賽莱默 (XYL) 2017 Q2 法說會逐字稿

Welcome to the Xylem's Second Quarter 2017 Earnings Conference Call.

(Operator Instructions) I would now like to turn the call over to Matt Latino, Manager of Investor Relations.

Thank you, Angie.

Good morning, everyone, and welcome to Xylem's Second Quarter 2017 Earnings Conference Call.

With me today are Chief Executive Officer, Patrick Decker; and Chief Financial Officer, Mark Rajkowski.

They will provide their perspective on Xylem's second quarter 2017 results and discuss the full year outlook for 2017.

Following our prepared remarks, we will address questions related to the information covered on the call.

(Operator Instructions)

As a reminder, this call and our webcast are accompanied by a slide presentation available in the Investors section of our website at www.xyleminc.com.

A replay of today's call will be available until midnight on September 2. Please note the replay number is (800) 585-8367 and the confirmation code is 41776981.

Additionally, the call will be available for playback via the Investors section of our website under the heading Presentations.

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 the 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 adjusted basis unless otherwise indicated, and non-GAAP financials have been reconciled for you and are included in the Appendix section of the presentation.

Now please turn to Slide 4. And I will turn the call over to our CEO, Patrick Decker.

Thanks, Matt.

Good morning, everyone.

Thanks for joining us to review our second quarter results.

Overall, we delivered a solid performance in the quarter operationally and with healthy margin expansion and robust order performance, which increases our visibility to stronger performance ahead.

In the second quarter, we generated top line growth in our base Xylem businesses and in Sensus.

We're continuing to execute well, building momentum in the markets we serve.

This is particularly notable in several of our emerging market regions.

Our progress in driving productivity continues to generate impressive results with another quarter of significant year-over-year gains.

The more focused approach we've applied to innovation and technology, partnering with more customers and external institutions, is accelerating our progress towards pilot-ready solutions to meet our customers' challenges.

And the integration of our Sensus and Visenti businesses is proceeding well with their teams capturing new opportunities as they collaborate together.

The investments we've made in these and other activities are beginning to bear fruit, and our second quarter results offer further proof points that our focus and discipline strategy will yield not only the short-term results we expect but also produce the improved growth we've embedded into our longer-term expectations.

So let me take you through our results in the context of the key priority areas we discussed at our Investor Day early this year.

There we laid out our clear focus on increasing profitable growth, and that begins with driving commercial leadership.

In the second quarter, we delivered pro forma organic revenue growth of more than 1% with the base Xylem and Sensus businesses each generating positive results.

Our strong growth in orders illustrates the momentum that's building in the business.

Globally, we generated an 8% increase in orders in the base Xylem business and double-digit order growth in Sensus.

Within the base Xylem business, the growth was broad-based across all of our businesses.

These results reflect in part the investments we've made in strengthening our teams and providing them with the right tools to increase their effectiveness in serving our customers.

Importantly, this type of order growth sets the stage for improved top line performance beginning in the latter part of this year and 2018.

I want to take a moment to thank our sales teams and those who support them around the globe.

They are the ones out in the field day after day working hard to develop the right solutions to help our customers and win the deals, and it's certainly not lost on me who the real drivers are of these results.

Now before I move to the second priority, I do want to address a couple of our end markets as I know it's on many investors' minds.

First, the public utility market where we delivered particularly strong results, up 15% last year.

In the second quarter of this year, we saw a modest decline in public utility revenue in our base business.

It's notable, however, that our treatment orders grew 21% and wastewater transport orders were up 10% in the quarter.

This momentum, along with market intelligence and strong bidding activity, speaks to a positive outlook for the public utility end market.

And it reinforces our confidence that our business in this sector will return to low- to mid-single-digit growth in the second half of the year.

I'd be remiss if I didn't address the welcome upturn in our industrial business.

This was driven principally by our dewatering business, which benefited from strength in the construction industry as well as improved conditions in mining and oil and gas.

It's still early days to declare a complete turnaround in this area, but it is encouraging to see solid results beginning to take hold.

The next priority area in our growth strategy is driving our business in emerging markets.

Now as I've said many times, I take the long view on these regions of the world.

There will be periods of variability as we saw over the past year, but we have been steady and disciplined in our continued investment in these areas.

And now as market conditions are improving, we are well positioned to grow our business and capture share.

During the second quarter, emerging markets revenue was up 7% and orders grew 27%, nearly double the orders growth rate we achieved in the first quarter.

Clearly, we are building momentum in this part of our business, and our longer-term outlook remains positive.

I'd like to update you on 3 of our priority markets.

Our team in China is continuing to outperform, delivering better than 20% year-over-year growth in both revenue and orders.

This strong performance reflects solid growth in public utility, and the team is beginning to reap the benefits of our product localization efforts.

In addition, our teams are working closely together to capitalize on our broader portfolio of Xylem, Visenti and Sensus solutions.

In June, I was in Zhenjiang, China, to celebrate the signing of new agreement with a large Chinese water utility for a pilot project utilizing our smart water network solutions to help them solve their non-revenue water issue, which is a growing challenge for water utilities around the globe.

The outlook in India is also quite positive.

Our team delivered 12% revenue growth in the quarter and a triple-digit increase in orders.

The order strength extended across both Water Infrastructure and Applied Water, and we expect product localization to further expand our opportunities there.

We're also making good progress in building out our new India Tech Center in Bangalore, which is enabling us to tap into our rich combination of local and global expertise to drive innovation.

The Middle East remains soft, but we see some leading indicators of a turnaround in the market.

Order growth in the region was up double digits in the second quarter, and this follows a 9% increase in orders in the first quarter.

