Xylem Q2 2021 Earnings Call Transcript

Quartr
Provided by Quartr
August 3, 2021

There are 14 speakers on the call.

Operator

Welcome to the Xylem Second Quarter 2021 Earnings Conference Call. At this time, all participants have been placed on listen only mode I would now like to turn the conference over to Matt Latino, Vice President of Investor Relations.

Speaker 1

Thank you. Good morning, everyone, and welcome to Xylem's 2nd quarter earnings conference call. With me today are Chief Executive Officer, Patrick Decker and Chief Financial Officer, Sandy Rowland. They will provide their perspective on Xylem's 2nd quarter results Following our prepared remarks, we will address questions related to the information covered on the call. As a reminder, this call and our webcast are accompanied by a slide presentation available in the Investors section of our website at www.xylem.com.

Speaker 1

A replay of today's call will be available until midnight on September 1. Please note the replay number is 800 585-8367 and the confirmation code is 8,774,036.

Speaker 2

Additionally, the call will

Speaker 1

be available for playback via the Investors section of our website under the heading Investor Events. Please turn to Slide 2. We will make some forward looking statements on today's call, including references to future events or developments that we anticipate will or may occur in the future. All references will be on an organic or adjusted basis, unless otherwise indicated. These statements are subject to future risks and uncertainties such as those factors described in Xylem's most recent Annual Report on Form 10 ks and in subsequent reports filed with the SEC, including in our Form 10 Q to report results for the period ending June 30, 2021.

Speaker 1

Please note that the company undertakes no obligation to update In the appendix, we have also provided you with a summary of our key performance metrics, including both GAAP and non GAAP metrics. For purposes of today's call, all references will be on an organic and adjusted basis unless otherwise indicated. Non GAAP financials have been reconciled for you and are in the appendix of the presentation. Now please turn to Slide 3, and I will turn the call over to our CEO, Patrick Decker.

Speaker 3

Good morning, everyone, and thank you for joining us. The call is starting a bit later in the morning than usual this quarter. So by now, you will have seen that second Quarter performance exceeded our expectations on all major veterans, including orders, revenue, margin and earnings per share. I'm very proud of

Speaker 4

the operator

Speaker 3

beating the healthy pace we set in the Q1 and delivering a very strong first half of the year. Underlying demand for our solutions was robust across all segments and in market. Everybody, please stand by one moment. Everybody did a great job converting that into better than expected performance and continuing to expand margin. They delivered even more exceptional results on orders, which grew 29% On changing underlying demand across all regions.

Speaker 3

In addition, backlog is up 35% versus this point last year. That broad expansion reflects commercial momentum that puts us in a strong position, both now and into the future, as we continue to invest in sustainable growth. At the end of the Q1, we raised full year guidance on revenue and earnings. The second quarter's performance shows a continuing strong trajectory into the second half, and we're reflecting that by further raising full year revenue guidance. The top line benefits are likely to be moderated somewhat by inflation and a challenging supply chain environment.

Speaker 3

But we've been proactive on price and are working with our supply chain partners to mitigate the impact of those headwinds. So we are also raising the midpoint on earnings per share guidance for the full year. In a moment, I'll provide some additional color on what we're seeing globally. But first, let me hand it over to Sandy to provide more detail on performance in the quarter.

Speaker 5

Thank you, Patrick. The 2nd quarter offered a strong story of continuing demand recovery as revenue grew 11% organically compared to the prior year. We also saw momentum across most end markets on a quarter sequential basis. Utilities, our largest end market, Was up 6% compared to the prior year, driven by clean water applications and continued wastewater utility OpEx demand. Industrial was up 17% on broad based strength as economies reopened and activity continued to ramp.

Speaker 5

Commercial grew 12% and also improved sequentially, led by strength in the U. S. And Western Europe, while residential, our smallest end market,

Speaker 2

through 29%.

Speaker 5

Geographically, Western Europe and China were both hot mid teens with increasing demand seen across all end markets. The U. S. Returned to growth with site access restrictions easing during the quarter. As Patrick mentioned, The team delivered exceptional organic orders growth of 29% and strong underlying demand across all segments and regions with particular pace in MNCS, which grew orders 70% on large water metrology contracts.

Speaker 5

This is our 4th consecutive quarter of sequential orders improvement and it reflects higher orders growth than in the same period in 2019. Importantly, we exit the quarter with overall backlog up 35%. Looking at the key financial metrics, Margins were above our forecasted range with EBITDA margin coming in at 17.3%. The 200 basis points of year over year EBITDA margin Expansion came largely from productivity, volume and favorable mix, partially offset by inflation and investments. Earnings per share in the quarter were $0.66 which is up 65%.

Speaker 5

Please turn to Slide 5, and I'll review our segment performance for the quarter. Water Infrastructure delivered strong results during the quarter. Orders were flat, but up 22% excluding the large prior year deal in Telangana, India. Order intake was robust in treatment globally. Revenues were up 6% organically.

Speaker 5

Wastewater utilities remained resilient and we are now seeing recovery in the industrial end market. Geographically, emerging markets delivered mid teens growth from industrial recovery, driven in part by increasing mining demand in Latin America and Africa, while Western Europe delivered double digit growth from continued strong utility OpEx activity. In the U. S, Healthy Utilities OpEx demand reflected in strong orders growth was offset by the lapping of prior year treatment project deliveries. EBITDA margin was in line with the prior year as strong productivity savings and volume effects offset inflation and investments.

Speaker 5

Now please turn to Slide 6. The Applied Water segment had a very strong quarter driven by continuing market recovery across all regions and end markets. Orders were up 43% organically in the quarter with particular strength in the U. S. And Western Europe.

Speaker 5

Revenue grew 18% in the quarter with double digit industrial demand driven by reopening activity and especially in marine and food and beverage applications. Residential growth continues to be robust on strong market demand. Geographically, the U. S. Was up double digits, while Western Europe contributed 27% growth on increasing industrial demand.

