Xylem Inc. (XYL) Earnings Call Transcript & Summary

All right. Good morning, everyone. I'm Nathan Jones. I'm the covering analyst for Xylem. Very pleased to have Mike McGann, who is Senior Vice President and President of Measurement and Control Systems and Americas; and Andrea van der Berg, who is VP of IR. As I've done for the last few years on these presentations, I'm going to present 3 bear cases. Mike and Andrea are going to tell me why I'm an idiot for proposing those 3. And then I'm going to present 3 bull cases, and they're going to tell me why I'm a genius for presenting those 3.

So on to the first one. Xylem's track record with acquisitions has not been overly impressive. Sensus is still earning margins below peers, maybe except for the last quarter. 7-plus years after its acquisition, almost the entire Pure Technologies price was written off and the company overpaid for Evoqua.

Thanks Nathan. Good morning, everyone. Great way to start.

We start with the bad ones so we could finish with the good ones.

So let me start with -- I mean, again, let's start with Sensus, right? The reason Xylem acquired Sensus, we have market-leading technology in the AMI space, strong analytics instrumentation portfolio. Yes, and while the margin expectations haven't achieved, I think it's really important to understand kind of the trajectory that this business is on relative to its performance. In Q1, we were 550 basis points year-over-year growth. And really, that had been building over the last couple of years relative to some of the improvements we've put in place, some of which I'm sure we'll talk about later. But the -- we see a very, very strong -- with the $2.3 billion backlog that we have in the segment, that really sets us up well. And with some of the other things that we're really focused on around simplification, strategic pricing and operational productivity, we really see a strong trajectory. And hopefully, from the perspective of the margin growth, we expect that to continue over the course of the next several years. Pure Technologies, again, acquired because of the complementary nature of that, their services business and pipeline condition assessment. Yes, we've had some struggles with that business over the years. But most recently, in January, when we created the Water Solutions and Services segment, that business moved over there. We see a lot of synergies there in the municipal market relative to some of those opportunities that we have. And on Evoqua, again, another very complementary business that we purchased to create the largest pure-play water company. And the early days of that acquisition, it's been 1 year now. Last week was a year, we are seeing tremendous runway for continued growth there, not just on the cost synergies, that was the basis of the deal. It was the cost synergies, but really around the revenue synergies. We shared some of those early wins last week at our Investor Day in Washington, D.C. But with the ISS, the legacy ISS segment and our dewatering business is now together, some of those early wins that we shared really make us very confident that we will be able to deliver the 1% revenue synergy growth through what we shared last week. So I think one of the other things to highlight too is we took a bit of a different approach. So I came over with the Sensus business 7 years ago. That was the creation of the Measurement & Control Solutions segment at that time. So a stand-alone segment, right, versus full integration where when the Evoqua acquisition happened and given Evoqua's track record for acquisition -- bolt-on acquisitions and full integration, we learned a lot as we were bringing those companies together from their leadership team to be very intentional about how we integrate and how quickly we integrate. We knew we wanted to integrate the teams, but we just -- we couldn't -- obviously, you're not going to integrate day 1 and break the business. But that's why it took us a few months before we created the WSS segment. But at the same time, we integrated the Applied Product Technologies business into our Water Infrastructure segment, parts of which are now and my team in the Americas, and that has gone quite well and really allowing our teams to work very closely together to be able to capitalize on those revenue synergies as we go forward.

So I know we're going to talk a bit more about Sensus and Evoqua in some of the other questions here. I want to ask one follow-up on Pure Technologies because the thesis behind buying Pure Technologies, I think was solid, right? Non-revenue water is a huge issue and it is something that's going to have to be addressed over time. Maybe Xylem overestimated the pace of adoption of that. So maybe some comments around potentially what was misjudged about that market, and what you think the opportunities presented by integrating it into the WSS segment provide going forward?