The presence of our Dubai factory is helping us better meet our customers' needs more quickly, and we expect that to have an increasing impact on future growth.

Our progress in driving innovation and technology continues.

We're already seeing some exciting ideas come out of the collaboration between Xylem and our new Sensus colleagues as we maintain a sharp focus on solving specific customer pain points.

In fact, we're already moving from the research lab to the pilot phase on certain solutions, and we look forward to deploying prototypes of those solutions with select customers in the coming months.

That's a nice lead in to our progress with the integration of Sensus, which is proceeding on track with our plans.

Our teams are working well in targeted areas, ensuring we remain focused on delivering our near-term financial commitments while beginning to execute against the revenue synergies we've identified.

We also continued to track on pace to deliver the cost synergies we outlined of a net $15 million in 2017 and $50 million plus by 2019.

The team delivered a signature win this quarter, valued at approximately $100 million over the life of the contract with the deal Sensus struck with Alliant Energy, which serves electric and natural gas customers across Iowa and Wisconsin.

This multiyear deal represents one of the largest deployments to date of FlexNet and includes both electric and gas smart meters.

This deal is another compelling illustration of the value that the electric and gas businesses bring to Xylem.

It also highlights the importance of our continued investment in electric and gas to develop a solution that our customers need.

As we continue to innovate, we expect to have more solutions that can be seamlessly connected to our network solutions, increasing the value we can bring to our customers across the water, electric and gas utility sectors.

The last area I'll touch on is continuous improvement, which continued to deliver quarter-after-quarter.

We generated nearly $40 million in cost savings in the second quarter, up significantly from the prior year period.

These savings continue to help fund the growth initiatives that are key to our longer-term objectives.

We're also seeing an uptick in the use of tools to reduce some of the complexities that still exist throughout our operations.

Our adjusted EBITDA was up 150 basis points to 18.6%, and this reflects both strong operational performance as well as a Sensus contribution.

We delivered adjusted earnings per share of $0.59 in the quarter, an increase of 23% year-over-year.

We also delivered solid improvement in free cash flow year-over-year and continue to be well positioned to deliver full year free cash flow conversion in excess of 110% of net income.

And finally, as you saw in our press release, we are raising our full year earnings guidance to reflect primarily our updated assumption for foreign exchange impact, which has strengthened recently.

We increased our adjusted EPS guidance and narrowed the range to $2.30 to $2.40 per share.

I'll come back to this when we discuss the outlook in a few minutes.

We delivered a solid performance in the first half of the year and are well on track to meet our full year commitments.

Importantly, we built strong momentum across many of our businesses that we see continuing through the second half.

That combined with improving end markets, is increasing our confidence for stronger growth ahead.

Now with that, I'll turn it over to Mark for more details in the quarter.

Thanks, Patrick.

Let's turn to Slide 5. I continue to be pleased with the progress against our strategic initiatives and the commercial momentum we're building.

As Patrick detailed, our teams executed well in the second quarter.

And their performance, along with improving order growth, positions us strongly as we move into the second half of this year.

Overall, revenues were up 25% to $1.2 billion in the second quarter.

On a pro forma organic basis, this represents more than 1% growth with Sensus contributing 2% and the base Xylem business increasing 1%.

Foreign exchange reduced revenues by $19 million or about 1 point.

In the base Xylem business, the 1% growth in revenues reflect solid performance in the residential and commercial end markets, up 15% and 3%, respectively, largely driven by strength in the U.S. as well as a 2% increase in our industrial end market.

This growth was partially offset by a decline in public utility, which reflects a particularly challenging comparison from the prior year period when we delivered 15% growth globally.

Regionally, the U.S. was flat year-over-year as the strength in residential and commercial was offset by the softness in public utility.

Western Europe performance was down 3% with specific pockets of weakness, including the U.K. Emerging markets continued its momentum into the second quarter when we delivered 7% revenue growth year-over-year.

In the Sensus business, the 2% growth in revenues was in line with the high end of our expectations.

This reflected strong double-digit growth across all applications with the exception of water, where there was a challenging prior year comparison due to significant distributor stocking of the new product in North America.

Moving to operational performance.

We increased our adjusted EBITDA margin by 150 basis points to 18.6% in the quarter.

This increase was driven by strong productivity in operating results from our base Xylem business as well as the continued solid performance from Sensus.

Adjusted operating margin was 13.3% in the quarter.

Excluding the 70 basis points of purchase accounting amortization for the Sensus acquisition, our adjusted operating margin increased 100 basis points year-over-year in the quarter.

Our teams continued to execute well in our productivity programs, delivering $38 million in cost savings in the quarter.

This is an increase of 27% from the prior year.

The acceleration of our cost savings enabled us to more than offset inflation and a modestly weaker revenue mix while continuing to fund investments for growth.

The strong operating performance in our base Xylem business, along with the significant accretion from the Sensus acquisition, enabled us to deliver adjusted earnings per share of $0.59, a 23% increase year-over-year.

Please turn to Slide 6, and I'll provide additional details on our segment performance.

Beginning with our Water Infrastructure segment.

We recorded orders of $521 million, up 10% organically year-over-year.

This includes double-digit growth in both transport and treatment applications.

And as Patrick mentioned, treatment delivered an impressive 21% increase in orders.

This performance builds on an already positive trajectory and sets us up for a solid second half of 2017 as well as a strong 2018, as many of these orders carry longer lead times.

We exited the quarter with total backlog for this segment of $589 million, up 14% year-over-year.

Of this amount, more than $400 million is due to ship in the second half of this year, an increase of 12% year-over-year on an organic basis.

