Xylem Inc (XYL) — Q2 2023 Earnings Call Transcript

Thank you, operator. Good morning, everyone, and welcome to Xylem's Second Quarter 2023 Earnings Call. With me today are Chief Executive Officer, Patrick Decker; Chief Financial Officer, Sandy Rowland; and Chief Operating Officer, Matthew Pine. They will provide their perspective on Xylem's second quarter 2023 results and discuss the third 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, August 9. Please note the replay number +1-800-839-1320 or +1-402-220-0488. 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/or adjusted basis, unless otherwise indicated and non-GAAP financials.

Thanks, Andrea, and good morning, everyone. Today is a significant milestone for Xylem as we have the pleasure to present the performance and outlook of quite a different company than just a quarter ago as we describe our ability to make an impact on the world as society deals with growing water challenges. The combination of Xylem and Evoqua has already begun taking shape as an even stronger global platform that will have a profoundly positive impact on our customers and communities. We have a responsibility in front of us to help at exactly the moment when the world's water challenges are coming into more acute focus than ever. When we completed the acquisition in May, our capability to meet this moment expanded along with our opportunities for growth. Now, 10 weeks into the integration of these two great enterprises, we are even more confident about the value we will create with our combined company. There are three things that underpin that confidence. First, the team is delivering impressive performance across both companies. I am so very proud of our team for staying focused on serving our customers at a potentially distracting time. Each team, both legacy Xylem and Evoqua turned in a quarter significantly exceeding expectations and giving us brisk momentum for the future. Second, our early progress on integration has increased our confidence in the cost synergies we previously laid out and the growth synergies ahead of us. We have moved well forward on both sources of value. And third, as water challenges continue to intensify for our customers across many parts of our economy and society, they are seeking simpler, more affordable ways to tackle them. While we are now even more strongly positioned to solve those needs and capture that demand with increased exposure to attractive, durable end markets. We'll come back at these bigger points in a few minutes, but I want to make sure we also give appropriate attention to the very strong quarter we just closed. As we shared in our press release this morning, we significantly exceeded expectations on revenue growth, margin and earnings per share. Organic revenue growth was 15%, with total reported revenue growth of 26%. EPS was up 32% and grew 28%, excluding the impact of the acquisition. And we delivered EBITDA margin well above our guidance at more than 19%. It was driven by strong demand and the team's continued focus on pricing as well as ongoing continuous improvement aimed at simplifying how we serve our customers. Organically, all segments contributed double-digit revenue growth in all end markets. And each of our regions grew, led by notably strong pace in the U.S. and a solid recovery in China. Our legacy backlog was up 7%. And then we added Evoqua's backlog of more than $1 billion, and the two together bring our total backlog to $5.3 billion. Well, we have a lot to do with the integration of these two great companies. We have strong commercial momentum, which gives us the confidence to raise our guidance for the year. And again, I want to thank every one of our team members around the world and our partners for what they are doing every day to deliver real impact to our customers and our communities. In a moment, we'll give more color on our outlook as well as detail on our end markets and regions. But first, I'm going to hand it over to Sandy to dig into the quarter's strong results.