Speaker 5

Emerging markets were up 24% due in part to broad industrial recovery and momentum in China. Segment EBITDA margin grew 200 basis points compared to the prior year. The expansion came from strong volume leverage and productivity more than offsetting material and freight inflation. Now please turn to Slide 7 and I'll cover our Measurement and Control Solutions segment. MNCS delivered a strong quarter as large project deployments began to ramp.

Speaker 5

We also realized gains in our industrial water quality testing business. Orders for the segment were up 70% organically on strong demand. Our MNCS backlog now stands at $1,500,000,000 which is a historic high and almost 50% higher than at this time last year. We have secured more than $400,000,000 in large contracts in the last 18 months. That reflects a number of major projects, which increasingly include our broader digital solutions in combination with our core metrology application.

Speaker 5

Revenue was up 11%, led by 17% growth in water applications, driven by large project deployments and double digit growth in water quality applications. Energy applications were down modestly due to project timing and supply chain constraints. Unpacking the results by geography, emerging markets in Western Europe were up 20% 25%, respectively. The U. S.

Speaker 5

Was up mid single digits on strong demand for water quality applications and assessment services. As a reminder, for this segment in particular, growth rates can be uneven due to the impact of project timing. Segment EBITDA margin in the quarter was up 4 60 basis points compared to the prior year. Strong productivity savings from prior year restructuring actions, Favorable mix and volume leverage more than offset inflation and investments. Now let's turn to Slide 8 for an overview of cash flows and the company's financial position.

Speaker 5

Our balance sheet continues to be very strong. We closed the quarter with $1,800,000,000 in cash and cash equivalents. In the Q3, dollars 600,000,000 of senior notes will mature to be paid with cash. Free cash flow conversion was 172% in quarter in line with our expectations and historical seasonality patterns. Net debt to EBITDA leverage was 1.3 times at the end of the quarter.

Speaker 5

Please turn to Slide 9, and I'll turn the call back over to Patrick.

Speaker 1

Thanks, Sandy.

Speaker 3

I'd like to touch on 3 areas briefly Our operating discipline, our growth platforms and sustainability. On operating discipline, the team did an excellent job on margins in the quarter, delivering 200 basis points of EBITDA margin expansion year on year in addition to quarter sequential improvement. We do anticipate some inflation and component supply challenges in the second half, but we're confident in our ability to manage through them and to mitigate their impact. Earlier, I noted our extremely healthy backlogs. As we work through these volumes, the team is doing a great job making sure we manage the pressure on working capital this can create.

Speaker 3

In fact, despite serving spiking demand, we've improved working capital both year over year and quarter sequentially. As Sandy just mentioned, that performance puts us firmly on track to deliver our commitment on attractive free cash flow conversion. We clearly have significant capacity for capital deployment. On top of strong organic growth investment options, We have an attractive and active pipeline of M and A opportunities. Our growth platforms are an area we'll be delving into at our Investor Day in September.

Speaker 3

So I'm going to refrain from too much detail here today. I do want to draw attention to 2 things, however. Last quarter, we highlighted the pace of growth in emerging markets. This quarter that pace has continued despite India's hard deceleration to the quarter due to COVID impact there. I'm very proud of the entire Xylem team's discipline and compassionate response in all countries affected by COVID, both in terms of our own operations And some of the dramatic water centric events we've been seeing recently around the world, by which I mean the flooding in Europe, China and Central Asia and the drought in the American West.

Speaker 3

These events reflect a trend as the effects of climate change become more and more apparent. And that trend requires an affordable response to keep communities safe, resilient and water secure. So we continue to invest in specific technologies in our portfolio that respond to these challenges. As an example, Automated wastewater network optimization is amongst our most advanced digital solutions. Its job is to manage overflows and prevent flooding.

Speaker 3

And our customer deployments are already preventing 1,400,000,000 cubic meters of water from flooding communities. Similarly, we also continue to innovate in the technology that make communities more resilient to drought, technologies like leak detection, Smart metering and especially water reuse. Already 1,000,000,000,000 gallons of water are being recycled using Xylem technology, Which brings me to the topic of sustainability more broadly. The numbers I just quoted come from our annual sustainability report, which we published in June. And I think they bear out what we've said for some time.

Speaker 3

Our sustainability strategy is fundamental to our business strategy. We were pleased to report, for example, that almost half of our major facilities are now operating on 100% renewable energy, helping reduce our greenhouse gas emissions intensity by more than 7% year over year. Beyond our own footprint, our solutions have enabled our customers to reduce their carbon emissions by 700,000 metric tons last year. The report details progress on all of our signature sustainability goals and shows how sustainability is deeply embedded in who we are as a company. Now with that, I'll hand it back over to Sandy to provide commentary on our end markets and guidance for the remainder of the year.

Speaker 5

Thanks, Patrick. Our full year outlook for our end markets remains largely consistent with our view from last quarter, with some positive evolution as a few end markets are showing even faster recovery. In utilities, demand continues to be strong in both wastewater and on the wastewater side, We have seen steady demand in Western Europe and North America as operators continue to focus on mission critical applications, while also investing in larger scale upgrades on affordable funding from capital markets. Good activity and long term capital Spending outlook in emerging markets remains solid, though some COVID concerns linger in certain markets. On the Clean Water side, Demand for smart water solutions and digital offerings continues to be robust as utilities increasingly turn their focus to more resilient infrastructure and affordable water delivery.

Speaker 5

Consistent with other technology companies, The connected nature of our solutions raises some risk in the second half, given prolonged supply chain constraints for electronic components. Our teams are working closely with our suppliers and manufacturing partners to optimize deliveries. Please turn to Slide 11. Looking at the industrial end market, where we had expected mid single digits growth for the year, we are now anticipated growing in the high single digits. The growth is broad based with rebounding industrial activity across all segments and regions.

