Xylem Inc (XYL) — Q1 2024 Earnings Call Transcript

Thank you, operator. Good morning, everyone, and welcome to Xylem's First Quarter 2024 Earnings Call. With me today are Chief Executive Officer, Matthew Pine; and Chief Financial Officer, Bill Grogan. They will provide their perspective on Xylem's first quarter 2024 results and discuss the second 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. A replay of today's call will be available until midnight May 9. 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 with references to prior year segment metrics being made on a comparative basis, reflecting the change in segment as of the beginning of the year. For purposes of today's call, all references will be on an organic and/or adjusted basis, unless otherwise indicated. 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 CEO, Matthew Pine.

Thanks, Andrea. Good morning, everyone, and thank you for joining us today. The Xylem team delivered a very strong first quarter, outperforming expectations on all metrics. The team drove high single-digit organic revenue growth, reflecting a healthy balance of both volume and price. We also expanded adjusted EBITDA margin almost 300 basis points, and without outperformance, we delivered EPS growth of 14%. The story is pretty straightforward. We have strong commercial and operational momentum with resilient underlying demand in the majority of our segments and end markets. I want to thank all our teams for doing a great job. But I want to highlight two teams in particular, Measurement & Control Solutions and Water Solutions and Services. In both segments, focused effort paid off in really outstanding numbers. In MCS, organic revenue grew more than 20% and margins are up over 500 basis points year-over-year. In its first quarter as a combined segment, WSS stayed focused on serving our customers and delivered both the highest orders growth of all segments, making a significant contribution to Xylem's overall margin mix. In addition to operational and commercial performance, the first quarter also reflected continued momentum on integration synergies with Evoqua. We saw a very solid Q1 run rate on cost capture, and we're confident in how we're tracking both on revenue and cost synergies. On the basis of our momentum, the team's disciplined performance and continuing resilient demand, we're raising our full year guidance for both revenue and margin and lifting our EPS guidance $0.08 from the midpoint. As we look forward, operationally, we're focused on maximizing value from every incremental volume we deliver. The team's impressive first quarter margin performance reflects our increasing operational discipline. We're driving simplification across our business, doing the few things that matter most even more efficiently. To solve water, we have to simplify water both for our customers and for ourselves. Strategically, our demand outlook continues to be supported by secular trends that are set to continue across economic cycles. As the headlines reflect, we're seeing an increasingly water-challenged world. And just as with energy, the water economy is intertwined with every part of business and life. So, as water security becomes pressing, we'll continue to see increasing demand for the solutions that can help make companies and communities more water secure, and Xylem's platform of capabilities is uniquely positioned to meet this demand. We recently announced we'll be hosting our Investor Day on May 30 to take place both virtually and here at our headquarters in Washington. We're looking forward to the opportunity to provide updates on our strategic outlook, long-term growth and financial framework and our 2030 sustainability goals. And with that, I'll hand it over to Bill to cover the quarter's results, our financial position, and our outlook in more detail.