Thanks, Patrick. Please turn to Slide 5. Since this is the first time we are reporting as a combined company, I would like to walk you through how we will cover our performance. We now have four reporting segments: Evoqua's Applied Product Technologies business has been integrated into water infrastructure, immediately combining our two complementary treatment product businesses. Evoqua's Integrated Solutions & Services business, or ISS, is reported as its own segment, providing continued transparency on the segment's results. Our other two segments, Measurement & Control Solutions and Applied Water are unchanged. Additionally, since this quarter includes about a month of Evoqua's results, we have laid out organic results compared to our previously shared expectations and broken out the impact of the acquisition. Unless otherwise stated, all growth rates shared are on an organic basis. And lastly, we have reported EPS on an adjusted basis that adds back noncash purchase accounting intangible amortization from the Evoqua acquisition and Xylem's previous acquisitions. We have therefore recast 2022 amounts for comparison purposes. And now let's turn to Slide 6 for our quarter's results. The team delivered strong performance, beating our expectations for both growth and margin expansion. Total revenues grew 26%, while organic revenue growth of 15% was led by double-digit growth in the U.S. and Western Europe and high single-digit growth in emerging markets. Each business exceeded our expectations, and we saw double-digit growth in all segments and end markets. Utilities was up 17% due to robust demand and price realization in both M&CS and Water Infrastructure. Industrial grew 11% on strong price realization and demand across all regions. And lastly, building solutions, which includes commercial and residential grew 15%. Overall, demand remains resilient as demonstrated by our $5.3 billion backlog, up 7% organically, as Patrick highlighted, and now includes Evoqua. And while orders were down 2% on the quarter, book-to-bill continues to be above 1. EBITDA margin was 19.1%, up 250 basis points from the prior year on higher volumes, productivity savings and favorable price cost dynamics. Excluding the impact of Evoqua, EBITDA margin was up 200 basis points, exceeding our previous expectations. Our EPS in the quarter was $0.98, up 32% year-over-year and up 28% excluding the impact of acquisitions. Please turn to Slide 7, and I'll review each segment's second quarter performance in a bit more detail. M&CS revenue was up 21%, driven by improved chip supply as well as strong demand in pipeline assessment services. U.S. and Western Europe saw robust growth, and we continue to see favorable momentum in emerging markets. Orders grew 6% with a book-to-bill ratio of 1.2 and our backlog of $2.4 billion is up 17% versus the prior year, demonstrating continued strong demand for our AMI offerings. EBITDA margin for the segment was up 590 basis points versus the prior year on strong incrementals. Volume conversion, price realization and productivity drove the expansion, more than offsetting inflation and unfavorable mix. And now let's turn to Slide 8, and I'll cover our Water Infrastructure business. Water Infrastructure, which now includes Evoqua's Applied Product Technologies segment grew 20% on a reported basis and 13% organically. Growth was robust across the portfolio, with revenues up double digits in all end markets and applications. Developed markets saw particularly strong growth driven by OpEx demand, while emerging markets grew 7%, driven by Latin America and Asia Pacific. Orders in the quarter were down 4% year-over-year, lapping prior year growth of over 20%, and book-to-bill was above 1. EBITDA margin for the segment was roughly flat year-over-year and up 20 basis points when excluding the contribution of Evoqua. Please turn to Slide 9 for an overview of Applied Water. Applied Water revenues grew 12% on continued strong price realization and backlog execution. The U.S. and emerging markets grew double digits, while Western Europe grew mid-single digits. Industrial demand was both resilient in both Western Europe and emerging markets, particularly due to recovery in China. And while orders were down 6% in the quarter, our backlog continues to be elevated versus historical levels, and book-to-bill is 0.9. Segment EBITDA margin was up 290 basis points in the quarter with continued strong price realization, coupled with productivity more than offsetting inflation. Please turn to Slide 10. I'm very pleased to introduce Integrated Solutions & Services as our newest reporting segment. ISS is a leading North American water treatment solution and services provider that brings access to a durable and highly recurring revenue stream as well as a diverse and attractive industrial verticals. With approximately 75% recurring revenue, ISS is known for dependability and bringing mission-critical water treatment expertise to our customers. Although we only reported ISS after our May 24 close, full quarter revenue was up 12%, driven by strong price realization and backlog execution. And orders grew 4% with a book-to-bill ratio above 1 due to broad-based demand across industrials and utilities. Backlog of nearly $1 billion at the end of the quarter, was up 15% year-over-year. And adjusted EBITDA margin post close was solid at 24%. And now let's turn to Slide 11 for an overview of cash flows and the company's financial position. After retiring over $600 million of debt in conjunction with the closing of Evoqua, our financial position remains robust as we exit the quarter with over $700 million in cash and available liquidity of $1.6 billion. Net debt-to-EBITDA leverage is 1.4x and in the second quarter, we had solid adjusted free cash flow conversion of 86%. Please turn to Slide 12, and I'll hand it back over to Patrick.

