Xylem Inc. (XYL) Earnings Call Transcript & Summary

Hi, morning, everyone, or afternoon, everyone. I guess. My name is Mike Halloran, Industrial analyst here with Baird. We're pleased to welcome the Xylem team with us. We are going to basically be doing a Q&A session here. So any questions you might have, send me an e-mail, raise your hand, we'll make sure we get them. Joining us today, Matthew Pine, COO, will be CEO?

Jan 1.

Jan 1.

Bill Grogan, new CFO; and Andrea Van Der Berg, who's IR extraordinaire. So we'll start with the easy ones.

All right.

We've had a 10-year journey under Patrick, where there's been a lot of asset accumulation, a lot of investment in growth areas. You guys are coming in here, what changes? Or in other words, the company is about to hit another's phase of its evolution. Where is the focal point from your twos perspectives, Andrea as well, and what is that curve going to look like? And why is it different?

Well, maybe I'll first and just say Patrick's done an incredible job over the past decade building out the portfolio that we have today and the platform that we built, being the largest pure-play water company in the world. And I think not that we haven't been executing, but we have been executing on that mandate of putting that portfolio together and now it's really the next phase is continuing to execute on that platform. I think first and foremost is the recent Evoqua integration or acquisition and integration is, first and foremost, making sure we get the value capture, both on the cost synergies and the revenue synergies. A big focus for us, which is a continuation of what we have been doing over the past few years is through digital acquisitions is expand our digital presence, moving from smart connected products to more SaaS recurring revenue and using a digital platform to pull through our content. And one of the, I'd say, the strategic pieces of Xylem is we play across the whole water cycle. So it gives us really, I'd say, a competitive advantage, but more of a holistic view on how to optimize and help utilities operate in a more efficient way. I would say lastly, the thing that would be the focus and maybe a touch of a pivot is focused on really transactional excellence, modernizing our systems, in getting after what I call productivity for growth, it's productivity to help enhance our leverage, our drop-through on our volume, but more importantly, being able to take some of that as well as invest in growth. So I think that's a little bit of the pivot. Not a big change in terms of the thesis and investment in terms of Xylem, but a little bit of a pivot and focus on execution of the platform that's been built.

Yes. Part of it just seems like you've got a lot of great pieces and now we just need to make sure we optimize how those pieces both work together, but also how you functionally go to market.

Right. Yes.

Bill, maybe your perspective as well, a lot of people know you from the IDEX days and very well thought of business model, business system approach to capital allocation. What do you see in your first days so far at Xylem and how do you integrate some of your history into Xylem moving forward?

Yes. No, I think, first and foremost, just the recognition that we do have the best portfolio in the water space. Obviously, that was hugely attractive as I was coming in and making the decision to make the move, lots of conversations with Matthew on how the Evoqua transaction is going to help complement that and creates the capabilities of the portfolio. My first day, we went to a wastewater treatment plant and we're able to see kind of the combination of the two organizations to be able to address kind of almost a 100% of the high-value content within that process. Then there's the operational focus, I think, that as Matthew said, it's a slight pivot, obviously, there's margin opportunity within the organization. And I think there's tools and some philosophies I think that the team was working on, and I can bring over to the organization to help complement to, one, free up some of the organizational capacity and reduce some of the complexity to increase the innovation for our customers, and then also free up resources to reinvest in some higher growth opportunities and then improve overall profitability. This is a cadence of some specific tools, 80/20 being one of them, but then also harmonizing the operating model and the cadence in which we operate the organization. This is a portfolio that's been built up over the years, and I think there's some opportunity to get some better synergies from an operational capabilities perspective to enhance our margin profile.

And one of the things when we had dinner last night together that struck me was both from Andrea's perspective, who's been there longer as well as your two is that it's an organization that wants to get better. And internally, there's a lot of momentum to try to take these tools, maybe not these tools specifically because it's still early days, but there's this desire for something more.

