Xylem Inc (XYL) — Q1 2022 Earnings Call Transcript

Thank you, Ashley. Good morning, everyone, and welcome to Xylem's First Quarter 2022 Earnings Conference Call. With me today are Chief Executive Officer, Patrick Decker, and Chief Financial Officer, Sandy Rowland. They will share their insights on Xylem's first quarter results and discuss the outlook for the second quarter and the full year. After our prepared remarks, we will take questions related to the information covered during the call. This call and our webcast are supported by a slide presentation available in the Investors section of our website. A replay of this call will be available until midnight on May 11, and the replay number is 1-800-934-5153 or 1-402-220-1182. Please look at Slide 2. We will be making some forward-looking statements during this call, which may reference future events or developments that we expect will or might happen. These statements carry risks and uncertainties, as outlined in Xylem's most recent annual report on Form 10-K and in subsequent SEC filings. The company is not obligated to publicly update any forward-looking statements to reflect new events or circumstances, and actual results could differ significantly from our expectations. We have provided key performance metrics, including both GAAP and non-GAAP metrics in the appendix. For today's discussion, all references will be on an adjusted basis unless stated otherwise, and non-GAAP financials have been reconciled and are included in the appendix of the presentation. Now please turn to Slide 3, and I will hand the call over to our CEO, Patrick Decker.

Thanks, Matt, and good morning, everyone. The team came into 2022 with strong momentum, and they've taken full advantage of robust underlying demand around the world to deliver our first 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. 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. M&CS at the fastest pace with a 25% order surge, as the value proposition of digital technologies continues to fuel demand. 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. 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. China's ongoing response to COVID is having a 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. 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. 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 for the 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.

Thanks, Patrick. Please turn to Slide 4, and I'll give some additional color on our first quarter 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 a double-digit result in Western Europe and mid-single-digit gains in the U.S. 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 were 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. 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. 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 290 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. 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 in our wastewater utility business in the U.S. and Western Europe and increasing demand for dewatering, particularly in emerging markets. 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. The U.S. and Western Europe were up mid-double digits driven by treatment deliveries in the U.S. and healthy utility operational expenditure in both regions. Emerging markets were down low double digits due to a challenging prior year comparison in China and impacts from the recent COVID lockdown. EBITDA margin for the segment was down 140 basis points; strong price realization and productivity benefits were more than offset by inflation and investments. Please turn to Page 6. In the Applied Water segment, first 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. 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 were up mid-single digits on backlog execution and activity. 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 & Control Solutions business. M&CS orders grew 25% organically in the quarter, reflecting continued strong demand for our metrology solutions as well as healthy demand pipeline assessment services. While a portion of our M&CS backlog includes orders that have been delayed due to chip shortages, our M&CS backlog is up 60% versus the prior year. It is now more than $2 billion. 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 is 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. Chip shortages pressed U.S. revenues down 14%. Segment EBITDA margin in the quarter was down 470 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. 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 and our balance sheet. Consistent with typical seasonality patterns, we used cash in the first quarter. 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 $1.1 billion in cash and available liquidity of approximately $1.9 billion. Net debt-to-EBITDA leverage is 1.5x. And please turn to Slide 9, and I'll hand the call back over to Patrick to look forward at the rest of the year.

Thanks, Sandy. 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 prices while holding and in many cases, even gaining share, as reflected in the level of our order growth trends and expanding backlogs. 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 continue to navigate the challenge and maintain current backlog while still winning new business. 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 will continue 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. 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. 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&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. 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 M&CS segments. In Europe, Hayati Arcadis 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 Sabinco will continue to lead commercial operations across the emerging markets. As a result of the changes we've announced today, Colin Sable 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. His leadership has contributed to our emergence as a market leader in digital technologies, as our M&CS 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. Our performance on social value creation is highlighted in our annual sustainability report, which will publish later this month. I won't steal too much of his thunder, but I am happy to share that Xylem is well ahead of schedule in reducing carbon emissions. Since 2019, we have reduced our greenhouse gas intensity by 12%, across Scope 1 and Scope 2 emissions. We've also driven our own water use down by more than 20% and doubled our rate of water recycling compared to just 3 years ago. The rigor and transparency of our reporting reflect our commitment to accountability as a sustainability leader. So I invite you to dig into the report when it comes out because sustainability is fundamental to our strategic differentiation and investment thesis.