Thanks, Sandy. Just a little more than two months post close, our excitement about the Evoqua acquisition has only grown. We've made great progress in three areas. First is our performance and outlook as the business stands today. We began the integration with an overarching principle, and that was to deliver continuity for our customers, keep our commitments and not disrupt business performance. The results tell a clear story of focused near-term delivery. The combination of our team's disciplined execution and healthy underlying market demand has given us the confidence to raise our full year guidance. But our current performance is, as you would expect, largely a reflection of our businesses as they are. What we're most excited about is our future potential and the opportunities ahead of us, which brings me to the second dimension on which our confidence is only growing. When the transaction closed, we announced a combined leadership team. And frankly, I'm energized by the strong cultural fit the team has already been demonstrating and the early momentum we've created. We are well on track to deliver the cost synergies outlined when we announced the transaction. As we progress through the integration, we have even more visibility of the operating efficiencies to be realized in coming quarters, along with the opportunity for significant further margin expansion. At the same time, the whole strategic rationale of this combination has always been about further accelerating our profitable growth. And that's the third dimension I referred to in my opening comments. We are now even more strongly positioned in attractive, durable end markets with a significant component of recurring revenue streams. Now that we have deeper insight into the intersection of our businesses and customers, we see those opportunities even more clearly. So moving on to Slide 13. This is the right combination at the right time. Together, we have the strongest platform of capabilities to address customers' critical water challenges. Those needs are increasing, and we have the scale and reach now to deliver differentiated solutions globally. Our teams are already detailing how we will do that. First, in utilities, we will deepen our penetration, especially with the addition of Evoqua's Applied Product Technologies to our Water Infrastructure offerings. In industrial, we'll use the power of our combined offering to scale our presence in attractive industrial end markets. And then we will expand our Services Solutions business by leveraging Xylem's well-established global distribution platform. Now as many of you know, this combination delivers on part of the strategy we laid out back in our 2021 Investor Day, and that was to expand our capability and our presence in industrial end markets. Increasing industrial exposure reinforces the durability of our overall business model and gains us greater access to attractive customer sets for even faster long-term growth. The recurring revenues of ISS, which deliver consistent performance throughout economic cycles, complement our M&CS and Water Infrastructure businesses, which also benefit from the resilience of utility spending. We've already taken the first steps in offering our combined portfolio to light and general industry customers and we're already targeting attractive industrial verticals such as life sciences and microelectronics. Both have strong long-term outlooks that are driven by secular trends that align well with Xylem's existing business. We look forward to keeping you up to date with our integration progress on a regular basis and anticipate providing a longer-term growth outlook at an Investor Day likely to be scheduled in the first part of 2024. Now with that, I'm going to hand it over to Matthew to say a bit more about our end market outlook.

Thank you, Patrick. Turning to Slide 14. Before I cover our end market outlook for the year, I want to thank the team and our partners for a great quarter. Our continued outperformance and momentum give us confidence to deliver in 2023 and beyond. We have record backlogs and the value proposition of our differentiated portfolio in attractive end markets puts us in a strong position even in a potentially dynamic macroeconomic environment. We continue to take a balanced approach in our outlook and are monitoring leading indicators watching for signs of moderation. That said, we expect resilient demand in utilities and continued steady growth in industrial water applications. And now I'll turn to our 2023 outlook by end market, which will be on an organic basis. Utilities, which is approximately 45% of our revenue continue to be healthy and we now expect growth of mid-teens, up from low teens. On the clean water side, we anticipate growth of low 20s, up from high teens previously due to robust demand for our AMI solutions, and backlog execution on improved chip supply. In addition, we are seeing great traction on solution selling with our digital platform and customers are increasingly interested in bundling offerings. On the wastewater side, we continue to expect high single-digit growth, resilient OpEx in developed markets as well as continued CapEx spend in emerging markets will underpin demand. Turning now to the industrial end market, which is 45% of our revenue, we expect steady global growth of mid-single digits, but are keeping a close watch for signs of moderation. We expect any softness from developed markets to be somewhat offset by growth in emerging markets including China, where industrial momentum has continued to outpace utilities. Lastly, in building solutions, which is about 10% of our revenue, we expect growth of mid-single digits, driven by steady replacement business and backlog execution. The overall demand outlook remains healthy. And although we are not including Evoqua in our organic outlook, we expect the contribution of mission-critical solutions and services in attractive high-growth verticals such as life sciences and microelectronics to further increase the durability of our business. That outlook, combined with our operating discipline, commercial momentum and large backlogs gives us confidence for the rest of the year and beyond. Now I'll turn it over to Sandy to walk you through the detail of our raised guidance.

Thank you, Matthew. Turning to Slide 15. We are increasing our full year guidance across revenue, EBITDA and EPS and also incorporating Evoqua. I want to take a moment to walk you through the puts and takes of how we now see the full year. We expect total revenues to be around $7.2 billion for the year, which includes approximately $1.1 billion from Evoqua and another increase in our organic revenue guidance. We now expect full year organic revenue growth of 9% to 10%, up from 8% to 9%. We are raising the low end of our EBITDA guidance to about 18%. And in addition, we are lifting full year adjusted EPS guidance to $3.50 to $3.70, up approximately $0.35 at the midpoint. This incorporates a $0.15 raise from our strong organic outlook and a $0.20 increase due to acquisition-related adjustments. This includes a contribution from Evoqua of approximately $0.45 and the add back of legacy purchase accounting intangible amortization of $0.30 and partially offset by incremental share dilution of about $0.55. As Patrick highlighted, we've made great progress on integration. We expect to be at $40 million of run rate cost synergies by the end of the year and we remain on track to deliver $140 million of run rate cost synergies within three years. Turning to Slide 16. For 2023, our organic revenue growth by segment breaks down as follows: approximately 20% growth in M&CS, high single-digits growth in Water Infrastructure and mid-single-digit growth in Applied Water and we are still on track to achieve free cash flow conversion of at least 100% of net income. We've also provided you with a number of other full year assumptions in the appendix on Slide 21. And now drilling down in the third quarter, we anticipate total company growth will be in the range of 40% to 45% on a reported basis and 4% to 6% organically. By segment, we expect revenue growth to be in the high teens in M&CS and mid-single digits in Water Infrastructure and remain flat in Applied Water. We expect third quarter EBITDA margin to be approximately 18%, driven by higher volumes, continued price realization and productivity gains. And with that, please turn to Slide 17, and I'll turn the call back over to Patrick for closing comments.

