Xylem Q1 2022 Earnings Call Transcript

Quartr
Provided by Quartr
May 4, 2022

There are 13 speakers on the call.

Operator

And the floor will be open for your questions following the presentation. I would now like to turn the call over to Matt Latino, Head of Investor Relations. Please go ahead.

Speaker 1

Thank you, Ashley. Good morning, everyone, and welcome to Xylem's Q1 2022 earnings conference call. With me today are Chief Executive Officer, Patrick Decker and Chief Financial Officer, Sandy Broland. They will provide their perspective on Xylem's first Quarter 2022 results and discuss the Q2 and full year outlook. Following our prepared remarks, we will address questions related to the information covered on the call.

Speaker 1

I'll ask that you please keep to one question and a follow-up and then return to the queue. As a reminder, this call and our webcast are accompanied by a slide presentation available on the Investors section of our website at www.xylem.com. A replay of today's call will be available until midnight on May 11. Please note that replay number is 818hundred-nine thirty four-five fifteen three or 14022201182. Please turn to slide 2.

Speaker 1

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. 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. Please note that the company undertakes no obligation to update any forward looking statements publicly to reflect subsequent events or circumstances and actual events or results could differ materially from those anticipated. We have provided you with a number of with a summary of our key performance metrics, including both GAAP and non GAAP metrics in the appendix. For purposes of today's call, all references will be on an adjusted basis unless otherwise indicated and non GAAP financials have been reconciled for you and are also included in the appendix section of the presentation.

Speaker 1

Now please turn to slide 3 and I will turn the call over to our CEO, Patrick Decker.

Speaker 2

Thanks, Matt, and good morning, everyone. The team came into 2020 with strong momentum and they've taken full advantage of robust underlying demand around the world to deliver our 1st quarter operational results above expectations. Revenues grew 4% organically, surpassing our guidance. Despite ongoing chip shortages constraining our utilities business, supply is slowly improving, which is reflected in quarter sequential revenue growth and EBITDA margin expansion in our metrology business. Revenue strength was also broad based globally.

Speaker 2

We saw healthy growth in every region excluding China given the COVID impact there. Western Europe was a standout delivering 10% growth in the quarter. But the robust global demand for our offering comes through most clearly in the pace of order intake. Orders were up 14% for the quarter With record order bookings in every segment, MNCS set the fastest pace with a 25% order surge as the value proposition of digital technologies continues Orders performance across the portfolio pushed our already healthy backlogs to 50% growth year on year. EBITDA margin performance was also above our previous guidance due to strong price realization, which mitigated much of the inflationary pressure, while at the same time we continue to drive productivity and further simplification throughout the business.

Speaker 2

As a result of that good work from the team, We delivered EPS of $0.47 again above our expectations. The quarter did present some fresh challenges. Shauna's ongoing response to COVID is having significant impact on our business and it will have flow on effects for some time in the global supply chain. And while our European business delivered exceptional revenue growth, the euro rate began to move unfavorably. So conditions are dynamic, But the quarter's operational results show that the team is doing an excellent job navigating the challenges and managing what it can control on a global basis.

Speaker 2

Looking ahead, we're in a very strong position as structural demand continues to be robust in all end markets and regions. And we have market leadership in the categories where demand is greatest, especially in digitally enabled solutions. So we are raising our guidance for the year and are on track to deliver the longer term growth and strategic milestones we laid out at our Investor Day last fall. Before turning over to Sandy for performance detail by segment, I want to mention how proud I am of the Xylem team And of our partners for their response to the war in Ukraine. When the war broke out, the Xylem team stepped up right away to provide for the safety and well-being of all of our Ukrainian colleagues and their families.

Speaker 2

Similarly, our team has shown Extraordinary support by raising money for the humanitarian relief work of our NGO partners, whose activities include providing essential water and sanitation services, both in Ukraine and to refugees. It's become one of our most successful mass giving campaigns ever and I could not be prouder of the team. Now I'll hand over to Sandy to review the quarter's results by segment.

Speaker 3

Thanks, Patrick. Please turn to slide 4, and I'll give some additional color on our Q1 results. Given the quarter's challenges, the team did a great job delivering on our commitments with particularly strong performance on price and backlog execution. Revenue growth was healthy in all regions, led by double digit result in Western Europe and mid single digit gains in the U. S.

Speaker 3

In emerging markets, revenues grew high single digits, excluding China, which was affected by COVID shutdowns. In a moment, I'll offer detailed performance by segment. But in short, utilities was down 3%. Strength in Western Europe was offset by ongoing chip supply constraints and their outsized impact on our smart metering business in the U. S.

Speaker 3

Industrial grew 10% on increasing activity in all geographies, excluding China, with particular strength in Western Europe. Commercial was up 11%, led by healthy growth in the U. S. And residential was up 15%, also driven by the U. S.

Speaker 3

Organic orders were up 14% in the quarter. As Patrick mentioned, the quarter set historically high order intake with robust demand for our technologies across all segments. EBITDA margin was 14.2%, which was above our guided range, primarily driven by stronger than expected price realization. Year over year EBITDA margin contracted 2.90 basis points. We got healthy price realization and productivity benefits, but they were more than offset by inflation and lower volumes from chip shortages impacting our higher margin smart metering solutions.

Speaker 3

As previously mentioned, we'll continue to offset inflation with progressive price realization. Our EPS in the quarter was $0.47 Please turn to Slide 5, and I'll review the quarter's segment performance in a bit more detail. Water Infrastructure orders in the quarter were up 12% organically versus last year, with growth underpinned by sustained demand our wastewater utility business in the U. S. And Western Europe and increasing demand for dewatering, particularly in emerging markets.