Speaker 5

We're seeing upticks in demand, particularly in our We're also seeing higher demand in marine and food and beverage, driven by recovery in outdoor recreation and the hospitality sector. We are increasing our outlook in the commercial end market as well. The U. S. Replacement business is growing at a brisk pace.

Speaker 5

New commercial building is expected to lag the recovery somewhat, but key leading indicators reflect optimism for late 2021 recovery in the institutional sector. With growth in Western Europe and China sustained through the second half, along with modest share gains and supply chain resiliency, we now Expect the commercial end market to be up mid to high single digits, up from the low single digits previously. In residential, we now anticipate low teens growth for the full year, up modestly from our previous expectations of high single digit to low double digit growth. We do expect growth will moderate through the second half due largely to more difficult year over year comparisons. And now let's turn to Slide 12 and I'll walk you through our updated guidance.

Speaker 5

As you can see, we are further raising our previous annual guidance. For Xylem overall, we now see full year organic revenue growth in the range of 6% to 8%, up from our previous guidance range of 5% to 7%. This confidence is based on clear demand recovery combined with the pricing actions we are taking to offset inflation. This revenue guidance breaks down by segment as follows. For Water Infrastructure, we expect mid single digit growth from a previous expectation of mid to high single digits.

Speaker 5

We expect low double digit growth in Applied Water, up from mid to high single digits. And in measurement and control solutions, we expect mid single digit growth. We also expect EBITDA margins in the range of 17.2% to 17.7%. This guidance represents full year margin expansion of 120 basis points at the midpoint. That's grounded in a strong first half performance with 300 basis points of expansion from restructuring savings on actions we took late last year, as well as volume leverage from the top line growth.

Speaker 5

The 3rd quarter is more challenging, primarily driven by the timing of inflation and price realization. However, price realization will increase into the Q4 as we work through the large backlog built over the last several quarters. Overall, we expect strong second half margins compared to the first half of the year. This yields an adjusted EPS guidance range of 2.55 to $2.70 reflecting increased confidence in our ability to lift the bottom end of the range, while still managing through inflation and supply chain challenges. That range now reflects a 28% increase in EPS guidance at the midpoint over last year.

Speaker 5

We continue to expect full year 2021 free cash flow conversion of 80% to 90% as previously guided, putting our 3 year average right around 130%. We have provided you with a number of other full year assumptions to supplement your models. Those assumptions are largely unchanged from our original guidance. However, one item worth noting is our updated assumption on foreign exchange for the second half of the year. Because of the recent dip in the euro and the disproportionate effect it has on our results, we've updated our euro to dollar conversion rate assumption for the second half from 1.22 to 1.18.

Speaker 5

This change along with some other currency movements Has a $0.04 negative impact on our second half outlook. As you know, foreign exchange can be volatile, So we've included our typical foreign exchange sensitivity table in the appendix. Also, we are making an adjustment to our restructuring and realignment guidance from $50,000,000 to $60,000,000 to now $30,000,000 to $40,000,000 while still expecting to realize similar restructuring savings due to high natural attrition and the timing of actions. And now before wrapping up, let me share some thoughts on our Q3 outlook. We anticipate total company organic revenues will grow in the range of 5% to 7%.

Speaker 5

This includes mid single digit growth in water infrastructure, to be in the range of 16.7% to 17.2%, largely in line with our strong second quarter. While inflation and component supply are likely to present some headwinds in the Q3, we are addressing them with the pricing and supply chain actions previously mentioned. And with that, please turn to Slide 13, and I'll turn the call back over to Patrick for some closing comments.

Speaker 1

Thanks, Sandy. The teams

Speaker 3

have been doing an outstanding job capturing market demand, giving us exceptional orders and backlog growth. We expect to continue capitalizing on that underlying demand. And the team will manage through the near term supply chain environment with the same spirit and discipline they've demonstrated through the many external challenges of the past year. Looking forward, Trends toward new investment in infrastructure and particularly in the modernization of infrastructure are accelerating hand in hand with demand to make communities more resilient to climate change and to do it in a more affordable way. Those trends only reinforce the strength of our investment thesis That our differentiated portfolio of leading technologies addressing scarcity, resilience and affordability We'll drive increased revenue growth and margins and sustainable growth with strong cash flow generation and increased opportunity for capital deployment.

Speaker 3

This puts us in a privileged position to create both economic and social value for our stakeholders now and over the medium and long term. We are genuinely excited about providing an update on our strategy and long term plans at our upcoming Investor Day, which is scheduled for September 30th. It will be the first opportunity for many

Speaker 6

of you to meet all

Speaker 3

of our business leaders and our entire senior leadership team, especially those who joined us over the past year. So it's a great chance to provide a full strategic update, including our long term financial targets and a deep dive into our vision of how digital solutions are transforming outcomes for our customers, including discussions with a few of those customers have deployed some of our most advanced technologies. Matt and the team will follow-up with invitations and logistical details in the coming days. Now, let's turn the call over to you and are happy to take any questions you may have.

Operator

Your first question comes from the line of Michael Halloran with Baird.

Speaker 7

Hey, good morning, everyone.

Speaker 2

Hey, Mike. How are you doing?

Speaker 7

I'm all good. Thank you. So two questions on MNCS here. First, maybe just a little deeper dive on how you see that backlog Conversion playing out. Obviously, a really nice sequential move in orders, really good commentary from an underlying perspective on what the underlying cadence demand, etcetera, looks like.

Speaker 7

But you also have the supply chain challenges, shortages, things like that. How do you see that playing out right now in

Speaker 2

The backlog growth in MNCS specifically was about 49% in this past quarter. So a really good uptick, Really encouraged by a number of not just the large deal wins that the team has achieved there, but also the base business, The day to day business grew quite nicely in the quarter and we see good momentum there. We feel that the site access issues have certainly eased. I wouldn't say they're completely resolved, but they're certainly trending in the right direction. Where we're really seeing and really the primary challenge out there right now, which the team is all over and working hard to mitigate that is some of the Component shortages and that's not limited to us.