Thanks, Sandy. We've covered a lot here. So we look forward to your questions. But just before we do that, I want to reiterate a fundamental point. This is a transformational step forward for Xylem, and we believe it is transformational for our customers and our communities. We are very excited about this strategic evolution, but the most important things about Xylem are not changing. Our investment thesis is one of those unchanging constants. We are creating significant economic and social value with a durable business model that addresses intensifying water challenges. And we're doing that with a differentiated portfolio of solutions and services in attractive and growing end markets. This gives us a multiyear runway of profitable growth with sustainable margin expansion on the foundations of a strong balance sheet and cash generation with capital deployment to further strengthen our portfolio. It has become increasingly apparent that the need for solutions to the world's water challenges is only growing, and we are in a very privileged position to serve those needs. So now we look forward to taking your questions. So operator, let me turn the call back over to you for Q&A.

Just a comment to start, and we really appreciate all the heavy lifting that went on, all these moving parts, recasting financials, the re-segmentation, the new end market mix and the move to cash EPS. And look, from our perspective, that all makes sense, but we appreciate all the work that...

Before your question, I want to acknowledge the entire team here and around the world who have contributed not only to closing this transaction but also to all the various moving parts you mentioned. During this time of exciting momentum and considerable effort, we truly appreciate that recognition.

Yes. That's exactly what I was doing. And just the fact you did not skip a beat on the organic side of the business. Cash conversion, order intake and so forth. So that was the comment part. And now I go to my question. On the re-segmentation, ISS is a stand-alone check the box. That's what we'd expect you to do. And then combining APT with Water Infrastructure that also makes sense because that's where there's some interesting overlap in terms of go-to-market, customer, not so much on the technologies, but on the go-to-market side. So first question, because that is where there's some integration that will be going on. So give us a sense of what that integration effort is on combining those businesses and anything about the cost synergies and any conceptual thoughts on revenue synergies?

Yes. Thanks, Deane. So I'm going to hand it to Matthew to comment on your specific question. I would say that the integration efforts are really off to a great start. And APT, that part of Evoqua is a clear and obvious opportunity for us, and I've been really pleased and impressed by the cultural assimilation of the teams. But with that, I'll let Matthew comment a bit more on why that integration, why now and what that kind of looks like for us.

Thank you, Patrick. Deane, first, as Sandy noted earlier, these are very complementary businesses. There are immediate synergies on both the revenue and cost fronts, enabling us to hit the ground running. The teams are making significant progress, as Patrick pointed out, and this allows us to quickly cross-sell our products in the industrial and utility sectors. For instance, in the utility sector, we can now bundle our solutions and provide a comprehensive solution covering the entire treatment process from start to finish, which we couldn't do before. Merging the two companies allows us to offer this complete package. Additionally, our technicians, referred to as AQUApros, are engaging with our customers and now have access to a wider array of solutions to address customer challenges. We are already seeing them recommend new products from our portfolio organically. This may not have been obvious, but it is already taking place. Furthermore, there are clear R&D synergies that arise from combining our treatment operations. Lastly, as Patrick mentioned earlier, we have incorporated three leaders from Evoqua into our senior leadership team. Hervé Fages will lead the combined treatment business, bringing extensive experience that will be crucial for our initial performance in terms of cost and revenue.

It's great to hear all of that. My second question is about digital. First, can you provide an update on the chip supply? Is there a continued gradual improvement? What does the outlook look like? Additionally, Patrick, Xylem has been pursuing a digital strategy aiming for 50% of revenues by 2025. I understand it's still early, and I'm not looking for a specific number, but conceptually, can you share how this intersects with Evoqua's digital efforts? Together, that should help you reach this goal. So, could you address the chip supply and then your conceptual progress towards achieving half of your revenues from digital by what timeframe?

I'll let Matthew start on where we are on chip supply and then he and I will tag team on where we are in digital.

