Business Context and Reporting Period
Xylem Inc. filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2023. Xylem provides water and wastewater equipment, technology, and services through four segments: Water Infrastructure, Applied Water, Measurement & Control Solutions, and Integrated Solutions & Services.
The May 24, 2023 acquisition of Evoqua Water Technologies materially changed the reporting base. Evoqua contributed $540 million of third-quarter revenue and $718 million for the nine-month period, and its operations are included from the acquisition date. Legacy Evoqua shareholders received approximately 25% of the combined company.
Financial Performance and Position
| Metric | Q3 2023 | Q3 2022 | 9M 2023 | 9M 2022 |
|---|---|---|---|---|
| Revenue | $2,076 million | $1,380 million | $5,246 million | $4,016 million |
| Gross profit | $764 million | $524 million | $1,961 million | $1,511 million |
| Gross margin | 36.8% | 38.0% | 37.4% | 37.6% |
| Operating income | $191 million | $168 million | $441 million | $425 million |
| Operating margin | 9.2% | 12.2% | 8.4% | 10.6% |
| Net income | $152 million | $12 million | $343 million | $206 million |
| Diluted EPS | $0.63 | $0.07 | $1.63 | $1.14 |
- Third-quarter revenue increased 50.4%, comprising 9.7% organic growth, 39.1% net acquisition and divestiture impact, and 1.6% favorable currency translation. Nine-month revenue increased 30.6%, including 13.8% organic growth and $718 million of net acquisition and divestiture impact.
- Adjusted operating income was $315 million, or a 15.2% adjusted margin, in the quarter, versus $205 million and 14.9% in the prior year. For nine months, adjusted operating income was $759 million, or a 14.5% margin, versus $512 million and 12.7%.
- Adjusted net income and adjusted diluted EPS were $240 million and $0.99 in the quarter, compared with $157 million and $0.87. Nine-month adjusted net income and adjusted diluted EPS were $586 million and $2.79, compared with $388 million and $2.15.
- Adjusted EBITDA was $411 million, or a 19.8% margin, in the quarter, versus $252 million and 18.3%. Nine-month adjusted EBITDA was $976 million, or an 18.6% margin, versus $659 million and 16.4%.
- Operating results benefited from price realization, productivity savings, volume, and improved electronic-component availability. These benefits were offset by inflation, strategic investment spending, unfavorable mix, inventory-management costs, employee costs, and Evoqua-related charges.
Cash Flow, Debt, and Liquidity
- For the nine months, operating cash flow was $382 million versus $234 million; capital expenditures were $177 million versus $148 million; and reported free cash flow was $238 million versus $86 million.
- Investing cash outflow was $539 million, including $476 million for acquisitions and $177 million of capital expenditures. Financing cash outflow was $71 million, including $219 million of dividends.
- Cash and cash equivalents were $705 million at September 30, 2023, down from $944 million at December 31, 2022.
- Total debt was $2.270 billion, including $2.253 billion of long-term debt, compared with $1.880 billion at year-end 2022. The increase primarily reflects Evoqua-related financing, including a $263 million term loan and $124 million of equipment financing.
- The $1.0 billion revolving credit facility was undrawn, and management reported approximately $1.7 billion of available liquidity, comprising cash and available credit facilities. Xylem stated that it was in compliance with applicable debt covenants.
Material Changes Versus the Prior Comparable Period
- Evoqua added a new Integrated Solutions & Services segment, which generated $368 million of third-quarter revenue and $493 million for nine months, but reported operating losses of $3 million and $10 million, respectively. Adjusted operating income was $49 million and $67 million.
- Goodwill increased to $7.149 billion from $2.719 billion and net intangible assets increased to $3.039 billion from $930 million, primarily because of the Evoqua purchase accounting.
- SG&A increased 67.0% in the quarter and 41.6% for nine months, reflecting Evoqua operating costs, acquisition and integration costs, higher amortization, realignment costs, and strategic investments.
- Restructuring and realignment costs were $34 million in the quarter and $82 million for nine months, compared with $6 million and $18 million. Acquired intangible amortization was $66 million and $120 million, compared with $18 million and $54 million.
- Third-quarter orders increased 43.1% to $2.031 billion, including 3.3% organic growth. Nine-month orders increased 13.3% to $5.457 billion, although organic orders declined 1.5%.
- Backlog reached $5.169 billion, up 41.0% from September 30, 2022. Approximately 27% was expected to convert to revenue during the remainder of 2023.
- The prior-year period included a $140 million U.K. pension settlement expense, which did not recur in 2023 and significantly affected reported comparative profit.
Guidance, Outlook, Risks, and Unusual Items
- Management updated 2023 total revenue growth guidance to approximately 32% and organic revenue growth guidance to approximately 11%. Expected organic growth was mid-teens for utilities, high-single-digits for industrial, and mid-single-digits for building solutions.
- Xylem expected approximately $95 million of 2023 restructuring and realignment costs; the filing separately stated expected full-year restructuring costs of approximately $55 million to $60 million. Actions are expected to continue through the end of 2024.
- Key risks include Evoqua integration and synergy execution, acquisition-related costs, goodwill and intangible-asset impairment, inflation, interest rates, supply-chain and semiconductor availability, demand and pricing pressure, foreign-exchange volatility, cybersecurity, geopolitical conflicts, regulatory and environmental compliance, product liability, large-project execution, and access to financing.
- Xylem disclosed an ongoing Swedish tax appeal involving an adverse assessment of approximately $75 million, including penalties and interest. Management believes it is more likely than not to prevail, but the final outcome could differ materially.
- The company is cooperating with a U.S. Attorney’s Office investigation previously disclosed by Evoqua concerning potential financial misstatements in Evoqua’s public filings and earnings announcements. Xylem stated that it cannot predict the outcome.
- General legal and environmental accruals were $14 million and $4 million, respectively. Guarantees, letters of credit, surety bonds, and related arrangements totaled $691 million.
- Management concluded that disclosure controls and procedures were effective as of September 30, 2023, with no material change in internal control over financial reporting.
Investor Verification Priorities
- Verify the sustainability of organic growth and order conversion, particularly as Measurement & Control Solutions orders declined organically and Applied Water orders declined for nine months.
- Track Evoqua integration costs, restructuring benefits, segment profitability, and whether Integrated Solutions & Services reaches the stated adjusted margin profile.
- Reconcile reported GAAP results with adjusted operating income, adjusted EPS, and adjusted EBITDA, noting the substantial add-backs for amortization, restructuring, integration costs, and special charges.
- Assess leverage, interest costs, covenant headroom, and liquidity after the Evoqua-related debt increase.
- Monitor the Swedish tax litigation, the U.S. investigation involving former Evoqua disclosures, environmental obligations, guarantees, and potential acquisition-related contingencies.
- Evaluate the large goodwill and intangible balances for impairment risk and the effect of purchase-accounting amortization on future GAAP earnings.