Speaker 2

That really is not just across our sector, but you all well know, broader sectors as well. But the team is all over. We're doing everything we can, whether it be kind of paying up for some components, making sure we lock in commitments around that. So We feel very good about the momentum. It really does feel like that part of our business is turning the corner In terms of converting things into backlog, we look at the margin in backlog, especially as we go into 2022 And feel very good about that, not just what they've achieved already this year.

Speaker 2

Again, challenges aside in the second half around component shortages and those are real. They're not insignificant, but we're confident we can work through that and it's shaping up very nice for 'twenty two and beyond.

Speaker 8

So you touched it a little

Speaker 7

bit on in the answer, but just dig a little deeper. Could you just talk about the mix of the backlog? How that's Tracking versus some of the more digitally oriented and the newer solutions you're putting in the marketplace, broader approach there versus more traditional? And then also Thoughts on how you think the backlog margin is tracking out as well in comfort level given all the moving pieces?

Speaker 2

Sure. Yes. And I think on the margin let me take the second one first. The margin on the backlog, we're confident about as we go into 'twenty two and beyond. Again, we've got This near term challenge we're working through in Q3 and Q4 on component shortages, etcetera.

Speaker 2

But again, we're holding our own there. As it relates to the mix, we continue to see a real adoption of even in these large metrology deals That we're doing, there is an ever going increased component of that, that is digital. And so we're And we continue to see a number of really impressive wins on the branding that we call XylemView, which is the purely digital Kind of data driven diagnostic capabilities and so we're very encouraged in that area as well. But there's definitely shifting mix towards the digital component.

Speaker 1

Great. Thank you for

Speaker 9

the time. And we'll have

Speaker 2

Mike, we'll have more that we'll share on that at our upcoming Investor Day to kind of Unpacking and bundle that for you all.

Operator

Your next Question comes from the line of Deane Dray with RBC Capital Markets.

Speaker 6

Just like to pick up where we left off there on the Supply chain, it looks like you are managing through this based upon your margin success. We were expecting you to get some price Increases in the second quarter, how did that play out? And then what's the expectation for second half on a price cost for the total company? Thanks.

Speaker 10

Yes. Thanks for the question, Dean. I think that we're very happy with how we've managed through the inflation dynamics through the first Half of the year and we were able to realize some incremental price in Q2. We do expect that that will continue to ramp throughout the year. Just as a reminder, we're now up on our 3rd price increase for the year.

Speaker 10

We got out of the gate early with a price increase in the Q1. Because of the continuous rise in the commodity prices, We've then taken that decision to take 2 additional price increases. I think there is one unique dynamic that we're working through. The Aplugs are a little higher than we typically find at any given period of time. And so, the realization, there's a little bit of a timing issue.

Speaker 10

But net net, I think we're doing a good job here and it will continue to ramp, particularly in the Q4.

Speaker 2

Yes, indeed, I would just offer that. So yes, as Sandy said, the most challenging timeframe we face right now is really in Q3, because we did have this big bump in backlog. And so that's we're shipping that out. There is price realization in there. But as you know, commodities especially have moved so quickly That we've gone out now, we'll go out again with further price increases.

Speaker 2

But as we look at the exit, especially in Q4, That really all comes back into complete equilibrium and we are net positive at that point once again.

Speaker 6

Great. Just a quick clarification. And Patrick, I don't know if you were anticipating, I was going to ask this question until you gave Partial answer earlier is in the orders, especially MC and S, The digital component, can you put a number just broadly? It doesn't have to be that precise, but How much of these orders have a digital component? And you can include Sensus and their smart meter Just part of that as well.

Speaker 2

Yes, absolutely. And I think, Dean, I'll give you an answer. And Dean, I think this is absolutely what we want To delve in a bit more at Investor Day, we really kind of want to lay out that baseline and that framework as to how we think about digital and what that kind of trend line is And where our metrics and incentives tied to that are so much more to come at Investor Day. But just to put it in perspective, and we've had In the last 18 months, we've had $400,000,000 roughly in large deal wins. And that has had a significant Digital component to it.

Speaker 2

And so that just gives you one sense of kind of proof point. And then there are a number of again really Interesting projects and deals that we've won within what we call the ZYTOVUE, which is again purely the diagnostic Kind of consultative side of the business that we'll be highlighting at Investor Day. So we'll cover more of that on September 30, but hopefully that gives you a bit of a flavor There is a real meaningful adoption here on the digital side that we want to give the appropriate color to. We are very excited about it.

Speaker 6

Of course, happy to wait till then for those specifics. And just last one from me. On Water Infrastructure, just tempering the guidance on the top line going to mid single digit, just what are the key Headwinds, and how would you calibrate those?

Speaker 10

Yes. I think it's a modest shift. I think if We did take the water infrastructure guide up in the first at the end of the Q1, we initially guided to about a 4% increase. We took that up. I think we're very close in the same spot.

Speaker 10

It's largely unchanged.

Speaker 2

Yes, I think there's some timing of project deliveries and shipments. We had some pretty impressive comps versus last year. Dean, I wouldn't read anything into that. I mean, we're trying to be prudent just in terms of the guide for the second half. But There is nothing happening from a market standpoint that is changing our view on that segment.

Speaker 2

We're very confident. It continues to be very much in that Healthy mid single digit kind of growth rate as we've expected. And there that also cuts across geographies, Dean. We're not seeing any kind of slowdown or shift in spending in the U. S.

Speaker 2

Because of infrastructure discussion or Any of that, it's just, again, I was trying to be prudent.

Operator

Your next question comes from the line of Ryan Connors with Boen and Scattergood.

Speaker 8

Great. Thanks for taking my questions. I wanted to not to beat the dead horse on the supply chain issues, but if you just want to drill down there. Some of the sort of peer companies have talked about sort of foregone revenue because it's so tough to get some Components and things, but it sounds like you're not really saying that. You mentioned, Patrick, paying up for components.

