Xylem Inc. 2017 Third-Quarter Form 10-Q Summary
Business Context and Reporting Period
Xylem is a global water technology company serving water infrastructure, applied water, and measurement and control markets. This unaudited Form 10-Q covers the three and nine months ended September 30, 2017, compared with the corresponding 2016 periods.
During the second quarter of 2017, Xylem reorganized its reporting segments by combining Analytics with the Sensus business, acquired in October 2016, into Measurement & Control Solutions. Historical segment information was recast without changing consolidated results.
Key Financial Metrics
| Metric | Q3 2017 | Q3 2016 | 9M 2017 | 9M 2016 |
|---|---|---|---|---|
| Revenue | $1,195 million | $897 million | $3,430 million | $2,676 million |
| Gross profit | $471 million | $357 million | $1,342 million | $1,055 million |
| Gross margin | 39.4% | 39.8% | 39.1% | 39.4% |
| Operating income | $152 million | $109 million | $377 million | $297 million |
| Operating margin | 12.7% | 12.2% | 11.0% | 11.1% |
| Net income attributable to Xylem | $105 million | $73 million | $260 million | $210 million |
| Diluted EPS | $0.58 | $0.41 | $1.44 | $1.17 |
| Operating cash flow | Not separately provided | Not separately provided | $379 million | $274 million |
| Free cash flow | Not separately provided | Not separately provided | $260 million | $184 million |
- Q3 revenue increased 33.2%; constant-currency growth was 30.8%, driven primarily by $234 million of Sensus revenue and $44 million of organic growth.
- Nine-month revenue increased 28.2%, including $715 million from businesses acquired in the fourth quarter of 2016 and $47 million of organic growth.
- Adjusted Q3 operating income was $169 million, with a 14.1% adjusted operating margin, compared with $131 million and 14.6% in the prior-year quarter.
- Adjusted Q3 EPS was $0.65 versus $0.54; adjusted nine-month EPS was $1.64 versus $1.37.
- Orders increased 32.0% in Q3 to $1,249 million and 30.5% for the nine months to $3,598 million. Backlog was $1,556 million at September 30, 2017, up 20.4% from December 31, 2016.
Liquidity, Debt, and Cash Flow
- Cash and cash equivalents were $283 million at September 30, 2017, compared with $308 million at December 31, 2016.
- Total debt was $2.286 billion, including $97 million of short-term borrowings and current maturities and $2.189 billion of long-term debt. Total debt declined from $2.368 billion at year-end 2016.
- The $600 million revolving credit facility was undrawn, and Xylem was in compliance with its debt covenants. The maximum leverage ratio under the facility was 3.50 to 1.00 after the post-acquisition transition period.
- Nine-month investing cash flow was an outflow of $122 million, including $119 million of capital expenditures and $16 million of acquisitions.
- Nine-month financing cash flow was an outflow of $299 million, including $184 million of short-term debt repayments, $97 million of dividends, and $25 million of share repurchases.
- Management stated that current cash, operating cash flow, commercial paper access, committed credit 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 increased revenue, operating income, amortization, research and development spending, and debt-related interest expense. Measurement & Control Solutions revenue rose 322.5% in Q3 and 314.2% for the nine months.
- Water Infrastructure Q3 revenue increased 8.8% and operating margin improved to 17.5% from 15.7%. Applied Water revenue increased 3.2%, while operating margin declined to 14.4% from 14.6%.
- Measurement & Control Solutions Q3 operating income increased to $26 million from $4 million, but adjusted margin declined to 9.7% from 10.5%, primarily due to Sensus purchase-accounting impacts and mix.
- Gross margin declined 40 basis points in Q3 and 30 basis points year to date, reflecting cost inflation, unfavorable mix, and Sensus purchase accounting.
- Research and development expense increased to $45 million from $23 million in Q3 and to $131 million from $75 million for the nine months, largely due to Sensus-related investment and new product development.
- Interest expense increased to $21 million from $16 million in Q3 and to $62 million from $50 million year to date, primarily due to acquisition-related debt.
- Other comprehensive income was $21 million in Q3 and $119 million year to date, compared with a $3 million loss and $17 million loss, respectively, in the prior-year periods, mainly due to favorable foreign-currency translation.
Guidance, Outlook, Risks, and Unusual Items
- Management projected 2017 total revenue growth of 24% to 25%, with organic growth in the low-single digits and most incremental growth from Sensus. The filing does not provide a specific GAAP EPS or operating-income forecast.
- Management expected approximately $20 million of restructuring costs for full-year 2017, approximately $5 million of net savings from 2017 actions, and approximately $20 million of incremental net savings from 2016 actions.
- Remaining restructuring costs were expected to continue through the end of 2018. Approximately 40% of September 30 backlog was expected to convert to revenue during the remainder of 2017.
- Q3 included $4 million of restructuring and asset impairment charges, $5 million of Sensus acquisition-related operating charges, and $3 million of special charges. The nine-month period included $22 million of restructuring and asset impairment charges and a $4 million gain from the sale of the United Kingdom and Poland membranes business.
- An Applied Water tradename impairment resulted in a $5 million charge in the first quarter of 2017.
- Key risks include macroeconomic and political conditions, foreign-currency volatility, pricing pressure, housing and weather exposure, customer order cancellations or delays, acquisition integration including Sensus, leverage and refinancing availability, goodwill and intangible-asset impairment, product liability, cybersecurity, litigation, environmental matters, and regulatory compliance.
- Legal and environmental accruals were $10 million and $4 million, respectively, at September 30, 2017. Product warranty accruals were $91 million. The company stated that existing legal claims were not expected to have a material adverse effect, although outcomes cannot be predicted with certainty.
- The term loan used partly to fund Sensus had $24 million outstanding at September 30, 2017 and was repaid in October 2017.
Important Facts for Investors to Verify
- Determine the sustainability of revenue and order growth after separating Sensus acquisition effects from organic performance.
- Monitor integration execution, purchase-accounting amortization, acquisition-related costs, and the effect of Sensus on consolidated and segment margins.
- Reconcile GAAP results with management’s adjusted operating income, adjusted EPS, EBITDA, and free-cash-flow measures.
- Track gross-margin pressure from inflation, product mix, currency, and purchase accounting, together with the realization of restructuring savings.
- Evaluate debt repayment, interest expense, leverage-covenant compliance, commercial paper usage, and liquidity after the Sensus acquisition.
- Assess backlog conversion, customer cancellation or rescheduling risk, and the concentration of backlog and revenue in international markets.
- Review exposure to warranty, environmental, litigation, tax, pension, cybersecurity, and goodwill or intangible-asset impairment contingencies.