Great. Chip supply, Deane, as you mentioned, is continuing to see gradual improvements as we expected. Q3 will look a lot like Q2. We do expect a pickup in Q4 and also as we head into 2024, we do expect chip supply to improve, but also our redesigns will be coming online as we head into the really the end of 2023 into 2024. So that gives us confidence that we'll see that ramp Q4 and then into '24. Maybe just a few comments on digital and then Patrick can wrap it up. We are making good progress towards the 50% of revenues digital goal. That was a legacy Xylem target. We can see it in the backlog. We have a lot of digital content that's trapped in the backlog. And that will start to release as we get better chip supply and we get better, just in general electronic supply over the course of the next six to twelve months. The continued adoption of AMI, as you see in the backlog increase this quarter with M&CS, we're up $300 million. So making significant progress on digital, especially buoyed by AMI. And then I'd say, lastly, the partnership with Idrica is really important because it enables us to pull through more digital content. We're already starting to see that play out. So I'd say, all in all, we're in a good trajectory, and we're making good progress.

Yes. I would like to conclude that this is a crucial aspect of our overall strategy and differentiation in the market, which is why your question is so relevant. I have high confidence in the foundational Xylem business. I am also very encouraged by the strong adoption of AMI in the market, as reflected in our increased backlog and successful deals. Regarding Evoqua, our approach there is more about complementing our digital strategy. In the Evoqua businesses, particularly within the ISS sector, the focus has been on utilizing digital tools and connectivity to enhance service productivity, making it easier for AQUApros to perform their tasks. This can lead to improved margins. There is significant potential within the ISS portfolio to increase our EBITDA margins by digitally empowering what they do daily, reducing the need for truck rolls and customer visits, and providing greater data insights to anticipate issues before they arise. There is a lot of exciting work happening here, and for those unfamiliar with either the Xylem or Evoqua stories, we will share more at our upcoming Investor Day. It's very exciting.

So the first question, I think, is a relatively straightforward question, but I just want to level set everything, given how many moving pieces here that there are. So it sounds like guidance was raised both organically as well as your expectations that have moved higher on the Evoqua piece if we compare this to, call it, two or three months ago, whenever you last gave an update. Can you just talk through the pieces of why those expectations have moved higher? I know some of it is the second quarter outlook, but it feels like that it's a little broader than that. So can you just maybe line out those moving pieces for us?

Yes, let me address that, Mike. If you take a look back to February, we are now forecasting approximately $300 million higher in revenue compared to our initial guidance. We did increase our guidance the last time we spoke, and this quarter we raised it by another $75 million. In the M&CS segment, we initially anticipated low teens growth for the year, but we are now expecting 20% growth in that area. We are also seeing strong incremental margins coming from this business. The growth is driven by metrology and other complementary businesses that contribute to the overall upside. The other two businesses are performing well and have managed to stay ahead of price and cost dynamics to maintain their momentum. Additionally, we are witnessing significant increases in volume across the board. Overall, all parts of our portfolio are contributing to the positive results. Regarding Evoqua, we previously projected around $1.1 billion in contributions for the year, and this past quarter, we generated approximately $175 million in revenue from Evoqua. The margins there are developing very nicely, and our outlook for the rest of the year shows that the margins for both companies are closely aligned. It is encouraging to see strong momentum from both sides, which reflects our deal operating principles, keeping both teams focused on executing the organic plan.

Great. No, that's exactly what I was looking for. Appreciate that. And then second question, maybe you could just talk a little bit about the momentum you're seeing on the utility side as we work through next year. Book-to-bill seems pretty good on the utility pieces. Obviously, M&CS is healthy. I think the infrastructure piece is healthy, though, obviously, you got some industrial in there. Backlog is very high on the M&CS side. Maybe just talk about the visibility you have on those pieces in the next year, wrapping ISS into that a little bit as well, and talk about how you're looking at the contribution from some of these regulatory drivers coming out of some of the funding that might or might not get released here?

Yes. I'll begin, Mike, and then I’ll pass it to Matthew. Regarding your question about utilities, we feel more confident than ever about the position of utilities globally in the market cycle. In the U.S., although we are still in the early stages of Advanced Metering Infrastructure adoption, there is a growing excitement around it. This is evident in our bidding pipeline, deal successes, and backlog, all of which indicate a strong trend in AMI adoption and our capability to compete and succeed in that sector. Additionally, the primary component of utility expenditures is Operating Expenses, particularly for repairs and replacements. Given the aging infrastructure globally, especially in North America and Europe, we anticipate a sustained increase in demand and positive outlook. Furthermore, there are other factors to consider, such as the Inflation Reduction Act and various infrastructure legislation in the U.S. We've received many inquiries about PFAS, and with our Evoqua capabilities, this is an exciting area for us. However, as we've previously mentioned and as Ron, the CEO of Evoqua, has indicated, the adoption process will be gradual, not immediate. This trend reinforces the favorable momentum we believe we have at Xylem. That sums up my thoughts on utilities, and Matthew, feel free to add anything.

