賽莱默 (XYL) 2013 Q2 法說會逐字稿

Good morning.

My name is Jackie and I will be your conference operator today.

At this time I would like to welcome everyone to the Xylem's second-quarter 2013 earnings conference call.

All lines have been place on mute to prevent any background noise.

After the speakers' remarks there will be a question-and-answer session.

(Operator Instructions)

Thank you.

I would now like to turn the call over to Phil DeSousa, Head of Investor Relations.

Please go ahead.

Thank you, Jackie.

Good morning, everyone, and welcome to Xylem's second-quarter 2013 earnings conference call.

With me today are Chief Executive Officer, Gretchen McClain, and Chief Financial Officer, Michael Speetzen.

They will provide their perspective on Xylem's second-quarter results and discuss the full-year outlook for 2013.

Following their prepared remarks, they will address questions related to the information covered on the call.

I'd ask that you please keep to one question and a follow-up, and then return to the queue so we will have enough time to address everyone on the call today.

We anticipate that the call will last approximately one hour.

As a reminder, this call and our webcast are accompanied by a slide presentation available in the investor 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 Tuesday, August 13, at 6 p.m.

Please note the replay number is 404-537-3406 and the confirmation code is 11620868.

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 two.

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 publically to reflect subsequent events or circumstances and actual results could differ materially from those anticipated.

Now, please turn to slide three and I will turn the call over to our CEO, Gretchen McClain.

Thank you, Phil.

Good morning, everyone, and thank you for joining us today.

Most of you have seen the news release with our disappointing second-quarter results.

Today we would like to walk you through the numbers and, of course, respond to your questions and feedback at the conclusion of the call.

As outlined in our earnings release, we experienced a 3% organic decline in revenue in the second quarter.

This lower-than-expected revenue, along with investments of growth and productivity, resulted in lower operating profits and led to adjusted earnings per share that were below our expectations.

During today's call, we will summarize the dynamics impacting our top line, show how they affected our financial performance, and give you our outlook for the remainder of the year.

Also tell you about some of the things we accomplished in the second quarter and outline the strategic and tactical actions we are taking to enhance our performance for both the short and the long term.

So let's start the quarterly summary with the key driver, our revenue performance.

Before jumping into the details let's take a look at what we assumed going into the quarter.

You may recall at the beginning of 2013 we were bearish on the macroeconomic conditions across Europe and we planned accordingly.

Even with this precaution, conditions have proven to be more challenging than we had anticipated.

A significant portion of our business is short cycle in nature, with 50% of our sales going through distribution.

These dynamics, coupled with customers requiring shorter lead times and distributors minimizing inventories, have led to more frequent and smaller transactions, thus limiting our short-term visibility and resulting in increased variability from month to month.

Let me also remind you of our seasonality of our business, with the fourth quarter being the largest, followed by the second quarter, and June being an especially important month for us as Europe prepares for its summer holiday.

We entered the second quarter with a solid backlog, early orders tracking to our expectations, and we were taking aggressive actions to close orders.

While June is the strongest month of the quarter, it did not play out as we had expected.

Our revenue shortfall was driven primarily by transport and treatment in our industrial and public utility markets.

While the revenue declines were fairly broad-based and not restricted to any one country, from a regional perspective the most significant headwinds were in Europe.

Unfortunately, our project pipeline continues to push out to the right due to the uncertainty around funding and budget constraints.

We are not experiencing meaningful order cancellation, so timing of revenue conversion is certainly -- is increasingly uncertain and in this competitive market we were unable to achieve our targeted price realization and faced strong foreign exchange headwinds.

Before discussing our adjusted operating profit, I would like to briefly highlight some of the bright spots -- namely commercial, residential, and agriculture.

These three growing markets represent approximately 22% of Xylem's revenue.

We continue to see strong performance in the US residential market, which posted a third consecutive quarter of organic growth.

Second-quarter results in the US were in the high teens.

