Xylem Inc (XYL) — Q3 2022 Earnings Call Transcript

Thank you, operator. Good morning, everyone and welcome to Xylem's third quarter 2022 earnings conference call. With me today are Chief Executive Officer, Patrick Decker; and Chief Financial Officer, Sandy Rowland. They will provide their perspective on Xylem's third quarter 2022 results and discuss the fourth quarter and full year outlook. Following our prepared remarks, we will address questions related to the information covered on the call. 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 in the Investors section of our website, www.xylem.com. A replay of today's call will be available until midnight on November 8. Please note the replay number is +1800-839-9881 or +1402-220-3100. Additionally, the call will be available for playback via the Investors section of our website under the heading Investor Events. Please turn to Slide 2. We will make some forward-looking statements on today's call, including references to future events or developments that we anticipate will or may occur in the future. These statements are subject to future risks and uncertainties, such as those factors described in Xylem's most recent annual report on Form 10-K 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. Please turn to Slide 3. We have provided you with a summary of our key performance metrics, including both GAAP and non-GAAP metrics. For purposes of today's call, all references will be on an organic and adjusted basis, unless otherwise indicated. And non-GAAP financials have been reconciled for you and are included in the Appendix section of the presentation. Now, please turn to Slide 4 and I’ll turn the call over to our Chief Executive Officer, Patrick Decker.

Thanks, Andrea and good morning, everyone. We're pleased to announce a very strong third quarter performance, continuing our momentum from the first half of the year. Across the board, the team delivered above expectations with all our business segments and regions posting strong double-digit revenue growth. And we see quite resilient demand in our backlogs and bidding pipeline. Overall, revenues were up 16% for the quarter, beating the high end of our guidance by 4 percentage points. Applied Water grew fastest at 20%. Water infrastructure exceeded expectations by the widest margin and M&CS came in right on target with healthy mid-teens growth. Regionally, Americas, Western Europe and emerging markets each grew mid-teens. Demand at all of our largest end markets continued to be strong driven by the essential nature of our solutions and services and by intensifying long-term trends in Water. The team, from our factories to our channel partners and distributors, also delivered a tremendous operational performance. Their actions entirely offset inflation with very strong price-cost discipline and effectively managed through continuing chip supply constraints. That focus paid off in growth but also with very strong EBITDA margin expansion. Margins exceeded the high end of our guidance by 130 basis points. This delivered on our previous commitment to significantly improve our margins in the second half of this year. Strong organic revenue growth and accretive margins drove third quarter earnings well above expectations, with earnings per share of $0.79. As you all know, our key end markets have consistently been resilient in the face of macroeconomic headwinds and we expect that underlying demand pattern to continue. M&CS orders continue to be very strong. Water Infrastructure was up solidly. Backlogs continue to be up sharply year-over-year and the digital solutions proportion of our backlogs continue to expand. That said, some of our smaller end markets are more cyclical, such as residential within our Applied Water segment. Orders in those markets were down in the quarter and are expected to remain soft. Looking forward, we anticipate the demand dynamics of the third quarter to continue into 2023. On supply, especially chip supply, the outlook remains consistent with what we said last quarter. As expected, we have not seen meaningful easing of chip supply constraints. But forecasting visibility has improved, as has the reliability of deliveries. We expect to exit the year as we've outlined before. Things are gradually improving. Given the resilience of our demand profile, the vitality of our business and the team’s strong operational track record in this environment, we are raising our full year guidance. We now expect full year adjusted earnings per share to be between $2.65 to $2.75 on organic revenue growth between 9% and 10%. In a few minutes, we’ll discuss dynamics in our different end markets, along with some trends we’re seeing through the current cycle. I’ll also touch on how we’re serving communities as they invest to become more resilient in the face of intensifying water challenges. But first, let me hand it over to Sandy to offer you some more detail on the third quarter.