Thanks, Matthew. Please turn to Slide 5. Q1 was an excellent start to the year, exceeding expectations across revenue, margin, and earnings per share. I want to echo Matthew's thanks to all of our teams for remaining focused and turning in an outstanding quarter. We continue to see resilient demand with our backlog increasing 4% to $5.3 billion. Organic orders grew 3% in the quarter with book-to-bill above 1, supported by strength across developed markets, particularly in WSS. Total revenues grew 40%, and organic revenues rose 7%, exceeding our guidance and reflecting a healthy combination of volume and price. Our performance was led by M&CS and WSS, and we saw growth in all regions, led by double-digit growth in the U.S. EBITDA margin was 19.2%, up 290 basis points from the prior year, with productivity savings and strong volume, price, and mix more than offsetting inflation and investments. Our EPS in the quarter was $0.90, above the high end of our guidance by $0.05, up 14% over the prior year. Our balance sheet remains healthy with ample liquidity to support capital deployment. We started the year with free cash flow conversion of 9%, which represents significant improvement compared to the typical seasonality of negative Q1 free cash flow conversion. This year, we delivered higher net income, offset slightly by increased CapEx. Please turn to Slide 6. Measurement & Control Solutions had a great quarter and exceeded our expectations. Orders grew 3% on continued smart metering demand. Backlog rose to $2.2 billion, up 6% organically and book-to-bill came in slightly under 1 due to greater backlog conversion. M&CS revenue was up 22%, driven by smart metering demand and backlog execution. We finished the quarter with EBITDA margins of 22.7%, up 550 basis points versus the prior year and up 440 basis points sequentially. Margin expansion was driven by productivity, higher volume and price, and favorable mix, more than offsetting inflation. In Water Infrastructure, orders grew 6% in the quarter, led by robust transport demand. Revenue exceeded our expectations with total growth of 40% and organic growth of 6%, driven by healthy demand across all regions and applications. EBITDA margin for the segment was up 320 basis points driven by productivity, mix, volume, and price offsetting inflation. In Applied Water, although orders declined versus a year ago, book-to-bill was greater than 1, reflective of a few large project wins. Revenues were down 4%, in line with our expectations against strong growth in the first quarter last year, primarily driven by a decline in developed markets. Segment EBITDA margin declined 380 basis points year-over-year, attributed to an unfavorable mix, higher inflation, and volume declines, partly offset by productivity savings. Wrapping up with Water Solutions and Services, orders grew 7% organically, led by dewatering and 19% on a pro forma basis with book-to-bill well above 1 in the quarter, driven by a large order for a 20-year outsourced water contract. Even excluding that large order, pro forma demand increased. Organic revenue was up 6%, while pro forma revenue increased 9%, with healthy growth across most of the businesses. Adjusted EBITDA margin was strong at 22.3%, driven by favorable mix in volume and price and productivity. The outperformance across WSS is a great reflection of our team staying focused on what matters, serving our customers throughout this integration and re-segmentation. Now let's turn to Slide 7 for our updated full year and second quarter guidance. Given our first quarter outperformance and both commercial and operational momentum, we are raising our full year guidance. We are increasing our revenue guide to approximately $8.5 billion. This reflects an additional point of growth versus prior guidance, putting total revenue growth at 15% to 16% and organic revenue growth at 4% to 6%. We are confident about driving further margin expansion with operational productivity and raising our EBITDA margin guidance to about 20%. That represents 110 basis points of expansion versus the prior year driven by higher volume, productivity, including cost synergies, and price offsetting inflation. Our updated EPS guidance of $4.10 to $4.25 reflects an increase of $0.08 at the midpoint. We continue to expect around $100 million of exit rate cost synergies in 2024, and free cash flow conversion for the year is still expected to be 115% of net income. The full year outlook at the segment levels remains largely unchanged from our comments in February. For the second quarter, we anticipate total revenue growth will be 23% to 25% on a reported basis and 5% to 7% organically. We expect second quarter EBITDA margin to be approximately 20%, up 90 basis points, driven by higher volumes, continued price realization, and productivity gains. This yields second quarter EPS of $1 to $1.05. We came into 2024 at a healthy pace, and we've had a strong start to the year, building further momentum. Our diversified portfolio positions us well to address our customers' evolving needs, and we anticipate healthy demand across most end markets and applications. While we are closely monitoring the macro environment, including inflation, higher interest rates for longer, a strengthening dollar, and geopolitical uncertainty, our overall outlook for the year remains positive. With that, please turn to Slide 8, and I'll turn the call back over to Matthew for closing comments.

Thanks, Bill. Two things I want to mention before we close. First, it's been such a privilege in my first 100 days as CEO to spend time with so many Xylem colleagues around the world. You can see they're doing fantastic work, and it's evident in today's results. Our integration progress is a great indicator of how smoothly the Xylem and Evoqua teams have come together. As a combined company, there is so much potential for growth and impact, especially as we pivot to even stronger execution of our strategy. To achieve our potential, we're being very intentional about the culture we're building. Specifically, we're creating a culture centered on behaviors that drive empowerment, accountability, and innovation. We call it our high-impact culture, and it's the heart of our strategy for creating the next phase of Xylem's growth and impact. Of course, culture change takes time, and it starts with myself and the leadership team. So it's incredibly energizing to see the cultural alignment already coming to life in our town halls and business reviews at all levels in the organization. We'll talk a bit more about how we're fostering our high-impact culture when we gather together for Investor Day at the end of May. Lastly, on Investor Day, we'll also be launching our 2023 sustainability report. We're very proud of what we've achieved and even more motivated by the work ahead. In this year's report, we'll be introducing our combined company goals for the first time, setting our ambition for impact through 2030. Given how fundamental sustainability is to Xylem's business model, I invite you to give it as much attention as you give our financial results. And as always, we welcome your feedback. And with that, I'll turn it over to the operator to lead us through Q&A.