Thanks, Patrick. Consistent with our previous presentations, we have provided key facts for each end market in the appendix. We expect healthy underlying demand to 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. On the wastewater side, we expect low to mid-single-digit growth due to resilient global demand. We anticipate wastewater demand in emerging markets to continue being driven by investment in public utilities, healthy operational expenditure 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 solid globally. On the clean water side, we continue to expect demand to remain very robust as the AMI and the advantages of static meters continue to gain momentum with an increasingly broad spectrum of utilities. 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. 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 expected to deliver mid-single to high-single-digit growth, up from mid-single-digit growth due to solid replacement activity and new product introductions in the U.S. 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 first quarter is giving us risk 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. 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. However, 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. Our initial full year guidance assumed a euro of 1.13. Our updated guidance now assumes the euro at 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 the 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. We continue to expect Measurement & Control Solutions to be flat. 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 expect adjusted EBITDA to be in the range of 16% to 17%. This yields an adjusted EPS range of $2.40 to $2.70 that I just mentioned. We still expect free cash flow conversion to be 100% of net income. We have also provided you with several other full year assumptions on the slide to supplement your models. And now drilling down on the second quarter. 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, and M&CS is expected to decline low double digits. We expect second quarter adjusted EBITDA margin to be in the range of 14.5% to 15%, a sequential improvement over the prior quarter.

Thanks, Sandy. We came into 2022 in a strong position, even in the face of headwinds from chip supply and inflation. Our performance in the first quarter 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. 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, D.C., which is one of the main crossroads of the global water sector. 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 simplify and lean our headquarters. The new location is on Water Street, right on the Anacostia River. We'll be officially opening the space in mid-June, and I look forward to welcoming all of you when you visit D.C. Before turning to your questions, I have one more special note of thanks. 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 energy, accessibility, and professionalism, and I benefited from his insightful counsel and his persistent positive encouragement through every kind of circumstance. So thank you, Matt.

Good morning, everyone. Let's begin with M&CS and some positive updates regarding the chip shortage. Can you provide insight into the record backlog you have, including the implied margins? Additionally, it's clear that customers are placing orders despite knowing there will be some delays. This suggests you haven't lost any competitive advantage. Let's start the discussion there.

Sure, Deane. 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, I think the team has done a great job working both with the suppliers of chips and also with our customers on hanging on to deals and backlog. 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 midsized 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, is that we've seen a gradual recovery. And so we're not changing our outlook for the full year. It's just more confident in terms of what we're seeing there. So really encouraging. Sandy, do you want to speak more to the margin profile?

Yes. Thanks, Patrick. I think, Deane, 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 million pickup in revenue and seeing very good margin recovery as the revenue line grows. So very satisfied with the profile of the orders that we've been bringing in.

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

That's really helpful. The follow-up question is about the recent challenges. We understand your exposure to foreign exchange, and I appreciate your detailed explanation. However, could you provide an update on China, which accounts for about 8% of revenues? What are your expectations regarding that situation, especially considering your headquarters are in Shanghai? I'd like a real-time update and insights on the reopening.

Sure, Deane. Yes, so our revenue exposure is roughly $350 million, about 7% of our total revenue. The impact in the first quarter was about $20 million in revenue. Our guide implies another $20 million in Q2. So first half of the year right now will be down about 20% in revenue. In the second half, we expect to be up about 20% because we saw some of the impacts of lockdown even in the fourth quarter, still lingering in China. We've got 4 factories in China. As you said, we got our headquarters in Shanghai. Three of those factories were closed for a few weeks. Later, they opened up at 50% capacity. All 4 of our sites right now are at 100% utilization. Our Nanjing plant, which supports our Applied Water business, actually never closed. And that's the reason why AWS actually had mid-single-digit growth in China here in the first quarter. So we expect there to be a gradual opening in China. We think it's all manageable within our guide. Obviously, there's a risk there. But our people are all safe and sound and they're working hard to ensure we deliver on our commitments. We did talk about also that there is a global supply chain effect. And we think that's the one that really is kind of the wild card going into the second half of the year, but we feel that we've got that embedded in our guide.