This gives us good confidence in our ability to accelerate revenue growth and deliver low- to mid-single digit revenue growth in the third quarter.

Water Infrastructure revenue of $482 million represents a 1% increase year-over-year on an organic basis.

In the U.S., the segment was down 1%, primarily due to a difficult comparison against the 22% growth in our public utility markets last year.

This was partially offset by the strength of our dewatering business, which grew 4% globally, with a return to growth in North America being the biggest contributor to this improvement.

The team capitalized on opportunities in construction as well as stabilizing mining and oil and gas markets in the U.S. and Canada.

The strength in these sectors in particular is reflected in the strong growth in Canada, which was up 37%.

This is our second consecutive quarter of meaningful improvement in these markets, which is a very encouraging sign.

Western Europe decreased 4% overall, primarily reflecting softness in the U.K. We have seen some slowing there due to a shift in timing of deliveries as well as delays in investment related to the AMP6 public utility investment cycle.

However, based on recent order momentum, we believe that much of this weakness to be a case of volume shifting from the first half to the second half of the year.

Our emerging markets results were strong with revenue growth of 11%.

We saw continued strength in China and India where government investment remained strong.

Our Middle East business remained soft in the quarter, down 15% year-over-year.

However, we are seeing encouraging signs of increased investment and funding, which is supported by the double-digit order growth we secured in the quarter.

Operating margin for the segment increased 150 basis points to 16.4% driven by productivity benefits in volume leverage, which more than offset inflation and investments for growth.

Please turn to Slide 7. Our Applied Water segment booked orders of $375 million in the quarter, which was up 6% organically.

We exited the quarter with backlog of $193 million, which is up 7% organically compared with last year.

Of this amount, more than $140 million is due to ship in the second half of 2017, up approximately 6% on an organic basis.

Our backlog level and order momentum provide us with confidence in our ability to deliver low- to mid-single-digit growth in the second half of this year.

Revenue for Applied Water was $361 million, up 1% organically versus the prior year quarter.

Emerging markets revenue increased by 3%, reflecting solid growth in the Middle East and Eastern Europe, partially offset by weakness in Latin America.

In Western Europe, revenue decreased 1% as the growth in Residential was more than offset by a decline in commercial building revenue, reflecting a difficult year-over-year comparison against the 14% growth we achieved a year ago.

We expect that the investments we've made in our European sales capabilities and channels as well as the new product investments we made over the past 18 months will drive improved growth in the second half of this year.

In the U.S., Applied Water segment revenue was flat.

Our U.S. commercial building services business grew 3% in the quarter, and that was without the benefit of any major project releases, which we do expect to see later this year.

Our U.S. residential business grew 14% in the quarter.

In addition to solid market growth, we also benefited from promotions and channel restocking.

The strength we saw in both Commercial Building Services and Residential was largely offset by the decline in agricultural product sales due to market softness and challenging weather conditions.

Segment operating margin in the quarter increased 20 basis points year-over-year to 15%.

The increase in adjusted operating margin was due to cost reductions from global procurement and continuous improvement initiatives as well as lower year-over-year investment due to the completion of our Middle East expansion last year.

This was partially offset by cost inflation, unfavorable mix and currency impacts.

Now let's turn to Slide 8 to discuss the performance of our Sensus and Analytics segment.

As a reminder, these segment results now reflect a combination of our Sensus and Analytics businesses.

Prior year results have been restated to include our Analytics business, which was previously in the Water Infrastructure segment.

Let me start by saying that we're very pleased with underlying momentum in our Sensus business.

In the first half of the year, the business generated about 5% growth on a pro forma basis and orders increased more than 10%.

I do want to highlight a point related to our orders numbers.

Some of our large multiyear contract wins, such as the Alliant deal that Patrick mentioned, are not yet fully reflected in our reported orders.

We will report orders under these contracts as they move closer to the execution date and purchase orders are issued.

That said, we're clearly building strong momentum in this business that we expect to result in accelerated sales growth in the second half of this year.

Now back to the second quarter.

Revenues for the segment were $321 million, up 2% on a pro forma organic basis over the prior year period.

For the Sensus business, revenue in our electric sector increased 53% with growth primarily attributable to the deployment of several large projects.

Further driving this strong performance was demand for new products, including the Stratus electric meter, which is helping us gain share.

The water sector was down 8% in the quarter.

However, this reflects a very challenging comparison with the prior year period, during which the water sector grew 20% as it benefited from the very successful launch of the new iPERL water meter and channel stocking.

In addition, in last year's second quarter, the business generated significant service revenues related to the initial deployment of the Thames Water contract.

Shifting to our Analytics business.

This business delivered 2% growth in the quarter with increasing demand in environmental monitoring in North America, which is a trend that we expect will continue through the second half of the year.

Orders in Analytics increased by 8%, led by 20% growth in emerging markets and strength in the U.S. We expect the orders momentum to lead to improved growth in the second half of the year for this business.

Now moving to our segment operating margins.

Adjusted operating margin for the segment increased 210 basis points from 8.5% to 10.6%.

The increase in adjusted operating income and margin was due to the inclusion of the higher relative year-over-year margins from the Sensus business and the benefit of significant cost reductions in the Analytics business.

To assist investors in better understanding the performance of this segment, we've included an additional slide in the Appendix, which reflects comparable sales and margin information on a pro forma basis.

Given the significant impact that amortization from purchase accounting has on this segment's margins, we have presented this analysis on an EBITDA basis.

On a pro forma basis, EBITDA margins in the quarter were down 170 basis points year-over-year to 19.9%.