Speaker 3

Water Infrastructure revenue was up 8% in the quarter. Industrial remained strong and we saw revenue acceleration in our U. S. Wastewater utility business as prior quarter order to revenue conversion delays eased. Geographically, results were mixed for the segment.

Speaker 3

The U. S. And Western Europe were up mid double digits, driven by treatment deliveries in the U. S. And healthy utility OpEx in both regions.

Speaker 3

Emerging Markets was down low double digits due to a challenging prior year compare in China and impacts from the recent COVID lockdown. EBITDA margin for the segment was down 140 basis points as strong price realization and productivity benefits were more than offset by inflation and investments. Please turn to Page 6. In the Applied Water segment, 1st quarter orders were up 8% organically, led by price and underlying global demand. Revenues increased 10% on strong backlog execution across all end markets, along with solid price realization.

Speaker 3

Geographically, the U. S. Was up mid double digits, all end markets showed strength and we benefited from the traction of new product launches. Western Europe delivered high single digit growth with healthy gains across all end markets and increased activity in large industrial accounts. Emerging markets was up mid single digits on backlog execution and activity.

Speaker 3

Segment EBITDA margin declined 380 basis points in the quarter. Similar to water infrastructure, we delivered solid price realization and productivity benefits, but they were more than offset by inflation. And now let's turn to slide 7 and I'll cover our measurement and control solutions business. MNCS orders grew 25% organically in the quarter, reflecting continued strong demand for our metrology solutions as well as healthy demand in pipeline assessment services. While a portion of our MNCS backlog includes orders that have been delayed due to chip shortages, our MNCS backlog is up 60% versus the prior year.

Speaker 3

It is now more than $2,000,000,000 As we anticipated, revenue declined 9% due to constrained chip supply. We are encouraged by the gradual improvement in availability and we realized significant quarter sequential gains. It's worth noting that the growing metrology backlog It's both margin accretive and resilient. There have been no cancellations of AMI awards. Geographically, Western Europe And emerging markets were flat with some growth from our pipeline assessment services business.

Speaker 3

Ship shortages pressed U. S. Revenues down 14%. Segment EBITDA margin in the quarter was down 4 70 basis points compared to the prior year, but higher than last quarter. As we've noted in previous calls, the business gets very strong operating leverage from higher volumes and revenues, and those are still being held back by the Supply constrained conversion of orders.

Speaker 3

We were able to partially offset those effects with price and productivity gains. And now let's turn to slide 8 for an overview of cash flows

Operator

and our balance sheet.

Speaker 3

Consistent with typical seasonality patterns, we used cash in the Q1. This year, we also strategically increased safety stocks to mitigate supply chain volatility and are carrying higher inventory balances. Our financial position remains robust with $1,100,000,000 in cash and available liquidity of approximately $1,900,000,000 Net debt to EBITDA leverage is 1.5 times. And please turn to Slide 9, and I'll hand the call back over to Patrick to look forward to the rest of the

Speaker 2

Thanks, Andy. We'll turn to detailed guidance in a moment. But as I mentioned, we are increasing our revenue outlook due to continued strong demand and higher price realization. We're also raising the bottom end of our EPS guidance by $0.05 despite increasing foreign exchange headwinds. The team is demonstrating that we are able to use our market leadership to drive price while holding and in many cases even gaining share as reflected in the level of our order growth trends and expanding backlogs.

Speaker 2

In fact, I want to give a big shout out to the team, including our channel and distribution partners for doing such a great job making sure our pricing moderated the effects of inflation. We also continue to foresee chip supply playing out much as we anticipated. We've had improved supply this quarter and we expect that trend to continue in each successive quarter through the year. Supply of chips remains well below our current needs and is expected to remain that way through at least early 2023. Yet our team along with our most critical suppliers and our customers continues to navigate the challenge and maintain current backlog while still winning new business.

Speaker 2

With our ability to capture price on surging demand and with progressive order to revenue conversion, we're confident in lifting our full year guidance. Inflation

Operator

will continue

Speaker 2

to be a significant factor of course, so we will keep driving further price realization as appropriate. In just a moment, you'll see we've significantly modified our euro exchange assumptions and that will have a moderating impact on our reported EPS. But we expect the team will be able to cover the majority of those headwinds operationally. Sandy will give more color on that at a segment level in a few minutes. But the overall picture is more positive than we previously anticipated for the year and puts us squarely on track to deliver our longer term growth and strategic milestones.

Speaker 2

When we laid out those milestones, we also detailed the strategic pillars that would enable us to deliver them. They included making it easier for customers to do business with us, making it easier for our colleagues to serve them and continuing to reduce business complexity. So today, alongside our quarterly results, we've announced that we are further unifying and simplifying our segment and regional leadership. Since the acquisitions that created our M and CS segment, we maintained a separate commercial interface to utility customers. This was necessary for some time to create a strong and focused new offering from Xylem, which has proven successful in achieving record deal wins and backlog.

Speaker 2

Now we believe we have the opportunity to move to the next phase of our journey in building a single platform, one that leverages the market leading breadth of our portfolio and makes it easier for customers to access it. We've previously done that across the rest of the world except North America. So today, we announced that we are moving to one interface for our customers across the Americas as well. We are integrating and unifying the leadership of the Americas commercial team. They will report to Matthew Pine, who will also now assume leadership of both the AWS and MNCS segments.

Speaker 2

In Europe, Hayati Arkeidis continues to lead commercial operations as well as the Water Infrastructure segment and will now lead the build out of Xylem services offering globally. And Fran Sawinka will continue to lead commercial operations across the emerging markets. As a result of the changes we've announced today, Colin Sabol will leave Xylem after a transition period during which he will focus on a smooth leadership handover and provide advisory support to me and the leadership team. Most of you know Colin and so you know he has been a stalwart contributor to Xylem's growth story since the beginning. In his 16 years with the company, Both with Xylem and our predecessor ITT, his insight has been at the center of our strategic vision.

