Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

Executives

Phil De Sousa – IR

Gretchen McClain – President and CEO

Mike Speetzen – SVP and CFO

Analysts

Deane Dray – Citi Research

Matt Summerville – KeyBanc

Ryan Connors – Janney Montgomery Scott

Chip Moore – Canaccord Genuity

David Rose – Wedbush Securities

John Moore – C.L. King

Jim Krapfel – Morningstar

Brian Konigsberg – Vertical Research

Stewart Scharf – S&P Capital IQ

Xylem Inc. (XYL) Q4 2012 Earnings Call February 7, 2013 9:00 AM ET

Operator

Welcome to the Xylem Fourth Quarter and Full-Year 2012 Earnings Conference Call. Hosting the call today from Xylem’s headquarters in White Plains, New York is Gretchen McClain, Xylem’s President and Chief Executive Officer. She is joined by Michael Speetzen, Xylem’s Senior Vice President and Chief Financial Officer. Today’s call is being recorded and will be available for replay beginning at 12 p.m. Eastern Standard Time.

At this time all participants have been placed in a listen-only mode and the floor will be opened for your questions following the presentation. (Operator Instructions) It is now my pleasure to turn the floor over to Phil De Sousa, Investor Relations Officer. You may begin.

Phil De Sousa

Thank you, Jackie. Good morning, everyone, and welcome to Xylem’s fourth quarter 2012 earnings conference call. With me today are Chief Executive Officer, Gretchen McClain; and Chief Financial Officer, Michael Speetzen. They’ll provide their perspective on Xylem’s fourth quarter and full-year results and discuss the outlook for 2013. Following their prepared remarks, they will address questions related to information covered on the call. I’ll ask that you please keep to one question then return to the queue, so we’ll have enough time to address everyone on the call. We anticipate that today’s call will last approximately one hour.

As a reminder, this call and our webcast are accompanied by a slide presentation available on the Investors section of our website at www.xyleminc.com. All references today will be on an adjusted basis, unless otherwise indicated. And non-GAAP financials are reconciled for you in the appendix section of the presentation. A replay of today’s call will be available until Thursday, February 21 at 6 p.m. Please note that the replay number is (404) 537-3406 and the confirmation code is 76727905.

Additionally, the call will be available for playback via the Investors section of our website, under the heading Presentations. With that said, 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 outlined in Xylem’s Annual Report on Form 10-K and those described in subsequent reports as filed with the SEC. These remarks constitute forward-looking statements for purposes of the Safe Harbor provision. Please note that the company undertakes no obligation to update such statements publicly to reflect subsequent events or circumstances, and actual results could differ materially from those anticipated.

Now please turn to Slide 3, and I’ll turn the call over to our CEO, Gretchen McClain.

Gretchen McClain

Thank you, Phil. Good morning and Happy New Year. Thanks for joining the call. We appreciate your interest in Xylem. We made substantial progress in 2012 putting a foundation in place and defining a clear path to realizing our full potential. We are confident in our course and we are moving forward this year with continued focus on leveraging our full power of our portfolio, our industry knowledge and our customers’ relationship to grow this business.

While we were disappointed from a top line perspective in 2012, we entered the New Year with relatively stable market conditions, a resilient portfolio and plan to earn to drive earnings growth centered on improving our competitive positions, simplifying our business and continue our focus on cost saving initiates to provide flexibility to expand our growth strategy. Later in the presentation we will discuss how we see 2013 from a market perspective and the actions we’ve been taking to deliver earnings growth and impact of these conditions.

Now I’d like to walk you through our fourth quarter results. We received orders of $926 million, up 3% in constant currency and 2% organically. Revenues from the fourth quarter was $969 million, down 3% compared to prior year, when we registered over $1 billion in revenue, an all-time record performance. Revenue in the U.S. and Europe was down 4% organically versus the prior year, while super storm Sandy provided a benefit of approximately $8 million, it did not offset weak Industrial and Public Utility markets.

Within the emerging markets which today represents approximately 20% of our revenue base, fourth quarter revenues were down 2% organically. However when you exclude the timing of large project shipments the fourth quarter of 2011, emerging markets grew 9%. Investments made in key countries like Russia and China resulted in double-digit growth in this quarter. We’re reporting gross margins of 39.4% for the fourth quarter, up 150 basis points over the prior year.

Adjusted operating margins expanded 140 points to 13.4%. These results demonstrate our commitment and ability to drive operating performance from our business even in a challenging growth environment. Our strong operating performance during the quarter resulted in earnings per share of $0.47 up 21% on a normalized basis. Overall, we delivered strong operating performance, delivering additional penny of earnings relative to our guidance, despite lower than anticipated volumes.

Our full-year 2012 financial highlights are as follows. Orders of $3.8 billion were in line with revenue and we are exiting the year with a backlog of $647 million, roughly in line with prior year. Revenues had increased 2.5% on a constant currency basis. Gross margin was 39.6%, up 120 basis points over the prior year. Operating margin was 12.9%, up 100 basis points on a normalized basis.

To put this into perspective, our full-year margin came in right around the midpoint of our original guidance we set last February, a significant achievement given that impact of lower volumes and dilutive transaction and integration cost from the MJK and Heartland acquisitions. It also includes the addition of incremental standalone costs of $28 million. At the bottom line, we’ve recorded EPS of $1.77 exceeding our previous guidance by $0.01. And finally, we delivered free cash flow of $312 million, a conversion ratio of 100%.

Now I’d like to provide you with an update on the business and the progress we’ve made on our strategic initiatives. We continue our focus on acquiring businesses that set our strategic objectives for growth, and we believe we’ll achieve attractive returns on invested capital. During the third quarter of 2012, we acquired MJK, followed by the acquisition of Heartland Pumps in the fourth quarter and earlier this week, we announced the acquisition of PIMS Group.