Maybe we can start with the Evoqua integration and discuss the potential revenue synergies and the rollout of the European business. Can you provide any insights regarding the potential for new outsourcing contracts? Additionally, any information on the large outsourced contract would be appreciated.

Yes, I can start us off, Deane. I'll have Bill cover the big win that we had in our newest WSS segment on the long-term build, own, operate contract. But maybe just broadly on the Evoqua integration update, it's really hard to believe that we closed about a year ago. Just to remind everybody, we closed that in record time, announced in January, closed in May of last year. I would characterize this as great momentum. Obviously, we've got an Investor Day coming up in about four weeks, and we're going to have some tangible proof points to the progress that the teams are making. Just briefly, cost synergies are tracking well to meet the $100 million run rate that we've talked about in our '24 plan. And Deane, on revenue synergies, we're ramping. That was the last thing that we were able to really focus on. Obviously, on the cost side, you can do a lot of work before the close. You can't jump on the revenue synergies before closing. But the teams have really ramped up. We're going to have some nice proof points to share in a few weeks here in D.C., but I don't want to steal the team's thunder there. But great momentum. And you're going to see examples across three of our four segments of those revenue synergies. Maybe specifically on international expansion to your point. We are making quicker progress on the capital side of that. But we're starting to build momentum on the services side. We have three or four large scale projects that we're working on in the Americas that are outside the U.S., and we have some work that we're starting to investigate in Europe. So, I'm happy with the momentum that the teams are making.

Yes. And Deane, maybe just to that project. I mean, it's a great win by the team. It's a $100-plus million 20-year outsourced water project to support a large hydrogen plant investment with one of our key customers. There's an upfront revenue recognition over the first 18 months, and it's about one-third of it, the balance will be recognized over the next 20 years. So excited about that. Sticky recurring revenue that this project will provide. The team has a really strong funnel of large opportunities continuing to work through, and we look to see continued wins as we progress through the year.

It's great to hear all of this. For my second question, I'm not trying to get ahead of the upcoming analyst meeting, but there's an expectation for portfolio optimization and targeted margin improvement. I would like to understand more about the growth strategy during this period. Are you still focused on mergers and acquisitions or exploring new opportunities? I want to ensure that we don't miss any potential growth during this portfolio optimization phase.

No, that's a great question, and you pretty much hit on three of my key messages that I'll be taking up in the Investor Day with me. Look, we're extremely focused on executing the platform that's been built over the past decade, especially over the past year with the Evoqua acquisition to drive above-market growth. This is our number one execution priority in our goal deployment process this year and in future years, and it's bolstered by the Evoqua synergies. Look, Q1 is one data point with our new leadership team in place here. We're up 6% in volume and 1% in price, which is a good beginning of what we're building on the top line. I'm super proud of our team's top line mindset. It's not a secret; I've been very vocal about our operating leverage. We want to make sure that we're driving profitable growth while expanding our margins. Again, Q1 is a good example of that, with roughly 60% incrementals on a pro forma basis. What we talk about with inward focus is really about simplifying our business to grow our business. We're doing both. That's our mantra. From a capital deployment standpoint, we'll get into more detail here in a few weeks, but we're going to focus on high-growth markets with accretive margin, and we're going to be more consistent in our capital deployment. We've just wrapped up some value mapping work that will inform where those opportunities are. We look forward to sharing that with you and others here in a few weeks.

So a couple here. First, maybe just taking a step back here, you've been in the role for over 100 days, and Bill, you've been there for about 6 or 7 months now. What are the initial impressions as far as the momentum you're seeing, how the messaging you two are pushing through is starting to sink into the culture, sink in to the people? And what kind of impressions do you have so far?