Speaker 2

His leadership has contributed to our emergence as a market leader in digital technologies. As our MNCS orders growth shows and I am profoundly grateful to have benefited from his considerable talent and unwavering commitment. We will miss him at the leadership table and our colleagues will miss him as a leader. Turning to sustainability. Our growth framework emphasizes the creation of both economic And social value.

Speaker 2

Our performance on social value creation is highlighted in our annual sustainability report, which we'll publish later this month. I won't steal too much of its thunder, but I'm happy to share that Xylem is well ahead of schedule in reducing carbon emissions. Since 2019, we reduced our greenhouse gas intensity by 12% across Scope 1 and 2 emissions. We've also driven our own water use down by more than 20% and doubled our rate of water recycling versus just 3 years ago. The rigor and transparency of our reporting reflect our commitment to accountability as a sustainability leader.

Speaker 2

So I invite you to dig into the report when it comes out because sustainability is so fundamental to our strategic differentiation, to our investment thesis and to our growth. Now I'll turn it back over to Sandy for more color on our outlook and guide.

Speaker 3

Thanks, Patrick. Consistent with our previous presentations, we have provided key facts for each end market in the appendix. We expect healthy underlying demand will continue through the remainder of the year with modestly better volumes and stronger price realization across our end markets. Our end market outlook remains largely consistent with the view we offered last quarter with a few notable changes. We continue to expect our utility business to grow low single digits.

Speaker 3

On the wastewater side, we expect low to mid single digit growth on resilient global demand. We anticipate wastewater demand in emerging markets to continue being driven by investment in public utilities, Healthy OpEx activity as well as the benefit of our localization strategy. One note though is some shift to the second half due to the impacts from COVID closures in China. The outlook for longer term capital project spending and bid activity remains very solid globally. On the Clean Water side, we continue to expect demand to remain very robust as the AMI and the advantages of the static meters continue to gain momentum with an increasingly broad spectrum of utilities.

Speaker 3

With double digit revenue growth in the second half on improving chip supply, we expect full year revenues to be flat. We expect continued momentum in our Test and Assessment Services businesses due to increasing focus on infrastructure and climate challenges. Please turn to Slide 11. Looking at the industrial end market, we continue to expect mid single digit growth on steady demand for our solutions globally. We foresee healthy growth in dewatering, especially in emerging markets from robust mining demand and our channel expansion strategy.

Speaker 3

In the U. S. And Western Europe, we expect solid order rates and backlog expansion as activity continues to ramp in light industrial applications with considerable traction from new product introductions and large account activity in Western Europe. The commercial end market is now to deliver mid single to high single digit growth, up from mid single digit growth on solid replacement activity and new product introductions in the U. S.

Speaker 3

And Europe. In residential, our smallest end market, we now expect mid single digit growth, up from low single digit to mid single digit growth on healthy demand. And now let's turn to slide 12 and I'll walk you through our updated guidance. As Patrick mentioned, our outperformance in the Quarter is giving us brisk momentum and we are increasing full year guidance for organic revenue growth and raising the low end of the adjusted EPS range. I want to take a moment to walk you through the puts and takes of how we now see the full year.

Speaker 3

We are lifting full year organic revenue growth to 4% to 6%, up from 3% to 5%. The 1% organic growth increase is driven primarily by stronger price realization. But from a reporting perspective, we anticipate it will be offset by a lower euro. We are narrowing the EPS range to $2.40 to $2.70 which boosts the low end from $2.35 This reflects strong price realization, which will be partially offset by inflation and the euro FX headwinds. The emerging impact from a weakening euro is significant to us.

Speaker 3

Our initial full year guidance assumed €1.13 Our updated guidance now assumes €1.05 which is a $0.10 headwind to the full year EPS guide. For your reference, we have included an FX sensitivity table in the appendix. We will closely monitor the global supply chain environment and continue to proactively manage impact from China's COVID lockdowns and the secondary effects of the war in Ukraine. On slide 13, we've shown how our guidance breaks down by segment. We continue to expect mid single digit growth in Water Infrastructure, High single digit growth in applied water, up from mid single digit growth due to stronger price.

Speaker 3

We continue to expect Measurement and Control Solutions to be flattish. This assumes down roughly double digits in the first half of the year and up double digits in the second half. Although growth is still likely to be constrained by the gradual return of chip supply as the year progresses. For 2022, we still Back to adjusted EBITDA to be in the range of 16% to 17%. And this yields adjusted EPS range of $2.40 to $2.70 that I just mentioned.

Speaker 3

And we still expect free cash flow conversion to be 100% of net income. We've also provided you with a number of other full year assumptions on the slide to supplement your model. And now drilling down on the Q2. We anticipate total company organic revenues will be flattish to up 1%. This includes low single digit growth in Water Infrastructure and mid single digit growth in Applied Water.

Speaker 3

And M and CS is expected to decline low double digits. We expect Q2 adjusted EBITDA margin to be in the range of 14.5% to 15%, a sequential improvement over the prior quarter. And with that, please turn to slide 14 and I'll turn the call back over to Patrick for closing comments.

Speaker 2

Thanks, Sandy. We came into 2022 in a strong and enviable position, even in the face of headwinds from chip supply and inflation. Our performance in the Q1 has shown the team's ability to capitalize on our market leadership and deliver with discipline despite the various challenges around the world. Demand has never been greater. We have strong commercial momentum and we have a powerful balance sheet giving us strategic flexibility.