Yes, I think that's right. And I think also the -- going back to the integration of Evoqua, we talk a lot about value capture, revenue synergies, cost synergies, but the soft side matters, too. But getting the right talent on the field, but more importantly, bringing the best cultures together. And I think Evoqua brings -- because it's more of a service-oriented business that sense of urgency, customer focus, hair on fire, pivot that we're looking to move within the legacy Xylem business. And I think bringing that into the business and that culture will help us move faster towards execution.

Maybe we start on the Evoqua piece. Early days, how has the integration gone so far? And I think what a lot of people are asking about and maybe we'll start with is just the revenue piece of it and how these businesses fit together and how much they can do together. And I know there's been a lot of anecdotes at early days. There's just been some nice test cases on what can happen over time. So maybe talk about some of those touch points that are very encouraging over time for what that revenue synergy piece could look like.

Yes. And so we're tracking on the cost synergies, which funds the deal. But the deal was put together for growth and putting two great companies together that are very complementary. I think out of the gate, the first thing that you get traction on right away is the services synergy and I would say that was a little bit, not a surprise, but how quickly we've been able to get the teams to kind of come together naturally. And for an example, where Evoqua has really helped the Legacy Xylem business pull through into the Industrial Services business, where in the Legacy business, we didn't have access before. An example would be refinery, we had issues in the wastewater treatment, not the Legacy Evoqua business did the process water, the wastewater was done by the customer themselves had an issue within 24 hours, both teams show up, laid 2.5 miles of pipe, put 8 pumps on the ground and can treat all at the same time with one phone call. That's very promising, and we've seen 4, 5, 6 examples of that where we get short-term contracts to come in and take care of these kind of emergency-related needs. When you go out and look at sites like heavy industrial sites like power, you get into oil and gas, you easily see that customers really only care about outcome. They don't care about what the products are in between. They want to know that the process water meets the spec, the wastewater meets this spec. So when you go look at these sites, we have Evoqua doing treatment, but we don't have Xylem pumps on the site, we don't have Xylem analytics on the site. So that's really exciting and a huge opportunity that we've already seen with customers and say, "Hey, we want to write you in to the contract, and we want to pull through more content with the new Xylem". So that's been very promising. We've moved quickly, probably more so on the industrial side. I'd say the municipal side of revenue synergies will take a little longer because it's more long cycle, it's more of the treatment train, if you will. We now have 80% to 90% of the treatment train both in clean water and wastewater. That takes a little bit more time as you walk through the front door, you meet with architects and engineers, but that's well on its way. I'm really excited that we did the integration of the Legacy segment APT, Applied Product Technologies into water infrastructure. We finished that in October. So that really greases the skids for that to happen quickly. And we have a lot of momentum there with the sales teams.

Yes. Part of it is you just have different sales cycles, right? I mean on the industrial side, it's a little more return oriented and it's -- let's just keep this going and make sure we can produce. And so bringing in some of that initial service content makes sense, longer sales cycle on the utility side, do you -- the front end side, do you think you have the right people in place to be able to say, "All right, we've got one source point that's going to go to the utility and sell this." Is that something that's just going to take more time? And maybe talk about what that go-to-market approach looks there.

Yes. So we've set up a good way to kind of pass the leads back and forth. We had, over the years, built what I would call is synergy sales teams in the regions that are already in play, and we've done a lot of that work over the years in the Legacy Xylem business. So there's a natural muscle that's been built on taking the entire portfolio to a customer that's looking beyond just a treatment system or a pump for an analytical instrumentation, they want a solution. So that muscle is in the Legacy Xylem business. And I think that helps us as we do the integration, we have solution selling teams that are in place in the regions, and that's a natural fit. We are integrating the CRMs as we speak. But in process right now, we've got some workarounds until that's kind of fully stood up over the next year. But yes, I think the communication sound and the teams are very collaborative, and we have, again, built the muscle over the years on solution selling.

No, it makes a lot of sense. Maybe also talk a little bit about what you're doing on the digital side of utility. With the recent joint venture, I don't know if a joint venture is the right word, you have a minority stake and over time that can grow. What that means for the ability to pull content through because that's part of what's going to happen here with the Evoqua piece, right?