Sure. So I think as I think about that business, when we purchased that business, we put it -- that was part of Measurement & Control Solutions. We had the advanced infrastructure analytics portion underneath M&CS. And that was coupled with a number of other digital acquisitions we've made at the time, right? And so I think kind of creating that AIA segment as we call it, underneath the M&CS segment isolated it a bit from the business, so we weren't able to capitalize on, hey, we have -- we're in thousands of utilities or municipalities, we can really build on that with those customers and get them to see the power of that. The biggest competition that business has is do nothing. These are buried pipes under the ground, and if I don't have to spend any money on condition assessment, then I won't, until there's a water main break, and it's on the news and then everybody wants into the action. So we have seen since being part of WSS, is that natural synergy where they're already doing services with us and being able to help them understand the value proposition of why it's so important to get proactive about your pipeline assessment, and with that because with -- especially with the Infrastructure Act -- or Infrastructure Bill and that money that becomes available, having the ability to go out and do that. And that's really where we win customers over is because we'll go out and say, okay, I want to do a small pipeline assessment, I want to understand our risk. And when you find the risk and you tell them you've got to dig up this area of pipe, and they find the leak or the potential leak or the wire breaks that are in there that could be a leak, then they're a customer for life basically because they're saying, this is super important and I've got to get after this so I stay off the news. We know utilities are risk averse. And so one of the core themes there is you've got to think ahead so that you can minimize your risk as you go through that. Does that help?

Yes. Go on to the next one. Operational performance has been generally disappointing over the last decade. Xylem set 5-year margin targets in 2015 it still hasn't reached. Margins just aren't going higher. I know we're going to talk in a minute about the margin expansion potential. So maybe if we could -- you could just comment on kind of what have been the headwinds over the last 5 or 10 years that have kept margins generally from expanding as much as they might have?

Sure. Very easy questions today, huh? So I think the first thing is, again, with the work that Xylem has done over the last 10 years to put together this portfolio of companies, right, and really focusing on trying to grow, I think it's fair to say -- it is fair to say that our operational performance hasn't met the expectations that we have expected, let alone the market. And so it's really that return to discipline of ensuring we're doing the right things relative to that. And yes, we'll get into a little bit more detail later. But I think for us, as we look at it, when Matthew Pine was made COO last year, a lot of turnover on the leadership team to really bring that operational discipline with the things that we do, and I mentioned kind of simplification and strategic price and operational productivity. It is that discipline that we have to stay focused on those operational levers that we know can drive growth. And I think for us, it's continuing that focus on the discipline while working on driving growth in the markets that we serve. And again, some of the things we just talked about with Evoqua and the other acquisitions made, are we capitalizing on that. And I think with, again, our strong backlog as an enterprise, is indicative of customers' willingness to want to continue to work with us and continue to find broader solutions. So we just have to ensure the other piece of that is around strategic pricing because this plays into it is -- and I think we shared last week at Investor Day, we were roughly around 40 bps of pricing per year and now targeting 100 bps of pricing per year. Having that strong discipline around strategic pricing and the deals we go after, in the drive for growth, it's easy to say, okay, if I want to win this -- if I want to win this large project, I've got to cut my price. And we are basically now saying, look, there's good projects to win and there are not so good projects to win. So getting our teams to understand that discipline. And we've kind of reset the bar. And I think that's really going to help us as well be able to achieve some of that.

So strategic pricing is part of one of the bull cases, but I might follow up on that there. And the 40 bps of price over the last 10 years going to a target now of over 100 basis points a year. Can you talk about what you think gives you the entitlement to go after that price and how you're going to go about generating it?

Sure. There's a couple of things there. I think the first is, obviously, through the COVID era and then the supply chain component issues that we saw and the inflation that came with that I mean, our entitlement went up as we had discussions with customers just relative to what we cannot absorb this and the impact on its business. That began the building of the muscle that we had. And so really, the other piece of that is really are we capturing the value for our solutions with our customers that we believe we are entitled to? And I can tell you, as we look at -- certainly within the M&CS segment, that has really been a bit of a game changer for us in that you don't know unless you ask. And through those discussions with customers to basically lay it out in a transparent fashion relative to, hey, this is what we're seeing, and this is what we need to, I'll say, pass through or increase prices on, that really helped us as we now look at newer projects to say we need to go out and get more value for that. Because it's not just about the solution we're selling them. It's about the solutions that can come after the solutions we sell them as we build that long-term partnership, that sticky relationship. And that's not just within M&CS, that's in water infrastructure, and that's within WSS specifically, too, now with Evoqua, that is really helping us capitalize more on being able to say it's okay to have a little swagger and say, look, we can help you solve these problems, and we want to ensure we're getting compensated for it.

Okay. Next one. The fixed network AMI solution gets progressively less competitive as the market moves to smaller utilities over time, which will result in Xylem losing market share. .