US commercial posted 9% organic growth, providing some confidence that this market could be seeing some fundamental improvement.

Agricultural was up 10% in the second quarter driven by strength in the US.

Another bright spot in the second quarter was orders.

We receive more than $1 billion in orders.

That is up 4% in constant currency and 1% organically, and is the highest level of orders since becoming a stand-alone company.

Sequentially, organic orders were up 5%.

For the second quarter, our book-to-bill ratio was in line with seasonal trends at 1.05.

We ended the quarter with a record backlog of $759 million, up $36 million, or 5%, from the previous quarter.

Our shippable backlog is up 7% year over year and we expect to deliver approximately $400 million in the third quarter and approximately $200 million in the fourth quarter.

Now to income.

We are reporting gross margin of 38.6% for the second quarter and operating margin of 10.2%.

Relative to the prior year, these results primarily reflect lower volume and the negative impact of foreign exchange rates.

We are partially offsetting margin dilution with contributions from new products, from the savings realized through restructuring actions taken in 2012, and further cost reductions resulting from our lean and global sourcing initiatives.

As a result of these items and the tax benefit realized from our realignment actions our adjusted net income was $66 million, or $0.36 per share, for the second quarter.

Our free cash flow performance was driven primarily by lower income for the quarter, typical seasonality, and timing of tax payments.

Let's turn to slide four.

For the remainder of the year, we have reforecasted both the top- and bottom-line assumptions to reflect current market conditions, our first-half results, and foreign exchange headwinds.

We now expect revenues to decline 3% to 4% organically; that is down 4 percentage points from our previous guidance.

And we expect to deliver EPS in the range of $1.40 to $1.50.

Our top-line revision is centered on Europe, Latin America, and the Middle East growth rates being weaker than we had expected, along with a slower-than-anticipated US industrial market recovery.

We expect public utility project activity to remain challenged into 2014 driven by the weak CapEx spending, especially in wastewater.

So what are we doing about this?

Across the Company we are taking out additional costs to drive efficiency and a lower cost base in the Company, while staying focused on growth.

We have initiated the majority of our previously announced restructuring and realignment action, and as a result, I am confident we can deliver the full-year cost savings we previously indicated, which will be in the range of $25 million to $27 million for the year.

Accelerated cost-saving initiatives will drive an additional savings of approximately $0.06 per share over the balance of the year and are reflected in our revised guidance.

These include aggressive cost management to drive further reductions in manufacturing costs by accelerating our lean initiatives and tighter sourcing controls and significant cuts in discretionary spending across the Company.

We've already made some immediate adjustments to our cost base while protecting our best processes for growth.

We are pacing investments in light of this current market environment.

In addition, we are dialing back capital expenditures and resizing our acquisition spend while still advancing our strategy.

On the other side of this balanced equation are the efforts to drive top-line growth.

We're launching a series of compelling new products over the balance of the year and staying focused on growth in emerging markets.

As always, we are evaluating all opportunities and are taking steps to position this Company to be more agile and more competitive.

We are leading from the front, actively meeting with our teams around the world, closely tracking progress in our critical initiatives, and sending a strong message to everyone across Xylem that our performance must improve.

I would like to quickly highlight some of the areas of progress against our strategic priorities for the year.

Turn to slide five.

We are sharply focused on delivering customer value and driving profitable growth through the launch of technologies that address higher-order solutions.

Some of these are evidenced by the following key wins.

One is a large project in the UAE to deliver a Leopold branded filtration system to pretreat seawater as a critical component to the desal process.

In Spain, we won a $2 million project to install our newest UV disinfection system, WEDECO Duron.

And we have a million-dollar project with our partner, Visenti, in Singapore to help monitor the country's water infrastructure through leak detection technology.

These projects are great examples of how we are leveraging our innovation, applications expertise, and offering new services to get after some of the world's most challenging water issues.

We are excited by new product launches that are winning in the marketplace and being recognized with technology innovation awards.