Thanks, Patrick. Please turn to Slide 5. The team did a great job over delivering on commitments with disciplined commercial and operational execution on continuing strong demand. As a result, revenues grew globally, high teens in the U.S. and mid-teens in emerging markets in Western Europe on strong price and backlog execution as supply chains modestly improved. In a moment, I'll detail performance by segment. But in short, utilities was up 15%, led by strength in the U.S. and Western Europe. Industrial grew 16% with strength across all geographies, particularly in emerging markets and Western Europe. Commercial was up 17%, mainly due to strong backlog execution in the U.S.; and Residential was up 19%, led by commercial execution and backlog conversion in the U.S. Global demand remains healthy on strong end-market fundamentals, especially in Water Infrastructure and M&CS. That said, organic orders were down 1% in the quarter versus up 20% in the same period last year. Water Infrastructure was up 3%, AWS down 4% and M&CS down 2%. Adjusted EBITDA margin was 18.3%, up 40 basis points from the prior year and up 170 basis points sequentially as price more than offset inflation. And as Patrick mentioned, our EPS in the quarter was $0.79, well above expectations. Please turn to Slide 6 and I'll review the quarter's performance by segment. Water Infrastructure revenue grew 13% organically in the quarter, exceeding expectations. Growth was broad-based, led by our wastewater utility business in the U.S. and Western Europe, both up high teens as supply chain constraints improved. Industrial growth remained robust, driven by continued dewatering demand in emerging markets and increased activity in Western Europe. Geographically, Western Europe grew mid-teens, driven by robust transport and treatment demand. The U.S. was up low teens, led by strong utilities OpEx demand. Emerging Markets was up low double digits, driven by strength across Latin America and Africa, a continued growth in dewatering. Orders in the third quarter were up 3% organically with robust dewatering demand in emerging markets and continued utilities strengths in the U.S. Segment EBITDA margin was largely in line with the prior year as favorable price realization offset inflation but was also impacted by unfavorable mix and strategic investments. Please turn to Page 7. In the Applied Water segment, third quarter revenues grew 20% organically, exceeding expectations. Growth was robust across all end markets, with each up high teens or greater. Geographically, the U.S. was up high teens with strength across all 3 end markets due to price realization and modest improvements in supply chain. Western Europe was also up high teens, led by growth in industrial, on strong price and continued demand. Emerging Markets was up almost 30%, driven by strong industrial demand in China and commercial development in the Middle East and Africa. Orders were down 4% organically with continued growth in emerging markets, offset by some moderation in Residential in the U.S. As a reminder, Residential, our most cyclical end market, is only about 5% of our overall revenue. EBITDA margin for the segment was up 110 basis points compared to the prior year and 200 basis points sequentially. Margin expansion was driven by strong price realization, more than offsetting inflation, supplemented with productivity savings. And now, let's turn to Slide 8 and I'll cover our Measurement & Control Solutions business. M&CS revenue was up 15% organically, in line with our prior guidance as chip supply played out as expected, with continued modest improvement sequentially. We also saw strong growth in test applications and our pipeline assessment services business. Geographically, the U.S. was up more than 20% on improved chip availability versus the prior year and favorable price realization. Emerging Markets was up mid-teens and Western Europe was up high single digits, driven by strength in our Test and Pipeline Assessment Services businesses. M&CS orders declined 2% organically in the quarter, lapping a tough prior year compare of 42% orders growth. Underlying demand for our AMI offerings remains strong and orders continue to outpace revenue, yielding backlog growth of 35% versus the prior year. Our M&CS backlog alone exceeds $2 billion. Segment EBITDA margin in the quarter expanded 400 basis points sequentially and is now approaching prior year levels. The team did a great job driving margin improvement, even though volumes continue to be constrained by chip supply. And now let's turn to Slide 9 for an overview of cash flows and our balance sheet. In the third quarter, we generated free cash flow of $149 million, driven by income conversion, partially offset by higher working capital. You will note that our working capital levels are elevated as we've chosen to carry about 30 days of extra inventory. And while supply chains are gradually improving, delivery metrics are below historical levels and we can best serve our customers and communities by making this short-term investment. Having said that, our financial position remains strong with $1.2 billion in cash and $2 billion of available liquidity and our net debt-to-EBITDA leverage is 1.3x. Please turn to Slide 10 and I'll hand it back to Patrick to give some color on underlying demand.