I think I'll add that we maintain strong relationships with our customers, particularly our utility clients. Based on discussions we’ve had with them in recent months, we believe there will be no slowdown. The preliminary municipal budgets for next year from some of our utility clients indicate year-over-year growth. That's the feedback we are receiving from our customers. We operate globally in the utility sector, with half of our revenue coming from outside the U.S. As Patrick mentioned, there is significant public funding available globally, including in the U.K. with the AMP cycle, as well as in China, the EU, and the U.S. Overall, we feel optimistic.

Can you talk through like kind of how the quarter went in Western Europe and China? I mean that's where the debt has been kind of squishy and maybe getting work there a little bit. And I'm just curious on your thoughts on potential for Chinese stimulus and where that might get directed if it does impact you guys?

Yes, it's Matthew. I’d like to share some insights on Europe. The market remains resilient, particularly in utilities, which makes up over 50% of our European revenue, primarily in OpEx, as Patrick noted earlier. We experienced a low teens increase in orders in European utilities, which is encouraging. The softer performance is mainly in building solutions, but industrial activities help to offset this. Overall, Western Europe has seen a low single-digit increase in orders, indicating a solid performance when considering the overall balance. In China, which accounts for about 6% of our revenues, we noticed positive trends in both orders and revenue during Q2, with an increase of over 20%. Although this was against an easier comparison, the efforts of Shuping Lu and the team in China have been impressive. They have shown remarkable resilience by localizing products and focusing on high-growth areas amid some sluggishness. Industrial has been a leading sector for us in China, and we are beginning to see some positive movements in utilities. Conversely, the commercial building market has shown weakness, but it represents a smaller portion of our business in China. About 75% of our operations there are utility-centric, so overall, we are very optimistic about China’s long-term outlook, particularly given the critical emphasis on water management in the country.

And Joe, you know this already, but for the rest of the listeners, I've been a long-term bull on China just because of the underlying demands and needs from a water and environmental standpoint there continues to be a top policy mandate of the government. You couple that with the strength of our team and our portfolio of offerings. We've weathered a couple of cycles in China over the time that I've been here. But when you go back and look over the last seven or so years, it's like a double-digit CAGR of growth, and we continue to see that potential going forward. So I'm very proud of the team and optimistic about China for us.

That's good information. I wanted to follow up on Idrica. What needs to happen for it to become a central part of your digitalization efforts on a larger scale? Sandy, I have one clarification for you regarding APT within Water Infrastructure. How did that perform organically in terms of revenue and orders over a full quarter?

Yes, let me knock that out of the way and then Matthew can take Idrica. When you look at the performance of the full quarter of Evoqua, the business grew 9% organically and the APT piece of Evoqua grew 4%.

Great. Yes. In terms of Idrica, for those who may not be familiar, we have a worldwide exclusive commercial partnership with Idrica, which is based in Valencia, Spain. They originated from a utility operator, and their digital platform addresses the major challenge utilities face: the need for a unified platform to integrate all their applications and data. We've gained significant momentum over the past four to five months, engaging with over 200 utilities globally. The reach is well-balanced around the world, and we've established a strong sales pipeline with notable synergy benefits from bundling our solutions. This initiative is becoming a foundational element for us and, as mentioned in Deane's question, it will assist us in promoting and driving more digital content as well as recurring revenue, which is crucial. For instance, in the U.S., we recently utilized this digital platform, referred to as Xylem View, which is the Idrica platform, to secure a large AMI order that's now reflected in our backlog. Consequently, our backlog increased by $300 million, and a significant part of that growth resulted from the digital platform facilitating that order. This will enhance our recurring revenue and also help deliver substantial content, which is a significant advantage.

I'm going to start on the cost synergy side. Pretty good run rate to be at $40 million by the end of the year, like 30% of the targeted cost synergy number. So maybe you could just start off by talking about where that's coming from to hit that kind of run rate that quickly in this kind of deal, the major buckets for the $140 million? And then if you can give us any color on how we should think about those layering in, in '24, '25, '26?

Yes. Sure, Nate. Let me kick that off. I think the cost synergy buckets that we outlined when we announced the transaction have not changed. So the first category was to go after public company costs, overlapping public company costs as well as some of the SG&A savings. And so that is making up the lion's share of the savings that we're going to realize in 2023. And the other two categories of savings, which are going to come from procurement savings as well as some site consolidations and manufacturing footprint overlap, we expect the procurement savings to start to kick in later in '24. And the manufacturing site consolidations, that's going to happen over time. We have those phased because we want to make sure we're purposely taking care of our customers. So about $40 million exit rate in Q4 as I look into '24, we'll be more than double that when we exit '24. So I think all signs, we're very confident about the $140 million.

