Xylem Inc. quarterly report, Q2 FY2017

Xylem Inc. 2017 Q2 Form 10-Q Summary

Business context and reporting period

Xylem is a global water technology company serving water infrastructure, applied water, and utility technology markets. The filing covers the three and six months ended June 30, 2017, compared with the corresponding 2016 periods. In the second quarter, Xylem moved its Analytics business into the Sensus segment and began reporting a combined Sensus & Analytics segment; prior-period segment data was recast without changing consolidated results.

Financial performance and key metrics

Metric	Q2 2017	Q2 2016	Six months 2017	Six months 2016
Revenue	$1,164 million	$932 million	$2,235 million	$1,779 million
Gross profit / margin	$459 million / 39.4%	$369 million / 39.6%	$871 million / 39.0%	$698 million / 39.2%
Operating income / margin	$139 million / 11.9%	$109 million / 11.7%	$225 million / 10.1%	$188 million / 10.6%
Net income attributable to Xylem	$99 million	$71 million	$155 million	$137 million
Diluted EPS	$0.55	$0.39	$0.86	$0.76
Operating cash flow	Not separately provided	Not separately provided	$151 million	$125 million

Q2 revenue increased 24.9%; constant-currency growth was 26.4%. Acquired businesses, primarily Sensus, contributed $238 million, while organic revenue increased $10 million.
Six-month revenue increased 25.6%, including $481 million from fourth-quarter 2016 acquisitions. Six-month organic revenue increased $3 million.
Q2 adjusted operating income was $155 million, with a 13.3% adjusted operating margin, versus $121 million and 13.0% in the prior year. Six-month adjusted operating income was $267 million, with an 11.9% margin, versus $213 million and 12.0%.
Q2 adjusted EPS was $0.59 versus $0.48; six-month adjusted EPS was $0.98 versus $0.83.
Orders were $1,212 million in Q2, up 31.3%, and $2,349 million for six months, up 29.7%. Backlog was $1,531 million at June 30, 2017, up 18.5% from December 31, 2016; management expected approximately 50% to convert to revenue during the remainder of 2017.
Free cash flow was $74 million for six months, or $96 million excluding $22 million of Sensus-related acquisition costs, compared with $63 million in 2016.

Liquidity, debt, and balance sheet

Cash and cash equivalents were $288 million at June 30, 2017, compared with $308 million at December 31, 2016. Foreign subsidiaries held $270 million in cash or marketable securities.
Total debt was $2,411 million, including $243 million of short-term borrowings and current maturities and $2,168 million of long-term debt. Total debt increased from $2,368 million at year-end.
Available liquidity included a $600 million revolving credit facility, which was undrawn at quarter-end, and a $600 million commercial paper program, of which $99 million was outstanding.
The €150 million term loan used partly to fund the Sensus acquisition had $103 million outstanding at June 30, 2017 and matured October 26, 2017.
Net cash from operating activities was $151 million; investing activities used $69 million and financing activities used $115 million. Capital expenditures were $77 million, dividends paid were $65 million, and share repurchases were $25 million.
Management stated that current cash, operating cash flow, commercial paper access, committed facilities, and debt-market access should provide sufficient liquidity for the next twelve months.

Material changes versus the prior comparable period

The Sensus acquisition materially changed the revenue, cost, debt, amortization, and segment mix. Sensus & Analytics revenue rose to $321 million in Q2 from $82 million, and six-month revenue rose to $640 million from $156 million.
Water Infrastructure Q2 revenue declined 0.4% as reported but increased 1.4% at constant currency; Applied Water revenue declined 1.4% as reported and was flat at constant currency.
Gross margin declined 20 basis points in both the quarter and six-month period, reflecting cost inflation, product mix, volume, and Sensus margins.
Q2 operating margin improved 20 basis points, but the six-month operating margin declined 50 basis points because of acquisition-related costs, restructuring, purchase-accounting impacts, inflation, and strategic investment.
Research and development expense increased 63.0% in Q2 and 65.4% for six months, primarily from increased investment in Sensus products and technology.
Interest expense increased to $21 million in Q2 and $41 million for six months, largely because of debt incurred to fund Sensus. The comparison also benefited from the absence of a $7 million 2016 make-whole premium.
Other comprehensive income was $56 million in Q2 and $98 million for six months, compared with losses of $40 million and $14 million, respectively, primarily because of favorable foreign-currency translation.

Outlook, commentary, risks, and unusual items

Management expected 2017 revenue growth of 24% to 25%, including low-single-digit organic growth and incremental contributions from Sensus and Visenti. Pro forma organic growth including Sensus was expected in the low-to-mid-single-digit range.
Management expected approximately $40 million of Sensus integration, restructuring, and realignment costs during 2017, approximately $20 million of incremental net savings from 2016 actions, and approximately $5 million from 2017 actions.
Full-year restructuring costs were expected to be approximately $18 million. Remaining expected restructuring costs were $15 million for 2017 actions and $2 million for 2016 actions, with actions expected to continue through 2018.
The company recorded $18 million of restructuring and asset impairment charges for six months, including a $5 million Applied Water asset impairment charge, and recognized a $5 million gain from the sale of its U.K. and Poland membranes business.
Key risks identified include macroeconomic and international conditions, foreign exchange, customer order cancellations or delays, competition and pricing pressure, housing and industrial markets, channel-partner performance, acquisition integration, refinancing and liquidity, goodwill and intangible-asset valuation, product liability, cybersecurity, litigation, environmental matters, and governmental investigations.
Warranty accruals were $94 million at June 30, 2017, compared with $32 million at June 30, 2016. Litigation and environmental accruals were $11 million and $4 million, respectively.
Unrecognized tax benefits were $68 million, with $3 million of accrued interest. The company also had $248 million of standby letters of credit, bank guarantees, and surety bonds.
Senior notes and credit facilities were subject to customary covenants. Xylem reported compliance with its debt covenants, and its revolving facility was undrawn at quarter-end.

Important facts investors should verify

Whether Sensus integration achieves the expected revenue growth, margin improvement, and approximately $25 million of 2017 incremental net savings.
The refinancing or repayment of the $103 million term loan maturing in October 2017 and the company’s leverage trajectory following the Sensus acquisition.
Conversion of the $1,531 million backlog into revenue, including the timing and cancellability of long-term customer contracts.
Whether organic growth improves in public utilities and industrial markets, particularly in the United States, western Europe, oil and gas, and mining.
The effect of cost inflation, purchase-accounting amortization, restructuring, and acquisition-related costs on reported and adjusted margins.
Future warranty, environmental, litigation, tax, and asbestos-related exposures, including reliance on indemnification from ITT.
The impact of foreign-currency movements and the concentration of cash held by foreign subsidiaries.