Thanks, Sandy. In our last quarter's earnings call, we discussed how demand in different end markets responds to macroeconomic headwinds. What we described then is what we're seeing in the marketplace now with healthy underlying demand in our largest end markets. Those patterns have repeated over past economic cycles. So they inform how we manage our operations in an environment like this one. Since all water is local, we experienced those patterns and trends playing out at a community level. What we're seeing is more and more communities feeling the increasing impact from climate change. They're finding their aging infrastructure isn't up to the task and then confronting the economic anxiety of major upgrades. So communities are investing both in short-term response and in longer-term resilience. Infrastructure investment is the much bigger driver of underlying demand. But our customers have to know we will also be there in near-term crises, which are happening all too frequently. For example, when Hurricane Ian hit Florida, our dewatering pumps were already in place ahead of the storm to prevent the worst and recover fast. And storms are not the only immediate need. One Southeastern U.S. city called us with sewer lines leaking waste into community groundwater and their aging pipes are on the brink of collapse. Within days of that call, we were building temporary systems that will help that city's wastewater treatment run without interruption while they make long-term repairs. Helping communities respond to shocks is a fundamental part of our mission. But the more durable value is in helping communities build the strength to withstand future water challenges and economic stresses. Xylem Solutions like advanced metering infrastructure, wastewater network optimization and municipal water recycling, among so many others, provide much more than compelling economics. They deliver game-changing resilience. With AMI as an example, cities can cut off water in the event of storm damage, respond instantly to customer crises, and even promote conservation through periods of scarcity and drought. All of that additional capability costs a city less than their conventional meter networks. That value equation isn't unique to AMI. It's a hallmark of digital solutions across our Xylem portfolio, contributing greater resilience and capability delivered far more affordably than conventional approaches. Those benefits are so important to our customers that we have been steadily extending digital capability into every part of our portfolio. The mini water crisis making headlines in recent months makes it clear that the effects of climate change are already driving rapid increases in costs at the community level. To attack the problem at its source, more and more cities are making net zero emissions commitments. Our opportunity is to help water utilities reduce their own carbon footprint. More than 80 leading utilities around the world have already set net zero targets. Last month at Webtech, which is one of the largest water trade events each year, we shared research showing how utilities can dramatically cut their emissions while boosting operational efficiency at the same time. The message is good for our customers, good for communities and good for our business. With existing technologies, you can reduce emissions quickly at low cost or even save money. I am so proud of the team for leading the way on this topic with our customers and our communities. Several of my Xylem colleagues will be speaking at the upcoming COP27 climate meetings in Egypt later this month to promote the discussion of water, which we believe is the most important topic of our time. Now, I’ll turn it back over to Sandy to provide detail on our increased guidance and outlook for the year.

Thanks, Patrick. Consistent with our previous presentations, we provided key facts for each end market in the appendix. The 2022 full year outlook across our end markets remains largely in line with our previous guidance, with an increase in commercial upon improved backlog execution. We expect healthy underlying demand will carry on through the remainder of the year with continued modest improvements in supply chain. The outlook for our utility business remains unchanged with mid-single-digit growth across both wastewater and clean water. In wastewater, we see continued OpEx strength and the CapEx outlook is supported by modernization of aging infrastructure and continued new development, particularly in emerging markets. For clean water utilities, although chip supply remains constrained, we do expect a continued modest easing of chip supply sequentially. We also expect momentum in our test and pipeline assessment businesses to continue due to increasing focus on infrastructure and climate challenges. Looking at the industrial end market, we now expect low double-digit growth lifted from a previous range of high single-digit to low double-digit growth, driven by strong global demand for dewatering and continued underlying demand for our solutions in the U.S. and Western Europe. We now expect the commercial end market to deliver high single to low double-digit growth, up from mid-single to high single digits on strong demand and backlog execution. In Residential, our smallest end market, we expect strong price realization and continued backlog execution to drive growth in the high teens. As a reminder, our Commercial and Residential exposure is largely replacement-driven and is approximately 15% of our total revenue. And now let's turn to Slide 12 and I'll walk you through our updated guidance. Our continued outperformance gives us confidence to raise our full year guidance for adjusted EPS to a range of $2.65 to $2.75, up from $2.50 to $2.70. Our raised guidance is driven by stronger price, backlog execution and continued underlying demand. We are also lifting the low end of our full year organic revenue growth, now 9% to 10%, up from 8% to 10%. Our revenue outlook on a reported basis is largely unchanged due to FX headwinds. Looking by segment, we expect high single-digit growth in Water Infrastructure and low double-digit growth in Applied Water. We expect Measurement and Control Solutions to be up mid-single digits as chip supply continues to modestly improve. For 2022, we are raising our adjusted EBITDA margin outlook to approximately 17%. We now expect free cash flow conversion to be approximately 80% of net income. This is lower than our previous outlook, largely due to higher working capital levels as I referenced earlier. While we’re carrying about an extra month of inventory, our position is fully aligned with the requirements needed to fulfill our backlog. As supply chain stabilizes, we will bring inventory down, enabling us to return free cash flow conversion of at least 100%, as we have consistently done in prior years. We’ve provided you with a number of other full year assumptions on the slide to supplement your models, as well as our latest assumptions on our basket of currency exposures which can also be found in the appendix. And now drilling down on the fourth quarter, we anticipate total company organic revenues will be up 12% to 14%. This includes mid-single-digit growth in Water Infrastructure, mid-teens growth in Applied Water, and M&CS growth of mid-20%. We expect fourth quarter adjusted EBITDA margin to be in the range of 17.5% to 18.5%. And with that, please turn to Slide 13 and I’ll turn the call back over to Patrick for closing comments.

