Xylem Inc. Form 10-Q Summary
Business context and reporting period
This filing covers the three and nine months ended September 30, 2011, with comparable periods in 2010. Xylem was spun off from ITT Corporation on October 31, 2011 and began regular-way NYSE trading on November 1, 2011 under the symbol XYL. The financial statements are unaudited carve-out combined statements of ITT’s former water equipment and services businesses and may not reflect the costs or capital structure Xylem would have had as an independent public company.
Xylem operates in two segments: Water Infrastructure, serving water transportation, treatment and testing markets, and Applied Water, serving residential, commercial, industrial and agricultural applications.
Financial performance and key metrics
| Metric | Q3 2011 | Q3 2010 | 9M 2011 | 9M 2010 |
|---|---|---|---|---|
| Revenue | $939 million | $806 million | $2.800 billion | $2.267 billion |
| Gross profit | $365 million | $309 million | $1.081 billion | $855 million |
| Gross margin | 38.9% | 38.3% | 38.6% | 37.7% |
| Operating income | $79 million | $107 million | $296 million | $277 million |
| Operating margin | 8.4% | 13.3% | 10.6% | 12.2% |
| Net income | $77 million | $91 million | $227 million | $232 million |
| Pro forma EPS | $0.42 | $0.49 | $1.23 | $1.26 |
Q3 adjusted net income, excluding $25 million of after-tax separation costs, was $102 million, or $0.55 per pro forma share. Nine-month adjusted net income was $281 million, or $1.52 per pro forma share. The filing does not present diluted EPS because Xylem common stock was not publicly traded on a regular-way basis before November 1, 2011.
- Water Infrastructure revenue increased 19.7% in Q3 and 32.8% for the nine months; segment operating income increased 19.2% and 40.0%, respectively.
- Applied Water revenue increased 11.2% in Q3 and 10.8% for the nine months; segment operating income declined 7.5% in Q3 and increased 0.8% for the nine months.
- Q3 orders increased 19.3% to $966 million, including 9.0% organic growth. Nine-month orders increased 22.5% to $2.942 billion, including 7.0% organic growth.
- Backlog was $754 million at September 30, 2011, up 4.6% year over year. Management expected approximately $500 million of backlog revenue to be recognized during the remainder of 2011.
- Management reported Q3 organic revenue growth of 6.5% and nine-month organic revenue growth of 7.9%. Acquisitions and favorable foreign exchange also materially contributed to reported growth.
Cash flow, liquidity and debt
| Metric for nine months ended September 30 | 2011 | 2010 |
|---|---|---|
| Cash from operating activities | $252 million | $226 million |
| Capital expenditures | $79 million | $44 million |
| Cash used in investing activities | $377 million | $1.024 billion |
| Cash from financing activities | $182 million | $841 million |
| Free cash flow | $235 million | $182 million |
| Ending cash and cash equivalents | $184 million | $127 million |
At September 30, 2011, total debt was $1.207 billion, compared with $4 million at December 31, 2010. The debt primarily consisted of $600 million of 3.55% senior notes due 2016 and $600 million of 4.875% senior notes due 2021. The notes were issued in September 2011, and proceeds were used to fund a special cash dividend and net cash transfer to ITT, repay borrowings related to the YSI acquisition and support general corporate purposes.
Effective October 31, 2011, Xylem entered into a four-year $600 million competitive advance and revolving credit facility, including up to $100 million of letters of credit. No borrowings were outstanding under the facility as of October 31, 2011. The facility includes a maximum total-debt-to-EBITDA leverage ratio of 3.50.
Management stated that approximately $200 million of cash, together with operating cash flow, was expected to provide sufficient liquidity for the following twelve months. Liquidity risk increased because Xylem no longer participates in ITT’s centralized cash-management and funding arrangements.
Material changes versus the prior comparable period
- Revenue increased 16.5% in Q3 and 23.5% for the nine months, driven by organic growth, acquisitions and foreign exchange.
- Gross margin improved by 60 basis points in Q3 and 90 basis points for the nine months, reflecting productivity, pricing and acquisition benefits, partly offset by commodity, labor and overhead inflation.
- Reported Q3 operating income fell 26.2% because of $46 million of separation costs. Excluding those costs, operating income was $125 million, up 16.8% year over year.
- Reported nine-month operating income increased 6.9%, but operating margin declined because of separation costs and higher operating expenses.
- Net income declined 15.4% in Q3 and 2.2% for the nine months. The nine-month effective tax rate increased to 24.0% from 16.2% in 2010, while the Q3 rate declined to 6.3% from 16.7% due partly to an international tax examination settlement and separation-related tax adjustments.
- YSI Incorporated was acquired on September 1, 2011 for $309 million, contributing approximately $10 million of Q3 revenue. The preliminary allocation included $192 million of goodwill and $124 million of intangible assets.
Guidance, outlook, commentary and risks
- No formal earnings or revenue guidance is provided in the filing. Management expected backlog to contribute approximately $500 million of revenue during the remainder of 2011.
- Management cited strong dewatering demand, mining and natural-gas-related activity, public utility investment, light industrial markets, residential and commercial building services, and agricultural irrigation as growth drivers.
- Southern Europe remained challenging, and the marine market was affected by stocked distribution channels and unfavorable boating weather. Commodity inflation, labor and overhead costs, customer and product mix, and competitive pricing remain pressures.
- Separation costs were $46 million in Q3 and $67 million for the nine months, or $25 million and $54 million after tax. Remaining after-tax cash separation costs were estimated at approximately $30 million to $50 million.
- Environmental liabilities accrued were $10 million at September 30, 2011, with approximately $23 million of reasonably possible losses in excess of accruals for environmental and legal matters.
- ITT agreed to indemnify Xylem for specified asbestos and silica liabilities and certain other pre-separation obligations. Xylem did not record liabilities for matters covered by those indemnifications and stated that it believed ITT had sufficient resources to honor its obligations.
- Key risks include significant leverage, access to credit markets, economic conditions, customer and project timing, pricing and material-cost pressures, integration of acquisitions, restructuring execution, product liability, environmental matters and the uncertainty of operating as a newly independent company.
- The company reported effective disclosure controls and procedures and no material changes to internal control over financial reporting during the quarter.
Important facts for investors to verify
- Confirm the post-spin standalone cost structure, since historical corporate expense allocations from ITT may not represent future Xylem expenses.
- Verify debt-service capacity, covenant compliance and leverage following the $1.2 billion senior-note issuance and the separation-related cash transfer to ITT.
- Assess the sustainability of organic growth and Water Infrastructure margins after acquisition, foreign-exchange and project-related benefits normalize.
- Review the final purchase-price allocation and integration performance for YSI, including goodwill and intangible-asset impairment exposure.
- Monitor remaining separation cash costs, transition-services arrangements and the final parent-company investment and separation adjustments.
- Evaluate environmental exposure, warranty obligations and the scope and financial strength of ITT indemnifications.
- Consider foreign-cash concentration and potential U.S. tax consequences if funds designated as indefinitely reinvested are repatriated.