of steps to increase our prices with our customer base. And so embedded in that growth number is a combination of growth from price which our commercial teams worked really hard to realize and also some volume growth. When you look back the past several quarters, I would say, a larger part of the growth in that particular segment came from price. And so that's going to be -- as inflation starts to moderate, that's going to be less of a tailwind going further. The reason I say that we're a little bit cautious about that part of the business in contrast to some of the other parts of our business, which we remain very bullish around. This tends to be a shorter cycle business for us. We do have an elevated backlog today. It's around 2x of what it normally is. We've got more than 1/4 of backlog in this business. Pre-pandemic, we probably had 4 to 6 weeks going into a quarter coverage and now we've got backlog to carry us out a little bit further. But within this segment, we see a little bit of exposure to residential, and that's been a little bit soft the past couple of quarters. And so it's one that we need to play -- pay close attention to and make sure we're prepared to respond if things were to tighten up.

You kind of talked about a lot of the growth being driven by price. How sticky is price? Like if you see inflation come down, like would you expect to give back some? Or is that kind of baked into numbers at this point?

And let me just clarify one point because maybe I wasn't clear. When we talk about our Applied Water segment, yes, price has been the grower. In contracts, if you look at our Measurement and Control Systems business, which has grown close to 20% in the first half of the year, the lion share of that growth has come from volume increases and that's related to having a really strong backlog in that business, continuing to see really strong momentum from an orders front and supply chain getting better, so we're able to get more throughput through the system. So when you look at the company in total, the growth has really been balanced between volume and price and M&CS more weighted towards volume growth and the other 2 segments a little bit more skewed to the price side of the equation.

And anyone have any questions? Okay. Then maybe going on to M&CS, like how are you seeing the growth differences?

There's a question.

Can you talk a little bit about the big disruptor PFAS. What the impact it does for Xylem?

Yes. So I mean I think that's a great, great question. When you look at the legacy Xylem portfolio, we didn't have a significant product offering around PFAS. That's one of the things Evoqua brought to the table through the acquisition. I would say we're still in the very early innings around PFAS. The regulations from an environmental perspective are still in process, if you will. And so we think that is a longer-term growth driver for the organization. And we have some near-term growth drivers that will probably be more impactful in the shorter term. Evoqua has solutions that are very well equipped at sort of containing and isolating the PFAS. The big challenge is then what do you do to destroy it. Kristina, what would you -- what would you like to add on?

Yes, I would agree with that, Sandy. We're still in the very early stages here. And in addition to just waiting for the national regulation to pass in the U.S., there's still questions around how much will it cost for utilities to comply with that regulation, who will help to pay for that? As well as how do you scale up the monitoring and testing of PFAS because a lot of the times, we don't know the levels of PFAS in the water. But as Sandy said, we're very well positioned now with the Evoqua when that time comes to help our customers with that solution.

Any other questions from the audience? Okay. Feel free to interrupt. So going back to M&CS. How are you seeing the growth differences between smart metering analytics and kind of the assessment optimization solutions you have within that segment?