No, that's a great question. I did mention that in my opening remarks about the first 100 days. We as a team feel good about where we are. We believe we had good momentum coming into 2024, and we're continuing to build on that momentum that you've seen in Q1. We're executing on a great platform, which I just teed up with Deane here. I'd say we did not have a cold start; we didn't start on January 1 and figure out how to turn the crank. With our COO having the opportunity to refine the strategic priorities in our strategy session with the Board last year, those themes centered on value capture from our Evoqua transaction, simplification, both in service of margins and growth, which I just mentioned to Deane. We're deploying that more systematically through the business. I'm proud of what I'm seeing when I'm out with the teams, scaling services. I'm pleased to see the progress on our Evoqua integration, both economically and in results. But culturally, the teams are coming together and working fantastically, and we're seeing momentum there. The most important factor is the culture because you can have objectives and strategies, but if you don't have the right culture, it's hard to execute consistently. The work we're doing on our high-impact culture started last year with our senior leadership team. Just engaging our top 150 in the organization at the end of last year coming into '24, we're seeing great alignment. I've spent a lot of time on the road the past 100 days globally. We're not satisfied, but I think we're off to a good start.

And then kind of a broad question on underlying dynamics in orders. One, can you give the pro forma organic overall orders for the company or give some sort of proxy for it? And then second, if I listen to the messaging here, it feels like not a lot has changed in terms of what you're seeing from an end market perspective across the various segments. I'd like to understand if there are any notable factors that have either inflected more or less than you thought in the quarter or from a trend line perspective?

Maybe I'll let Bill open up on your orders question, then I'll provide some commentary and color on the markets.

Yes. So obviously, organic was reported at 3%. The pro forma organic was 7%, so more than double that.

Good momentum on orders in Q1. Book-to-bill was greater than 1, and backlog was up 4%. Not a lot has changed; demand remains healthy in the majority of our end markets, supported by favorable drivers we've talked about regarding secular trends. Government funding is trickling in globally across different parts of our coverage, and there is a lot of resiliency in municipalities or utilities for both OpEx and CapEx. There have been questions about potential rate slowdowns, especially in the U.S. and Europe, but we're not seeing any slowdown. With our results in the WSS segment this quarter, we're seeing durability in that business model, and I'm proud of the M&CS team's backlog conversion. We continue to win orders, and our orders are up year-over-year, showing good momentum there. Our watch areas continue to be Applied Water; it largely was what we expected, and we're working on some things to continue improving performance there. That would be my commentary on where we are right now from a demand perspective.

Congrats on the first 100 days and having a good quarter here. Big picture, Matthew, when you see a synergy target after a deal like yours, I have to wonder, is it input or output, meaning are you trying to find $100 million in synergies? Or is it a natural output of the actions that are taken integration-wise? The second derivative of the question is, if those synergies track above the target, will you likely be more inclined to invest that back into the business or show it on the margin line?

Yes, if you're referring to the cost synergies as a part of the Evoqua transaction? We announced $140 million when we did the deal, so it is a little bit more than $100 million. We're targeting above $140 million. We're going to make sure we land at 140, and we'll probably allocate any excess to the bottom line and invest in growth. It's a mixed bag of whatever the overage would be falling half to the bottom line and half to top line growth. While there are cost synergies that are easier to achieve, like procurement and back office, there is a lot of work that goes into this and much tracking is necessary. I'm impressed with the capability we've built through this transaction, which will help us in the future regarding capital deployment.

That makes sense. When you think about the areas where Xylem is historically perhaps over-invested or under-invested, what stands out as areas of improvement? You've mentioned cultural changes and some operational rigor, but can you be more specific about areas that could use more attention?

Yes. I think the first area is cultural, and we're already making good progress. You've heard me talk about simplifying water, which boils down to this. Over the years, as we've built this platform, we've faced some complexity that has conspired against us, impacting our margin profile. We're not going to be super inwardly focused; we need to focus inwards to serve our customers better. Our approach is to simplify our business to grow our business, and we’re working on internal processes to improve stakeholder relationships significantly. Our mantra is about ensuring that we execute commercially, enhancing the focus on customers and products, which will bring us dividends going forward.

Matt, I know you mentioned you continue to watch Applied Water. I think you did say that you won a couple of larger projects there resulting in book-to-bill being over 1 times. Can you characterize what's going on in that space? Is it as expected, better, or worse?

I'd say it's largely as we thought. We’re up 10% in past Q1s, which makes for a tough compare. However, it is cyclical, and we expect low single-digit declines this year, which aligns with our plans. To your point, we did have good Q1 order performance with a few larger future projects. So these are not necessarily book and ship; they represent future plans. Soft markets continue, especially in Europe and emerging markets, leading to down orders. We're watching developed markets closely as well, with several initiatives set to reduce complexity and refocus efforts on growth moving forward. We're confident in the business' long-term potential despite these near-term headwinds.