I think it's my favorite question.

I actually wrote this question before you disclosed your market share is lower at smaller utilities last week.

Okay. All right. So in this case, it's interesting, you've got to understand the market, right? We kind of look at the market and break it apart in kind of, what I'll say, 3 segments. There's over 50,000 water utilities in the U.S., right? And so the top 4,400 make up 80% of the endpoints that are available out there in the market. The other 45,000 utilities make up the balance of the 20%. And so when you look at our -- we've got about 1,200 AMI deployments just in our business alone, And it follows that 80-20 principal pretty well. So 20% are large -- medium or large-sized utilities, and they make up 80% of the end points out there. But we have 80% of those projects, so around 1,000, make up 20%. So just when you look at that from a pure math perspective, it takes a lot of those small ones to add up to a larger one. And that large utility focus came into play really as we were being acquired by Xylem. We built a key accounts team to really go after. Sensus in its history was usually a small, medium-sized utility target because of the pricing difference when you get to the large utilities -- and again, as we rethought that in our solutions and our pricing methodology, we look at that. So I share that because 80% are in the small utilities, there's still a ton of runway out there. There's only 45% adoption of AMI in North America. So when you do that in a pure math, there's a lot of utilities that haven't made their technology choice. Most are on walk-by or even drive-by technology, the older technology. So for us, as we look at that landscape, we have the strongest distribution network in the industry. We believe that. And when we talk to -- when you hear from our customers who talk to our competitors, that's an envy point for them. And really, for us, as we look at that going forward, is how do we leverage that distribution network to really go after? Because they're the ones serving the smaller customers. And that's where the solutions and the breadth of solutions really helps us here as we go forward, because our partnership with Idrica, now they have another tool in the tool belt that they can go off and say, hey, where do you want to start? And how do you want to start? We look at our utility landscape, and we shared this last week, but when you look at the digital journey, many of them are on different levels of that digital journey. And so for us, it's can we meet them where they are on that digital journey? If they're not ready for a full interoperable platform and they just want to connect some assets, okay, we can help you there. And then as they get comfortable, we can grow with them through -- if they're ready for AMI, you put a tower up, and boom, you're there. And I know there's competing technologies that do quite well in the smaller markets. But as we look at our -- even our -- this was a question, I think, last week, as we look at our product development cycle, cellular may be an option at some point in the future, but it won't dilute our market-leading FlexNet technology, right? Because it's a utility-grade network built for utilities to be able to operate seamlessly. But it may be complementary to do some gap filling, hard-to-reach areas kind of things that may be more cost-effective to put that solution in versus put in another tower kind of a thing. So we evaluate those things as part of our piece, but I'm extremely confident about that. And I think having that landscape and the picture of those utilities and the breakdown of those utilities is really important just to understand that from kind of the macro, oh, okay, yes, here's where we are, here's what we're reading about in terms of who's winning smaller utilities and where that plays. And we were very close with our distribution partners to really understand what do we need to do to help you win in some of those smaller utilities as we go forward.

Okay. Thanks for taking the 3 bad ones. Let's get on to the 3 good ones. The rollout of 80-20 across Xylem has the potential to significantly expand margins through strategic pricing and business simplification, more optimally allocate resources to drive profitable growth and focus the business on the most important opportunities.