Thanks, Sandy. I'm very proud of the team's performance overall. We delivered strong results this past quarter by continuing to do what we said we would do. And indeed, the team overdelivered, thanks to our commercial momentum and operational discipline. Even in an environment of macro uncertainty, the durability of our business model and the discipline of our team gives us great confidence in our continued growth and significant value creation over the long run. Before we turn the call over to your questions, I'd like to share a couple of executive appointments we've just made, adding even further strength to Xylem's leadership bench. Earlier, I referred to our strategy of extending digital capabilities across Xylem's product, solutions and services portfolio. We've just taken an important step in accelerating that process, appointing Xylem's first Chief Digital Officer. This individual joined our senior leadership team last week, bringing extensive experience of growing digital businesses in the industrial sector. He'll be working with the team to further build out a simple powerful platform of digitized solutions for our customers and communities. He joins us from Danaher and I look forward to introducing him to you in future conversations. Before sharing our second recent appointment, I first want to recognize a colleague many of you know. Tony Milando, our Chief Supply Chain Officer, has been looking forward to retirement for a while, but he graciously agreed to stay on while helping us guide the company through the challenges of the pandemic. He's built agility and durability into our supply chain, put safety and sustainability at the center of our operations, and created a culture of continuous improvement that has made operational excellence a core part of Xylem's competitive advantage. We're finally letting Tony retire, but his contributions will continue to benefit our stakeholders for many years to come. To build on the foundation of excellence that Tony has laid, we've appointed another individual as Xylem's Chief Operations and Supply Chain Officer. This person joins us next week coming from Generac Power Systems and he brings over 20 years of experience leading global supply chains and operations in the industrial and services sectors. We're very pleased to welcome him at a time when supply chain and operations continue to be a foundation of competitive advantage. His remit is to take our operational excellence to the next level. Tony is going to stay on for a brief time to ensure a smooth transition. So with that, operator, let's now open it up for Q&A.

Can I start by wishing Tony all the best. He’s been a tremendous help all along. We’ll miss him but wish him well. I also want to welcome the two new leaders, Tom and someone else.

Thank you, Deane. Happy to have him on board and with mixed emotions to see Tony move on. But yes, it's been a great run.

All right. So first question, really good numbers here, good growth. That stands out. I'd like to discuss the forward look for the fourth quarter, specifically regarding the backlog conversion, earnings visibility, and how did October start in terms of demand?

Yes, Deane, let me start there. I think we've built good momentum throughout the year with strong order growth. We have good visibility into Q4, which looks very much like Q3. We anticipate strong top-line growth and EBITDA margins that are similar to the notable increase we saw from Q2 to Q3 this year, with some differences in mix. Water Infrastructure usually has a stronger Q4 as projects are completed towards the year's end. There's a slight moderation in AWS as they are catching up on orders related to supply chain issues, along with a gradual increase in M&CS. As we've mentioned in previous calls, we are observing a more modest improvement regarding the chip supply situation. In the second half of 2023, as redesign work progresses and more supply becomes available, we expect a more significant ramp-up. In summary, Q3 and Q4 should look quite similar. We have consistently predicted a stronger second half compared to the first half, and we're pleased to report that this is aligning well with our expectations.

And specifically on backlog, what would be the typical 4Q backlog conversion on a percent basis versus what you’re expecting this quarter?

Yes. I'll give you some color around the backlog. When we look year-over-year, the backlogs are up about 30%. It's a little higher than that in M&CS and a little bit lower than that in the other 2 businesses. So all around, Deane, backlogs remain elevated. And so we're not able to convert as much of the backlog as we would have in other periods. And that's not because production levels are falling short. It's just because backlogs still remain elevated.

Deane, I want to point out that as we entered this quarter, our Applied Water backlog has increased by more than a month compared to what we typically see. This is due to supply chain constraints and demand. We expect this situation to improve in Q4 and continuing into Q1. As a result, Applied Water will adjust back to its historical levels, which remains appealing with very good margins. However, the real strength will continue to come from the Water Infrastructure resilience, driven by utility demand and the improvement in chip supply for M&CS, along with the deals we’ve secured.