Great to drill down on M&CS margin performance; the step-up in profitability there is eye-catching. Can you provide finer details on the drivers, which seem broad-based in terms of productivity, volume, price mix in the quarter? Are there any one-time benefits to consider? And is it still expected that margins will improve sequentially throughout the year?

Yes. The M&CS team delivered an outstanding quarter, with EBITDA margin up 550 basis points and almost 50% incrementals. This team's been on a journey, overcoming significant external challenges related to the supply chain and internal challenges to ramp production levels historically. They drove significant labor and material productivity, increasing efficiency and output. They've also achieved effective pricing strategies, coming back from being price cost negative. The first quarter exceeded our expectations due to better mix towards North American water meters. Although we anticipate some unfavorable mix impacts later in the year from lower-margin projects, we're optimistic about the team's momentum as they initiate 80/20 projects, which we believe will yield additional benefits as we close the year.

Very helpful details and encouraging trends. Matthew, you mentioned the government money trickling in, and you touched on the outlook for PFAS. Could you share your updated perspective on the IIJA related growth opportunities? You've consistently tempered expectations, which is understandable, but there has been some acceleration in obligations and outlays recently. Looking at the funding categories and intended spending, you seem well-positioned to participate in a wide array of areas.

Yes. I wish I could turn the hose nozzle and make the process faster, but I've been consistent regarding funding in both the U.S. and other markets. It’s going to be a slow drip, helping to support market growth over the next 3 to 5 years. That's how we view it; it's a gradual enhancement to our long-range plan regarding incentives or subsidies. It’s important to keep that in perspective with our overall market growth expectations.

I wanted to pick up on one of Bill's comments regarding the expectation that prices will offset inflation. Years ago, Xylem had been aimed at price plus productivity offsetting inflation expectations. Looking ahead, how are you planning to implement that? What factors will enable Xylem to be more aggressive with pricing?

Yes. Price capture has been a major focus with rising inflation. We will discuss more on that at the end of the month regarding strategic pricing. Our goal is to offset material inflation with price while allowing productivity to address any indirect and SG&A inflation needs. The teams are proficient in operational productivity, so enhancing our value capture process for the customer will be essential moving forward.

I guess my follow-up question for Matthew is regarding the heightened focus in Europe on non-revenue water, which will likely see substantial increases in funding post-2022 droughts. Can you discuss potential material opportunities for Xylem as this funding becomes available?

Yes, I do see opportunities primarily through our Idrica platform, which will help visualize data through AMI systems. This focus area is critical for utilities in Europe and globally, and we're seeing strong funding in this region, especially with the AMP cycle in the U.K. for non-revenue water. There's also a focus on analytical instrumentation and accountability for water contaminants. Therefore, we anticipate growth opportunities in smart metering and analytical instrumentation with an overlay of our Idrica partnership.

On PFAS, where exactly are you exposed? Are there capabilities that you are currently lacking, such as sampling or destruction, that you're exploring either internally or through acquisitions?

We obviously have technology for capture from our acquisition with Evoqua, and we have over 80 PFAS installations around the country. We recently captured PFAS from a well in Maine to serve an increasing population, so we have proven technology on the capture side. However, innovation is required for destruction and real-time sensing. We possess sensing capabilities for bringing samples to labs, but real-time flow sensors for PFAS are an area where innovation is necessary. Our teams are working on this through our innovation labs, combining efforts from Xylem and Evoqua for quicker progress and reduced costs. As for data centers, it's one of our high-growth verticals, and we're excited about the opportunities. You heard Bill mention the significant $130 million build-to-operate win in hydrogen. Data centers represent a smaller revenue stream, likely under $50 million, but we are seeing opportunities. Data centers require considerable water for cooling, particularly in water-stressed areas, placing pressure on water resources. We have various solutions for them, from comprehensive treatment solutions for reuse to outsourced water management services to help mitigate this issue. We believe this sector will represent a growing opportunity for us.

Well, we'll wrap it up there. Thank you for your questions, and thanks to everyone who joined today. We hope to see many of you either in person or online at Xylem's Investor Day on May 30. We look forward to sharing further insights into our priorities and strategic direction then. Until then, all the best.