The reduction was primarily driven by increased R&D and commercial investment for new product development and to drive revenue synergies.

Cost reductions more than offset inflation, and mix was slightly negative year-over-year.

Now let's turn to Slide 9 to discuss cash flows and the company's financial position.

We closed the quarter with a cash balance of $288 million.

Free cash flow in the quarter increased almost 20% from the prior year to $70 million and was driven largely by the addition of Sensus.

Free cash flow conversion was 56% for the first half of the year, which is on track with our expectations to deliver greater than 110% conversion for the full year.

We invested $34 million in capital expenditures in the second quarter and returned $52 million to our shareholders through dividends and share repurchases, of which $21 million was for share repurchases to manage dilution.

Working capital improved by 170 basis points year-over-year, largely driven by the strong performance in the Sensus business.

We remain committed to maintaining our investment grade credit rating.

And as a result, our capital deployment is focused primarily on debt repayment at this time.

Please turn to Slide 10, and Patrick will cover the update to our 2017 outlook.

Thanks, Mark.

We delivered a solid performance over the first half of 2017, which strengthens our confidence in our ability to deliver on our financial targets for the year.

The changes in our 2017 guidance reflect primarily updates to our foreign currency assumptions.

At the top line, we now expect to deliver full year revenue of $4.65 billion to $4.7 billion.

On a pro forma basis, we project organic revenue growth of 3% to 4%, which includes organic growth in the base Xylem business of 2% to 3% and organic growth of 6% to 7% in our Sensus business.

Here, we raised the bottom end of our total company and base Xylem business growth expectations by 1 point.

Our Sensus organic growth rate expectations are unchanged.

We anticipate achieving $130 million in cost savings for the full year, a 10% year-over-year increase, and we remain on pace to meet that target.

Our adjusted operating margin is now forecast to grow in the range of 30 to 80 basis points, excluding roughly 70 basis points of margin dilution from Sensus purchase accounting.

This is an increase of 10 basis points in operational margin improvement over our previous guidance.

At the bottom line, we now expect to generate earnings per share of $2.30 to $2.40, which excludes integration, restructuring and realignment costs of approximately $40 million.

We've increased our projection for those costs from our previous forecast of $30 million as we've accelerated certain activities that we now plan to execute in the fourth quarter.

Excluding foreign exchange impact, EPS growth is projected to be in the range of 13% to 18%.

Finally, as we discussed previously, we expect to deliver free cash flow conversion of at least 110% this year.

This contemplates anticipated capital expenditures of approximately $190 million to $200 million.

Now please turn to Slide 11, and I'll walk you through our end market assumptions.

Please note that our commentary and growth estimates on the slide reflect pro forma organic revenue from 2016 for Xylem and includes the impact of Sensus.

Public utility constitutes 47% of total pro forma 2016 revenue.

In 2017, we expect pro forma organic revenue to grow in the low- to mid-single digit range.

We continue to forecast organic growth in our Sensus business of 6% to 7%.

As we've seen in the first half of 2017, Xylem-based businesses are lapping a very strong public utility performance in 2016.

As a result, we expect organic growth for the base business for the full year to be up low-single digits.

The year-over-year comparison in the U.S. market is particularly challenging as we delivered 17% growth in 2016.

As a result, we believe growth in this region will be in the low- to mid-single digit range.

Large project activities are expected to drive mid- to high-single digit growth in the emerging markets, primarily in China and India.

And in Europe, we anticipate low-single digit growth.

Our industrial end market represents 37% of pro forma revenue.

In 2017, we continue to expect that full year organic revenue will be up low-single digits.

While the year started off soft, we are encouraged by the modest growth we saw in the second quarter.

As a result, we are cautiously optimistic that this is the beginning of a market recovery, and we anticipate modest growth over the second half of the year.

We expect emerging market performance to be mixed with strength in China and Latin America, offset by continued weakness in the Middle East.

Moving to commercial, which represents 11% of pro forma revenue.

We project organic growth to be in the low- to mid-single digit range in 2017 with a solid U.S. market.

In Europe, new energy efficient products and our continued investment in our sales channels are expected to help drive growth.

Residential revenues reflect 5% of pro forma revenue.

Based on the strength we've seen in the first half of the year when we grew 14%, we are now anticipating full year growth to be in the high single-digit range.

In the U.S., we did have a better-than-expected first half of the year, but we believe that growth will moderate somewhat in the second half.

We do continue to see an increase in residential building permits in the European market, which has helped drive modest growth.

Now please turn to Slide 12, and Mark will walk you through more details on the outlook.

I'll take a few minutes to update you on the seasonal profile of our business as well as the updates to our 2017 planning assumptions.

For the third quarter, based on orders momentum, improving backlogs and favorable compares, we expect the public utility market to grow mid-single digits on a pro forma basis and our industrial businesses to grow mid-single digits as well.

We expect commercial building services to accelerate modestly to the mid- to high-single-digit range, and we anticipate moderating growth in residential, up mid- to high-single digits.

All in, we anticipate this will result in pro forma organic revenue growth in the range of 4% to 5% in the third quarter.

We expect foreign exchange translation to favorably impact revenue by $15 million.

Acquisitions are expected to add approximately $230 million to $240 million with Sensus growing organically at 6% to 7% in the third quarter.

As for our third quarter operating margins, we expect margins to be flat to up 20 basis points, excluding the 70 basis point reduction due to the noncash amortization of Sensus purchase accounting.

There are couple of items that will put some pressure on our operating margins in the third quarter.

The first item is driven by higher cost of batteries that we have secured from alternative suppliers for our Sensus water meters.