I wanted to ask a couple of questions, or perhaps one long question, about revenue synergies, which is a significant reason for pursuing this deal. I'm not looking for specific figures, but I would appreciate a discussion about the areas where you see potential for revenue synergies and how they might unfold over time. For instance, the combination of APT and Water Infrastructure suggests there are revenue synergies to be explored, as you have mentioned before. Additionally, could we consider expanding Evoqua's service-based business model internationally and using their U.S. presence to enhance service-based offerings with Xylem's legacy products? Are there any other channels you could discuss that would help us understand the opportunities available?

Sure. So Nate, this is Patrick. I want to highlight the three main areas we are concentrating on. We have also implemented special incentives for our teams to pursue revenue synergies since we want to ensure they are highly motivated to go beyond their regular duties. First, we're focusing on deepening our utility penetration, which involves leveraging the complementary treatment product portfolios of both companies and utilizing Xylem's strong utility position globally. This opportunity extends beyond North America. Secondly, we're looking to scale our offerings for industrial customers, where we see considerable potential to meet their needs. Lastly, we aim to expand the ISS offering internationally. The second and third points are closely related. In our evaluation of Evoqua, we found they have a remarkable list of leading customers across industries such as power, food and beverage, life sciences, and microelectronics. These sectors require more capabilities than Evoqua has provided historically, especially in international markets. Xylem possesses the necessary footprint, scale, and resources to facilitate this expansion effectively.

Operator, I think we've heard from him.

Maybe digging into building solutions a little bit. Commercial demand has continued to be strong. I think this is one area that you're anticipating a slowdown previously. So maybe just an update on what you're seeing there.

Yes, I apologize for the interruption. You asked about our commercial business? It has been quite resilient this year, showing strong revenue growth. Our outlook for the remainder of the year remains positive, as we continue to have an elevated backlog, so there have been no significant changes.

Saree, you were a bit choppy and breaking. I want to make sure we clarify your question in terms of which segment.

Yes, I think you were anticipating a slowdown previously. Just trying to get an update on building solutions. Additionally, regarding residential, it's obviously a small market for you, but how did that trend throughout the quarter? Are you seeing any positive signs there?

Yes. Saree, I mean, I think when you look across the portfolio, we're seeing really good orders momentum and strong book-to-bill. The one soft spot in our portfolio is residential. And before the acquisition, that made up about 5% of our revenue base. Now it's even lower than that. It's 2% or 3% of our revenue base. So yes, that is the weakest part of our portfolio. You're seeing a slower growth outlook in AWS for the second half of the year, offset by the other businesses that have more resilient end markets such as utilities.

So Patrick, dewatering has obviously remained strong for you guys. We talked about it in the past being a little more cyclical, but it seems like it's sort of holding up well. So maybe you can talk about sort of what you see going forward, maybe even into '24 in that business.

Yes. So dewatering had historically, for those that may be relatively new to the story of Xylem, had historically been one of our more cyclical businesses. And because it's such a high-margin business, it would tend to capture spotlight even with a little bit of movement in terms of downturn. And there have been a number of moves that we've made over the past handful of years to diversify the end market exposure of that. I'll hand it over to Matthew to kind of give his take on kind of where we are positioned right now. But I'm certainly proud of the work the team has done. And there's been a lot of work done on synergy, commercial integration even before the acquisition of Evoqua and I know it's like stronger now.

Yes. No, it's great, Patrick. We've put a lot of time and effort into dewatering over the past couple of years, Andy. And I would say maybe a couple of things. One is we invested in the fleet, both in Europe and in the U.S., which has really helped us capture more wins. Number two, really coming out of 2019, we needed to diversify our segments in dewatering. We were too oil and gas dependent. And we've done a nice job of mixing into light construction as well as into mini bypass and some different areas that are a bit more profitable and a bit more steady and less cyclical. So those are a couple of key drivers, I would say that's really helped us. And the last thing I would say in the U.S. where predominantly our revenue is, we've done a good job of driving the businesses together and driving synergies with our service organizations, passing leads back and forth to one another, with our pipeline assessment service businesses, our valve maintenance business and whatnot. So really good on the synergy side that's helped drive growth as well.

I would conclude my answer by emphasizing that in this business, especially in this area, leadership is crucial. We have a strong leadership team that collaborates effectively. They are utilizing the portfolio and concentrating on local service levels. This business, similar to our ISS operations, is very much focused on people. It's a 24/7 environment where day-to-day operations are vital. The dedication and engagement of our team truly impact customer experiences in real-time. I want to commend the leadership team for their achievements.