Speaker 8

And it sounds like in your case, it's more of a You're willing to take it on the margin side if you have to and to get the business and be able to shift the business. And it hasn't really been a revenue headwind leaving business on the table either in the past or in the second half. Is that a fair characterization of What I'm hearing is that not

Speaker 2

No, that's fair, Ryan. I mean, again, I'd be remiss if I didn't give a huge shout out to The team that's working through this because it is challenging. I mean, it's not an insignificant challenge that they're trying to overcome at this point in time. But Just to put some kind of parameters around this. And we estimate right now, we probably move roughly at least $20,000,000 of revenue Out of the second half of the year into 'twenty two, obviously, there's never any guarantee.

Speaker 2

And obviously, that comes with healthy margins. And so if it weren't for that, we would probably be talking about a further adjustment to our guide, but that's the reality that we are working through at this point in time. And it's not without risk. So our teams are working their backsides off in that regard. But yes, we don't feel that we are losing Revenue from a competitive standpoint, because we're all facing the same challenges, and this is a pretty sticky business.

Speaker 2

It's hard to swap out Suppliers, so that's the right characterization, Ryan. Hopefully, that little bit extra color can be was helpful.

Speaker 8

Yes, it certainly was. And then as a follow on to that, you at the corporate level as well as all your salespeople that you've Given us all access to at the trade events and things, always talk about pricing for value as opposed to pricing for commodities. So how do you handle this Weird environment where you're suddenly having to price for commodities. I mean, do you build in deescalators if certain things go down in the future? I mean, it just seems like a very different Discussion than you normally like to have around sort of pricing for value.

Speaker 2

Yes. No, you're absolutely right, Ryan. I mean, we the teams are Continue to remain primarily focused on pricing for value. And that again, really tying back to, again, what are the Some more outcomes that we're looking to achieve here in terms of helping them achieve their goals. And so, we are getting better, I think at pricing for value.

Speaker 2

I would say in these kinds of interesting environments, we're not really doing sur So it's not like we're putting it out there where we have to then dial it back later. And so we're trying to be disciplined in that regard. At the same time, we also dealt with this, it wasn't that long ago, we were talking about the tariffs and all the other Interesting pricing challenges that we had to overcome. So again, I don't want to minimize the incredible hard work The teams are going to deal with this pricing environment, but I'm very pleased and very proud of what they've accomplished thus far.

Speaker 8

Okay, good. And then I did have one last one. I didn't hear a 2 question restriction, so hopefully I'm not overly over here. Okay. Just a big very big picture, but just obviously, stock is sitting at an all time high.

Speaker 8

You've got a great currency. And we've seen this weird kind of valuation gap develop. You've got a great story to tell around ESG, Maybe others do not. So this huge valuation gap has opened up. I mean, has there been any thought to how that influences your M and A strategy where you use that currency Practice is there.

Speaker 8

I mean, is that something that you thought about?

Speaker 2

Absolutely. Right. I mean, it's a great point. If I bring it back to center on that theme around kind of capital deployment, Again, the pipeline is very active. It's we believe there are things that are actionable there of different shapes and sizes.

Speaker 2

We absolutely would believe in using our currency in the right way and leverage that in the right way to go after really attractive strategic assets that are a good strategic fit. Obviously, we still are going to be disciplined around returns and it really is around growth, making sure it's accretive, Making sure margins are accretive. There is a technology component. We believe it's very important that there is a Services recurring revenue component that are very attractive. So those fundamentals don't change.

Speaker 2

But your question around Using stock as a currency, that is something that we are very much open to in a disciplined way. And I like the point you made. I do believe that and again, I'm very proud of what the entire team has done here on making sure that sustainability for us And the broader ESG is not just some kind of standalone thing. It's deeply integrated into our business. It's what we do As a company and it's in our operating processes, we have incentives tied around it.

Speaker 2

And I do think that that is an area of synergy as we look at other companies that we could bring into the portfolio. So I think very good point on your part, Ryan. Great.

Speaker 8

Well, thanks. And thanks for letting me squeeze that one in.

Operator

Your next question comes from the line of Connor Lynagh with Morgan Stanley.

Speaker 11

Yes, thanks. I wanted to return to the orders, which obviously pretty much across all segments look very impressive. I'm curious and I appreciate this is Probably difficult to quantify, but I'm curious if you're seeing behavior from customers that would suggest that they are anticipating supply chain bottlenecks of their own. In other words, are you seeing Over ordering or

Speaker 3

do you think this is just representative of

Speaker 11

a very strong demand trends in a true underlying sense?

Speaker 10

Yes. Thanks for the question. I think, first of all, we are seeing great momentum on the orders front. And so We do believe that demand is coming back in a very sustainable way. I think if you break it down a little bit by our segments, I think in Water Infrastructure in particular, we're probably seeing the most natural order flow and not really an acceleration or deviation from Historical timing.

Speaker 10

When you shift over and look at AWS and MNCS, I think we're up 43% In AWS in the quarter and 70% in M and CS, there is true demand returning. But we are seeing customers try to get in line a little bit, whether it's ahead of longer lead times that we've published, Some incremental pricing actions that we've announced, more importantly, the supply chain components that we've talked about extensively on the call, All of that in combination is certainly impacting some of the buying behaviors. But I think the order momentum that we have is We're really excited about and we think it positions us well not only for the second half of the year, but as we look forward into 'twenty two and beyond.

Speaker 11

Yes, that's helpful color. Thank you. Just on the guidance, water infrastructure is the lone area where you seem to revise down the view a little bit. I'm just curious if there's specific projects or specific regions that are driving that. And I guess, How would you contrast that with the strong ordering activity that you've seen year to date?

Speaker 11

Is it more of just a temporary supply chain issue or is there something More significant underlying that?

Speaker 10

I think it's minor. We tried to tighten the range a little bit as we move into the second half, but we did have some U. S. Treatment orders That just got pushed out a little bit in this that we had in Q2 that have gotten pushed out and some of that plays through the rest of the guide. But I think fundamentally, we're seeing good orders momentum in treatment.