Speaker 2

And we have a great team showing resilience, agility and experience in managing the dynamics of a truly global business. While our customers are as local as water is, the biggest water challenges are global and the water sector is increasingly well networked internationally. Still Xylem is one of only a small handful of global water players. That puts us in a strong position to play a leadership role in support of both the sector And our mission to solve water. So as you likely saw in our March announcement, we made the decision to move Xylem's headquarters to Washington DC, which is one of the main crossroads of the global water sector.

Speaker 2

Washington is not just the seat of U. S. Water policy. It's where water thought leaders from all over the world convene, including the private sector, governments from around the world, multilaterals, Academia and Civil Society. We've also taken the opportunity of the move to reimagine our footprint for more flexible ways of working and simplifying and leaning our headquarters.

Speaker 2

The new location is on Water Street. Yes, it's on Water Street, right on the Anacostia River. We'll be officially opening the space in mid June. I look forward to welcoming all of you when you visit DC. Before turning to your questions, I have one more special note of thanks.

Speaker 2

This is Matt Latino's last quarterly earnings call at the helm of Investor Relations. We previously announced that Matt is taking a new role in Xylem and it's an exciting new chapter for him. I know from comments so many of you have made over the years that you deeply value Matt's Synergy, accessibility and professionalism. And I've benefited from his insightful counsel and his persistent positive encouragement through every kind of circumstance. So thank you, Matt.

Speaker 2

Some of you have already met Andrea Vanderberg, who's taking the reins as our Investor Relations leader. Andrea has had great impact as the Head of Financial Planning and Analysis for Xylem. So she brings distinctively deep knowledge of the business to her leadership of IR. I'm confident you'll really enjoy getting to know Andrea and will find great value in working with her and from her insights and perspectives. Now, operator, I'll turn the call over to you for questions.

Operator

The floor is now open for Thank you. And we'll take our first question from Deane Dray with RBC Capital. Please go ahead. Your line is open.

Speaker 4

Thank you. Good morning, everyone.

Speaker 2

Good morning, Dean.

Speaker 3

Good morning, Dean.

Speaker 4

Hey, maybe we can start with MCNS, and Just more encouraging news on the chip shortage front. Can you give us a sense now you've got record backlog orders knowing they're going to be delayed to a degree. So it doesn't sound like you've lost any competitive positioning there. So maybe we can start there. Thanks.

Speaker 2

Sure. Thanks, Dean. I'll start with the latter half of your question, then I'll have Sandy speak to the margin profile in more detail. You're right. I mean, we've I think the team's done a great job working both with the suppliers of chips, but also with our customers on hanging on to deals and backlog.

Speaker 2

So we've had no losses of deals here in terms of cancellations. Also what we're seeing is really good traction in terms of momentum, especially around midsize utilities as we're seeing greater adoption There as well, which is really encouraging. And so it smooths out kind of what our demand is going to be over time. What we would say on the chip supply as we said in our comments We've seen a gradual recovery. And so we're not changing our outlook for the full year.

Speaker 2

It's just more Confident in terms of what we're seeing there. So really encouraging. Sandy, you want to speak more to the margin profile?

Speaker 3

Yes. Thanks, Patrick, I think, Dean, when we look at the profile of the orders that we've been bringing in, we're really encouraged about the margin structure. It's accretive to the company. And as you already know, this business gets really good leverage. I think you can see that already when you look at this Quarter sequential improvement even from Q4 to Q1 where we've had about a $20,000,000 pickup in revenue and Seeing very good margin recovery as the revenue line grows.

Speaker 3

So very satisfied with the profile of the orders that we've been bringing in.

Speaker 2

Not out of the woods yet, Dane. I mean, obviously, still risk there, but we think we've got that embedded in our guide for the full year.

Speaker 4

That's really helpful. And then the follow-up question on the recent headwinds. And look, FX has always been We know your exposure. That's the math, and I'm glad you laid that all out. But how about reflect on China?

Speaker 4

It's roughly 8% of revenues. Just true me up on that. And how what's the expectations on how this We know your headquarters is in Shanghai, and just some real time update and expectations of

Speaker 2

the reopening. Sure. Thanks, Dean. Yes, so our revenue exposure is roughly $350,000,000 about 7% of our total revenue. The impact in the Q1 was about $20,000,000 in revenue.

Speaker 2

Our guide implies another $20,000,000 in Q2. So first half of the year right now would be down about 20% in revenue. Second half, we expect to be up about 20% because we saw some of the impacts of Lockdown even in the Q4 still lingering in China. We got 4 factories in China. As you said, we got our headquarters in Shanghai.

Speaker 2

3 of those factories were closed for a few weeks. Later, they opened up at 50% capacity. All 4 of our sites right now are 100% At utilization, our Nanjing plant, which is the one that supports our applied water business, it actually never closed. And that's the reason why AWS actually had mid single digit growth in China here in the Q1. So we expect there to be a gradual Opening in China, we think it's all manageable within our guide.

Speaker 2

Obviously, there's a rest there. But our people are all safe and sound and They are working their backsides off to make sure we deliver on our commitments. We did talk about also that there is the Global supply chain effect, and we think that's the one that really is kind of the wildcard, going into the second half of the year. But, we feel that we've got that embedded in our guide.

Speaker 4

That's all helpful. And just lastly, with all the comings and goings, want to wish Colin all the best. We'll miss him. He's a class act, great insights on the water sector. For Matt, well deserved promotion.

Speaker 4

I still have his cell phone. Just Welcome to Andrea as well. Thank you.

Speaker 2

Thank you, Dean. Really appreciate the comments. Thank you.

Operator

And we'll take our next question from Mike Halloran with Baird. Please go ahead. Your line is open.

Speaker 5

Hey, good morning, everyone. I just want to echo Dean's comments on the comings and goings.

Speaker 2

Thank you, Mike.