I’ll spend some time on the next slide walking through the PIMS acquisition. We’ll just say for now is that our integration process is working both MJK and Heartland are already exceeding our expectations. In fact well we expected the impact of Heartland to have been $0.01 dilutive to the fourth quarter, it was neutral to earnings. We are excited to have added these three acquisitions to what is already the world’s broadest portfolio or water focused solutions and we believe our pipeline provides opportunity to deploy our capital in a disciplined fashion in this fragmented market to drive growth and return for our shareholders.

Last year we began several steps to better align ourselves to maximize our presence and efficiency in Europe. The European market is and will continue to be a critical region for us. We’ve operated there successfully for more than 100 years and have built a large install base with trusted customer relationships. By capitalizing on our entire portfolio of products and services and leveraging our scale and expertise more efficiently, we not only preserve but enhance our competitive positions.

We made significant progress on this initiative beginning with the establishment of a new European headquarters in Schaffhausen in Switzerland. We also initiated some restructuring steps in 2012 and this year we will be taking additional restructuring and realignment actions targeting at advancing this new European management structure for growth. By driving our strategic and operating decision making aligns Xylem in Europe we will best – we will best positioned to take a more focused view of our customers’ needs and optimize our cost savings, differentiating Xylem in the marketplace.

We made good progress in delivering customer value. For the year, we achieved the Vitality Index of 15% which is our internal measurement for our new product as a percent of total revenue. This is up from 12% in 2011 and reflects the successful deployment of innovative new product applications and services for the relevant customer segments. This means we generated over $0.5 billion in revenue from new products – new innovative product launches including more than one-third from application self designs reducing the energy consumption of our customers processes.

During the quarter, we announced plans to open a new office in Saudi Arabia to continue to build our already strong position in the Middle East and Africa region which today represents approximately 5% of total Xylem revenues. Accelerating our presence in market penetration in the emerging markets will continue to be a key focus area for Xylem. And I am pleased to announce that we recently proposed and achieved Board approval to increase our first quarter dividend by 15%.

Our annual dividend payout will be approximately $86 million assuming the Board approved each of the next three quarter dividends at the same amount as the first quarter. This reflects our confidence in continuing to generate strong free cash flow from the business. Beyond 2013, our dividend policy will be to propose dividend increases in line with earnings growth.

Turning to Slide 4, this week we announced the acquisition of privately held PIMS Group with fiscal year 2012 revenues of $38 million for a purchase price of $57 million. This acquisition is consistent with our strategy to expand our aftermarket service business and accelerate our expansion in the contract services. Located in and servicing more than 10,000 locations in the U.K., PIMS specializes in the installation and maintenance of water and waste water pumping systems, sewers and drains and waste water treatment plants. The business provides municipal, industrial and private customers with 24x7 support services.

We expect to leverage its market leading business processes throughout our global footprint with minimal additional capital investments, while enhancing the services we already provide today. With Xylem’s large install base, PIMS is a perfect match to ensure customers are provided with industry leading products, application solutions and enhanced aftermarket support services.

We expect to generate cost synergies with the acquisition and to generate revenue synergies in the U.K. and as we expand globally. We expect the PIMS to be margin dilutive during 2013 as we get through the normal purchase accounting step up adjustments and integration costs. And we expect that PIMS will be EPS neutral in 2013 and accretive in 2014.

Now let me turn the call over to our CFO, Mike Speetzen to walk you through the 2012 detailed results. Mike?

Mike Speetzen

Thanks Gretchen. Please go to Slide 5. In the fourth quarter Xylem revenues were $969 million, down 3% from our record fourth quarter in 2011. Let me provide some perspective on our fourth quarter and full-year revenue performance by end-market and by region.

First in our largest end-market Industrial, organic revenue was down low single-digits, year-over-year in the fourth quarter. Despite the impact from super storm Sandy, U.S. continued to be negatively impacted by dry weather conditions and the slowdown in water transport supporting natural gas fracking. European industrial market weakness continued in the fourth quarter down mid single-digits. Industrial performance in emerging markets was robust with Latin America and the Middle East and Africa regions posting double-digit gains over the prior year.

On a sequential basis, Industrial grew mid single-digits in the fourth quarter driven by Europe, reflecting normal seasonal patterns. Overall, full-year organic revenues for Industrial were up low single-digits. Fourth quarter revenues from the Public Utility market declined high single-digits year-over-year. This was weaker than our expectation of a low single-digit decline. As we mentioned on our last quarter’s call we saw the acceleration of some deliveries into the third quarter and we knew we were facing a difficult time given the sizable projects we delivered in 2011.

The varying levels of uncertainty among public utilities both in the U.S. and Europe resulted in the delay of smaller projects in discretionary maintenance and drove the additional weakness in this market. Overall, full-year organic revenues for Public Utilities were down approximately 1%. Commercial Building services were up low single-digits. In the U.S. we saw market conditions weaken in the back half of the year.

Super storm Sandy partially offset this weakness providing approximately $1.5 million in revenue for the quarter. Outside of the U.S., we saw strength in Latin America driven by several small project shipments and Europe was flat year-over-year. Overall full-year organic revenues were flat for the Commercial end-market in line with our expectations. Residential was up low single-digits in the fourth quarter. U.S. market was up mid single-digits driven by seasonal promotions and the benefit of approximately $0.5 million contributable to super storm Sandy.

Despite the contribution from our recently launched high-energy efficient Ecocirc Circulator, Europe was down low single-digits given continued weakness in the housing market. Overall, full-year organic revenues were down low single-digits for the Residential end-markets, in line with our previous expectations. And as far Agriculture, we were up mid single-digits for the fourth quarter driven by better than expected results out of Europe. Overall full-year organic revenues were up low single-digits in line with our previous expectations.

Let me spend just a few minutes on our overall geographic performance. The U.S. was down 4% on an organic basis in the fourth quarter and 5% for the year in line with our previous expectations. Europe was down 4% in fourth quarter and was down 1% for the year slightly below our expectation of flat year-over-year performance, driven by weakness in the residential market. Emerging markets organic revenue declined 2% for the fourth quarter primarily due to the timing of several large project shipments which we delivered during the fourth quarter of 2011.

