Xylem Inc. 2017 First-Quarter Form 10-Q Summary
Business context and reporting period
Xylem is a global water technology company operating through Water Infrastructure, Applied Water, and Sensus. Sensus was acquired on October 31, 2016 and is reported as a separate segment in this quarter. The filing covers the three months ended March 31, 2017, compared with the three months ended March 31, 2016. The financial statements are unaudited and prepared under U.S. GAAP.
Key financial metrics
| Metric | Q1 2017 | Q1 2016 | Change |
|---|---|---|---|
| Revenue | $1,071 million | $847 million | Up 26.4% |
| Gross profit | $412 million | $329 million | Up 25.2% |
| Gross margin | 38.5% | 38.8% | Down 30 basis points |
| Operating income | $86 million | $79 million | Up 8.9% |
| Operating margin | 8.0% | 9.3% | Down 130 basis points |
| Net income | $56 million | $66 million | Down 15.2% |
| Diluted EPS | $0.31 | $0.37 | Down $0.06 |
| Adjusted EPS | $0.39 | $0.35 | Up $0.04 |
| Operating cash flow | $52 million | $41 million | Up $11 million |
| Free cash flow | $9 million | $4 million | Up $5 million |
| Free cash flow excluding Sensus acquisition costs | $26 million | $4 million | Up $22 million |
Reported revenue growth was primarily attributable to $242 million of Sensus revenue. Organic revenue declined $7 million, while constant-currency revenue increased 27.7%. Orders increased 28.0% to $1,137 million, including 2.7% organic growth. Backlog was $1,146 million at March 31, 2017, up 47.7% year over year and 6.3% from December 31, 2016; management expected more than 65% to convert to revenue during the remainder of 2017.
Segment performance
| Segment | Q1 2017 revenue | Q1 2017 operating income | Comparison |
|---|---|---|---|
| Water Infrastructure | $496 million | $47 million | Revenue down 3.5%; operating margin declined to 9.5% from 10.5% |
| Applied Water | $333 million | $36 million | Revenue flat; operating margin declined to 10.8% from 11.7% |
| Sensus | $242 million | $18 million | Newly acquired segment; reported operating margin of 7.4% |
On an adjusted basis, Applied Water operating income increased 7.1% and its adjusted margin increased to 13.5%. Sensus adjusted operating income was $26 million, or a 10.7% adjusted margin.
Financial position, debt, and liquidity
- Cash and cash equivalents were $287 million at March 31, 2017, compared with $308 million at December 31, 2016.
- Total debt was $2.387 billion, including $261 million of short-term borrowings and current maturities and $2.126 billion of long-term debt.
- Net debt increased modestly from year-end, while total assets increased to $6.527 billion from $6.474 billion.
- The $600 million revolving credit facility was undrawn, and the company reported compliance with applicable debt covenants.
- The company reported sufficient liquidity for expected needs over the next twelve months based on operating cash flow, cash balances, commercial paper access, committed facilities, and debt-market access.
- Capital expenditures were $43 million. Investing cash outflow was $38 million, including a $6 million Sensus working-capital purchase-price adjustment, offset by $11 million of divestiture proceeds.
- Dividends paid were $33 million, and dividends declared increased to $0.18 per share from $0.1549 per share.
Material changes versus the prior comparable period
- The Sensus acquisition materially expanded revenue, assets, amortization, research and development spending, debt, and operating expenses.
- Amortization increased to $31 million from $12 million, principally due to acquired Sensus intangible assets.
- Research and development expense increased to $42 million from $25 million, reflecting investment in new products and Sensus technology.
- Interest expense increased to $20 million from $14 million because of the debt structure used to finance the Sensus acquisition.
- The effective tax rate increased to 20.4% from negative 1.6%. The prior-year period benefited from a tax examination settlement and other discrete items.
- Restructuring and asset impairment charges increased to $12 million from $6 million, including a $5 million impairment charge for Applied Water assets and $7 million of restructuring charges.
- Xylem divested its United Kingdom and Poland membranes business for approximately $11 million, recording a $5 million gain. The business had approximately $8 million of 2016 annual revenue.
- Beginning in the second quarter of 2017, Xylem planned to combine its Analytics business with Sensus for segment reporting.
Guidance, outlook, commentary, and risks
Management forecast 2017 total revenue growth of 20% to 22%, including low-single-digit organic revenue growth and additional contributions from Sensus and Visenti. Management expected industrial and public utility markets to stabilize or improve modestly, while commercial and residential markets were expected to deliver low-single-digit organic growth.
- Approximately $30 million of Sensus integration, restructuring, and realignment costs were expected during 2017.
- Management expected approximately $22 million of incremental net savings from 2016 actions and $5 million from 2017 actions.
- Approximately $15 million of restructuring costs were expected for the full year, with approximately $4 million of net savings from 2017 actions.
- Key risks include integration of Sensus, order cancellations or delays, foreign-currency volatility, economic and political conditions in international markets, competition and pricing pressure, housing and industrial market weakness, leverage and refinancing requirements, goodwill and intangible-asset impairment, product liability, cybersecurity, litigation, environmental matters, and other contingencies.
- Accrued liabilities included $12 million for general litigation, $5 million for environmental matters, and $94 million for product warranty claims at March 31, 2017. Management did not expect asserted or unasserted legal claims, individually or in aggregate, to have a material adverse effect, although outcomes cannot be predicted with certainty.
- Foreign subsidiaries held $268 million of cash or marketable securities. Repatriation of foreign cash could result in additional U.S. taxes.
- The company early adopted 2017 goodwill impairment guidance and income-tax guidance; the latter reduced retained earnings by $7 million. Other recently issued accounting standards, including revenue recognition, leases, and expected credit losses, remained under evaluation.
Most important facts for investors to verify
- Whether Sensus integration delivers the expected revenue growth, synergies, and adjusted-margin improvement without exceeding projected costs.
- Whether organic revenue and order growth recover in public utility, industrial, and other pressured end markets.
- Progress against the 2017 revenue outlook of 20% to 22% growth and the expected restructuring savings.
- Debt reduction, leverage covenant compliance, refinancing of the October 2017 term loan maturity, and continued access to commercial paper and capital markets.
- Conversion of the $1.146 billion backlog into revenue and cash flow, including timing and customer concentration.
- Potential impairment, warranty, environmental, litigation, tax, and foreign-currency exposures.
- The effect of moving the Analytics business into the Sensus segment beginning in the second quarter of 2017 on comparability of reported results.