Speaker 5

So first on the On the utility side of the equation, it's kind of a broad question because it's both for the wastewater and the water side. But You look at the tailwinds that are emerging there, really across regions, and it just feels like there's a lot of momentum, With the backlog, the underlying demand, where tax receipts are, etcetera. If you take a step back and obviously you've got some geopolitical concerns out there, but What do you think could derail that momentum at this point? It seems like it's on a pretty good track.

Speaker 2

I think the it's a great question, Mike. I think from a demand standpoint, we don't see many storm clouds on the horizon here right Just where we are in the overall investment cycle, I know some may have questions even around what's happening in Europe From a geopolitical standpoint and focus on moving towards oil and gas alternatives, etcetera, will money be Derailed or directed there. That's not even the way that the funding mechanisms work in Europe, from a water utility standpoint. So we think even that's Pretty robust at this point in time. I think in the near term, the challenges remain, in our case, chip supply And just being able to continue to execute what we have in our pipeline, our bidding pipeline remains very healthy, North of almost $2,500,000,000 in the bidding pipeline at this point in time.

Speaker 2

So again, I'm paid to be paranoid. We're looking at any storm cloud out there that we could possibly see, but it feels pretty healthy right now.

Speaker 5

How far out are your backlog stretching at this point? And how do you think about the conversions? And that's more of a broad comment. I'm hoping you can compare that to what a typical conversion cycle looks like. Look, we all know that everything is getting stretched into 2023 given the chip shortages, but Help give some magnitude for how far out you have visibility at this point?

Speaker 3

Yes. I think great question. And it obviously it varies by Segment, when we look at our AWS segment, that's where we typically carry a very small backlog. But as we look over the Past 18 months there, orders have really been high and we've been constrained from a delivery perspective because of supply chain challenges. So in that case there we have a backlog that gives us really good coverage for the next quarter next couple of quarters out.

Speaker 3

In water infrastructure, it's a little bit of a mixed bag. We have some short cycle businesses there and we have some longer cycle businesses there. And so in the shorter cycle, we have coverage as we look out for more coverage than we typically have as we look out for the rest of the year. At MNCS, the story there is we keep getting orders that are outpacing the amount of revenue that we're able to deliver. And I think it's going to take us about 2 years to catch up on the demand that we have today and the balance between supply chain.

Speaker 2

And Mike, I would just I would offer up, I think, to your question around visibility from an overall market sentiment standpoint. Our bidding pipeline, especially on the treatment and on the wastewater side, meaning treatment and even on the clean water side being metrology, We've got visibility there and a bidding pipeline of at least 2 to 3 years out. And that's why we're speaking with the level of confidence around what the overall market sentiment is.

Speaker 5

Thanks for that. And then follow-up then is the capital deployment side, you've been pretty constructive the last few quarters on What the pipeline looks like and seems optimistic on your ability to convert some of that pipeline, maybe just an update on what you're seeing in the market and how actionable it is?

Speaker 2

Sure. Yes. So we still feel really good, Mike, about the pipeline in terms of opportunities and may range from larger opportunities So it moves into various end markets. But even in the small to medium size opportunities that are there, We've got some things here that we're pretty excited about in the near term that hopefully we'll be able to execute on. So more to say there over the coming quarter or 2.

Speaker 2

But in general sense, we feel I feel certainly we feel the M and A pipeline is as healthy as it's ever been. But we're we continue to be disciplined on valuation.

Speaker 5

Really appreciate it. Thanks everyone.

Speaker 2

Thank you.

Operator

And we'll take our next question from Conor Langer with Morgan Stanley. Please go ahead. Your line is open.

Speaker 6

Yes, thanks. Just wanted to follow-up on that capital allocation conversation. So given what the share price has done, I'm assuming that you would Be less interested in using share currency for deals, but just curious how you view the calculus of that, how you think about Share repurchases, how do you complete the competing uses of capital between organic investment, M and A and buybacks and sort of how you pay for M and A?

Speaker 2

Sure. Yes. So again, we come into the year with really strong balance sheet. Sandy laid out what our firepower is at this point in time, and we are not hesitant to do deals. Obviously, we're going to be disciplined around valuation.

Speaker 2

I would not preclude equity from being used in the right situation, but it's not our first lever to really lean on Around capital deployment in general, we also don't see M and A and any repurchase of shares being at odds with each other. In the past, we've used share repurchase authorization that we have out there right now to offset dilution of our long term incentive grants. But we realize now there are times to be opportunistic given the current environment. And again, we think we're able to be both opportunistic on share repurchase as well as still do Strategic M and A, these are not binary decisions in our case.

Speaker 6

Makes sense. And I just wanted to follow On a separate line of questioning from earlier, which is basically it seems like your customers at this point have to be pretty aware What's going on in Chip Supply Chain? I'm curious, have they changed their behavior around awarding new contracts? Is most of the ordering that you're seeing related to existing customer relationships or has the pace of sort of newer deployments stayed steady, Accelerated, decelerated. And on the other side, are you changing how much you're bidding, where you in terms of timeline or how How aggressive you're being on some of these bigger projects given the time to deliver?

Speaker 2

Sure. Great question. So let me parse it apart a bit. In terms of kind of existing contracts and deals, we've seen no cancellations there. Our customers Are very well aware of the challenges.

Speaker 2

In many cases, they've got multi source and so they're seeing the same thing from our competitors along the way. So They realize that we're not alone here. But secondly, it's the fact that so much work Has gone into getting the regulatory approval of these large AMI deployments. The returns on investment for them are so substantial in terms of revenue generation That they just want to continue to move forward and execute these things. And so the likelihood of them going back is minimized in that context.

