Xylem Inc. — Form 10-Q Summary
Business context and reporting period
Xylem is a global water technology company serving utility, industrial, residential and commercial customers through three segments: Water Infrastructure, Applied Water, and Measurement & Control Solutions. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2020, compared with the corresponding 2019 periods. Results were materially affected by the COVID-19 pandemic.
Financial performance and key metrics
| Metric | Q2 2020 | Q2 2019 | Six months 2020 | Six months 2019 |
|---|
| Revenue | $1,160 million | $1,345 million | $2,283 million | $2,582 million |
| Gross profit | $434 million | $526 million | $843 million | $1,000 million |
| Gross margin | 37.4% | 39.1% | 36.9% | 38.7% |
| Operating income | $54 million | $171 million | $115 million | $280 million |
| Operating margin | 4.7% | 12.7% | 5.0% | 10.8% |
| Net income | $31 million | $139 million | $69 million | $218 million |
| Diluted EPS | $0.17 | $0.77 | $0.38 | $1.20 |
- Q2 revenue declined 13.8%; constant-currency revenue declined 11.9%, entirely from organic declines across all segments and major end markets.
- Six-month revenue declined 11.6%; constant-currency revenue declined 9.9%.
- Adjusted Q2 operating income was $108 million, with a 9.3% adjusted margin, versus $192 million and 14.3% in the prior year. Six-month adjusted operating income was $178 million, with a 7.8% margin, versus $325 million and 12.6%.
- Q2 adjusted EPS was $0.40 versus $0.79 in 2019; six-month adjusted EPS was $0.63 versus $1.31.
- Net cash provided by operating activities was $179 million for the first six months, down from $206 million. Free cash flow increased to $84 million from $77 million, reflecting lower capital expenditures of $95 million versus $129 million.
- Cash and cash equivalents were $1,577 million at June 30, 2020, compared with $724 million at December 31, 2019.
- Total debt was $3,243 million at June 30, 2020, compared with $2,316 million at year-end 2019. Long-term debt increased to $3,031 million from $2,040 million.
- Liquidity was approximately $2.4 billion, consisting of $1.6 billion of cash and $800 million of available revolving credit capacity. The revolving facility was undrawn, and the company reported compliance with debt covenants.
- Q2 orders were $1,232 million, down 11.5%; first-half orders were $2,493 million, down 7.9%. Total backlog was $2,013 million, up 11.8% from December 31, 2019, with approximately 46% expected to convert to revenue during the remainder of 2020.
Segment performance and material changes
| Segment | Q2 2020 revenue | Q2 change | Q2 operating income |
|---|
| Water Infrastructure | $501 million | Down 10.7% | $73 million |
| Applied Water | $337 million | Down 14.5% | $41 million |
| Measurement & Control Solutions | $322 million | Down 17.4% | $(46) million |
- Water Infrastructure was pressured by weaker construction, mining, oil and gas, emerging-market activity and COVID-19 effects; treatment activity provided partial offset.
- Applied Water declined across all major end markets and regions, particularly building services and industrial water.
- Measurement & Control Solutions was the weakest segment. Its results reflected lower utility, test, energy and software-related activity, prior-year project comparisons, COVID-19 effects, restructuring, impairments and a $15 million first-quarter warranty charge related to a firmware issue in certain meters.
- Gross margin declined 170 basis points in Q2 and 180 basis points for the first half, primarily due to lower volume, cost inflation, inventory management costs, unfavorable mix and COVID-19-related costs, partly offset by productivity savings and price realization.
Outlook, management commentary, risks and unusual items
- Xylem withdrew full-year 2020 guidance on March 31, 2020 and did not reinstate it. Management expected Q3 revenue to decline 10% to 14%, including an 8% to 12% organic decline.
- Management expected COVID-19 to continue adversely affecting results beyond June 30, 2020. Production capacity was just over 90% globally, with all facilities operational at the reporting date.
- On June 26, 2020, Xylem issued $1.0 billion of green senior notes: $500 million due 2028 at 1.950% and $500 million due 2031 at 2.250%. Proceeds were intended primarily to fund eligible green projects and enhance liquidity flexibility.
- The company amended its revolving credit facility to use a net-leverage covenant through September 30, 2021 and restricted stock repurchases through March 31, 2021, subject to exceptions.
- Management committed to global restructuring and cost actions. The filing presents expected 2020 restructuring and realignment costs of $80 million to $100 million, while a separate discussion describes restructuring costs of $60 million to $80 million; these categories are not fully identical and should be reconciled. Approximately $25 million of the broader expected costs were expected to be non-cash, with approximately $67 million of net 2020 savings anticipated.
- Q2 included $48 million of GAAP restructuring and asset impairment charges, including $38 million of restructuring charges. The company also recorded a $10 million impairment of internally developed software and $17 million of impairments primarily related to discontinued Measurement & Control Solutions product-line assets.
- Material risks include the uncertain duration and severity of COVID-19, supply-chain and customer delays, foreign-currency exposure, project cancellations, industrial and construction weakness, refinancing and liquidity risk, goodwill and intangible-asset impairment, cybersecurity, product liability, environmental matters and litigation.
- Xylem disclosed an approximately $80 million Swedish tax assessment, including tax, penalties and interest, related to a 2013 intercompany intellectual-property transfer. Management believes it is more likely than not to prevail and has not recorded unrecognized tax benefits for this matter.
- At June 30, 2020, unrecognized tax benefits were $126 million, and accrued warranty liabilities were $60 million. General legal matters and environmental matters were accrued at $4 million and $3 million, respectively.
Most important facts for investors to verify
- Whether COVID-19-driven volume and order declines stabilize or worsen, particularly in Applied Water and Measurement & Control Solutions.
- Conversion, timing and cancellation risk for the $2.013 billion backlog.
- Actual restructuring and realignment spending, headcount reductions, non-cash charges and realized savings versus the disclosed ranges.
- The cause, settlement cost and recurrence risk associated with the meter firmware warranty issue.
- Debt refinancing requirements, especially the $600 million senior notes due in 2021, and compliance with the amended net-leverage covenant.
- Allocation and qualifying use of green-bond proceeds, as well as continued access to commercial paper and revolving-credit liquidity.
- Potential goodwill or intangible-asset impairments, including the Advanced Infrastructure Analytics reporting unit whose fair value exceeded carrying value by less than 20% in the 2019 assessment.
- Resolution and potential cash impact of the Swedish tax assessment and other contingent liabilities.