As we discussed on our last earnings call, an accident in the spring required our previous battery supplier to temporarily close its plant.

The team has done a fantastic job identifying alternate suppliers on short notice to largely mitigate this supply issue and minimize customer disruption.

However, the costs are substantially higher.

Third quarter margins will also be negatively impacted by a significantly higher mix of sales in our treatment business and large project revenues in the emerging markets.

Finally, please note the summary of our FX assumptions on this slide, which includes our updated euro guidance assumption at $1.15 from $1.07.

This adjustment puts us in line with the July month-to-date average actual rate of $1.15.

Aside from our current view of assumptions, all other assumptions remain unchanged from our previous guidance.

With that, I'll turn the call back over to Patrick for some closing comments.

Thanks, Mark.

We've had a solid first half of the year.

We're increasingly encouraged by the momentum we see continuing to build in our businesses, and a number of our end markets are showing signs of improvement.

Our Sensus integration work remains on track, and we continue to uncover new growth opportunities based on the combined offerings from Xylem and Sensus.

And as we do so, we're remaining focused and disciplined to ensure that we execute our near-term plans and continue to deliver on our long-term financial commitments.

There is no doubt that we are still in the early days of realizing our strategic ambitions as we outlined at Investor Day, and we look forward to continuing to develop significant further value creation for our shareholders.

Now operator, we can open up to questions.

(Operator Instructions) Our first question comes from the line of Ryan Connors of Boenning and Scattergood.

My question is on the public utility market.

Obviously, tremendous order performance there, but obviously, the underlying markets aren't growing that pace, 21% for treatment and 10% for transport.

So do you think you're taking any market share there?

And can you give us some color about how you analyze the respective contributions of market growth and your own competitive performance?

Sure.

Thanks for the question.

So I'd break it down into the 2 most meaningful businesses that operate the public utility sector, and that today is our treatment business and our transport business.

So -- and I think the answer to your question is different for each of the 2. I would say where we saw the significant orders growth in treatment, that really, in my view, is more attributable to timing of projects being awarded.

And so I wouldn't necessarily attribute that to a share gain per sale, though we do feel good about our share position in that market.

The flip side of that, on the transport side, where we had 10% orders growth in the quarter, again, predominantly attributed to the public utility sector.

That one, I do believe is -- we do believe, is a level of share gain that's really being driven by, one, new product introductions, but also we've got a very large share position in terms of install base.

And so as we see continued healthy growth in the repair and replacement part of the business, we obviously benefit differentially in that sector.

So I would attribute a portion of that to share gain.

Got it, okay.

And then my other question was on oil and gas and mining, and two questions there.

One, how big a contributor was Godwin to the improvement there on the rental side?

And then why not more bold in calling a recovery there?

It seems like a couple of straight quarters of pick up.

And what would it take to raise your conviction level and get more bullish on that energy market?

Yes.

I think it's a fair question, Ryan.

I think that our view -- I guess we've been down so long in what is, otherwise, a small part of our total revenue base on a business that obviously is one of our most profitable.

I think we'd like to see another quarter of continued momentum here to be able to declare a definitive turnaround where we saw particularly healthy growth this last quarter within our indirect channel with our distribution partners with some restocking there as well as they were deploying capital again, which is obviously a very healthy sign.

And so rig counts going our way, a number of other positive signs there, but we just think it's prudent right now to keep our expectations very levelheaded here.

Okay.

And Godwin, any color there?

Yes, Godwin was the predominant contributor to the growth in that area.

Actually, we've got a little bit of softness in our Applied Water business in more of the downstream applications there.

That was down a little bit -- not much, but a little bit, but that was more than offset to drive growth in dewatering.

Your next question comes on the line of Deane Dray with RBC Capital Markets.

And maybe we can start with China.

I wasn't expecting to see that kind of growth coming out of the region, up 20% revenues and orders.

And maybe a part of your answer is where -- what kind of range of products are you seeing?

Because the facilities we visited in Shanghai seem to be enamored with your UV treatment, some of your advanced treatment products.

So how's the take there?

And then also, industry reports have been saying China is really ramping up this focus on nonrevenue water, more so than anyone expected, and so maybe that's part of your growth rate you're seeing.

And will you use any of that combination with Pure Technologies and Visenti there?

Yes.

Well, thanks, Deane, for the questions.

So a couple of things in there that I'd point to.

If you look at our growth in the quarter, it was really outpaced with transport and treatment.

We were actually up about 50% year-over-year in that part of the business.

Actually, our Applied Water business was down about 10% as we're still lapping some of the weakness there on the industrial commercial building side.

So it really is heavily oriented towards the water sector and the wastewater sector specifically.

And that really is being driven by the continued focus, as you well know, on top policy mandate around water and environmental quality.

And so we really have continued to see the money flow there.

Now we were also facing some easier comparison last year, but nevertheless, we see good solid momentum continuing there.

To your second point on the nonrevenue water mandate, your industry intel is absolutely spot on.

When I was over there just several weeks ago, a number of the water utility CEOs were letting me know that the last 5-year mandate has been extended now to include a targeted reduction in nonrevenue water, which right now is about 27% is estimated, and they want that number to be down below 10% over the next handful of years.

That's an ambitious aim, but certainly, it will lead to money flowing.

The pilot that we announced that we signed there in Zhenjiang is the first one of those.

And so the good news here is the nonrevenue water opportunity is all in front of us as a sector, Deane.

And so it absolutely is going to be the opportunity for us to leverage our partnership between the Xylem Analytics business, Visenti and Sensus, but also perhaps leveraging the Pure combination as well.