Speaker 2

Are they frustrated? Of course, we all are. But we've been weathering this for a while now and we've been working closely with them to find alternatives just to meet their needs, even though it may not be the level of metrology they originally spec, it's good enough right now to move forward, But still with a clear view of what the original approved implementation is going to look like. In terms of new deals, yes, this is not just with existing customers. We're winning a number of new customers along the way, especially in that medium sized part of the utility sector, which is really encouraging for us.

Speaker 2

In terms of Changing our own behavior, we are we've been very disciplined along the way on being very open and forthright on what delivery frictions are right now, so that we are not over promising and under delivering To any new deals that we're winning, we're being very clear about that. And I think customers appreciate that transparency as I'm sure our competitors are being transparent As well with them on what their own delivery lead times are.

Speaker 6

All right. Thanks very much. Thank you.

Operator

And we'll take our next question from Nathan Jones with Stifel. Please go ahead. Your line is open.

Speaker 1

Good morning, everyone.

Speaker 2

Good morning, Nate. Good morning, Nate.

Speaker 7

Patrick, I'd like to follow-up on some of the comments there about medium sized utilities Starting to adopt this AMI technology. All of the conferences I've been going to, which admittedly are probably larger utilities that are attending those, It seems like the shift to AMI is going to become ubiquitous here and it's the inflection point has been hit and I don't think there's any doubt that that's getting adopted. So it's Definitely encouraging to hear about medium sized utilities beginning to get on board with that kind of stuff. Can you talk about the market opportunity that that presents? Because I know a few years ago when you bought Sensus, it was really targeting those larger and leading utilities To try and drive that waterfall down into the market.

Speaker 7

So just any update you can give us on what you're seeing out there, what that market opportunity could be, How long that drives this high level of order growth for you?

Speaker 2

Sure, Nate. Again, good question. You're right. We have been very focused on the large utilities initially, because in many cases, as you well know from the conferences that you attend, Oftentimes, the medium to smaller utilities are looking to some of the larger ones for the lead in terms of proven technology, etcetera, but not always. I mean, they've got their own They've got their own minds and their own investment plans.

Speaker 2

Oftentimes for those medium utilities, they're looking at entire implementations of AMI as opposed to Maybe for a larger metro area, it could be sections of a city. So when they make the decision to go full scale, It takes them a little bit longer to make that decision because it's a bigger strategic choice for them to make. And so it is encouraging To see that level of adoption happening, they also their timing typically is tied more to the retirement The existing metrology deployment that they have within their cities or communities. And so we see this as being a really healthy Steady stream of conversion over time, because while they may study, AMI for a while, getting ready for A complete upgrade or overhaul. These things are phased out over time.

Speaker 2

It's not going to happen all within a few years. It's going to be staged out over a decade or more, at least across the course of the U. S.

Speaker 7

Which is then good for long term demand trends. I think is the point that I'm trying to get to out of that, that you should have that steady stream of continued orders in the M and CS business. Yes, I think on Okay.

Speaker 2

Nate, sorry, just really quickly. I mean, just another data point for you. I know you're aware of this and maybe others are not. I mean, again, when you think about the U. S.

Speaker 2

Alone, We're talking about more than 50,000 water utilities. And the largest majority of those are small to medium size. So that's why we're so excited about this part of the market. And still less than half of that market has adopted AMI.

Speaker 7

Yes. I did want to ask one on price cost. The math I did this morning shows you're about $35,000,000 negative on price cost and that's responsible for a large portion of the Margin compression that you saw year over year. Great to see the pricing step up from 200 basis points in the 4th quarter to 4 20 basis points in this quarter. Can you talk about the outlook for continuing to close that gap and to generate more price to cover the inflation that you're seeing in the business?

Speaker 3

Yes. Great question, Nate. This is something that our teams have been very focused on. And since we saw inflation start to rise last year, we've implemented numerous price increases. In some cases, we had to work through existing backlog before the new prices took effect.

Speaker 3

And so we saw a big step up from Q4 to Q1 in our price realization. And as we look forward throughout the year, we would expect that to continue to ramp in each successive quarter. As we look at Q1, we our price did cover material inflation and freight. But you're right, we were still underwater. We didn't cover Sort of our labor inflation or overhead inflation, as we look out to Q2, we expect that to be neutral.

Speaker 3

And then in the second half of the year, price should outpace the inflation effects. And I think it is important to note in our guide, We did increase it for stronger price realization based on what we experienced in Q1 and what our outlook is for the next quarter. And we also did up our inflation outlook.

Speaker 7

So the point there is that by the second half of the year, those Price and inflation numbers that you put on the first page of the slide deck are going price is going to cover all of that inflation?

Speaker 3

That's our expectation.

Speaker 7

Great. Thank you very much.

Operator

And we'll take our next question from Brian Lee with Goldman Sachs. Please go ahead. Your line is open.

Speaker 8

Hey, everyone. Thanks. This is Miguel on Brian Lee. Thanks for taking the question. I just had 2 quick ones, follow-up questions from the prior questions.

Speaker 8

On price cost real quick, So price cost was it seemed negative in the Q1. I think that was expected. And then you just mentioned expected to

Speaker 3

That's our expectation for the full year, yes.

Speaker 8

Okay. Thanks. That's helpful. And then I appreciate all the Additional color on the backlog on MNCS. So the backlog gives you visibility on orders For I think you said next 2 to 3 years.

Speaker 8

I know you haven't seen any cancellations yet, but at what point would customers consider canceling orders if the lead times Become so stretched out or maybe is there a way to think about it where our customers intentionally placing orders well in advance of projects to get They're spot in line. Hopefully that makes

Speaker 2

sense. Sure. Yes. So we've not seen any there's been no double ordering in that regard. I mean the team is very disciplined Around that and the nice thing about these large metrology implementations is we know exactly what the endpoint count is that they need.