That's all helpful. And just lastly, with all the comings and goings, I 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. I still have his cell phone, just let them know that possibility. And welcome to Andrea as well.

I just want to echo Dean's comments on the comings and goings. So first, 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, particularly with the backlog, the underlying demand where tax receipts are, etc. 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.

I think it's a great question. From a demand perspective, we currently don't see any major concerns on the horizon given the overall investment cycle. While some may question the impact of geopolitical issues in Europe and the shift towards oil and gas alternatives, that doesn't significantly affect how funding works for water utilities there. We believe that segment remains strong. Our challenges continue to be around chip supply and our ability to execute on our projects. Our bidding pipeline is very healthy, currently exceeding $2.5 billion. While I am naturally cautious, we are not seeing any significant red flags at the moment, and everything appears to be in good shape.

How far out is your backlog stretching at this point? How do you think about the conversions? I'm hoping you can compare that to what a typical conversion cycle looks like. We all know that everything is getting delayed into 2023 due to the chip shortages. Can you provide some insight on how far out you can see at this moment?

Yes. I think great question. And 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, we have a backlog that gives us really good coverage for the next couple of quarters out. In water infrastructure, it's a mixed bag. We have some short-cycle businesses there, and we have some longer cycle businesses there. In the shorter cycle, we have more coverage than we typically have as we look out for the rest of the year. And M&CS, 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.

And Mike, I would just offer up, I think to your question around visibility from an overall market sentiment standpoint, our bidding pipeline, especially in treating and in the wastewater side being 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 a level of confidence around what the overall market sentiment is.

And then a follow-up then it's the capital deployment side, you've been pretty constructive in the last few quarters on what the pipeline looks like? And it 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.

Sure. Yes. So we still feel really good, Mike, about the pipeline in terms of opportunities, and they range from larger opportunities of moves into various end markets. But even in the small to medium-sized 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. But in general sense, we feel the M&A pipeline is as healthy as it's ever been. But we're continuing to be disciplined on valuation.

I wanted to follow up on the capital allocation discussion. Given the recent performance of the share price, I'm assuming you may be less inclined to use shares as currency for acquisitions. I'm curious about your perspective on this situation, particularly regarding share repurchases. How do you evaluate the competing uses of capital among organic investments, mergers and acquisitions, and buybacks, and how do you finance mergers and acquisitions?

Sure. Yes. So again, we come into the year with a 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. I would not preclude equity from being used in the right situation, but it's not our first lever to lean on around capital deployment in general. We also don't see M&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 that 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&A. These are not binary decisions, in our case.

That makes sense. I wanted to revisit an earlier question regarding your customers' awareness of the chip supply chain situation. I'm interested to know if their behavior regarding new contracts has shifted. Is the majority of your current ordering from existing relationships, or has the pace of new deployments remained consistent, sped up, or slowed down? Additionally, are you adjusting your bidding strategy or the aggressiveness of your approach on larger projects, considering delivery timelines?

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. In many cases, they've got multisource, 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. 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 to meet their needs, even though it may not be the level of metrology they originally specified, 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. In terms of changing our own behavior, 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 overpromising and underdelivering 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.

Patrick, I want to follow up on the comments regarding medium-sized utilities beginning to adopt AMI technology. At the conferences I’ve attended, which tend to feature larger utilities, there appears to be a significant shift towards AMI that is becoming widespread. It’s clear that we’ve reached a turning point and the adoption is evident. It’s encouraging to see medium-sized utilities getting involved with this technology. Could you discuss the market opportunity this creates? A few years ago, when you acquired Sensus, the focus was on larger utilities and how that would eventually impact the market. Any insights you can share on the current landscape and the potential market opportunity would be appreciated, especially regarding how long we can expect to see this robust order growth from you.