Yes. So I think we have a really interesting mix of products that are embedded in that segment. The Metrology business makes up just north of 70% of that business. And so that part of the business gets a lot of attention and focus from the investor community. Within our Metrology business, we're seeing a really robust pipeline and bidding activity. We're seeing a lot of activity in both large-sized utilities and midsized utilities. The AMI metering value proposition that we have is very compelling. It offers a lower cost and better outcome for our customers. They're able to get more precise readings on a more frequent basis and therefore, leaks and other issues can be identified on a much more timely basis, which saves their customers' money. And then, of course, not having to send -- labor is one of the big issues that utilities are facing. They're facing an aging workforce and not having to send out trucks, staffed with people to collect the data, saves them -- helps them address some of their labor shortage issues. And it also helps them achieve some of their own sustainability targets without having to do truck rolls. And so when we look at North America, we're only about 1/3 of the utilities have adopted AMI. And so we believe that there's a lot of room to run in that space and that we're very well positioned, particularly for utilities who want to take advantage of our proprietary communications protocol which is really one of the key differentiators in our offering. And so longer term, we said that, that business should grow high single digits. We're seeing a tailwind as we work to clear some of the backlog and so we'll see elevated growth rates there for the next couple of years. The second largest business within M&CS is our Analytics business. We also call it sometimes our Test business, and that's $350 million to $400 million business. It is -- has very nice growth characteristics. Actually, probably approaching what we can realize on a longer term in metrology and very good margin -- a very good margin profile. Assessment Services is a smaller part of that portfolio, but it has I think, a really compelling value proposition. It allows our utility customers to identify the parts of their piping network that are most prone and vulnerable to breakage. And therefore, as they're thinking about their repair cycle and where do they deploy their capital, they can do it more strategically rather than along a time-based model. And so our business in -- pipeline assessment services has been focused largely in North America, and we have opportunities to scale that on a global basis. And so I think that business can grow at least at the segment average or faster. It's a relatively small part of the segment today, but one that I think is very valuable to the portfolio.

And then now we talked a lot about top line. If you think about margin expansion, especially in M&CS, given that there's a return on investment for your customers, there is a digital component like what -- can this be the highest margin segment over time? And what's stopping that today?

Yes. It probably has the highest incremental leverage of any of our -- any of the businesses in our portfolio. It has very good contribution margins. There is a fixed cost -- a higher fixed cost dimension in this business because we have to maintain the communication protocol that differentiates us from the competition, but that's a significant fixed cost block, which is why when we see -- we tend to get the top line going in that segment, we see very good drop-down leverage. And when you couple that with the fact that a lot of our organization has had been pulled away from productivity initiatives to focus on chip redesign initiatives, and that should settle out. I think there's opportunity for further productivity to take -- to come back in and be a focus in this segment. And you're going to see -- I think when you look at M&CS, it would be the fastest grower in our portfolio. It should have the most robust margin expansion. So as you sort of map out where our businesses sit today, the other 2 businesses have been very resilient during sort of the COVID period and the COVID after shock period. The M&CS business is well on its way to recover it. I think you'll see maybe it be a move from a slower grower with lower margins to one that has the most margin improvement and the fastest growth over the next -- next part of our planning cycle.

And if you look at the first half, M&CS had around 40% incremental margin. So we were very pleased by the progress there, and that's more in line with our long-term framework.

Questions from the audience?

I couldn't help but notice, I guess the big management transition that you announced. Can you give us some context? I mean it's not so often that both the CEO and the CFO -- basically go at the same time?

Yes. I mean we did address it at the beginning of the conversation probably before you stopped in. I'll just -- I think it's a little bit unconventional, but we thought that was the right thing for our organization to do to move forward with. We appointed a COO in Matthew Pine back in -- he took effect in January and he's ready to go. And the company wanted to give him the opportunity to be involved in all parts of 2024. And we're -- the organization is really excited to have Matthew step into that role effective January 1. And I'm also going to be leaving. I think it's the right time for me to leave personally, and we wanted to give Matthew a partner that will be with him for the long term.

And I guess with 60 seconds to go, you [indiscernible] at your Investor Day, you want to increase your vitality index to 25% by 2025. Where does this initiative stand today? And how should we think about the investment needed to support new product introductions?

Yes. I think it's a great question. I think that the organization is very focused on innovation. We have a really active early phase innovation program, an innovation hub that continues to bring in new ideas. Our vitality index is -- goals are tracking as we sort of outlined at our Investor Day. We're seeing an increasing part of our revenue come from new products. With the local coming in, we have to look at their -- how they track that and how that works and set new targets on a combined basis. But I think innovation is a core part of our culture and it's where we allocate a meaningful amount of capital to continue that differentiation.

Thanks for the time today.