Speaker 2

And so we work very closely with our customers there to make sure that we're not taking duplicate orders. We are prioritizing Customers, we have someone allocation. Obviously, we're trying to prioritize those that are most stressed at this point in time. You never say never on these things in terms of at some point in time somebody canceling. But I think again, as I mentioned earlier, The customers understand that there are few other alternatives and these implementations have gone through such rigorous long range regulatory approvals And they're so critical to their own revenue generation capability, that as long as we're able to meet their kind of Basic demand as best we can and give them as full transparency as possible.

Speaker 2

We've been very proud and very pleased in working with them As well as with our chip suppliers, we talk a lot about the customers. We are working as closely as possible with our suppliers To redesign a number of our chip requirements for next generation, we're redesigning our own products to meet minimum needs here in the immediate term. It's a multifaceted angle here and that's why I'm so proud of the effort of the team to navigate this, including our customers' patience.

Operator

And we'll take our next question from Andrew Buscaglia with Berenberg. Please go ahead. Your line is open.

Speaker 9

Hey, good morning, guys. Good morning. Just looking at your organic growth guidance raise, So underlying that applied water is really the only one you nudged up. I was surprised infrastructure, you wouldn't you weren't willing to take that up. And could you so could you comment on that first off?

Speaker 9

And then secondly, Shouldn't we start to see some of like the benefits of this water infrastructure stimulus bear fruit later this year? Or what are you guys thinking on that front?

Speaker 3

Yes. I think when we looked at adjusting our revenue guide and our forecast, The primary reason that we adjusted it is for a stronger price realization and we're seeing that in AWS more than any other segment. As we look out for the rest of the year, we're still monitoring chip supply for the other segments. And water infrastructure has a high concentration in China. When we saw the impacts in Q1 from China, they were largely concentrated in water infrastructure and that's also where we'll see the impact in Q2.

Speaker 2

And on the infrastructure bill, No real meaningful change there. I mean, we do think it's going to be a positive over time. Don't really see that being a big impact here in 2022 as things continue to settle out. We see that more as a benefit in 2023 and beyond.

Speaker 9

Okay. And then Just to be clear, so you obviously expect some nice pricecost tailwinds in the back half of the year. But based on your Q2 guidance, it really does That's some pretty big step up in margins in the second half. Is there anything else specifically that would provide that tailwind beyond just price cost? Or is it Yes.

Speaker 9

Recent cost savings or anything that you expect will drive higher incrementals or something like that?

Speaker 3

It's really four things. You touched on the first thing. The first thing is price cost and that will continue to improve throughout the year. The second thing is chip supply in MNCS as that Revenue ramps in the second half, it has very good contribution margins. The third point I would say is China.

Speaker 3

We have a very modest We have revenue declines in the first half in China. We're expecting to see a good pop in the back half in China. And then we announced today some leadership changes. We're pursuing some simplification opportunities and some of those will drive cost savings in the back half of the year as well. Okay.

Speaker 9

Yes. And presumably free cash flow, same thing. You're in kind of a hole in Q1, but as that EBITDA goes up, you'll generate more cash and then I Looking capital management probably takes over from there.

Speaker 3

Yes. What we saw from a free cash flow perspective Q1 is very much in line with our historical patterns. We typically use cash in the Q1. As we work through the rest One of the things you may note is that our inventory balance is up. That was purposeful.

Speaker 3

We've taken on some incremental inventory to try to mitigate some of the impacts of the supply chain challenges. And we're going to be thoughtful as we try to work that down in the back half of the year.

Speaker 7

Okay. Thank you.

Operator

And we'll take our next question from Scott Graham with Loop Capital Markets, please go ahead. Your line is open.

Speaker 10

Hi, good morning, Patrick, Sandy, and once again, congrats,

Speaker 2

Matt. You'll be great.

Speaker 5

So I have

Speaker 10

sorry to be dead horse here on this Sandy, but the pricing and the price cost, Now I think I heard you say during your prepared comments that you had increased your assumption for inflation. I'm just wondering whatever other metrics you can give us around pricing would be helpful, whether it's where you're expecting that ramp to go in the second Or what your full year pricing will be, because the gap is still pretty large right now. So anything you can give us on pricing To give us a little bit more color on what you mean by ramp? Thanks.

Speaker 3

Yes. I think just to give you some context, Scott, in Q4, we had about 200 basis points impact from our price increases. That doubled to 400 basis points in Q1 And we would expect that to continue to increase. Since the invasion of Ukraine by Russia, we've seen some of our commodities increase Our costs, particularly around stainless steel, which is impacted by nickel. And so as we roll forward inflation assumptions for the next three quarters, We see more headwinds in the neighborhood of $40,000,000 to $50,000,000 And so in response to that, our teams have gone out and implemented Incremental price actions, some that were they were not contemplated when we put together our budget.

Speaker 3

And so our teams are acting quickly. We've changed some of the practices around price increases. We used to have over a 60 day lag time between when we announced a price increase and when it went into effect. And now we're down to less than 2 weeks across our businesses.

Speaker 2

And I would just offer up, Scott, that Again, I think what we've been really pleased with is the resilience of our volume and our share, and in some cases, even gaining share in certain parts of the business. And so we The market really has shown a level of resilience in this area. And I think again, we've been acting as a leader in this area. And So pleased and as things continue to move from an inflationary standpoint, we'll continue to act responsibly.

Speaker 5

Yes. The only

Speaker 3

thing I would add, Scott, is the impact on our margins, price cost has gotten a lot of attention. The secondary impact is mix. When you look at our revenue mix with MNCS being down this year, the revenue that we've lost because of the chip Supply constraints comes with high margins.

Speaker 10

Yes, get it. I was going to say who would have thought utilities would have given up So much on pricing, but it's a brave new world out there. Okay. My other two questions are around, what is the percentage of the backlog for MNCS that is being held up by the shortages. If you got it, you could ship it kind of thing.