Excluding these projects, emerging market revenue was up approximately 9%. Emerging market organic revenues were in mid single-digits over the full-year in 2012. Adjusted operating income was up 8% despite lower than expected organic revenue, fourth quarter operating margins came in at 13.4% up 140 basis points after absorbing the minimal impact of incremental standalone ramp up costs.

Gross margin was 39.4% for the fourth quarter, up 150 basis points versus the prior year as price and cost improvements more than offset inflation and unfavorable mix. By driving gross margin performance we are able to continue to invest in our business while expanding operating margins. Investments in the fourth quarter impacted operating margins by 30 basis points. For this quarter, our operating margin contribution for price offset material cost inflation. The MJK and Heartland Pump acquisitions were 10 basis point headwind operating margins for the quarter, reflecting the impact of purchase accounting and integration costs. The impact of foreign exchange translation and transaction favorably impacted our operating margins by 20 basis points.

Please turn to Slide 6. This slide shows our EPS walk for the fourth quarter. This has been a transition year for Xylem and as such there were lot of moving parts. So I am going to spend some time this morning as we have on previous calls describing the components of our performance. As the middle section of the chart depicts we’ve adjusted both 2011 and 2012 EPS to a normalized basis to provide a clear picture of how we performed operational efforts last year.

The walk starts with GAAP EPS for 2011 and ends with GAAP EPS for 2012. In between we made two sets of adjustments. For the fourth quarter on the left side of the chart, we increased 2011 GAAP EPS of $0.28 by $0.11 to show 2011 on a comparable basis. For the fourth quarter of 2012, on the right side of the chart, we adjusted GAAP EPS of $0.39 by adding back the net negative impact of 2012 one-time separation costs, restructuring and realignment costs and special tax items. Making these adjustments for the fourth quarters on a comparable normalized basis to allow for better view of operational performance.

This analysis shows that normalized EPS increased 21% or $0.08 and was completely driven by core operations including actions taken to reduce costs and restructuring activities initiated in the third and fourth quarters of 2012. Acquisition impacts, foreign exchange translation and our operating tax rate were neutral to our EPS performance. We previously provided a range of restructuring and realignment costs of $15 million to $20 million with related savings of approximately $10 million.

For the year, restructuring and realignment came in at $24 million and will yield savings of approximately $12 million in 2013. Now let me provide more detail for each of our reporting segments. Please turn to Slide 7. For the fourth quarter, Water Infrastructure reported revenues of $637 million, down 5% over prior year on a constant currency basis and down 7% organically.

The MJK and Heartland Pump acquisitions contributed two points to top line growth and foreign exchange was a one point headwind. Transport declined 5% for the fourth quarter driven by weakness in both Public Utility and Industrial markets were we saw mid single-digit declines. Despite approximately $6 million of revenue due to super storm Sandy, our U.S. dewatering business was down significantly from the prior year due to ongoing drought conditions, lack of public utility funding for projects and lower industrial rentals particularly for natural gas fracking applications which peaked in the fourth quarter of 2011.

Treatment revenues declined 18% for the fourth quarter, by the general decline of project activity and the delay of project shipments in 2013. Additionally in the fourth quarter of 2011, we saw a 21% increase in Treatment driven by the timing of large shipments in the Latin America which did not repeat in 2012. Test revenues were up 1% due to strength in emerging markets partially offset by continued weakness in Europe.

Fourth quarter operating margins came in at 16.5% of a 120 basis points for 2011. Operational excellence and restructuring savings expanded operating margins by 380 basis points, where our customer excellence initiative drove price to 270 basis points and as a result, more than offset the impact of inflation and provide a flexibility to continue to invest in the business.

Our margins were however negatively impacted to the previously mentioned lower rental dewatering volume and acquisition headwind from purchase accounting and operation costs. Let me now turn to Slide 8 and talk to our Applied Water segment. Applied Water’s fourth quarter revenue was up 4% on both the constant currency and organic basis. Foreign exchange was a 1% headwind bringing our total growth in the segment 3%.

Building services was up 2% driven by Commercial and Residential performance I covered earlier. Industrial water was up 6% due to favorable general industrial market conditions across most regions. In the U.S. our results were favorably impacted by the timing of shipments we mentioned during the last quarter call. Excluding these dynamics U.S. Industrial Water applications were slightly weaker than expected. Europe was up low single-digits driven by growth in Russia and we continue to see favorable results in Asia-Pac. And lastly Irrigation was up 4% with Europe up mid single-digits, partially offset by the U.S. which was down low single-digits.

Fourth quarter operating margins came in at 11.6%, up 240 basis points from 2011. Price and productivity actions and benefits from severance actions taken in the fourth quarter of 2011 more than offset the impact of lower volume, unfavorable mix and inflation enabling continued investment in this segment.

Now let me turn to Slide 9 and review our financial position. We generated $312 million of free cash flow for the year, a conversion on adjusted net income of a 100%. Our cash flow is down from 2011 as anticipated, driven primarily by interest payments of $53 million related to the debt put in place as a result of this spin on from ITT. In addition, we had an incremental U.S. Federal and State tax payments in 2012. As a reminder the 2011 figures are a result of the carved out financials provided in the Form-10 and reflected in allocated portion of U.S. tax payments that were deemed as Xylem obligation for the purposes of the Form-10 statement.

Note that adjusting to these tax payments would bring the 2011 conversion in line with our current year performance. As you can see from the slide, working capital as a percent of revenue increased 80 basis points year-over-year. Foreign exchange had an unfavorable impact of 100 basis points and was partially offset by 20 basis points of operational improvements.

Improved collection performance and favorable supplier terms more than offset investment inventory to support shorter lead times expected from customers. As it relates to our capital structure, we ended the year in a strong position. Our available cash on hand was $504 million. We have a solid net debt to net capital ratio of 25% and our credit metrics are in line with expectations at current rates. Our commercial paper and revolving credit facilities remain in place and continue to be unutilized.

Before we turn to the guidance details, let me turn the call back over to Gretchen to provide you with the framework we are working in 2013. Gretchen?