Exactly. Yes. So we took a step back and looked at our digital journey. And obviously, we want to go from really on off, what I'll call, dumb products, their mechanical products to smart connected products, which do carry more margin. But over time, it's about really using that data, and that's really important. But as you go out and talk to utility customers, especially, they have data coming out of the years. And the biggest pain point they have is how do I consolidate all this data, whether it's PLC data, whether it's SCADA data, whether it's their ERP, whatever it is, they've got lots of data coming out of them and they can't make sense of it. So we looked at doing something on our own, but that was going to take years and lots of millions of dollars to do it. And we partner with a company out of Spain called Idrica, which was a spin-off of a company called Global Omnium, which is like [ Aveolia, ] in terms of they go out and they manage concessions, they manage over 300 concessions. So they spend about 15 years building this platform. It's very light. It takes 3 to 4 months to implement it. What it does is it provides a single pane of glass for utility customer to engage with all the data, one password, one dashboard, can democratize the data across the entire utility and gives them a platform to do analytics. On top of it, bringing in not all our data, but all their data, we can drop in applications that help them with specific use cases like non-revenue water, optimizing treatment. And on top of that, then because of our position that I talked about earlier, across kind of the water value chain, we can pull our content in. So for example, we had a customer in the Southeast of the U.S., large utility, put the platform in, dropped into applications, which is SaaS recurring revenue and then pulled through a $40 million AMI deal. Same thing in Europe. We put the platform in, put in some applications on non-revenue water. We got an AMI deal and a treatment deal worth $20 million. So it's a little bit of a land and expand. You're helping the utility manage a major pain point and then you're pulling through the content into a singular interface.

Yes. I mean I think a lot of people had kind of a mixed relationship with the messaging over the years on how digital is going to matter for you. But it certainly feels like the pieces are finally more in place and you're at the point where the utilities are more willing to move forward on these. Maybe talk about what that engagement looks like. So when you're looking at these new projects and you're starting to go through these bid cycles, are there conversations just always including this kind of data management and process or how pervasive is it today?

I think COVID really stepped it up because utilities, they dealt with a lot of challenges during COVID, especially with labor. So they really want to optimize and drive productivity. So I would say, obviously, the electric utilities are way ahead of water and gas in terms of their digital journey. But the water and gas utilities, especially water, they've been slower to a -- but during COVID, they realize they've got to get with the program. I just came back from a user conference in Orlando, Florida Saturday, Sunday and Monday of this week where we had over 1,000 utility customers and channel partners and one of the biggest pain points we heard there was, "Hey, we need a platform to stitch all of our data together." And we have that demo there, lots of engagement. So as we're engaging the utilities now, before we were pushing rope. Now we're being pulled into, "Hey, we need a solution for all of our data, quit giving us all these discrete bespoke applications. We need a platform like an iOS platform for a phone to [ just scale ] all of our data."

So why don't we stay on the utility side and maybe just talk about the demand cadence. I think the M&CS order trends can be choppy quarter-to-quarter. 3Q, some pressure points, but holistically still good book-to-bill ratios, I think you feel really good about the demand curve. Can we talk about the sustainability of the opportunity set as we work into next year, the utility side and how you feel about the momentum underneath that business today?