Certainly, Nate. That's a good question. We have primarily focused on large utilities initially because medium and smaller utilities often look to the larger ones for guidance on proven technology. However, they have their own strategies and investment plans. Medium utilities tend to consider complete implementations of AMI, unlike larger areas that might only focus on parts of a city. Consequently, their decision-making process for full-scale adoption takes longer as it's a significant strategic choice. It's encouraging to see the level of adoption increasing. Their timelines often align with the retirement of existing metrology systems in their communities. We anticipate a steady stream of conversions over time. Although they may spend a while studying AMI to prepare for a total upgrade or overhaul, the process will be gradual, taking place over a decade or more throughout the U.S.

Which has been 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&CS business. I just want to ask one on. Go ahead.

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

Yes. I did want to ask one on price cost. The mass saving this morning shows you about $35 million 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 that pricing step up from 200 basis points in the fourth quarter to 420 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?

Yes, that's a great question, Nate. Our teams have been very focused on this issue. Since inflation started to rise last year, we've put numerous price increases in place. In some cases, we needed to work through the existing backlog before the new prices were effective. Consequently, we experienced a significant increase in price realization from Q4 to Q1. Looking ahead throughout the year, we expect this trend to continue in each subsequent quarter. In Q1, our prices did cover material inflation and freight; however, we were still at a deficit because we didn't cover our labor and overhead inflation. For Q2, we anticipate the situation to be neutral, and in the latter half of the year, we expect prices to exceed the impacts of inflation. Importantly, our guidance includes an increase for stronger price realization based on our Q1 experience and our outlook for the next quarter. We also raised our inflation outlook.

The key takeaway is that in the second half of the year, the price increases will offset the inflation figures mentioned on the first page of the slide deck.

That's our expectation.

This is Miguel on for Brian Lee. I just had 2 quick ones, follow-up questions from the prior questions. On price/cost real quick. So price/cost was seemed negative in the first quarter. I think that was expected, and then you just mentioned you expect it to improve for the rest of the year. Is the expectation still for the full year that the price cost would be positive?

That's our expectation for the full year. Yes.

Okay. That's helpful. And then I appreciate all the additional color on the backlog on M&CS. So the backlog gives you visibility on orders for, I think you said next 2 to 3 years. 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 are customers intentionally placing orders well in advance of projects to get their spot in line? Hopefully, that makes sense.

We've not encountered any issues with duplicate ordering. Our team remains quite disciplined in that aspect. The benefit of large metrology implementations is that we have a clear understanding of the endpoint count needed. We collaborate closely with our customers to avoid taking duplicate orders and prioritize those who are currently under the most pressure. It's important to acknowledge that there could always be potential cancellations, but customers recognize the limited alternatives available to them. These implementations require extensive regulatory approvals and are crucial for their revenue generation. As long as we can meet their basic demands and maintain transparency, we are pleased with the collaboration with both customers and chip suppliers. While we focus a lot on our customers, we are also working diligently with our suppliers to redesign our chip requirements for future generations, and we are modifying our products to meet immediate needs. This is a complex situation, and I’m proud of how our team is handling it, especially considering our customers' patience.

I wanted to ask about your organic growth guidance range. It seems that applied water is the only segment you increased. I was surprised that you didn't raise the outlook for Water Infrastructure. Can you comment on that? Additionally, shouldn't we expect to start seeing some benefits from the water infrastructure stimulus later this year? What are your thoughts on that?

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.

And on the infrastructure bill, no real meaningful change there. I mean we do think it's going to be a positive over time. I don't really see that being a big impact here in '22 as things continue to settle out. We see that more as a benefit in '23 and beyond.

No. Okay. Okay. And then just to be clear, so you obviously expect some nice price cost tailwinds in the back half of the year. But based on your Q2 guidance, it really does assume a 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 recent cost savings or anything that you expect will drive higher incrementals or something like that?

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 and M&CS as that revenue ramps in the second half; it has very good contribution margins. The third point I would say is China. We have a very modest revenue decline 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. 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 assume working capital management probably takes over from there.

