Business Context and Reporting Period
Xylem Inc. is a water and wastewater equipment and services provider operating through Water Infrastructure and Applied Water segments. This unaudited Form 10-Q covers the three and six months ended June 30, 2014, compared with the corresponding 2013 periods.
Financial Performance and Position
| Metric | Three Months 2014 | Three Months 2013 | Six Months 2014 | Six Months 2013 |
|---|---|---|---|---|
| Revenue | $1,005 million | $960 million | $1,911 million | $1,839 million |
| Gross profit | $388 million | $371 million | $730 million | $705 million |
| Gross margin | 38.6% | 38.6% | 38.2% | 38.3% |
| Operating income | $116 million | $70 million | $192 million | $136 million |
| Operating margin | 11.5% | 7.3% | 10.0% | 7.4% |
| Net income | $86 million | $46 million | $135 million | $87 million |
| Diluted EPS | $0.47 | $0.25 | $0.73 | $0.47 |
- Second-quarter revenue increased 4.7%; constant-currency growth was 4.0%. Six-month revenue increased 3.9%, or 3.8% on a constant-currency basis.
- Water Infrastructure revenue increased 6.7% in the quarter and 5.0% for six months. Applied Water revenue increased 1.8% and 2.3%, respectively, although second-quarter Applied Water revenue declined 0.5% on a constant-currency basis.
- Operating expense excluding restructuring and realignment costs declined 3.7% in the quarter and 3.4% for six months. SG&A as a percentage of revenue improved to 24.1% from 26.4% in the quarter and to 24.4% from 26.6% for six months.
- Operating cash flow for the first six months was $98 million versus $62 million in 2013. Free cash flow was $50 million versus $2 million.
- Capital expenditures were $48 million versus $60 million. No acquisitions were completed during the first six months, compared with $81 million of net acquisition spending in 2013.
- Cash and cash equivalents were $450 million at June 30, 2014, down from $533 million at December 31, 2013. The decline primarily reflected $130 million of financing cash uses, including $102 million of share repurchases and $47 million of dividends paid.
- Total debt was $1.242 billion, including $1.199 billion of long-term debt. The $600 million revolving credit facility was undrawn. Cash held by foreign subsidiaries was $361 million.
- Backlog was $816 million, up 7.5% from June 30, 2013 and 15.4% from December 31, 2013; management expected approximately 79% to convert to revenue during the remainder of 2014.
Material Changes Versus the Prior Comparable Period
- Net income rose 87.0% in the second quarter and 55.2% for the first six months, while diluted EPS rose to $0.47 and $0.73, respectively.
- Operating income increased 65.7% in the quarter and 41.2% for six months. The improvement reflected higher sales volumes, lean six sigma and global sourcing savings, and restructuring benefits.
- Restructuring charges declined to $3 million from $20 million in the quarter and to $18 million from $25 million for six months. Total restructuring and realignment costs were $9 million versus $28 million in the quarter and $27 million versus $40 million for six months.
- The effective tax rate declined to 17.2% from 20.3% in the quarter and to 17.9% from 19.7% for six months, primarily due to geographic earnings mix.
- Foreign-currency translation had a substantially smaller adverse effect on comprehensive income than in 2013. Six-month comprehensive income was $126 million versus $27 million.
- Share repurchases increased materially: $102 million during the first six months versus $18 million in 2013. Up to $100 million remained available under the principal repurchase authorization at June 30, 2014.
Guidance, Outlook, Risks and Unusual Items
- Management expected modest recovery in U.S. industrial markets, modest European industrial improvement, modest public-utility growth, and continued mixed mining performance. Commercial building applications were expected to grow modestly, while residential building applications were expected to be flat to slightly negative.
- For full-year 2014, management expected $30 million to $35 million of restructuring costs and $10 million to $15 million of realignment costs. It expected approximately $25 million of incremental savings from 2013 actions and $15 million from 2014 actions, with approximately $15 million of total net savings during 2014.
- Restructuring actions initiated in 2014 were expected to continue through the second quarter of 2015 and generate approximately $20 million of annual future net savings beginning in 2015.
- On July 2, 2014, Xylem divested its Wolverhampton, U.K. pneumatic and hydraulic valves business for approximately $30 million. The business reported approximately $25 million of 2013 revenue.
- Material exposures include foreign-currency fluctuations, cost inflation, unfavorable pricing and sales mix, uneven industrial, residential and commercial markets, project delivery timing, and continued weakness in mining or institutional construction.
- The company accrued $18 million for general legal matters and $6 million for environmental matters at June 30, 2014. Management did not expect asserted or unasserted legal claims, individually or in aggregate, to have a material adverse effect, but noted that outcomes cannot be predicted with certainty.
- A purchase-price dispute with minority shareholders from a historical acquisition remained subject to settlement negotiations. Xylem also faces potential asbestos claims, for which former parent ITT has indemnification obligations.
- Xylem was in compliance with debt covenants, including the 3.50 maximum leverage ratio, and expected existing funding sources and additional borrowing capacity to meet liquidity needs over the next twelve months.
- The filing reported no material changes to previously disclosed risk factors or market-risk information. Disclosure controls were determined to be effective.
Important Facts for Investors to Verify
- Verify whether revenue growth and backlog conversion continued, particularly in Water Infrastructure and emerging markets.
- Assess the sustainability of margin expansion after restructuring, lean six sigma and sourcing benefits, including the effects of inflation and price/mix pressure.
- Monitor cash conversion, inventory growth, share repurchases, dividends and the reduction in cash balances.
- Review the $600 million senior notes due in 2016, total leverage, refinancing plans and compliance with debt covenants.
- Track restructuring and realignment spending, expected savings and completion of actions through the second quarter of 2015.
- Evaluate foreign-currency exposure, international cash holdings, tax implications of potential repatriation, and derivative losses recorded in other comprehensive income.
- Review the subsequent Wolverhampton divestiture and its effect on Applied Water revenue, earnings and reported growth.
- Follow the historical acquisition purchase-price dispute, environmental matters, warranty obligations and asbestos indemnification arrangements.