Gretchen McClain

Please turn to Slide 11. I want to say a few minutes providing you with our strategic framework that guides and drives our decisions and actions. We will spend more time in our upcoming Investor Day on March 7 explaining this to you. But simply put these are our key goals and initiatives and from here we develop plans for change and ways to measure the change. It’s our business model to drive excellence throughout the business.

In 2012, we made substantial progress putting a foundation in place as a pure play water technology company, taking it to the next level and positioning Xylem for the long-term requires a few things. First an incredible focus on delivering customer values. We price customer intimacy above all and working to meet customer needs and deliver the unique value as part of our company DNA. We will continue to deliver value across our portfolio, products and services and actively seek new ways to create more value to bring together our application expertise and integrated processes across the business to help solve the complex water challenges our customers confront.

Through our Xylem Total Care program coupled with the benefits of the PIMS acquisition, we’re enhancing our aftermarket capabilities to protect and expand our large install base. Our applications knowledge gives us the ability to provide energy audits, system upgrades and solutions focused on reducing our customers total cost of ownership. Second, drive profitable growth. We are balancing growing our main lines of business with pursuing dynamic new opportunities, both through organic investments and our disciplined acquisition strategies.

We will accomplish this by indexing and innovative offerings in high potential areas like smart products, energy efficiency and reuse, expanding our gross platforms, analytics and dewatering and extending our geographic position in the key markets, both emerging and underserved matured markets. And we will maximize revenue and profitability and carefully manage how we use our capital to invest in our business, balance risk and opportunity and return to our shareholders.

Third, improve business sustainability. We are focused on continuously improving the efficiency and effectiveness in all we do, which translates into greater competitive advantage and builds a sustainable product goal of financial stability and flexibility. We will continue our focus on optimizing our cost structure. We plan to invest $60 million to $70 million in restructuring and realignment in 2013.

As I discussed earlier, in Europe we are repositioning our business as well as talking other targeted actions to better position us in the future. And we are driving robust operating rhythms throughout the organizations. These changes will lead to achieving our goals and enabling innovations, agility and speed which are necessary to address the long-term market drivers of demand in the water industry.

So let me set the stage for our 2013 guidance before I hand it over to Mike to walk through the details. Turn to Slide 12. This slide shows our revenue profile on a trailing four quarter basis since 2011 and highlights some of the key major drivers that have influenced our actual performance and our forecast for 2013. As the chart illustrates, we experienced strong growth in 2011 driven by the delivery of large project orders received in 2010.

Strong performance from dewatering and analytical businesses acquired in 2010 and general strength across all end-markets driven by the recovering global economies. We started to see order rates for a large public utility CapEx project flow in the second half of 2011 impacting Public Utilities revenue growth in 2012. Compared to the strong performance in 2011, the U.S. dewatering business was impacted by drought conditions along with the slowdowns in natural gas related fracking activities.

While European political and economies concerns made headlines in 2012, our European business remained resilient down only 1%. Like most other companies, we saw a general slowdown in the U.S. and European industrial markets in the latter half of 2012. Taken together this led to a flat organic revenue growth with a more difficult second half of the year. Looking forward to 2013, we expect the second cash flow down experienced in 2012 continue to impact the first half of 2013. Compared with relative prior year periods, we expect revenue will be down mid single-digits in the first quarter of 2013, down low single-digits in the first half of 2013 and up low single-digits through the balance of the year.

We expect Europe to remain relatively stable and expect the U.S. to strengthen in the second half along with reacceleration in emerging market growth, this sequential improvement in underlying demand for our business as the year progresses. Please turn to Slide 13 where Mike will walk you through each of the end-markets and our 2013 guidance.

Mike Speetzen

Thanks Gretchen. On a global basis Industrial remains our largest end-market representing 43% of our revenues in 2012. In this market we provide cards which are critical running our customers base operations for energy efficient products and total cost of ownership of value by our customers. In addition the majority of our dewatering revenues are associated with Industrial end-markets.

With some uncertainty around where U.S. industrial demand will go and European industrial production is expected to remain challenged, we anticipate our revenues will be flat to up low single-digits organically in 2013. In addition to slightly improving economic conditions in the U.S. and emerging markets, we see additional expansion of our Treatment solutions into Industrial applications and a return to more normal weather patterns for dewatering business in the U.S.

Revenues from Public Utility is now 35% of our total revenue, and are expected to be flat with 2012 levels. We continue to expect stability and required operations and maintenance activities as this spin is largely non-discretionary and is funded by tariffs end-users. As we’ve discussed during previous quarters, the portion of Public Utility revenue does drive from CapEx project spending continues to be constrained by project orders.

Given the longer lead times for such projects and the absence of insignificant change in CapEx spending levels our forecast for 2013 assumes that this continues to be case for this year. We expect the demand for emerging market public utility infrastructure will drive growth for Xylem in 2013. Our revenues from commercial markets are expected to be flat to up low single-digits. While indicators such as the Commercial Architecture Building Index have improved slightly in recent months, we expect market demand in the U.S. to remain flat for at least the first three quarters.

European commercial construction is expected to remain challenged, offset by growth in emerging markets. Residential markets support flat to low single-digit growth as our product sales are largely driven by replacement sales associated with our large install base. Agriculture remains a small market for us and revenues are likely to be flat given the benefit we received from drought conditions in the U.S. in 2012.

Taken together, the low growth economic environment along with the relative stability of demand from the variable types of products we sell across the variety of end-markets suggest flat to low growth in 2013.

Please turn to Slide 14 and I’ll walk you through the guidance details. We anticipate 2013 revenues of approximately $3.9 billion which reflects total growth 3% to 4% consisting of flat to 1% organic growth, two points of growth from acquisitions of MJK, Heartland and PIMS and a one point benefit from foreign exchange. For Water Infrastructure we expect 2013 revenue of approximately $2.5 billion reflecting total growth of 4% to 5%. Organic growth for Water Infrastructure is expected to be flat to 1%. The previously mentioned acquisitions will contribute three points of growth while foreign exchange has a one point benefit.