Yes. So we -- as I mentioned, as we look at the operational productivity, strategic price, I mentioned strategic pricing already, but we kicked off our 80-20 program late last year. Started in the M&CS segment as well as the Applied Water segment in the Americas. And we just recently kicked off for our transport business globally. So about 40% of our portfolio is being represented. And we're in the early days of going through the data analytics. And for those that aren't as familiar with 80-20, I mean at its core, it's really a way to look at data through -- we look at our data by customer and by product, and we segment that data so that we can better understand. It's a different lens. Has a pretty deep continuous improvement background where you're looking at data and trying to find defects or waste in a process. But when you break it down and look at customers and you look at products differently, it really shines a different light on that data set. And so through that process, we are really identifying opportunities that we say, and the way we break it down is you have A products and you have B products. And the B products are your low running products. And so are we -- the first action, and it's the easiest one to get around is pricing, is my B products, I'm not getting the value for them today. Because when you look at the 80-20 principle, in M&CS, I think the number is 95% of our revenue comes from 6% of our products. That's staggering, 6% of our products. So when you look at that long tail, the first thing we did was raise price. Because the flip of that is 20% of our resources focused on those customers that are bringing in 80% of revenue, rough numbers there. But the rest of them are working on the B customers, right, or the lower running customers. So how we serve those customers is really the part of that analysis to say, will we be better served to pass them through distribution? And as we increase the pricing on those products, we're not necessarily going to dilute the margins based on the fact that, sure, distributor discounts and those kind of things. But additionally, as we look through that, it's also looking at our processes and policies in terms of how our resources support those customers. So a few examples would be kind of our return policies. How if we give customers a year to return a product with a restocking fee, what does the data look like relative to how they're doing that? How much they're doing that? And we've just rolled out, like we've shortened that to 6 months. And we've increased the restocking fee. And again, we don't expect there to be a huge backlash of that. But really, when we look at it, is those B products that are going to return because maybe a customer finishes a project or maybe they bought a little excess and they're saying, I just want to return it. And so that's a cost hit for us, right, or an inventory hit as well. And so that's just one example. I mean really the other piece of that is how we support our legacy products. So we have AMI, and we also have the AMR products that we don't really market and sell, but a lot of resources supporting AMR products. Another area to say, we're going to increase the pricing on our AMR support, free up resources to put them on AMI support as we try to create raving fans, which is our top customers that want to basically say, I'll only do business with Xylem because of how they serve us. And so that's a journey. That piece takes a little longer, but we've interviewed customers to say, what's it going to take to make you a raving fan? And how do we put actions in place. And so as we look at that 80-20 rollout, that will clearly help us to expand margins. But additionally, that won't all drop to the bottom line because we'll look at that and say, hey, we're going to reinvest for growth over here, whether that's a new product in reduction or whether that's our WSS expansion internationally, we talked about a lot last week, we're being very thoughtful about that. But we're going to need some of that investment to really capitalize on the 100-plus branches that we have in Europe that when we get ready to go there and have a beachhead just to land on, that will really help us move that forward, which I think in the Evoqua days, they were primarily in North America. That was one of the reasons they couldn't, because they didn't have that beachhead to be able to capitalize on. So those are just a few examples of how we are looking at that and through the 80/20 lens. But I'm super excited because the culture shift additionally within the business is another big piece of that, and getting -- we've recently rolled out our high-impact culture, Matthew talked about a lot last week. But it's really getting people to feel empowered as they look at this data. And we have, in my business, we have 5 -- or 6 work streams. And those leaders are within the business. And it's like, when your team makes a recommendation, and we review it, we're going to -- let's go, right? Let's not wait. And I think my take on a lot of that is the people within the organization might have thought of these things in the past, maybe even raised them, but this felt like every dollar of revenue is a good dollar of revenue, and just kind of retraining our brains to think, no, that's not the case. Let's use that discipline. So it's really going to help us.

Speaking of synergies from Evoqua and expanding internationally. Revenue synergies from the Evoqua deal could be material to growth with the potential to compound this growth for the foreseeable future, particularly in the outsourced water business internationally and cross-selling to water utilities and industrial customers.

Yes. So I mean we have a couple of examples...

That's the answer? Yes?

Is that a mic drop moment? No. So I think, as I said, we're 1 year into the integration. And again, some of the details we shared last week relative to some of those early wins, I mean there's a few top-of-mind examples. One of those, an industrial customer had a wastewater treatment plant that Evoqua was servicing had some -- had a failure and they needed some help. And again, the team is working together to really drive that and create a significant opportunity for our customers to be able to fix that problem and move forward. And I think when I mentioned ISS and dewatering, we had an industrial customer in the South that had a failure over a weekend that they had wastewater kind of going through and our dewatering team and ISS team worked through the weekend. Within 24 hours, we're deploying the technology and the equipment to help the customer solve that problem and move the water, I think it moved 7 miles to get it to the -- to where it needed to go. And again, that would have taken that industrial plant weeks to go out for bid and say, who can help me. And because there was already a standing relationship. So that's some of the low-hanging fruit that we really look at from that perspective that will help us capitalize on some of these -- the early days, right? I think when we talk about the 1% growth over a 3-year period, 4-year period, those early wins we build upon. And again, the momentum we're seeing in the business and the way the teams are working together is really exciting. And again, I think just to reiterate what I said about the international expansion, we are taking a much more deliberate and thoughtful approach around that. In early days, it's customers that we are already working with, that are global companies that are saying I want to do the same thing in another part of the world. And we've already got some of those underway, where we're going to Europe or we're going to some of the emerging markets. We see Europe probably being the first opportunity to do true international expansion. And then we will look very strategically at the emerging markets there. And I think the beauty of it is Evoqua had such a strong international -- or sorry, industrial market presence, and they have a pretty strong muni business, but it was smaller than ours. And if you look at the Xylem portfolio, right, heavier in the utilities as part of our kind of revenue profile breakdown. And so bringing those 2 together and just kind of getting the teams to believe and see some of those early opportunities and early wins, I think we can continue to build upon as we go forward.