Speaker 10

What's that percentage?

Speaker 3

Yes. So I think if you look at our MNCS backlog, it's around $2,000,000,000 And we have, I would say between 20% 25% of that backlog is held up by the tip delays. And that's been growing each quarter because our Orders have been outpacing our revenue conversion.

Speaker 10

Yes, got it. And then lastly, Sandy, I know as you entered here, I guess it's over a year ago now. I don't know, have you ever calculated it or you and Tony calculated What is the organic sales rate that you guys need to generate a certain level of operating leverage? Is it 35? I mean, how do you look at that?

Speaker 3

I'm not sure I totally follow your question, Scott. I think we when we model our long range plan, we Understand assumptions around inflation. We also set productivity targets across our organization, shrink centers and across the functions. And we have a goal as an enterprise for productivity to outpace Inflation now, the past 18 months have been a little bit different, but that's our overall philosophy.

Speaker 2

And I think Scott, the I mean just some other Trying to parse out your question here. I mean, if you think about the incrementals in this business, I mean, any dollar of growth that we get And this business is going to drop very healthy incrementals to the bottom line between the 30%, 40% range. In terms of what we've laid out in our Long term guide is in that mid single digit range, which obviously really drives heavy margin expansion, especially given the mix with MNCF. So Maybe that helps frame out a little bit, but I mean this is a business that generates very healthy incrementals at whatever level of growth there is.

Speaker 9

Yes. I got it. Thank you both. Thank you.

Operator

And we'll take our next question from Pavel Mark Connaugh with Wainwright James, please go ahead. Your line is open.

Speaker 11

Thanks for taking the question. First on the M and A front, Given that blue chip companies such as yourself are struggling with semiconductor and other component availability, it's Presumably, safe to say some smaller players are struggling even more. Does that create any kind of opportunistic Quasi distressed M and A opportunities that perhaps you would not have seen a year ago?

Speaker 2

It's an interesting angle. It's not really one that we're prioritizing right now. I mean, the things that we have in the Again, we really focus on the strategic logic behind them in terms of the long run. We kind of look through this cycle In terms of chip demand, I understand where you're coming from with the question, but I wouldn't say that that's really heightened our view on any particular asset based upon chip

Speaker 11

Understood. Following up on Europe, the weakness in the currency, Does that reflect any underlying softness in kind of European GDP and demand patterns that might impact the volume in the second half of the year?

Speaker 2

Not as we see it. Based upon our experience in Europe over many years, Europe is Very resilient when it comes to underlying demand. So it's a much heavier OpEx element there in terms of repair replacement of installed infrastructure. It's less reliant on new CapEx. And even when there is new CapEx, the funding mechanisms tend to be Pretty well sheltered at least in the larger economies across Europe.

Speaker 2

I'm not saying there are no economies that are not immune But we've really never seen big swings there on the CapEx side. In terms of What we do see is the lion's share of our business there is repair and replacement, which is very stable, very steady, as well as really attractive margins. And so we feel pretty confident right now around the outlook for Europe As we see it today. Thanks

Speaker 11

very much.

Speaker 2

Thank you.

Speaker 1

Ashley, I think do we have any more questions?

Operator

We'll go next to Joe Giordano with Cowen. Please go ahead. Your line is open.

Speaker 12

Hey, guys. Thanks for squeezing me in here.

Speaker 2

Sure, Joe.

Speaker 12

We talked a lot about price, but just curious how you think about like is there a level where Just the amount of price that's required to increase, like just starts causing demand destruction because projects start to be to not make sense and customers are like, I understand why you're raising, but Just not going to buy right now?

Speaker 2

Joe, it's something that our teams stay close to every day. That's one of the biggest challenges obviously in this kind of inflationary environment is where is that limit. And we're always looking at win loss ratios. We leverage our capabilities in sales force And our bidding pipeline there to get a feel for what that trade off is. And so the team stays very close to that.

Speaker 2

We look at that on a regular basis. And so Until we see meaningful moves in that win loss ratio, that tells us that we need to continue to make sure we cover the inflationary impacts. What we're encouraged by thus far is that in the areas where we've taken price increases, we continue to see volume growth in those businesses. And so that's a good healthy indicator as well. But it's not something by any means, Joe, that we take for granted, Something we're very, very close to.

Speaker 12

Just last, Patrick, I think raising the low end of the guide was it was Such an important kind of tone here for you guys. But just on the other side of that, was there thoughts on trimming the high end and maybe talk through Your thoughts around that and or what the scenario is that gets you there this year?

Speaker 2

Sure. Yes. I mean, yes, we know you can imagine All management teams spend a lot of time thinking about when you make a change in guidance, how you want to approach that. We just felt that it was Prudent at this point in time and confident to raise the lower end. Trimming the top end, we still see a path there.

Speaker 2

And obviously, things have to go in the right direction. But and obviously, there are clouds on the horizon that every company is seeing right now, But we see a path there and we'll continue to monitor that. In terms of what those are, it's what we've talked about before. We need to continue to see Pricing momentum, we need to continue to see improvements in the chip supply and delivery around those areas. And Hopefully, we'll see some improvement on the outlooks for China.

Speaker 2

China is not a demand issue for us. It's really a matter of when we're able to ship out our backlog there as well as mitigate what the downstream impacts on the supply chain are.

Speaker 12

Thanks guys.

Speaker 2

Thank you, Joe.

Operator

And there are no further questions at this time. I'll turn the call back over to Patrick Decker for additional or closing remarks.

Speaker 2

Well, thank you all again for your time and attention this morning and for your support, and look forward to catching up with you between now and the next earnings call.

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Earnings Conference Call
Xylem Q1 2022
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