Finally for Applied Water, we expect revenues of approximately $1.4 billion. This reflects growth of 1% to 2% driven by organic growth of flat to 1% and one point benefit from foreign exchange. Segment margins are anticipated to be in the range of 13.8% to 14.3% and company operating margins are projected to be in the range of 12.3% to 12.8%. We anticipate earnings per share of $1.80 to $1.90. This range excludes one-time restructuring and realignment costs of approximately $60 million to $70 million pre-tax. That includes approximately $5 million pre-tax of additional one-time separation cost and $5 million pre-tax higher pension costs.

Of the $60 million to $70 million we plan to execute restructuring actions in 2013, which will cost approximately $40 million to $50 million with an expected payback of approximately two years and we expect approximately $13 million to $15 million of net savings to be realized in 2013. This is in addition to the $12 million of savings resulting from the actions executed in 2012.

Free cash flow conversion is forecast to be approximately 95% slightly lower than 2012 after taking into account restructuring payments and capital expenditures related to the European realignment and targeted expansion of dewatering. We also have the remaining actions required to separate from ITT including IT systems to exit service agreements and as well as the required relocation of our corporate headquarters.

Our operating tax rate is expected to be approximately 21% a reduction from 24% in 2012. This rate reflects a sustainable benefit from the establishment of our new European headquarters in Schaffhausen, Switzerland. Please note, because of certain milestones including the rollout of the European structure across our regional businesses, we expect the operating tax rate to average approximately 22% over the first half of 2013 and 20% over the second half.

Our fully diluted share count is expected to be a 186.4 million which takes into account our share repurchase program targeted at offsetting dilution associated with the various Xylem employee stock plans. Finally, let me summarize our capital deployment plans. Our first priority remains organic investments as this is the highest returning investment we can make. To this end we see investing 2.5% to 3% of revenue in CapEx, 3% into R&D and just under 2% into restructuring and realignment to enhance our competitive position [ph].

Inorganic growth remains a top priority. Our acquisition capacity and pipeline support continued investments. As Gretchen mentioned we’re increasing our dividend by 15% and have the intention to grow at future years in line of earnings. Please turn to Slide 15 which illustrates our EPS and operating margin walk in 2012 to the midpoint of 2013 guidance.

For 2013, we are incorporating a remaining required one-time separation costs in the – for IT systems and corporate headquarter relocation into our guidance. These costs result in a $0.02 reduction in EPS and a decrease of 10 basis points for operating margins in 2013. The impact of foreign exchange and the acquisitions of MJK, Heartland and PIMS are neutral to EPS that reduces our 2013 operating margin by 40 basis points. Operating margins related to the acquisitions are unfavorably impacted by certain purchase accounting adjustments and integration and transaction costs.

Excluding these impacts, operating margins for all the three acquisitions will be accretive to Xylem’s operating margin. Cost savings initiatives and productivity are expected to drive a $0.07 benefit to EPS and 50 basis points to margin improvement, more than offsetting the unfavorable impact of higher pension costs of approximately $0.02, continued investment growth initiatives and the headwind from a low organic growth environment.

Finally, our European realignment led $0.03 to EPS. The lower tax rate discussed on the previous slide will more than offset the higher run rate costs associated with new European organizational structure. At the segment in operating marginalize this is expected to have a 30 basis point negative impact. The combination of all these items result in an adjusted EPS with $1.85 and adjusted operating margin of 12.6%, consistent with our guidance midpoint of 2013.

Please turn to Slide number 16 and I’ll turn it back over to Gretchen to wrap up.

Gretchen McClain

In summary, 2012 was certainly a challenging but rewarding first full year. Looking back we established an organization with the ability to handle adversity, adapt to changing market dynamics and deliver strong performance. We’ve discussed in detail how we’ve advanced our strategic position over the past 12 months. Launched new innovative products and services and were recognized by organizations and customers as best in class.

We delivered strong financial and operational performance despite macro challenges which resulted in softer top line performance than we expected at the beginning of the year. We drove significant growth margins and operating margin expansions in line with our original guidance and we are taking actions to project our progress and continue our efforts we initiated in 2012.

As we move forward to 2013, we will focus and maintain our focus on improving our competitive position, investing for long-term growth and increasing our efficiency and effectiveness. We ended the year well positioned in the marketplace with a strong balance sheet and an organization still to succeed. With that we’re happy to take your question. Operator?

Question-and-Answer Session

Operator

The floor is now open to the questions. (Operator Instructions) Thank you. Our first question is coming from Deane Dray with Citi Research.

Deane Dray – Citi Research

Thank you, good morning everyone.

Mike Speetzen

Good morning.

Gretchen McClain

Good morning, Deane.

Deane Dray – Citi Research

I was interested in hearing more about the PIMS acquisition, the move with the services does cope up with the equipment model but if you can comment on how you scale the service business, there is a lot of headcount in terms of returns of that business model, so how much has it been growing and how do you scale it and do you get a flow through of your aftermarket products through service organizations like PIMS?

Gretchen McClain

Yes, Deane let me step back a little bit and we’ve been talking about our aftermarket strategy for quite some time. We’ve been spending enormous amount of time driving what we call our Total Care program is. And so in all of our businesses where we have a large install base, our sales teams have been working aggressively to make sure that we’re capturing the parts and services but also bringing advanced services where we can bring the broad portfolio of products that we have and our ability to going and do energy audits and so forth.

What we get with PIMS is, one, some very nice processes. We also get a very talented group of folks that have a core competency that we can help train geographically our teams that are positioned very well. So we not only do we get a great position in the U.K. which complements where today we play in the public utility and 90% of their customer base is non-public utility. We also get a core competence of talent that we can actually use to help our teams geographically expand.

Deane Dray – Citi Research

Great, and then just a quick follow-up for Mike. Can you comment on the lower tax guidance and you know what’s driving that and sustainability?