Speaker 10

We're seeing good orders momentum in deepwatering and transport continues to be strong. So there's nothing there from an order perspective that gives us any concern. And I view it just As we're tightening the range a little bit as we move into the second half.

Operator

Your next question comes from the line of Nathan Jones with Stifel.

Speaker 4

I had a follow-up question on the MCS order rates. Obviously, all time record, so fantastic stuff there. I know you guys account for that a little bit differently. You don't stick the entire order for a 10 year project into the backlog When you receive it, you need to have POs in hand to actually book it as an order. So can you talk about what's driving that?

Speaker 4

Is it The ramp up of projects that you had previously won or are they orders here for new projects that you're just winning now?

Speaker 10

So I think great question, Nate. I think you've got the flow well understood. The first step For us is to bring something into our backlog, and we tend to see that around large metrology Deployments. And as we get closer to the rollout phase, we start to see real orders that come in from our customers. And I think we're seeing a pop in the order rate because some of the large orders large awards that we brought into backlog Are starting to convert into orders now that some of the site access restrictions are easing.

Speaker 10

And some of it also is what I just We are seeing that some of the customers are trying to get in line sooner to get in front of some of the component shortages. But I think the backlog is a leading indicator and the orders means that it's starting to will start to convert into revenue in a more short term basis.

Speaker 2

And I would Nate, it's not so much specifically in a reaction to your question on the order flow and so forth. But We didn't call it earlier. And I really do want to give a shout out to our team within MNCS that manages our analytics business. They've been performing very well. It's really high margin.

Speaker 2

And that business really has been showing robust growth and strength. So That's it doesn't move the numbers dramatically in the aggregate, but it's very rich in margin. And I'm just I'm very proud of what the team is doing there.

Speaker 3

Great. I have

Speaker 4

a follow-up question on the restructuring expense and the high natural attrition comment. I Obviously, you were looking to take some of those heads out anyway. But can you talk about whether or not you're worried at all about high natural attrition, If you're losing talent for one reason or another and any steps you might need to take there to protect that talent base?

Speaker 2

Yes, it's again another great question. I would say, labor shortage, managing attrition, It is a challenge. It is a headache. It's something that I and management team worry about a lot. But it's not our primary challenge.

Speaker 2

I mean, I think our primary challenge right now is again working through the component shortages and the supply chain challenges, which in some cases, is an indirect Impact of labor shortage, broadly speaking. I would say one of the areas also that we are very focused on is Retaining some critical areas like software engineers, the very competitive landscape at this point in time. I mean, we are focused on it. We feel that our not only our purpose and mission as a company is very compelling For attracting and retaining a wide variety of talent. But 2, we are continuing to look at some flexible areas that we can just Drive for the retention.

Speaker 2

Obviously, the pandemic has been hard on everyone around the world. And there is some dislocation occurring right now. And We're being very thoughtful as to how we work through that. We've built any of that incremental cost into our outlook, but that's something that we are I'm going to continue to stay very close to because the talent is just so essential here in terms of what we're trying to accomplish.

Speaker 4

Great. Thanks very much for taking my questions.

Speaker 3

Thank you. Thanks, Nate.

Operator

Your next question comes from the line of Scott Graham with Rosenblatt Securities.

Speaker 3

So a couple of things. If you said it, I didn't hear it. Did you can you offer us a single point Number for what pricing was?

Speaker 10

Yes, it's about 50 basis points in the quarter.

Speaker 3

Okay. And then to that end, it looks like the pricing occurred in the applied Water and MTS segments, and it looks like Water Infrastructure pricing was negative. Is that

Speaker 10

In Water Infrastructure, it's about it's flattish. And then we did See the greatest price realization within AWS and that's where we're seeing some of the more the commodity increases hit most rapidly. And we did see a little bit of pricing benefit in M and CS, which is Tied into our contract terms with our customer. I think what's important to note is that We're going to see we do expect incremental pricing benefits as we move through the year. And you're going to see that number rise in each of our upcoming calls.

Speaker 2

Yes. So the other thing I'd add, Scott, is just and I think Sandy touched on this in her response to you was, Commodity inflation has not hit us equally or consistently in each aspect of our business. It really is a different issue of mix. So obviously, our pricing is driven by our views on obviously selling value, but dealing with commodity inflation. So We just saw more of that earlier on given the shorter cycle nature of our Applied Water business and because of some of the component shortages and other things in MNCS.

Speaker 2

I'm not saying it was not an issue in water infrastructure. Our team would not be happy hearing me say otherwise. They've dealt with it also. But it's just the timing of when those commodity inflation impacts have hit us. But we feel good about the run rate within each of the segments.

Speaker 3

I have no doubt the price is going to get better. You guys have made that clear. I just want to stay on Water and Infrastructure for one more second, then I have a quick follow-up. Then it would imply from the slide on, Slide 5 that mix was then negative Inward Infrastructure, right?

Speaker 8

Yes. That's right.

Speaker 2

So Scott, we have we did see dewatering return to growth, which was great to see. It was more in the sale of pumps into our channel than it was about the rental side, which would have driven a higher incremental margin for us with just how rich That rental side is. So it's really just a little bit of the mix of where we were seeing the return, particularly in the industrial side. You saw it in the emerging markets and you saw it in some of the areas where we serve the mining sector, and it was a lot of pump sales as opposed to the We have seen rental start to come back here. I think that's something that Could be something that we see in the second half, particularly in North America as the construction markets and other areas get going.

Speaker 10

I think one thing is important to recognize if you look at water infrastructure, if you look at it quarter sequentially, we did see an uptick in margins as we move from the Q1 to the 2nd And we think that they were well positioned on that front.

Speaker 3

Okay. And then my last question is, Sandy, this is With you, I think you said you're expecting strong margins in the second half, But flat based on the construct of your guide. That would you would be happy with your second half margins. You're pulling them strong, but I I think the guide implies that they're essentially flat, right?