That's great to hear.

And then on Sensus, really interested in hearing anything you can share on this transition to some of the pilot stage of the products, that's what everyone's watching.

To the extent you can comment like what kinds of applications is this in areas like watershed monitoring, but some color there would be real helpful.

Sure.

I'll give you the color that I can from a competitive standpoint, Deane, in terms of how much detail I share there.

But let me speak directionally.

So we've got some pilots that are just about ready to go forward in Asia Pacific as well as some here in the U.S. with some of the leading water utilities.

And we are piloting, quite frankly, different solutions or will be piloting different solutions with each customer.

I would describe them as cutting across a few different areas.

One is absolutely focusing in on the watershed management and the ability to connect our outdoor water quality monitoring capabilities there.

Second would be across the wastewater part of the network in terms of our pumping stations, et cetera, et cetera.

And then third, I would say there are, again, the opportunities that I talked about around non-revenue water being a big future play for us.

So those are 3 of the areas.

There are couple of others that are out there that we're still in the early stages of developing.

Right now, we're really focused on getting the technologies enabled and making them pilot ready to then go out and begin to commercialize them.

Good to hear.

And just last question, I really like seeing this new segmentation with Sensus paired with Analytics.

And just, Patrick, if you could just, a moment, take us through where Analytics focus for growth is from here.

A lot of people just think it's immediately a chemical test, but it's much more on the environmental side.

So where and how do you expect to grow the Analytics piece from here?

Yes, it's a great insight, Deane.

It is a business that is very much focused in on environmental quality monitoring, the whole outdoor water management space.

The acquisitions that we haven't talked about in a while with HYPACK in Tideland.

Ocean and coastal monitoring is another opportunity for us in that area.

And I think that what we are really excited about right now with the Sensus Analytics combination is the leverage and power we get out of the combined R&D and engineering efforts.

And so you'll see an accelerated ramp and some new product introductions there over the coming, I'd say, over the next year or 2. And we've been a little bit still, quite honestly, in the Analytics business.

And I'm encouraged by the opportunity the team sees there now to refresh the portfolio.

Your next question comes from the line of Nathan Jones with Stifel.

Just following up on some of Deane's questions here about the Sensus business and more directly on some of the overlap that you can get with Sensus and the legacy portfolio.

What kind of level of investment do you see ramping up to?

I mean, it looks like a very fertile area for investment.

Where are you kind of now?

Do you need to ramp up the number of engineers you've got?

What kind of investment could the business take, where it's at now?

How should we think about the trade-off between these investments for growth and delivering margins?

Sure, Nate, let me start and I'll have Mark chime in here as well on some of the numbers.

So when we -- in Investor Day, you recall, we talked about between now and 2020 that you would see an uptick of between 100 and 150 basis points of R&D over that time frame.

And as I commented at Investor Day, that was really a proxy for overall investments that we would need to make in the business, whether it ends up in the R&D line, whether it ends up in sales and marketing support as we look at different solutions offerings, but we talked about somewhere between 100 to 150 basis points of margin -- sorry, cost investment that we had embedded in getting to our margin targets over 2020.

We'll continue to modulate that and see what is needed.

We made some of that investment in Q2, and we'll make some here in the second half of the year.

Our efforts right now have really been building out a center of excellence around systems intelligence in Raleigh-Durham that you would have seen the early stages of.

And we'll certainly be adding some sales and marketing resources in targeted areas to really support and drive the deployments over time.

But again, we'll modulate that as we go along.

Mark, you want to add anything?

Just a couple of other points.

We -- the teams are now at the point where they have a much better understanding of what they really need to deliver and execute.

And so you will see some ramp-up in the R&D spend levels.

To Patrick's point, as we develop those products and solutions, we'll also need commercial -- additional commercial capabilities to bring them to market.

But we -- we're also looking at significantly enhancing what we're bringing in terms of the data Analytics, data scientists.

And we certainly see that as a big opportunity going forward for the company, Software-as-a-Service and -- but we're also trying to do it smartly, so we will be taking advantage of building out our India Tech Center, which can support some of that at a lower cost as well.

So you will, bottom line, see some ramp in our R&D spend as a percentage of sales as we go through the remainder of this year.

But Nate, to be clear, and what we said here is what we're talking about in terms of any level of investment is not different than what we talked about in Investor Day.

So it's not -- this is not incremental to what we had laid out back in April.

I'm wondering, given the pace that this seems to be going at, if there's an opportunity to maybe accelerate some of these investments, I know maybe that'd a little bit of a drag on short-term margins, but are you seeing as you get deeper into this an opportunity to maybe accelerate some of those investments to accelerate growth?

Nate, I think it's a fair observation.

I think right now, it really is a more a function of bandwidth, not so much resources per se, but making sure that we're working with specific customers on prototypes, and we have to move also at their pace as we develop some of these new solutions and technologies.

So if we see opportunities to accelerate, we'll certainly do that.

We wouldn't be constrained financially.

Quite frankly, we see there being other opportunities on the synergy side as well that we could fund a number of these things.

So it really is not a financial constraint.

Yes.

And Patrick, to that point, you talked about net synergies.

A chunk of those investments are reflected as a reduction to the gross synergies that we're delivering.

So as you said, the more we can deliver in terms of gross cost synergies, it provides more opportunity for further investment.

Okay.

And then your order numbers are ramping up faster than your revenue outlook.

Can you talk about maybe the sequencing of backlog and how this is setting you up for growth in 2018?

Yes.

Yes.

We've got -- we certainly have strong backlog going into the second half.