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

Patrick, Sandy, and once again, congratulations, Matt. You'll do great. I apologize for revisiting this topic, Sandy, but I wanted to discuss pricing and cost. I believe you mentioned in your prepared remarks that you've adjusted your inflation assumptions upward. I'm curious if you could provide additional metrics related to pricing, such as your expectations for pricing to rise in the second quarter and your full-year pricing outlook, as there still seems to be a significant gap at this point. Any insights on pricing to clarify your comments about the ramp would be appreciated.

Yes. I think just to give you some context, Scott, in Q4, we had about 200 basis points impacts from our price increases. That doubled to 400 basis points in Q1, and we would expect that to continue to increase. Now since the invasion of Ukraine by Russia, we've seen some of our commodities increase, particularly around stainless steel, which is impacted by nickel. And so as we roll forward inflation assumptions for the next 3 quarters, we see more headwinds in the neighborhood of $40 million to $50 million. And so in response to that, our teams have gone out and implemented incremental price actions, some that were not contemplated when we put together our budget. 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.

I would just like to mention, Scott, that we are really pleased with the resilience of our volume and market share. In some areas, we have even gained share in certain parts of the business. The market has demonstrated a level of resilience in this area. I believe we have been acting as a leader, and as conditions continue to evolve with inflation, we will maintain a responsible approach.

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

I was going to mention how surprising it is that utilities have reduced their pricing so much, but it is indeed a new reality. Additionally, I have two more questions. Could you share what percentage of the backlog for M&CS is currently affected by shortages? If you had the supply, how much could you ship? What is that percentage?

Yes. So I think if you look at our M&CS backlog, it's around $2 billion. And I would say, between 20% and 25% of that backlog is held up by the chip delays. And that's been growing each quarter because our orders have been outpacing our revenue conversion.

Yes. Got it. And then lastly, Sandy, I know as you entered here, I guess, 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 3%, 5%? I mean, how do you look at that?

I'm not sure I completely understand your question, Scott. When we create our long-range plan, we take into account our assumptions about inflation. We also establish productivity targets throughout our organization, including in our manufacturing centers and across other functions. Our overall goal is for productivity to exceed inflation. The last 18 months have been somewhat unusual, but that's our core philosophy.

I think, Scott, to clarify your question, any growth in this business will lead to significant incremental profits, generally in the range of 30% to 40%. Our long-term guidance indicates a mid-single-digit growth, which contributes to substantial margin expansion, particularly due to the mix with M&CS. This context might provide better understanding. Overall, this business generates strong incremental profits regardless of the growth level.

On the M&A front, considering that leading companies like ours are facing challenges with semiconductor and other component availability, it's fair to assume that smaller companies are likely experiencing even greater difficulties. Does this situation create any potential opportunistic distressed M&A opportunities that may not have been apparent a year ago?

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 pipeline, again, we really focus on the strategic logic behind them in terms of for 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 distress.

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?

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 operational expenditure element there in terms of repair replacement of installed infrastructure. It's less reliant on new capital expenditure. And even when there is new capital expenditure, the funding mechanisms tend to be pretty well sheltered, at least, in the larger economies across Europe. I'm not saying there are no economies that are not immune to it, but we've really never seen big swings there on the capital expenditure side. In terms of what we do see is the lion's share of our business there is repair and replacement, which is stable, steady, and really attractive margins. And so we feel pretty confident right now around the outlook for Europe as we see it today.

Ashley, do we have any more questions?

We talked a lot about price, but I'm curious about whether there is a point where the necessary price increases begin to destroy demand because projects become unfeasible. Customers may understand the reasons for the price hikes, but they may decide not to purchase right now.

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. And 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.

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

Sure. Yes. I mean, yes, you can imagine all management teams spend a lot of time thinking about when you make a change in guidance and 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. And obviously, things have to go in the right direction. But 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, 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 outlook for China. 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.

Well, thank you all again for your time and attention this morning and for your support, and I look forward to catching up with you between now and the next earnings call. In the meantime, stay safe, stay well, and I wish you all the very best. Thank you.