So maybe one follow-up question on the international expansion of outsourced water. Obviously, that will be staged over a pretty long period of time. Can you talk about the first steps towards that and kind of how many years or decades does it take to fully expand that business out? Because I mean it should be an area where you can just continue adding resources and capital to that year after year after year after year and just continue to capture market share.

Yes. So I think, as I said, following some of our larger industrial customers that are expanding internationally, step one. And that's kind of, I'll say, the easy way to take that solution over there. But it's not as easy as you think because you've got to look at, hey, do I have the support structure wherever they are going to make sure I have that? Can I capitalize on top of what a Xylem facility or legacy Xylem facility that might already be there? Where it's not, they're looking at the market data and really even engaging with customers to be able to say, hey, we're considering this, what's the appetite for you? What problems can we solve for you? And then really build upon that. So I mean, it will be one of those journeys that I think it's fair to say, in 2 to 3 years' time, we would begin that expansion. But again, we've seen this historically. One of your bear cases about our operational discipline, and we would expand into markets because we thought we saw something there or maybe customers told us or others told us externally, and then only to find out it wasn't as robust as we needed it. And so those are the lessons you learn that you hope you don't repeat. And so that's hence the more thoughtful approach to why and how we will expand. But I do believe once we begin that expansion, it won't be, okay, we're going to expand in 100 areas, we're going to expand in these areas, let's prove it out, let's show the growth. That will then build up within that market or that region as we move forward.

Compounds on itself.

Exactly.

All right. Last one, balance sheet remains in very good shape with less than 1 turn of net debt. Cash flow has been strong with an average 95% conversion over the last 5 years despite the COVID-related working capital increases. Xylem likely has up to $10 billion of capital that could deploy through 2027 to advance strategic goals and/or repurchase shares.

Yes. So I think I would start this with Evoqua remains our #1 priority, making sure we get that integration right. Not just on the cost synergy side, but on the revenue synergy side, right? Sneh shared last week, we have built some pretty significant muscle over the last year through that process, whereas some of the previous acquisitions maybe not so much. That being said, we have also established a very strong M&A process where we review monthly kind of targets within the business segments and things like that. But as we look at that process, we want to ensure that, number one, how would we integrate it? Number two, where would it focus? And so for us, we're focused on kind of 3 key areas as we look at that, as we did some -- we recently did some value mapping work. We refreshed our work we did about 10 years ago. And what it showed us was there's $100 billion of total available market that we could address, and we look to kind of 3 key areas, which would add about $25 billion to our SAM. And that's really around intelligent solutions, whether it be software or hardware products, solutions, analytics, you name it. Treatment -- around treatment when we think of emerging contaminants, right? PFAS, obviously, with the PFAS ruling and also other technologies there because we have a full treatment portfolio. We can cover most of that, but it's the destruction of PFAS that is still an emerging contaminant. So we have partnerships through our Xylem innovations lab, where we're looking at those emerging technologies and trying to see, hey, will any of these hold because that's going to be a big element, right? And then the third area is around services. Again, we will continue to do bolt-ons. Evoqua was very good at, hey, we have bolt-on acquisitions. And so as we look at that, we will do those where they make sense. And then, of course, we want to put our capital to work. But with that, if it's not there, we'll look at strategic share repurchases where it makes sense from that standpoint. So I think it's a very promising time for us as we look to the future relative to some of that.

Yes, I had [indiscernible] the number after last week because I had it only at 7.5 billion or something. All right. We are right on time. So thanks very much for attending and thank you guys for making it.