That's really helpful. As a follow-up, regarding free cash flow, I completely understand the adjustment with increased inventory. We're observing similar trends elsewhere. Sandy, could you explain the impact of adding an extra 30 days and how that influences each segment? Additionally, could you discuss how lead times with your suppliers are trending? Are they approaching normalization?

Yes, great question. I think, first of all, Deane, our inventory is most elevated in our AWS segment. In that supply chain, we have more reliance on China and a greater global dependency than in our other businesses. That's where we've experienced more disruptions as well, which is why we’ve increased our inventory levels there. We've done a lot of analysis to ensure that this inventory aligns with our backlog, and we feel very confident about that.

I will start by discussing pricing and cost. It was encouraging to see that prices exceeded inflation this quarter. Can you elaborate on the pricing and inflation trends? Are we expected to see prices continue to increase in the next few quarters as more adjustments are made? Should we anticipate inflation to moderate for the year? If so, could pricing and costs provide an even greater benefit to our margins in the coming two to three quarters?

Yes. I think, Nate, obviously, this has been something that our teams have been really focused on all year long. And I really applaud the good work that our commercial teams have done securing these important price increases to get in line with inflation. So a couple of milestones. On a year-to-date basis now, we're price-cost neutral. In the quarter, we were ahead from a price-cost perspective on both a dollar perspective and a percentage perspective. We still expect that price will be a tailwind in Q4 and that's part of the year-over-year margin expansion that we're calling for. Having said that, we start to anniversary some of the quarters where we secured price momentum. And so that starts to happen a little bit in Q4 and more as we move into Q3. But I think as we go into 2023, we'll be in a better spot from a price-cost perspective than we certainly were going in this year.

And you probably start to anniversary the worst of the inflation comps at the same time, right?

Yes. And so I think inflation, we've definitely seen an increase inflation compared to what we guided initially this year. We sort of came into the year thinking inflation would run around 10% or 11%. When we look all in for the year, inflation is running more in the mid-teens. I would say there is some slight moderation from a commodity perspective but we're still seeing headwinds on inflation in both areas like energy, particularly in Europe. And labor inflation is still out there. And when we look at labor inflation, that's not transitory, that's probably more permanent. So our pricing strategies are dynamic and they need to be in line with what we're seeing and experiencing from a costing perspective.

And I would think we should probably see the pricing improve in M&CS as we go forward. It’s the segment where it looks like pricing is coming through the lowest. Some of that backlog that doesn’t get repriced. I would pick some of that, it’s a bit hard to tell your customers you’re raising prices when you have all that pass-through backlog. So should we see price read through more in 2023 in the M&CS segment as we start to clear some of that?

Yes, I believe our price increases have aligned with the highest inflation levels we've experienced. In terms of ordering, this has been particularly evident in AWS and our Infrastructure and M&CS segments. However, if we look at the last few quarters, we are beginning to see the impact of our price increases in M&CS. We are maintaining positive momentum in pricing and I expect this trend to continue in the upcoming quarters. This has played a significant role in the improvement we've observed in the M&CS EBITDA rate.

And I think, Nate, I would just offer on the M&CS side, specifically, AMI deals. Again, these are long lead time negotiated regulatory approval deals. They’ve got great economics associated with them. And I think our customers understand that we’re operating in a fairly high inflationary environment and they understand. And they understand that we’re being very transparent with them, around what the inflation impact goes in us and that we’re being responsible and disciplined. And the economics of these deals are so important to them that right now, the most important thing we can do is just continue to get chips and get the meters installed. And the good news is we’ve not seen any cancellations of those deals and backlog. So we feel good. We wish we had more chips, of course. But again, these projects require multiyear planning and utilities don’t tend to go backwards on these deals.

I have a couple of questions. First, regarding the utility building cycle, what does the frontlog look like at this point, and what is the thought process at the utility level today? Secondly, do you have any updates on the adoption of the more technology-oriented aspects of the utility sector?