Mike Speetzen

Yes, good question, Deane. We do quite a bit of work around the tax planning. As we have mentioned in prior discussions, we actually were fortune to take the tax leader [ph] that was at ITT with us given the global footprint that we have. So we’ve been doing a lot of work around the planning aspects. I think the key elements is this is a sustained tax rate improvement from some of the restructuring that we’re doing in Europe and we look at it as a great position not only the leverage, including other parts of our current portfolio but as we look to bring new acquisitions into the full that will give us a good leverage point in terms of doing some sustainability around further improvements in our tax rate.

Deane Dray – Citi Research

Great, thank you.

Operator

Your next question comes from the line of Matt Summerville with KeyBanc.

Matt Summerville – KeyBanc

Good morning. Can you talk a little bit more, I understand the relocation of the headquarters, but just what you are doing from – heavy lifting perspective in terms of restructuring, are you taking out facilities, people, can you put other numbers sort of behind that, and then what do you expecting the payback to be on the $60 million to $70 million year investing in ‘13 as we think about at ‘14?

Gretchen McClain

Sure, Matt, let me first talk a little bit about what we’re trying to do in Europe. We’ve been positioned in Europe for quite some time, and as a separate independent company, we have not really been totally utilizing or leveraging our unique and broad capabilities as a total Xylem in the water industry. And so our objective here is to setup the headquarters, one headquarters, today we have three headquarters in Switzerland. We will be aligning our strategies around our end-markets that we go to and so couple of the restructuring actions will lead to consolidating multiple sales companies in one country.

And we’ll be able to leverage our back office more efficiently and effectively. We’ll be able to set up shared services to support the teams across Europe. They have centers of [ph] excellence and ultimately be able to get some opportunity to leverage, manufacturing, our supply chain leverage, commodity-wise across the whole organization. So I feel like we’re going to be able to position ourselves to be able to work more effectively and efficiently in the market, but ultimately be able to bring more value to our customers. Mike, you can walk through the numbers.

Mike Speetzen

Yes, so Matt let me just kind of step back and hit some of the numbers. So in 2012, we executed about $17 million from a cost perspective of restructuring. We got about a $1 million of benefit in 2012. The remaining $12 million will be a benefit in 2013. Out of the $60 million to $70 million of restructuring and realignment, $40 million to $50 million of that is restructuring and we see that giving us a benefit in 2013 of about $13 million to $15 million. So think about the total restructuring benefit from actions done in 2012 as well as 2013 in a range of $25 million to $27 million.

The payback period on these like we’ve articulated before given the fact that we’re focused primarily around Europe is going to be approximately two years.

Matt Summerville – KeyBanc

Okay and so then we should think about that, in other words [ph] you are getting a one to one dollar payback that there is somewhere in the range of $35 million to be – they will be back in ‘14, is that the right way to think about it, Mike?

Mike Speetzen

Yes, we’re essentially from an execution standpoint for the actions being done in 2013, pardon me, planning in Q1 execution in Q2 and then we’ll be looking for run rate savings to have achieved in Q3 and Q4.

Matt Summerville – KeyBanc

Thank you.

Operator

Your next question comes from the line of Ryan Connors with Janney Montgomery Scott.

Ryan Connors – Janney Montgomery Scott

Thank you, good morning.

Gretchen McClain

Good morning.

Ryan Connors – Janney Montgomery Scott

I had a question in regards to foreign exchange, last year you all made a downward guidance revision based on the Euro and translation and given now strongly the Euro in particular has rebounded and look at the guidance assumptions, a little bit surprised that Forex has a little tailwind as it is in that 100 basis points, so you can just talk us through Mike, kind of the assumptions you’re making around currency and the Euro in particular? Thanks.

Mike Speetzen

You bet. Euro is clearly the largest driver we have. In the guidance we used a $1.32. Rates have been trading at slightly higher than that, but just from a modeling perspective if you look back the average rate that we had during the 2012 time period is about $1.20. And so as we look at that, it’s about 1% pickup from a top line perspective. Obviously if the rate were to hold at a $1.35 you would see some incremental pickup. If anybody shot in terms of where the Euro is going to go, if you look at what the projections are through the balance of the year, the Euro is supposed to moderate some based on what they are projecting with interest rates but certainly if it were to hold at the levels it is today we would see potential upside from where we’re at today but again it’s all translation, it has a minimal a impact on the bottom line.

Ryan Connors – Janney Montgomery Scott

Great, thank you.

Operator

Your next question comes from the line of Chip Moore with Canaccord.

Chip Moore – Canaccord Genuity

Good morning, thanks. On the repositioning, I was wondering if you could talk a little under term once you get through the actions in Europe, how much more runway that you have streamline in the business in where you’re at?

Gretchen McClain

So we’ve been making actions as we established Xylem, and so if you were to look at our Asian organization today, we have aligned around the Xylem organization across our Asian region. We’ve been making some moves in Europe, a couple of countries have already integrated and so that has been positive. And so we’ll be making actions. Europe is critical. It’s a market that’s challenged right now. It’s an important customer base. And so those are the first major steps.

But I do feel overall we’ve got a nice alignment in the organization and we’re trying to take those big steps now to position ourselves for the long-term. We’ll give a little bit more color in March at our Investor Day but the big step is in Europe.

Chip Moore – Canaccord Genuity

Great, thanks.

Operator

The next question comes from the line of David Rose with Wedbush Securities.

David Rose – Wedbush Securities

Good morning, couple of quick questions. On the spin cost, can you elaborate a little bit more of what we’re seeing and why we’re still seeing that cost, (inaudible) and then maybe a little bit more differentiating the orders for the fourth quarters given that they were up so much and your commentary about public utility is being down, I am assuming that the order growth is more industrial than public utility maybe you can get down for us?

Mike Speetzen

Yes, let me David take the one-time spin cost. Obviously at the time of spin we did our best estimate what do we take to effectively separate ourselves from ITT. When you look at the total amount of money that was spend to exit, the remaining $5 million that we’re talking about in guidance is relatively small. It’s not related to anything that we did not know about. We spent the better part of 2012 trying to make sure that we had a good effective strategy for the IT systems exit as well as exiting our current location for our new corporate headquarters.