Yes, I think in general, we feel good about the momentum. We had a really strong quarter in Q3. We've got good momentum with two companies come together, building this large global platform that we have that's unique in the industry. If I think about some of the drivers out there that I think about '24, we've got an incredible backlog, $5.3 billion of backlog, $2.3 billion of that is metrology, our M&CS business that if you look over the past 2 or 3 years, you just look at our revenue and say, well, and hasn't grown well. Margins haven't done well, but a lot of it is trapped in backlog because of chip supply, which is now improving. So that's going to be a great story over the next coming years. You look at the ISS segment, the Integrated Solutions and Services segment that came over from Evoqua, 75% recurring revenue and aftermarket, sticky business, gives us good diversity in the business as well. That helps manage some of the cyclicality in the Legacy business. If you just look at the trends that are out there around water scarcity, water quality, when we talk about PFAS and other forever chemicals, if you look at the flooding that's going on around the world, just here in the U.S. that you've seen in different cities, the secular trends are lining up nicely, and then you throw on top of a government subsidy around the world, not only in the U.S. with the infrastructure bill, but you've got the European investments, U.K. AMP cycle and then some other investments in China and parts of emerging markets, the setup is that our end markets are going to be fairly resilient. Now there's a few watch items I would point out, that's our Applied Water business, which tends to be a little bit more cyclical. And the discussion we had on the earnings call around China, which is more for us a little bit about what we think is a push to the right versus a long-term issue. And it's really a funding issue because our book-to-bill is greater than 1, and our backlog is growing there. So it's really -- for us, it's just getting the funding squared away in China.

China is not a huge percentage of the revenue?

It's not. It's probably 5% now with the Evoqua acquisition coming in. It's come down to 5%.

Yes. But what it seems to me is that the confidence in continuing to be able to backfill the backlog with the opportunity sets that you still see in the conversations you're having, it's quite high that, that momentum is sustained.

Yes.

On the industrial side, utility, you have the architecture and now you have the components. The industrial side, you're building something comparable?

Correct.

Maybe talk about how these pieces can fit together in the value chain today and what that system offering might look like over time with that industrial base.

Yes. Well, I think the Evoqua transaction gives us a pull-through into industrial. We played industrial in the business, but it was more on the fringes. So they open up the door for us to bring a total solution together, like I talked about before. The customers are looking for an outcome, so now we can put together our entire portfolio into a solution and then take that to the customer. So that's very strong. I think the other thing that I didn't talk about earlier with industrial is it also enables us to take the legacy of Evoqua business international, where they were more focused in North America, which made sense because a lot of companies were still in fairly early innings in terms of outsourced water. And so staying focused in North America made a lot of sense. But because Xylem's got a global reach, we've got fixed overhead in Europe and emerging markets. We've got legal entities. We can make it easier to make that jump into international. We've already seen it on the capital side early on around using the Legacy Xylem business to sell capital to the Legacy Evoqua customers in Europe and emerging markets, but the services piece will be a little bit longer pipe, but we have customers calling us today saying, "Hey, we want the same level of quality water that you give us in the U.S. in Spain, in Germany, in U.K. and South Africa", for example. And that will be kind of a land and expand, we'll follow them, set up shop, we'll do some inorganic or organic building out of the assets we need, and then we'll start to grow the international business. So I think it's very exciting.

Yes. So I mean, short term is basically you have the APT segment, the product content, you can push it to your distribution and then it's about being selective on how you want to expand the service networks over time. What's the criteria behind the decision-making on that service move internationally? So what's the return threshold? What's -- how do you manage that risk?

Yes. So I think it's looking at where we have -- where Xylem -- Legacy Xylem has a presence in these markets. It's obviously where the customer wants us to go and then taking those two, marrying them up. And there's no doubt that we have to build the muscle, the capability with the service technicians, which we call Aqua Pros, and that's going to happen through either just building it, which will take longer and then through acquisition over time. So that's kind of the -- in terms of the recipe we look at. And we'll, at the end of this year, kind of start the journey on making those implementations into those countries.

So when you think about the portfolio on the industrial side, do you feel like you've got the right template in place as far as product categories go? Are there gaps that you need to have maybe the full service offering or maybe solution offering might be the [ right way ]. Think about a water reuse system or managing the water through the facility. You've got the pumps, you've got the Legacy Evoqua. Is that enough to have that picture? Other pieces you need to do inorganically, organically?

I'm sure there will be small rounding out of the portfolio that's always probably been there for the Legacy Evoqua business, but I don't see anything major today. It's more rounding. And it's really about continuing the journey that they've been on and doing the service tuck-ins and building out the service footprint. One of the things that the Legacy Evoqua business pride themselves on was being two hours away from any customer. So continuing that journey, both in the U.S. as well as building that footprint out internationally in a very strategic focused way.