Yes. As you know, approximately 70% of our demand in utilities is operational expenditure, which is stable and includes repair and replacement. Currently, we might be experiencing increased demand due to aging infrastructure and climate change, resulting in strong growth in this area. The capital expenditure, which makes up roughly 30%, is a global figure, not limited to the U.S., and we monitor it closely throughout various cycles. Historically, one factor that could lead to a decrease in capital expenditure is a slowdown in municipal tax receipts or a prolonged downturn in residential expansion in the U.S. These are typically later-cycle indicators, meaning any effects would emerge a couple of years down the line. However, we are not observing any of these signs presently; our backlog and bidding pipeline are currently robust. In terms of the wastewater sector, historically, even during past global recessions, if we discount dewatering—which tends to be more short-cycle—we have gradually diversified away from purely mining and oil and gas to focus more on municipal and broader industrial markets. We have not yet detected any downturns despite these risks, and we would anticipate perhaps low single-digit growth in water infrastructure should a recession occur, though our current frontlogs do not indicate any immediate concerns. We remain vigilant and are committed to responsible planning in this area.

Great. Second one, just on the European side of things. It seems awfully resilient from you at this point. Just some thoughts on the trends you’re seeing on that side.

We are observing very strong results in Europe, with significant growth in orders, particularly on a year-to-date basis. Historically, when we compare regions, Europe remains stable, demonstrating disciplined and resilient spending. On the industrial front, we are not witnessing any slowdown either. We are maintaining close communication with our commercial teams, who are in regular contact with our customers, and for now, everything is holding steady.

Can we talk a little bit about M&A and your pipeline and it seems your balance sheet is in just great shape and asset prices are coming down a bit. So just some color on that would be helpful.

Sure. Yes. So as you said, Scott, we've got a really strong balance sheet. I mean we've got $2 billion liquidity. We got the firepower of north of $4 billion. We're not going to hesitate if the opportunity presents itself. The pipeline remains really robust. It's a combination of larger opportunities, but we've got a number of small, medium-sized opportunities that are out there, mainly in the utilities space but also in the industrial services space. And so we're going to continue to be disciplined. As you well know, it always takes two to tango. But nothing's changed in our view on valuations and our discipline in that space.

Okay. Helpful. Can you remind us about the significant fluctuations in foreign exchange? Sandy, could you clarify how these extreme changes impact your situation compared to the other companies we cover? What do all the various movements in foreign exchange mean for you?

Yes. So I mean, I think when you look sort of year-over-year, actually compared to our budget, we're seeing significant headwinds from an FX perspective. I would say from an EPS perspective, it's been a negative by about $0.15 to $0.20. We'll see where the things ultimately shake out in the fourth quarter because even over the past months, the FX rates have been volatile. But I think we're really proud of the team. That's one of the challenges we've been able to overcome when we look at sort of we started the year and where we stand today. Just as an example, we started the year planning for a euro assumption at 1.13, dipping down below a 1:1 ratio for the end of last quarter and into this quarter. So good work that we've been able to overcome, continue to stay disciplined and controlling what we can control.

I thought it was interesting on the new role for a Chief Digital Officer. Can you talk about like the buy versus build proposition for a true digital platform kind of like on top of your AMI platform?

Sure. That's a great question, Joe. So digital is certainly not new. So we've got a great foundation that we've already built, both organically as well as through a number of the acquisitions we've done. So the new Chief Digital Officer comes in really building on that solid foundation. We are continuing to look at the opportunity to both build internally, which is really as much about talent capability, commercializing, and selling those opportunities. But our pipeline from an M&A standpoint is still very much focused on adding other solutions and technologies to the mix. And I look forward to having this individual join us on one of our upcoming calls and share his perspective on what he sees and the opportunities in front of us. But it's a combination, Joe, between organic and M&A.

It's great to see the progress at M&CS, but I understand you're not satisfied with the current margin situation. Can you explain how we can move from where we are this year to achieving a 20% margin at M&CS in terms of EBITDA? What needs to happen to reach that goal?

Yes, that's a great question, Joe. We've been putting in a lot of effort to improve our margins in the M&CS division. Volume is certainly a significant factor in this. Historically, we've noted that when our revenue reaches around $350 million per quarter, we can expect EBITDA margins in the mid-teens. To achieve margins in the high teens or around 20%, we need to surpass $400 million in revenue each quarter. We're focused on various productivity initiatives, including disciplined pricing strategies and evaluating our backlog for additional pricing opportunities, which are critical drivers for us. Additionally, our backlog has a higher digital component, which should contribute to improved margins. It's a mix of several factors, and the positive news is that we've observed a revenue increase, although there's been a slight flattening from Q2 to Q3. We anticipate continued moderation and expect a further increase in the latter half of next year.