So it’s nothing that wasn’t anticipated. It was tough to put a number around it. At the end of the day we weren’t going to compromise an effective and efficient exit. I do not see anything beyond this, this effectively ends all the inter-learnings [ph] that we have with ITT this year. So this is the reason we pointed out is to ensure that as you think of the margin going forward it’s not an ongoing cost.

Gretchen McClain

Yes, let me talk a little bit about the fourth quarter dynamics. As we all saw the confidence level in Europe and some of the confidence level around the U.S. fiscal cliff, had people falling back high on their budgets. So we saw that both in Public Utilities and Industrial. In the Public Utilities, part of that was driven by some of the orders that were pulled forward in third quarter but we did see some pulling back. We’ve done a lot of discussion with our customers to understand what’s going online and what to expect going forward. We did see them extending some of their business activities not something we think is a trend or difficult and we also had some very difficult comparison in the fourth quarter.

As I mentioned earlier, it was our all-time record fourth quarter in 2011 at $1 billion and a significant part of that growth was tied to treatment orders in the fourth quarter of 2011 – sales in 2011 which didn’t of course repeat. The good thing is we held some nice orders in the fourth quarter of 2012 around treatments so we are feeling good about that. Let me just come back in terms of the order rates we’ve seen, we’ve talked about bidding activities still being strong, bidding activity is still good, our pipeline or I should say our funnel is very full but there is not a significant change in terms of the release of those bids into orders. So see something happen in the fourth quarter, not sure that’s the trend. It’s too early to say that at this point in time and so we’ve not take that in. We think we’re going to still see that market very challenged going forward.

David Rose – Wedbush Securities

Okay, great. Thank you.

Operator

Your next question comes from the line of John Moore with C.L. King.

John Moore – C.L. King

Thank you, good morning. Can you quantify any benefits that Sandy had on the order rate in the fourth quarter, and do you expect to have any benefit from Sandy related demand in the first quarter or longer term?

Gretchen McClain

Yes, let me comment. On fourth quarter we saw $8 million from Sandy that came from both of our segments. The largest portion of it from dewatering business, the team did a remarkable job in executing and being there helping our customers. In terms of 2013, we all know that the Disaster Spending Bill has been approved, projects are being worked. We’re working very closely with our customers. I think we’re well positioned to be able to benefit when you look at the portfolio that we have, the expertise that we’ve got but again it’s early in the stages of those projects getting laid out that should be something that falls out later. So it’s tough to quantify 2013 impact at this point.

John Moore – C.L. King

Okay, great. The $8 million was the revenue, but was there a similar benefit to orders in the quarter?

Gretchen McClain

Yes.

John Moore – C.L. King

Thanks.

Operator

Your next question comes from the line of Jim Krapfel with Morningstar.

Jim Krapfel – Morningstar

Hi, good morning. I think you partially answered this question already, but would you think the driving – the weakness you’ve seen from your Public Utility customers, do you think it’s more due to weaker electricity usage trends or the necessitated need for doing product plans or do you think it’s more to due to continued low [ph] power prices making utilities more conservative with available cash. So just trying to get a better sense of whether the utility end-market weakness is more secular in nature or is this typical?

Gretchen McClain

I think you have two dynamics. The Public Utilities have been down in the CapEx expenditure for quite some time. They’re at low ends I think 60 years, that’s not changing. We don’t see any indication of that changing. That’s a big piece from the CapEx perspective. From the operational, OpEx side of the house, as I said we felt some dynamics so we pulled some things into the third quarter. We don’t think the aftermarket is a very strong market and given our large install base that we will reposition very well.

I also think public utilities are looking at how they can reduce their total cost of ownership that again positions us extremely well to be able to bring solutions to help them take their costs down.

Jim Krapfel – Morningstar

Okay. And then how is the acquisition pipeline looking and what evaluations are you encountering especially relative to the past few quarters?

Gretchen McClain

So our acquisition pipeline is quite strong. We continue to cultivate a lot of different businesses as we know the water industry is quite fragmented and feel good that we have a healthy acquisition pipeline. And it’s working I mean we had three acquisitions over the last three quarters and we feel very good about that. I also felt very good about our acquisition strategy – our pipelines and integration process.

Each one of our acquisitions that we’ve acquired are getting well integrated with the businesses, are performing quite well. In terms of evaluation, in the fragmented market you still have various different acquisitions. We have been looking primarily on bolt-ons, smaller, many those who are private companies and it varies whether you are going after a businesses in the services areas, sources whether you are at more of a high attractive value in the analytics or treatment area.

Jim Krapfel – Morningstar

Okay. Thank you so much.

Operator

Your next question comes from the line of Matt Summerville with KeyBanc.

Matt Summerville – KeyBanc

I just have a couple of follow-ups, can you talk about, you know from putting Sandy aside for a minute, what was the magnitude of drop-off you saw throughout 2011 in your dewatering business, and given that some of the longer term kind of drought related statistics that at least we look at are still indicating a pretty severe situation here in early ‘13, were you driving the confidence so that business gets better?

Gretchen McClain

Yes, so the water is two dynamics, two very significant dynamics. One an all-time drought in the U.S. which brought that down. And then the other area where we felt 2011 flow is the pickup that we saw in 2011 around the national gas fracking activities. The positive things about our dewatering, dewatering is well positioned in the U.S. We have been able to take that business model and expand ourselves in Australia, now into Brazil and we intend to take that business model into other regions around the world.

We think that will ultimately be significant in terms of growth for us and also help cycles with their when you do have some kind of a drought activity. Overall our position in dewatering does serve many multiple different end-markets but we did see a spike in the natural gas which makes it tougher compare [ph]. But we were flat for the year.

Matt Summerville – KeyBanc

Your global dewatering was flat?

Gretchen McClain

Our overall business.

Matt Summerville – KeyBanc

Got it. And then, as we think about the margin dynamics, your core business flat to up 1%, Mike sort of talked to my last question about the anticipated cost savings from the ‘12 actions, what’s going to happen in ‘13 following through for the year. I guess I am having a hard time reconciling to your operating margins being down as much as 50 basis points and I would assume you are looking to take more prices this year?