So you touched on it a bit. Maybe just talk about the risk element as we move into next year here. Record backlog, the backlogs remained at very elevated levels, even sequentially. What kind of visibility does that give you into next year? And how do you balance that against some of the maybe interest rate sensitive or some of the more challenging end markets?

I'm going to get my colleagues involved here. So I'll let Bill and Andrea maybe answer this one.

I'll give you my high-level view. I think one of the things is just the durability of the portfolio with some of the end market exposures. Obviously, a significant exposure to the utility space and where we think the funding levels are and growth rates into the next year will be pretty solid, actually compound that with the significant backlog we have. And then the Evoqua business, 75% of that business is a recurring revenue. So relative to visibility, I think strong fundamentals going into next year kind of across the portfolio with the exception of the AWS business, which is more book and ship. That's the one area we've seen a little bit softer order patterns and probably is the biggest area of risk just as we look at their end market exposures going into next year. We talked a little bit about China. Not a huge part of the business, but that's probably from a geography, the biggest area of concern. So confident though in the top line visibility as we sit here today and then really confident in a lot of the economic drivers just from things we're doing ourselves. Continue to look at internal cost and SG&A profile and opportunities there. We just kicked off the [ 80-20 ] tool within a couple of facilities, and that will start to pay dividends next year. Obviously, we just started to lap some significant pricing that we went out with in 2022 here, but the team is actively working on trying to maintain that price cost spread going into next year to prop up the top line and the bottom line as well. So there's things -- obviously, on the macro side, we're taking a look at, a lot of the things that are in our control, I think, give us confidence in the bottom line aspect as well.

Maybe touch on one more thing you said in there. I mean a lot of people hear 80-20, and they think margins, you were meaning in 80-20 from a growth perspective. Maybe talk a little bit about what that implementation looks like and how you're moving this to the organization, what you think you can do?

Yes. There's, I think, three pilot sites we're testing the tool out to North America and one over in Europe. But ultimately, 80-20 is a complexity reduction tool. So obviously, you think about there's the hard benefits of the analytics you're going to leverage to figure out your product and customer portfolio and actions to really understand what's driving true economic value within the business. But at a high level, though, there's also the complexity reduction. We talked about the organizational desire to get behind some of these things. And you talk to the individuals and you say, "Hey, I'm going to give you a tool that's going to free up your time and eliminate the non-value-added activities and free up capacity to go spend on the highest growth drivers that we have in the organization and rally resources around that, both from an individual and team perspective." I think that unto itself will unlock some additional revenue opportunities for us as the teams have a lot more time to spend on the commercial synergies with Evoqua, and then some of the own new product introductions that the teams are working on across the portfolio.

You mentioned the pricing side of things. I think the last couple of years have been far more encouraging about disciplined Xylem on the pricing side of things. So two for one, how do you feel about your ability to maintain price and price cost spread on a forward basis? And second, margins in the backlog, how do you feel about that because that will be a factor as we move into next year as well?

Yes. I mean I think really in the business in the past, we've been, I'd say, in general, pretty good at price execution. Parts of our business that went through the 232 and the 301 tariffs, obviously, got really good at price other parts that had been going through that, they went through the pandemic and the supply chain challenges and the inflation that came from that. We've developed some good muscle in the past 12 to 18 months. And we see that, that will continue on. We feel good about the pricing that we put out in the marketplace. Obviously, price is negotiated every day. It's not -- you put it out, and it sticks for a year. You got to make sure that you're managing that. But we feel good about where we are in the marketplace and the pricing will be resilient. And I think we built -- like I said, good muscles around this. And I do think the Legacy Evoqua business coming in has also been on a journey the past couple of years, especially in the Service side of their business, really focused more on value-based pricing and I think on the Services part of our business, that will be something that as we integrate that, that will help our Services business even get better value capture on pricing on the services side as well. So we feel good about the momentum going forward. I do think that in '24, we'll get back to kind of a little bit of the normal cadence of what price looks like in terms of kind of between 1% and 2% capture as inflation comes down.