We continue to execute our inorganic growth strategy, having completed the acquisition of Pollman Pumpen during the second quarter.

While this acquisition is small compared to those that we have completed in the past, it is strategically important and squarely in line with our geographic expansion strategy in dewatering.

Pollman complements our existing capacity in Germany and enables us to help better serve our customers across Europe.

We have an active acquisition pipeline and we are advancing our bolt-on strategy.

Having spent $80 million on acquisitions year-to-date, we now expect to deploy up to $200 million in total this year.

Lastly, we continue to focus on our business sustainability.

As I have already discussed our cost-saving initiatives, let me provide you an update on our regional transformation in Europe.

You may recall that we opened our European headquarters office in Schaffhausen, Switzerland, and completed the transition of our European Water Solutions business to the newly formed European management structure in the first quarter.

During the second quarter, we moved forward with our second phase and our Applied Water business is now operating under the new structure.

And our sales companies across each country across Europe have been integrated into one Xylem team, which will result in greater efficiency and growth as we move forward.

I will wrap up later and take your questions, but for now let me turn our call over to our CFO, Mike Speetzen, to walk you through the second-quarter 2013 results in detail.

Mike?

Thanks, Gretchen.

Please go to slide six.

Given our second-quarter results, we feel it is important to walk you through our performance relative to our expectations.

Organic revenue was unfavorable by 2 percentage points.

Strong performance across all end-markets in the US was more than offset by weaker conditions in Europe and the emerging markets, lower price realization, and unfavorable foreign exchange impacts.

Let me cover the market dynamics in more detail.

First, we saw better-than-expected market conditions in our US residential and commercial building service business and our Ag business continue to benefit from drought conditions in the Southwest.

Europe was generally weaker than expected, but most significantly down in the public utility and industrial markets.

We also encountered greater-than-anticipated pricing pressure as continued market demands challenged our ability to gain more significant price increases.

Foreign exchange was a significant headwind as we saw the US dollar and Swedish krona appreciate against other currencies.

The most significant impact was from the non-economic translation of financial statements into US dollars.

The impact of Xylem's revenue was $14 million and the impact to earnings was $3 million.

Acquisitions in our restructuring and realignment activities tracked expectations.

During the quarter, we realized restructuring savings of $4 million, reflecting our 2012 actions and the initial savings from actions initiated in 2013.

Lastly, our adjusted tax rate of 22% was in line with our previous guidance and expectations.

As you can see from the bottom of the chart, our EPS shortfall was primarily driven by the volume miss of $0.05.

In addition, price and foreign exchange were each $0.01 unfavorable during the quarter.

Please turn to slide 7. Xylem revenues were $960 million, down 1% from the prior year, driven by a 3% organic decline and partially offset by acquisitions.

Let me provide some perspective on our revenue performance by end-market and by region.

First in our largest end-market, industrial, organic revenue was down 5% with Europe and the US down mid-single digits.

Public utilities declined 6% year over year, primarily driven by slowing activity in Europe and emerging markets.

CapEx spending was weak in both regions, but had a greater relative impact in emerging markets where we have a modest installed base and rely on projects to drive our revenue.

Globally, residential and commercial building services were up 6% and 1%, respectively, primarily driven by improved market conditions.

Lastly, Ag was up 10% driven by favorable weather conditions.

Let me spend a few minutes on our overall geographic performance.

US was up 2% on an organic basis, and as I mentioned, better than our expectations.

Europe and emerging markets were both down year over year in the range of 4% to 5%.

In Russia and China we continue to generate double-digit growth.

The decline in other emerging markets was driven by timing of project shipments and a decline in market demand.

Our profitability was significantly impacted by the volume decline.

Cost reduction actions drove 330 basis points of margin improvement.

This includes restructuring savings of $4 million from the actions executed in 2012 and 2013.

As previously mentioned, price pressure has unfavorably impacted our performance.

As a result, price only drove 30 basis points of operating margin improvement, short of our previous expectations and indicative of the environment we expect to see over the balance of the year.