And Joe, I would just add that one of the things that we've not really punctuated in the past is as we were going through the redesign of our chips to be able to help support our customers through this challenging time to move these installations along, there were costs that we added in our P&L to support that. At the same time, we had to redirect some engineering resources away from classic productivity and continuous improvement. So we're working through that. But despite that, you see the margin expansion that we've laid out in the quarter and that we expect for the year and that we expect to win the next year. So I just want to make sure we're making strategic choices here to take care of our customers, not just for the future, for the long run, but like right now because that's the value they expect from us.

That all makes sense. Just a quick follow-up from me. Considering how short the AWS cycle is, I know the backlog is extended there, but it has the shortest backlog across the company. When I think about this quarter's pricing at 1,000 basis points, as prices start to normalize and orders decrease, and that business starts to reach more reasonable levels, how should we approach margin deleveraging in that scenario? You've made significant progress, so how much of that do you expect to retain as volumes decline?

Yes. I think one thing that is important to remember is if you look back the past few quarters, our price increases were not in line with inflation. So we're now at a point where we're getting back to our more historical margins and we can drive margin expansion through productivity levels and incremental growth. So I think we're getting back to a place that's good and healthy for that business and a lot of work to make that happen.

And we continue, Joe, to make investments in innovation and R&D within that segment, also within Water Infrastructure. I know M&CS has kind of gotten more the headline over the last few years. But we continue to make increases in R&D spend in those segments because that kind of refreshment of our offerings and portfolio, we see and our new products that we bring to market that they've got much higher margins and growth rates than what they’re replacing. So it’s important to note that there’s a refresh that continues to go on in both of those segments.

Patrick, I know you’ve said that you have elevated backlog and a strong pipeline of opportunities but just focusing on orders for a second, down a bit this quarter, they decelerated over the last couple of quarters. I know it’s really just more difficult comps. But you did mention a little slower U.S. in Applied Water, for instance. So could you give us some more color into what you’re seeing in orders and whether you believe orders will continue to decelerate or how to think about orders going into '23?

We are optimistic about the demand trends. This relates to our frontlogs and bidding pipeline, including both AMI and treatment, which are key to wastewater demand. We are seeing strong demand from our channel partners, particularly in Applied Water. It's important to note that we are comparing year-over-year figures. Our orders are up 7% year-to-date, but we face tough comparisons in the third quarter. Demand varies by end market, and while we haven't discussed China much, it accounts for 7% of our revenue and saw a 10% increase in revenue in the third quarter. However, public utility funding in China has been delayed due to lockdown restrictions, and we anticipate a recovery in utilities, but not until late next year. Our long-term outlook for China remains unchanged as it contributes significantly to our revenue, and we are managing to maintain overall demand across our portfolio. We are closely monitoring all indicators, particularly in our short-cycle businesses, where we've noticed some moderation, as mentioned by Sandy, especially in Residential, which is a minor segment for us. Some other small parts of our business have also shown a slowdown, and we will stay vigilant. However, in the commercial sector, the Architectural Billing Index is still strong, indicating growth. We are keeping a close watch on all developments.

Very helpful, Patrick. And maybe if I could just follow up on your dewatering business. Kind of a similar question. I know you raised your industrial growth to low teens but what are your industrial customers telling you about the opportunities in dewatering? And do you see those orders staying positive and dewatering into ‘23?

Yes, Andy, that's a great question. We are witnessing strong revenue conversion in dewatering, along with positive momentum in orders. As Patrick mentioned earlier, it's important to recognize how our business today differs from a couple of years ago. We are experiencing solid growth in emerging markets, particularly in Latin America where activity is strong. We've invested in our rental fleet across all global markets, and these projects are yielding good returns and fast paybacks. A lot of equipment is on order and converting to revenue, and we continue to see stability in our equipment sales segment within dewatering. This remains a key area for us to focus on. It is definitely one of the shorter cycle businesses, so understanding what our customers are experiencing is crucial. However, it has shown considerable resilience so far.

I would just add that when we talk about customers and dewatering, there are two aspects we manage. One involves our rental fleet, and the other includes our channel partners, who maintain their own rental fleets and rely on us to replenish their inventory. In the past, our channel partners, primarily located in the U.S., could quickly react if they felt uneasy about the market, leading them to cut back on replenishment. This can occur within a short time frame. We maintain regular communication with them to gauge their perspectives on the current macro economy. So far, things appear strong and resilient, but we will continue to closely monitor that area.