Mike Speetzen

Yes, so let me comment it from a couple of different angles, Matt. From a pricing point we’ve talked firstly about having a target of 100 to 200 basis points. We’re obviously entering a – continued to be in a tough economic cycle and pricing is going to be towards the lower end of that range versus this year we ended up at about 150 basis points. So there is going to be a little bit of headwind now although we do still see a positive contribution from price. But I think the slide we put together in the deck hit of the some key points, I mean first of all we’ve got a pretty substantial pickup from foreign exchange and acquisitions and while they are not dilutive from an EPS standpoint, they are not bringing any income for the most part to the bottom line and that ends up diluting the margins by about 40 basis points.

The foreign exchange piece is more of a triangulation effect of the currency change. The acquisitions, it’s more of a short-term impact of the upfront purchase account and some of the transaction cost. The European realignment was a pickup from an EPS standpoint and drives a substantial portion of the tax benefit. We do have to setup infrastructure in Europe to support that. That’s a 30 basis point headwind. Now the good news is over time that’s going to give us a platform to drive future benefit to the business from an operating (inaudible) and then we’ve articulated really two of the – what I’d say is out of the norm adjustments, one it is the pension discount rate came down about 75 basis points and for us its about $5 million impact.

And then the one-time separation costs which we’re about just really trying to make sure we exit the connections with ITT in the right way. And then if you look at our core operations, we’re doing a lot of the same things that we did in 2012, dealing with a low growth environment, we have very robust lean and sourcing initiatives and sure we’re driving productivity to not only offset inflation that give us a little bit of room to continue to invest in the key parts of our business and I think that’s a critical element is we have not backed off making sure that we’re investing in the future of the company.

And then the restructuring savings obviously to that to help offset what is some headwind from the other cost increases that I had mentioned a little bit earlier.

Matt Summerville – KeyBanc

Pretty detailed walk, thanks Mike.

Operator

(Operator Instructions) Your next question comes from the line of Brian Konigsberg with Vertical Research.

Brian Konigsberg – Vertical Research

Good morning. I just had a only question really on the Public Utility, you hit on some of it but I am just curious what you’re thinking actually is going to take to get the capital projects part of the business to trend upwards, I mean if you think about what – historically how can you refine that, it seems like the healthy – the municipalities is able to issue debt now that we’re seeing some improvements in the residential market, you would think that health of the municipalities are improving. But I am curious is there a kind of a period of absorption that needs to occur or kind of the – the municipalities go less before they are able to get to a point where they are able to improve the bond issuances at the municipal level to start doing these capital projects on a more significant level. We know there is no shortage of demand for new projects, it’s really a matter to regain that capital into the system I think. Can you just – if you could address that?

Gretchen McClain

Sure. It’s a great question. Here is how I think about it, I mean the economy is down until the economy gets dressed in some of the key issues that we’re talking about in the U.S. and other areas it’s going to be a challenge area. Now that’s not stopping us ultimately in terms of strategically looking how we position ourselves in working with our customers to get after cutting, to reducing their operating costs so that they can actually invest in those areas.

There are a lot of bills that are out there that are being kicked around and addressed. There are indicators that will say later this year or into 2014 you will see activity taking place, but right now the trends and the orders don’t reflect that. Our teams are aggressively investing in the right technology, so we are well positioned once that opens up.

Brian Konigsberg – Vertical Research

Okay, thank you very much.

Operator

Your final question comes from the line of Stewart Scharf with S&P Capital IQ.

Stewart Scharf – S&P Capital IQ

Can you talk a little bit about the mix in base line, the new products and end-markets, is there – what areas that you are focusing or where the mix generally is better and the margins or is it just pretty even based on the various new products and end-markets?

Gretchen McClain

I would say one thing when I talked about our Vitality Index, we are getting a large percentage of our revenue coming from our new product launches which is a good indication that we have the right technology going into the market. I feel good about that. When I look at the mix, going into ‘13 we think our mix is going to be net neutral. You’ve got emerging markets that is pulling down and that’s an area that is growing and an area that we continue to expand in. Analytics and dewatering is positive.

Mike Speetzen

Yes Stewart and maybe just from a financial standpoint I mean 2012 we saw a lot of negative mix and we had a lot of the drivers around the dewatering business being the primary impact. As we look into 2013, as Gretchen stated, we see mix being less of a factor for us, where we see positive upticks in areas like dewatering and analytics. We’ll see a little bit of an offset from an emerging markets standpoint but nothing that’s significant at this point.

Stewart Scharf – S&P Capital IQ

Okay and just going to your financial allocation, it is pretty much the same, focused on the strategic acquisitions, just raised your dividend, maybe change in planning for use of cash, share buybacks and so forth?

Mike Speetzen

No, I mean we have a share repurchase program as we’ve stated in the past, it’s primarily in that managing the dilution from the equity programs. At this point we have a very robust acquisition pipeline and an ample supply of internal investments and our strategy is going to be to focus in those two areas and continue to reevaluate as time goes on.

Stewart Scharf – S&P Capital IQ

Okay, thank you very much.

Mike Speetzen

You bet.

Operator

That was our final question and I’d now like to turn the floor back over to Gretchen for any closing remarks.

Gretchen McClain

Yes, I just want to say thank you for joining us. It’s been a great year. We’ve got a great plan laid out. We are watching the economy very closely. We’re sizing our business to ensure that we’ve got the flexibility for growth. We’re driving of course for growth in our strategic activities. So if we did it and the market changes, that’s a positive thing that we will see in the future. I look forward to seeing you in our Investor Day on March 7. So thank you very much for your time.

Operator

Thank you. This does conclude today’s Xylem Fourth Quarter and Full-Year 2012 Earnings Conference Call. Please disconnect your lines at this time, and have a wonderful day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Xylem's CEO Discusses Q4 2012 Results - Earnings Call Transcript
This Transcript
All Transcripts