These benefits more than offset 250 basis points of inflation and partially mitigated the foreign exchange and acquisition impacts.

Foreign exchange movements negatively impacted year-over-year operating margins by 90 basis points.

Acquisitions were neutral to income, but dilutive to margins in the amount of 30 basis points.

Gross margin was 38.6% and operating margin was 10.2% for the quarter.

Gross margins were down 100 basis points, primarily driven by the volume decline and foreign exchange impacts.

Operating margins were down 380 basis points as a result of loss volume leverage and our continued investment in strategic initiatives.

Please turn to slide eight.

This slide shows our EPS walk for the second quarter.

We're reporting $0.36 of EPS, down $0.13 from the prior year.

Core operations were down $0.11, driven primarily by volume decline and partially offset by a $0.02 benefit from restructuring savings.

Ongoing European realignment actions provided a $0.01 benefit to EPS and foreign exchange was unfavorable by $0.03.

Now let me provide more details on each of our reporting segments.

Please turn to slide nine.

Water Infrastructure reported revenue of $596 million, down 2% over prior year on a constant currency basis and down 6% organically.

Acquisitions contributed 4 points to top-line growth.

Transport declined 6%, primarily driven by weakness in Europe and decreased mining and public utility CapEx spend in Latin America and Asia Pacific.

Treatment revenues declined 12% with the majority of the decline occurring within Europe and the Middle East.

As was the case in the first quarter, developed markets continued to see market softness, particularly in wastewater capital spending, driven by municipal funding constraints.

We anticipate that these regions will continue to lag in performance, at least until confidence is restored and project orders are released.

And, lastly, test revenues were down 2% as growth in Europe was offset by sequestration-related softness in our YSI business, which sells to government agencies and the academic market.

Operating margin came in at 10.6%.

This segment is our highest gross margin segment with significant volume decline impacted operating margins by 480 basis points, given our direct selling overhead cost structure.

Cost reduction activities yielded 350 basis points of margin improvement, largely offsetting inflation and investments.

Foreign exchange volatility and its impact on margins were significant this quarter, totaling 160 basis points, while acquisitions reduced margins by 40 basis points.

Let me now turn to slide number 10 and talk to our Applied Water segment.

Revenue was up 1% both on a constant currency and organic basis.

Building services was up 3% driven by the commercial and residential performance I covered earlier.

Industrial water was down 2%.

Soft market conditions in the US and Europe resulted in organic declines of 6% and 4%, respectively, in this short cycle business.

And, lastly, irrigation was up 10% with the US up over 20% as weather conditions continue to drive strong demand.

Operating margin was 13.4% as price increases and cost reduction initiatives more than offset inflation.

Year-over-year margin was impacted by favorable reduction of a contract loss accrual in 2012.

Let me now turn to slide 11 and review our financial position.

Free cash flow was slightly positive in the second quarter.

Our performance is below our expectations, but reflective of the profitability in the quarter.

As you will recall from last quarter, we had $11 million of Sandy relief deferred tax payments.

In addition, working capital was unfavorable for the quarter.

As a percentage of revenue, working capital increased 120 basis points, driven by longer collection periods and higher inventory as we continue to deal with customers' expectations for short lead times and an increasingly competitive environment.

Our available cash on hand was $360 million.

Our net debt to net capital ratio remains at a healthy 29%.

Our commercial paper and revolving credit facilities are in place and continue to be unutilized.

Please turn to slide number 12 and I will cover our guidance provision in detail.

As you can see on the upper left of the chart, for the full-year 2013 we expect to generate revenues of approximately $3.7 billion, down $135 million before the unfavorable impact of foreign exchange translation.

To help illustrate this provision, we have summarized our end-market expectations which we highlighted when we set guidance earlier this year, our performance over the first half of the year, and our current outlook.

As you can see, we have revised our outlook downward for both our two largest end markets, industrial and public utility.