For all of 2017, we're looking at 12% increase year-over-year, but the interesting thing is it's even higher in terms of our backlog going into 2018.

And in 2018 and beyond, our year-over-year improvement is 17%.

So it's really -- and as I highlighted in some of my prepared remarks, we really see that as enabling us to provide really solid second half growth in 2017, but we're even more excited about what we see ahead of us for 2018.

Your next question comes from the line Brian Lee with Goldman Sachs.

Maybe to follow up on that last one.

If I do look at the end market outlook, all the segments here are getting a slight bump versus the organic growth used from the first quarter COGS for public utility, but that seems to be an area where you had a couple of straight quarters of pretty robust order growth, particularly in treatment.

So I'm wondering, how should we think about maybe the timing of orders translating to P&L?

I know lead time wise, you mentioned these could be a bit longer.

And then maybe how you think about the potential for the outlook for public utility getting upgraded and moving through the second half of 2017, similar to what's happened here with your other end markets?

Sure.

Yes.

So I would characterize it as such.

We are outlooking and expecting to be growing in the 4% to 5% growth range in the back half of the year to get to our base Xylem kind of growth here.

And if you look at the orders that we delivered in Q2, and we obviously are pleased with that order performance, it was against a rather weak comparison last year where we were actually down slightly in orders in Q2.

So if you normalize for that, we're kind of in that mid-single digit range all else equal, and that's a pretty much in line with what we're outlooking in terms of organic revenue growth in the second half.

And as Mark pointed out, there is some of this order growth that really extends well into 2018, which we view that as an encouraging sign because obviously, as we get closer to the endpoint of the year here, our minds are turning towards the outlook for '18.

And I think the order performance that we've seen here really provides us with even more conviction of the longer-term growth targets that we laid out back in Investor Day.

And I'd add to that, Patrick, to the second part of the question there.

Clearly, there's -- we're going to see a change in trajectory relative to growth in public utility.

And we were down through the first half, but certainly, with that order growth, we'd expect to be up low-single digit to mid-single digits for the second half of the year, and on a pro forma basis, with Sensus squarely in the mid-single digit range.

Okay, great.

That's helpful.

And then just the second question, maybe a bit more of a housekeeping one.

On the EPS guidance update for 2017, it sounds like a bit of additional organic revenue growth for base Xylem and then the new euro ForEx assumption of $1.15.

But if I take just the new euro rate and flow it through, I get the entire EPS rate, which is consistent with your commentary.

So wondering if there are some offsets to the slightly better organic growth or if there's something unique about the incrementals on that new revenue?

Any clarity there would help.

No, I think you've summarized it well relative to the driver of the increase, it is almost entirely FX.

We have updated the range.

We've narrowed it.

The -- we've moved up the low point to 2.30, and that's reflective of really some of the improved order momentum and what we see as improved growth profile in the second half.

But most of -- just about everything in that updated guidance is all FX related.

Your next question comes from the line of Joe Giordano with Cowen.

So I think with what's going on with Sensus and the synergy opportunities and how attractive that looks, I think part of what gets lost here is the opportunity ahead just nuts and bolts with the stand-alone legacy businesses and the cost set opportunities you have there.

So can you kind of update us where you are year-to-date versus some of your, whether it's the 2017 kind of internal target or relative to your comments you made at Investor Day and just -- on just the core Xylem cost set opportunity?

Sure, Joe.

Let me go first and then Mark can chime in here.

So we feel very good about where we are in terms of the progress on the margin expansion goals that we laid out, not only for the total company, but certainly the base business, which is really where the big productivity opportunity lies.

And you see that with respect to the continued strong growth in our cost set activities in Q2 as well as year-to-date.

And when you look at our overall margin expansion goals of up to 80 basis points in the year, that's a good pace for us in terms of margin expansion, particularly given the fact that we're really not seeing a meaningful level of net synergies from Sensus this year.

I mean, we're calling for $15 million out of the $50 million over time here, only because the negative synergies hit us on day 1 and that, obviously, minimizes some of the net synergy in year 1. You'll see the full on gross impact of that in 2018.

So if you set that aside, very good progress in the margin side.

And quite frankly, we feel that the best is yet to come.

And we talk about the business implication work that we're doing, next generation procurement.

We're still early on in terms of our deployment of Lean and Six Sigma.

So we remain very confident around the margin expansion goals that we laid out.

Yes.

We're tracking very well.

And we saw a ramp in the second quarter year-over-year, and we'll see that continue in -- through the second half.

So we're very confident about our ability to achieve those targets that we've laid out.

And as we look at the net synergies from Sensus, that too will really start to ramp, particularly in the fourth quarter of this year.

Okay.

And if I shift over, one of the themes we've been hearing for a while now from a lot of companies is just on rising input costs.

So if you guys can comment on that.

I'm guessing the commentary is very different when you're talking about maybe Flygt Concertor versus some of the stuff in Applied.

But how are you seeing price -- cost inflation in your ability to compensate on pricing?

Yes.

Let me take that one.

It's -- we're clearly seeing a bit of a ramp in inflation, and it's really driven by commodities.

In the first quarter of this year, we were -- we saw 150 basis point impact year-over-year.

On the second quarter, that did ramp up to 200 basis points, and that was really all commodity-based.

And the -- we would expect that to continue at that level through the second half of the year, at that elevated level.

And it's really being driven by copper, stainless steel, these metals are probably the most significant drivers.

But the team understands that.

We're pushing hard to drive additional opportunities of savings around procurement to offset some of that.

And most importantly, to your question on price.

Year-to-date it's been relatively flat, but there's a lot of movement under that flat result.