Speaker 10

Yes. So I think if you look first half, second half, we expect higher margins in the second half of the year. If we look Q2 to Q3, those two quarters actually are shaping up to look very similar. They're about the same size from a revenue perspective and Our guide is very close to what we realized in Q3. And then we do expect an uptick in margins in the 4th quarter, but not as much year over year improvement in the second half.

Speaker 10

And I think that's very consistent with our guide for the year. We expected to come out of the gate strong from a margin expansion perspective. And I think we've realized about 300 basis points of margin expansion In the first half, as we look into the second half, we don't have that same tailwind. Last year, we had restructuring And most of those savings came in the second half of the year and we realized that in the first half of the year. And I think we've also been very purposeful about How we phased our investments, so we were purposely phasing those in, in the second half of the year and some of those investments We'll start to ramp up a little bit in the second half.

Speaker 10

And then, of course, inflation is just higher than what we had Initially incorporated into our initial guide. And I think those are all the pieces.

Speaker 2

Yes. I think the only thing I would add, Scott, is that I think probably the most The read through is how we see margins in our backlog. We are looking at very high backlogs here. The margin looks very, Very encouraging, very sound, taking into consideration pricing, the mix, etcetera. So it sets up well for even more for 'twenty two and beyond.

Speaker 2

And it's Andy, we are making some investments here in the second half, as you would expect us to do. I mean, we always do, but we were purposeful on how we phase those into our outlook.

Speaker 3

Patrick, do you mean that the margins in the first of all, Sandy, thank you for that clarity. That was great. Patrick, do you mean margins in the backlog are up versus the first half gross margin?

Speaker 2

What I'm saying is margins will continue to Continue to be accretive coming through the backlog.

Operator

Your next question comes from the line of Andrew Buscaglia with Berenberg.

Speaker 9

Morning, guys. Good morning. As of last year, you guys were talking, things seem pretty positive Around some movement in emerging markets. And things sound like they're going okay so far year to date. But I wonder, You mentioned some site access issues, just broadly and some other some of your peers are experiencing similar things.

Speaker 9

So what about Some of these countries that are maybe less vaccinated, do you think puts a pause in what you're seeing? Do you think there might just be a lag there before we start to see some of that?

Speaker 2

Sure. Yes. Phil, I mean, you're absolutely right. I mean, we are very global business. And so we monitor This whole issue of not just the most recent variant, but the pandemic overall very closely.

Speaker 2

And we've not seen any meaningful change in customer demand as a result of that. Obviously, we continue to take all precautions to keep our own people safe to respect our customers' protocols. And I'm very, very proud of the work that the team has done from the very get go. I mean, Q1 of last year, we saw a first in China And it's hard to believe now we're a year and a half on. But our teams are very disciplined around this.

Speaker 2

We the really, I mean, despite the sharp deceleration in India in the quarter because of the delta variant there, We still saw very strong growth in emerging markets collectively. China, most notably, but Eastern Europe and others Are performing extremely well. So we're keeping it close eye. But again, really haven't seen any meaningful impact as of now on the Delta variant.

Speaker 9

Yes, interesting. Okay. And then just broadly, it's been an active year for M and A. I'm just wondering What's the latest with you guys on that front? It definitely seems like you're in a strong position to make a move if you'd like to.

Speaker 9

So any sort of update there would be great.

Speaker 2

Yes. So, again, our the pipeline is very active and attractive And again, it's a combination. We I always bring it back to what are we solving for with M and A. And so We look at it first by end markets in terms of what we're trying to build out in our offerings for customers. And then I look at it, we look at it from a technology and kind of Application standpoint, I'd say on the utility side, we will continue certainly second half this year and onward, we will continue To look at and do bolt ons and tuck ins from a technology standpoint to round out that Utility offering and feel very encouraged by what we see in the pipeline there.

Speaker 2

We talked a lot in the past about industrial And certainly that continues to be something we are very interested in and we've got an active pipeline there. As I always say, it takes 2 to tango. And so we can't control the timing of when these things happen, but we continue to cultivate those opportunities. And then there are other verticals, I mean in commercial and regi and ag that we certainly keep on our radar screen to look at. So We feel good about the pipeline.

Speaker 2

And you'll see some things there that we'll continue to do on the bolt on front. And we'll continue to cultivate some of the larger opportunities here over time. We're going to continue to remain disciplined on valuation. And as I mentioned earlier to one of the other questions, we certainly are open to using our stock as a currency Where it makes sense, so that will not be a disabler, it's an enabler, when and if that makes sense to do. Got it.

Speaker 2

Thank

Speaker 1

you. Thanks, Andrew.

Operator

Your next question comes from the line of Joe Giordano with Cowen.

Speaker 6

So now it's one question. Okay.

Speaker 1

All right.

Speaker 3

Yes. So just like with Delta and Fotis, if you touched on this earlier, but are you hearing just on the margin, like You said orders are kind of getting released because of site access opening back up. How are you like viewing the risk internally of that being walked back by your customers a little bit with like Vaccine requirements and having that issue in that.

Speaker 2

Yes, no, it's definitely something, Joe. I mean, my comment when I say, we're monitoring Closely, we've rather thus far. We've not seen meaningful impact. You're absolutely right to remind all of us. And we certainly are on top of it that We don't take this for granted.

Speaker 2

And I think again, we do build contingency plans into our thinking here as a leadership team. Unfortunately, we've had too much experience in dealing with this over the course of the last year and a half and have weathered it well. But we just all I'm saying is we haven't seen it yet at this point in time. And obviously, we We're being very vigilant. We're encouraging vaccinations within our own team.