Thank you, everyone. I apologize for joining the call a bit late, so if this has already been addressed, please bear with me. Could you discuss the relationship between pricing and costs? You mentioned improvements in the supply chain, so I'm curious about how pricing is affected by that. Additionally, as you consider Evoqua, are there any differences in the markets regarding pricing versus costs as we approach the second half of this year and into 2024?

Thank you for the question, Andy. We have observed a positive trend in the price cost dynamics, which has benefited our margins. We are beginning to anniversary some of the price increases implemented during the peak of inflation. As a result, we do not expect to see as significant a benefit from price increases in the second half of the year compared to the first half. The encouraging news is that this is the first quarter where we have seen inflation begin to moderate, and we anticipate some continuation of this trend in the latter half of the year. This progress is a testament to the exceptional efforts of our commercial teams over the past year.

A question on the M&CS margins. Kudos on super solid execution there. I don't think we've seen margins at these levels since I think right after you bought Sensus, so it's been a while. So just trying to get a better sense of what drove that, how sustainable it is? And then what we maybe should be thinking of run rates through year-end. And if you think this is a good sort of jumping off point for potentially getting back to a double-digit margin on a full year basis next year. Is that a reasonable sort of target to have at this point?

Yes. Thanks for the question. I'll start us out and then turn it over to Sandy. But we've spent a lot of time in the past six to twelve months, really, the past twelve months on M&CS margins. And I'd say there's probably two or three things I would point to. Number one, obviously, we were hampered by chip supply, not being able to unlock the backlog. And so being able to unlock the backlog has really helped with absorption in our factories and helping cover fixed costs. So that's probably number one. Number two is we're getting back to productivity in that business. We had to redeploy resources to go after redesign our products for chips. And so productivity has increased this year year-over-year, and we'll continue to drive that in the business. And then thirdly, I would just say, in general, price cost has been a very good positive over the past two to three quarters in M&CS, which has helped buoy margins as well. So we'll continue that pace going forward and expect margin improvement sequentially going forward.

And Brian, this is Patrick. I would like to provide some historical context for those who may be new to this story. M&CS is not a turnaround. This has been a challenge in delivering on a backlog that has impressively grown over the past few years. We have had insights on the margins related to that backlog for a long time. We made commitments previously regarding revenue levels and corresponding margins, and you are seeing that reflected now. I would like to commend the entire team, particularly in the metrology segment of our business, as they have been executing this ever since the acquisition. It has always been a process, and now it seems that obstacles are clearing, revealing the full potential or at least the next stage of potential for this part of our business.

Thank you for the insights. I have a follow-up question regarding the acquisition of Evoqua. With this deal, we clearly have a larger scale and a more diverse business model, which suggests it may be less cyclical in the future. Previously, Evoqua has reported on their recurring revenue as part of their sales mix. Now that we have merged, could you share your thoughts on the recurring revenue aspects of the different segments we are exposed to and how that compares to Xylem on its own?

Yes, that's a great question, Brian. While it was not the main reason for the acquisition, one significant advantage is the recurring revenue aspect. The Evoqua business provides us with a clear view for each year based on contractual commitments regarding their revenue. A major portion of their revenue is predictable and repeatable. This is especially true for ISS, which is the largest segment we acquired from Evoqua. In addition, our M&CS business, focusing on metrology, has a substantial amount of revenue secured by contracts as well. We can foresee most of that revenue over the year and even up to a 10- to 12-year period, thanks to the AMI deals. Water Infrastructure is similarly stable, given our extensive installed base of submersible wastewater pumps and long-term treatment projects. We are confident in this consistent repair and replacement market. Our Applied Water business has traditionally been shorter in cycle, but we estimate that 30% to 40% of its revenue, while not contracted, comes from a replacement model. Once our pumps are specified in commercial or industrial settings, customers are unlikely to switch to another supplier. This creates a strong customer retention. In the future, we will provide specific aggregate numbers, but we are now much more optimistic about the durability and nature of the recurring revenue from this business than we were a quarter ago, thanks to the integration of Evoqua.

Well, again, I mean, thanks to all of you for your time this morning and for your ongoing support. I look forward to seeing many of you over the coming months here before our next call. And just a reminder, lastly, again, really excited today about the power of the combination of two companies coming together that were strong on their own and performing well. And now is the time. It's the right time in this world for these two companies to come together because there are so many great water challenges out there to be dealt with, and we feel that we are in a position to really be a meaningful part of that. So thank you all very much.