I guess first question I had just following up on an earlier one. Price read out by almost 250 basis points more this quarter than in 2Q. It sounded like based on Sandy’s comments that maybe you’re starting to see a peaking sort of cadence in terms of price. So I just wanted to make sure that I heard that correctly. And as we start to lap some of the price increases over the past year and we head into ‘23, are we thinking more like a typical low single-digit price year starting early next year, just kind of get a sense of the cadence of price are into next year?

Yes, Brian, I mentioned this earlier. Last year, starting in Q4, we began to notice the effects of our price increases on our revenue. As we look ahead, the comparisons will become slightly more challenging next quarter. However, I believe we will continue to see strong pricing, which should significantly contribute to the margin expansion that we are anticipating. Additionally, our pricing strategy has become very dynamic; it’s not a one-time decision. We must continuously assess all inputs related to the various elements of our bill of materials, including the commodities we purchase and the freight costs to deliver the product. Therefore, I cannot provide information on our price realization for 2023 at this moment. Nonetheless, we are in a significantly better position as we enter 2023 in terms of achieving a balance between price and cost.

Absolutely. Yes, makes sense. And I guess a follow-up here, just to focus too much on the short term. But if I look at the guidance here for 4Q, I know nothing about the past couple of years has been sort of normal but it does imply a pretty flattish performance across key metrics, revenue, EBITDA, operating margin. Seasonally, you typically have a pretty meaningful increase from 3Q to 4Q across a lot of those headline metrics. So kind of walk us through, is there anything impacting near-term seasonality in the model here? You just kind of working off more backlog in 3Q than you expected. Just any sense of why this year, maybe 3Q to 4Q is a little bit lighter than you typically see in past years?

Yes, you touched on some of it, Brian. Looking specifically at our water infrastructure business, we usually experience a significant decline from Q2 to Q3. However, this year we didn't observe that as much, which contributed to our higher revenue. Consequently, we anticipate a bit of leveling off from Q3, although we do expect some increase as we move into Q4 for Water Infrastructure, just not as substantial. Part of this is due to slight improvements in our supply chain and the completion of more projects. Overall, Q3 and Q4 appear strong for the full year, marking a significant increase from the first half, and we are finishing the year in line with our expectations.

Yes. I think, Brian, the other areas where we are noticing different trends this year compared to the past are primarily in China, where things are shifting further out, and in Europe, where we are facing uncertainties. We believe it's wise to incorporate these factors into our outlook for Q4.

A lot has been covered on the call but there is a big differential between the strong order growth between Applied Water growth and the decline in orders. So since you expect to work down the backlog through this year, how do you think about growth as we head into 2023?

Is that specifically for Applied Water?

Yes for Applied Water. Yes, I’ll take it. We have a significantly elevated backlog in AWS, more than double what we usually see in any quarter. We're actually able to work through some of that backlog, which is a positive indication that supply chains are improving and customers are returning to more typical ordering patterns. Looking at that business long-term, it’s likely the slowest grower in our portfolio, providing substantial cash flow and functioning well operationally. However, over the long term, it’s expected to grow at a low to mid-single-digit rate within our portfolio. Determining when we will return to those growth levels will take some time as we address the backlog. That’s how we envision that business fitting into our portfolio in the long run.

I mean we look at that part of our portfolio as market growth itself is GDP on a global basis. And we always look to and have historically beaten that by some share gain. And that comes through investments in innovation through R&D. We continue to refresh the portfolio. But to Sandy's point, we're coming off of elevated backlogs due to one demand but also supply chain constraints. We'll see that normalize as we go into 2023. And in our upcoming call, we'll lay out by segment what our outlook is for '23.

Great. That’s helpful. And then obviously, you put out the strong book to build in AMI. How long and advanced are you seeing customers place their orders? And then when does this show up in revenues?

AMI has a very long selling cycle, as it's a significant decision for utilities. We are currently working on RFPs that can take anywhere from 1 to 3 years. We have a substantial backlog in M&CS, with about a quarter of it being overdue. We plan to address this as chip supply improves. What excites us most is that our pipeline remains strong, and we are successfully winning a good percentage of those awards. The value proposition is very solid.

We are still early in the conversion of large utilities across the U.S. to AMI let alone the smaller- to medium-sized utilities. So that’s why the front log, the bidding pipeline looks so attractive across the market, and that’s why we remain confident. But these are long-term deals that take a while to negotiate and we’re pleased with our position.

Well, thanks, everyone, for joining us this morning and for your continued interest and support. Really appreciate it. I know between now and the next earnings call, we’ll have a chance to meet with many of you in person. Between now and then, stay safe and safe travels. Look forward to seeing you. Thank you.