Speaker 2

We are During the face masking, we continue to maintain all necessary safety protocols within our own operations and again, Very much respecting the wishes of our customers. I would say that one of the things and you probably heard this elsewhere, Joe, is at least from a deal flow standpoint, I think we've all kind of learned how to negotiate these projects and do these deals without being in front of each other all the time. I don't think that's going to change dramatically. To your point, it really is, but when the deal actually has to get executed and something gets implemented and installed, yes, we keep our eyes wide open for that. But again, we've not

Operator

Your next question comes from the line of Jacob Levingston with Melius Research.

Speaker 2

Good morning, everyone. Good morning, Jake.

Speaker 12

Just had a well, I mean, I think it's pretty unusual that we're talking about having your working capital improve At these levels in the middle of an upcycle, so maybe you can parse for us what's really driving that. Certainly not the Q1 we're seeing that, but Is it lean manufacturing? Is it restructuring? Is it the supply chain initiatives? Really just any color you can provide there would be helpful.

Speaker 10

Yes. Thanks for the question. I think the team is doing really good work keeping their eye on all of working capital and That's one of our key KPIs that we monitor very closely throughout the year. And I think it's really it's All aspects of working capital. So our credit and collections team is doing a really good job driving down the past due.

Speaker 10

So we're seeing Good results there. On the inventory front, actually, we'd actually like to carry a little bit more inventory right now to manage through some of the Supply chain challenges, and we had actually built into our plan building up a little more inventory. But the reality is as soon as we are getting that in, It's going back out the door to meet demand, which is a good thing. And we have an Active supply chain financing program that helps us take advantage of our strong credit rating and we're seeing good adoption with some of our suppliers on boarding into that program and that's giving us some benefits. So it's really across the board and we're going to continue to drive it through for the rest of the

Speaker 12

year. Thanks, and I appreciate the color. I'll pass it on.

Speaker 13

Thanks, Jason.

Operator

Andrew, your line is open.

Speaker 13

Yes. Hi. Good afternoon. I think it's the afternoon now. How are you guys?

Speaker 5

Can you give us

Speaker 13

more color into your Applied Water business? I I know Residential is smaller than commercial, but residential seems to be driving quite a bit of strength. So how sustainable is that? And then in commercial, it does seem like your commentary

Speaker 2

Let me take the first piece and then I may ask you to repeat the second part of your question. On Applied Water, I would remind everybody that It is predominantly a GDP kind of business. I mean, we're confident that we can outperform that and grow faster than GDP. But what we're seeing right now is obviously a fair amount of reopening activity. And so some catch up there.

Speaker 2

Obviously, it's a short cycle business. So as we've gone out with Successive price increases, there has been some pull in and buy in there, no doubt, but we do feel good about the momentum. I would say also One of the things that we're very pleased about there is, the team has made an increasing number of investments in new product development In that business to refresh some product lines and so we're seeing the impact and success of that and we're going to continue to make those investments, really focused on things like energy efficiency as one example. But Again, I think that it's a similar rebound right now that we're seeing from previous downturns on a global scale. So Good about it, I think it's sustainable.

Speaker 2

But again, that really what explains here in the immediate term what that stronger demand is. And again, we expect that to continue Through the second half of this year and into 'twenty two.

Speaker 13

And Patrick, I was just the second part of the question was around commercial Specifically, I mean it does seem like your commentary has turned more positive here. Obviously, we're all worried about the virus, but anything specifically that's changed in your business over the

Speaker 2

Yes, that's okay. Thank you. Yes, our average so if I talk about it first in the U. S, our replacement business, which is our book and ship It's very solid there. And we do expect new commercial building to be a bit soft Through 2021, so that's not really driving our growth here.

Speaker 2

It really is a replacement piece. You may have heard us say before, when we talk about commercial, we talk about the institutional sector of commercial, not so much kind of the pure non res. And that outlook actually is improving. And we think that will further improve just based upon some of the discussions around infrastructure spend, etcetera. We've also seen healthy activity in Europe, where we had double digit growth in the Q1.

Speaker 2

That's come from some modest share gains, as well as we believe the resilience of our supply chain versus some of our peers. And again, really focusing on new product launches. It's tied to things like smart drives, Again, eco friendly products being launched, the whole energy efficiency play that we're trying to get ahead of in terms of impending regulations That are coming forward.

Speaker 13

Thanks, Patrick.

Speaker 2

Thank you.

Operator

Your next question comes from the line of Pavel Molchanov with Raymond James.

Speaker 3

Just one It will be about software in your M and C business. Can you give an update on what the demand picture looks like In terms of digitization, virtualization from the utility sector vis a vis Software Solutions.

Speaker 2

Yes, certainly. We are and we'll talk more about this at Investor Day with real hard specifics and numbers around that to dimensionalize kind of where we see the Conversion kind of pace being within the utilities specifically. But no, we are encouraged By the adoption there and that is not only a U. S. Phenomenon, we're seeing that in Europe and the emerging markets as well.

Speaker 2

And it really is what we see it's tied to most importantly is around affordability. As we as our utility customers are looking to deal with these challenges in front of them around against scarcity, Water equity, building resilient infrastructure, it always comes down to how they're going to pay for it. And that's where we're really getting most traction right Now is whether it be around reducing the initial capital outlay because of smart infrastructure, whether it be reducing things like water losses, which is immediate revenue generation for them. Those are the areas that we're seeing most traction right now in that dialogue. And we're seeing some of those pilots that we've been talking about the last year or more, really converting now into sustainable revenue.

Speaker 2

So Absolutely interest, absolutely adoption. Wish it was even faster. We'll have more to talk about that in the Investor Day.

Operator

At this time, there are no further questions. I would like to turn the floor to Mr. Decker for any additional or closing remarks.

Speaker 2

Well, thank you. Again, thanks for all of you for your continued interest. We look forward to our Investor Day On September 30th, again, as I mentioned, Matt and the team will keep getting the details logistically out to you very shortly. Meanwhile, Stay safe, stay well, and we wish you all the very best. Talk to you soon.

Operator

Thank you for participating in today's conference call. You may now disconnect your lines at this time.

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Earnings Conference Call
Xylem Q2 2021
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