So maybe talk about what you're seeing on the regulatory funding side of things, [ IJ, ] IRAs, [ trick chips, ] all those things. Are you seeing capital dollars come your way? Or are these still conversations and when do you think that can have an impact on the P&L or even the bookings?

I think it's going to be a long process. We're starting to see interest or projects that are coming through that are funded through state revolving funds as the money flows down from infrastructure through the EPA. It goes into what we call state revolving funds, then they get into shovel-ready projects. So we're starting to see that come through now. We'll start to bid that. I think that's more of a back half '24 in terms of seeing that turn to revenue. But this is -- like I call it a [ dimmer ] switch, it's going to be 6, 7 years of just incremental subsidy that will roll through. You're not going to see some big pop. Same thing. A piece of that funding is also PFAS, which is getting after water quality forever chemicals. That will be the same issue. It will just be a long drawn out lift every year.

So let's do the PFAS things because I said there were a couple of questions about it. How real of an opportunity is for Xylem and maybe talk remediation versus elimination and where we are in that curve right now, very heavy on the remediation side -- aspiration?

Yes. I mean before the Evoqua acquisition, we were looking at this more in our innovation lands through start-ups and venture capital and doing tech scouting and looking at it through that lens and trying to develop innovation around that. But with bringing on Evoqua, we instantly get the capture portion of the equation. And I think like everybody, there's invention required to get to how do you sense it, how do you sense for these chemicals at a very small micron level. And then how do you remediate it. And so I think there's still -- the jury is still out on what that looks like. People are using incineration today. That's probably not the most sustainable way to do it because you're just reintroducing that back into the atmosphere. And so a lot of times, in my experience over the years with regulation is, a lot of times, you're doing innovation alongside the regulation. The regulation has got a 3-year horizon and you're trying to figure out how you're going to drive innovation to solve the problem. We're in the same case here, so on the sensing and the destruction part of it.

Another one on the M&CS margin trajectory, it's been cadencing higher through the year. I know there's a lot of internal confidence in the momentum that those margins can track higher. Maybe just talk about what gives you that confidence and how to think about puts and takes into next year from a volume mix, pricing and backlog, all that stuff.

Yes. I think a lot of confidence. The first thing is when you get volume and get the leverage on the fixed overhead, it helps. And so as we get the volume continue to ramp from getting better chip supply, that's the first part of the road map. Getting after price cost there, we've done well in the exiting last year and then into the first part of this year. We need to continue that momentum into '24. So price cost will be something we've got to stay laser-focused on. I think the third thing is driving productivity, one of the areas that we're focused on in 80-20 is our Metrology business, driving out that complexity and taking that effort out and redeploying that effort for not only growth, but for margin expansion. We had to dedicate a lot of our resources during the chip redesign, out of productivity into getting products available through new chip supply. So big focus on productivity, focus on price cost, really two big drivers. And obviously, the volume converting the backlog will help the fixed overhead.

So last one, 30 seconds. How are you thinking about capital allocation in the short term? Does Evoqua prevent you from doing anything or...

Yes. I'll start and turn it over to Bill. I think, obviously, in the short term, we're very focused on Evoqua in making sure that we drive that. We just -- it was our largest acquisition in our history, $7 billion acquisition, we will make sure we get the value capture there. But we're very committed to M&A. A large part of our company is ring-fenced away from what we just did with Evoqua and we have a good pipeline. So maybe, Bill, if you just want to add...

Yes. No. I mean in terms of balance sheet flexibility, the team is working actively on several transactions. So I don't think there's a pause there. But yes, it's a couple of small focus areas with the core execution on the Evoqua [ trend ].

If a lot of these things work, it frees up more capital for more compounding. Anyways, please join me in thanking the management team for their time today at Xylem.