There are certainly areas in our business where we have opportunity because of competitive advantage, value proposition to push for price, and we're doing that.

There's other products that are less advantage, where it's tougher to do that.

But we are -- this is clearly an area that we're working with our teams to get more aggressive on price because inflation is ramping.

It's not going away in the near-term, and we just need to be better at getting paid for the value that we're providing our customers, in those instances particularly.

The good news, Joe, is we've seen this coming for a while now, so we've been working closely between our procurement team and our sales teams to make sure they understand which product line is impacting us.

And therefore, where we really want to emphasize going after price.

And so we do expect that benefit to begin to come through in the second half of the year going into next year.

And two, certainly those areas where we are a definitive market leader, we will behave as such and make sure that we drive pricing in the market.

Right.

And one just quick clarification.

Mark, how much of that $100 million large order in Sensus was actually booked into orders in 2Q?

It was roughly 15% to 20%, just off the top of my head.

And that's really -- a lot of that is for next year.

A lot of that order will be realized next year.

It's a -- the key with this one, Joe, is on these large deployments, they're quite complex.

They go over a few years, are just getting the meters deployed.

And obviously, the team worked closely with the customer on exactly what their delivery schedule is.

And so the orders that we would've booked in Q2 would've been a small portion of the overall deal -- very small portion of the overall deal, and those will be shipping out, quite frankly, later this year into '18.

Our next question comes from the line of Jim Giannakouros with Oppenheimer.

I'm just tacking onto Joe's question there on that win.

Any color on how we should be modeling that deployment?

I understand you weighted to '18, '19, is that an equal weight?

Is it ratable?

Or is it only weighted in '18?

Is it a net positive for Sensus?

Or do you have projects rolling off that we should mindful of that kind of offset that and so it don't necessarily impact that 6% to 7% growth rate that you've guided?

Yes.

Jimmy, just to clarify for everybody.

So the deployment itself will take place.

So the way-- it's a two-part contract.

So we've got the actual deployment of the meters as well as getting the network built out.

That takes place over the course of the first 2.5 to 3 years of the contract.

And then we've got a service agreement, software agreement, that goes down beyond that over a 12-year time frame, so both software and service.

And in terms of the modeling, so you're going to see the heavier revenue flow in the first 2.5 to 3 years.

That was embedded in the 6% to 7% growth that we had in the core Sensus business, partly because we do have contracts that potentially rollout that will be up for a bit.

But two, at the time of the acquisition and the time of Investor Day, we had good line of sight to a number of these large deals that are out there and had -- the team had pretty high confidence they were going to win this one.

So that was part of our confidence in committing to at least that 6% to 7% growth over the long range time.

Understood.

And one follow-up if I may.

Industrial exposure over a 30-year exposure.

I understand you're seeing some modest "improvement" overall, but stripping out oil and gas, sticking with that general industrial bucket, where are you seeing increasing activity and where would you call out spending is slow to improve?

Yes.

I think we've certainly seen a modest level of improvement in capital spending in the U.S. industrial sector as well as in, certainly, Canada have benefit there as well.

And as we've said before, we tend to sell into more of the general light industrial, so not so much tied to the actual production activity itself but as long as the sites are up and running, they will burn through some level of pumps that are there.

You'll recall that we saw some unexpected softness there in Q4 and Q1.

We had talked about that we would surpass that and things would normalize, and that's very much what we saw happened in Q2 and we expect that to normalize now for the second half.

Your next question comes from the line of John Walsh with Vertical Research.

So a lot of ground covered already.

Just 2 quick ones here.

I guess a quick modeling question around how to think about Sensus for the full year.

A little bit of movement on the acquisition impact and the outlook, but is the low 10% still the right ballpark there from last quarter?

From an operating margin perspective?

Correct.

Yes.

So Sensus, as on a stand-alone basis, that really hasn't -- that outlook has not changed.

So there's nothing in the profile in the mix of our business or investment levels that would suggest that would be any different than we had outlooked previously.

And we're expecting to achieve that 6% to 7% revenue growth for the full year as well.

Got you.

And then I'm sure it's still very noisy, but I'd be remiss if I didn't ask.

Anything out of your customers around infrastructure or any thoughts around there?

Obviously, a lot of noise coming out of Washington, but any thoughts around there?

Sure.

Our view -- and we obviously do stay close to this as best we can.

And our view continues to be that any kind of infrastructure bill would likely be in that 2018, 2019 time frame, as clearly things are kind of shuffling around in DC these days.

I would say that we wouldn't expect there to be a direct federal funding benefit on the water sector.

There might be a little bit there, but we're not counting on that in our outlook.

I think where there could be positive impact for our customers would be, as you probably well know, oftentimes the local and state muni budgets, when they're under pressure or under constraint, one of the first areas they tend to go after in terms of deferring or delaying is water.

And so obviously, any alleviation of funding pressure for them on other types of infrastructure would obviously help us indirectly from a water standpoint.

But we're not seeing a lot right now other than chatter.

There's been no real activity that we've seen in terms of projects moving forward that weren't otherwise going, but we'll keep you updated as we go along.

Ladies and gentlemen, we've reached the allotted time for questions.

I would now like to turn the call to Patrick Decker for any additional or closing remarks.

Great.

Well again, thanks everybody for joining.

Thanks for your continued interest.

Appreciate the fact you hung on.

We ran a little longer today, but appreciate the questions.

Safe travels.

Have a good end of the summer, and we look forward to catching up with you on our next earnings call.

This does conclude the Xylem Second Quarter 2017 Earnings Conference Call.

Please disconnect your lines at this time and have a wonderful day.