Industrial is now expected to be down mid-single digits for 2013.

Through the first half of the year, industrial was down high-single digits.

While we saw sequential improvement during the first half, performance was below expectations.

In the US and Europe we believe the lack of corporate confidence to move forward with projects will significantly impact our performance in the second half of the year.

And while we still expect some modest sequential improvement, we are reflecting a slower recovery than originally anticipated.

With approximately 13% of our industrial end-market exposure tied to global mining, we expect to face significant headwind in the second half of 2013.

For public utilities, we now expect full-year revenue to be down mid-single digits.

In the US, we have seen slightly better-than-expected results through the first six months and expect the positive trends to continue through the back half, resulting in a slightly positive organic growth for the full year.

However, more than offsetting this favorable trend is the challenging market we face in Europe.

Based on first-half activity, including significant challenges in the treatment market and weakening customer confidence, we expect that Europe will be down high-single digits.

We have also lowered our expectations for the public utility end-market in the Middle East region, reflecting project timing delays and uncertainty around when large projects will be released.

While we saw the commercial market down low single digits during the first half of 2013, we see the potential for improvement in the US over the balance of the year.

This expectation is based on market data, customer feedback, and our improved performance during the second quarter.

We have seen favorable performance in our residential and agriculture markets, primarily driven by conditions in the US which I covered earlier on the call.

We have slightly increased our expectations in these markets reflecting our first-half performance and expect continued favorable conditions over the balance of the year.

Finally, foreign exchange translation is expected to be a headwind of $70 million to revenue and $0.09 to EPS relative to our previous guidance and is based on currency rates at the end of the second quarter.

With that said, you can see how the market dynamics I just described are driving what amounts to be a $0.30 reduction to our full-year EPS projection.

In summary, we now expect full-year revenue of approximately $3.7 billion and EPS in the range of $1.40 to $1.50.

Please turn to slide 13 and I will provide some color specific to our second-half planning assumptions.

We are anticipating second-half revenue of approximately $1.9 billion driven by sequential improvements in the US and emerging markets.

We are monitoring Europe and have assumed that conditions will remain relatively consistent with what we have seen during the first half of the year, which represents a weaker outlook than originally anticipated.

We are forecasting third-quarter revenue to be down sequentially in the mid single digits, consistent with our typical seasonality given the European vacation season.

This reflects a low single-digit year-over-year decline.

We expect an increase in second-half operating profit of over 25% driven by the sequential uplift in volume, the incremental savings attributable to the 2013 restructuring actions underway, and the impact of recovery actions being taken to reduce costs.

Based on rates at the end of June, we anticipate that foreign exchange will be a sequential headwind.

Despite volume decline, we expect a modest sequential operating margin rate improvement in the third quarter, driven by the incremental restructuring and accelerated cost savings, totaling $10 million.

Please turn to slide 14.

Let me highlight a few of the items I have not yet covered.

First, we expect free cash flow conversion to be approximately 90% of net income.

This is a 5 percentage point decline from our previous guidance and reflects the impact of higher working capital.

Our operating tax rate is expected to be 21% for the year, consistent with what we had previously guided and is indicative of the progress against the realignment initiatives we initiated this year.

We expect our share count to be approximately $186.4 million, and we now expect restructuring and realignment cost to be in the range of $60 million to $80 million, reflecting a $10 million increase in realignment costs.

Consistent with our prior guidance, we expect 2013 restructuring costs in the range of $40 million to $50 million, which will generate 2013 net savings of $13 million to $15 million.

With that, let me turn the call back over to Gretchen.

This is not easy news to deliver and we are not pleased to deliver it.

We know we must take tough decisions and accelerate our actions given the market conditions we face.

But remember, we are seeing a number of positive signs across the business.

Our order rates are improving.

We have a good backlog.

We are launching compelling new products and the commercial efforts we are making are all starting to yield positive results.

Building the Xylem business is a journey.

We are taking the necessary steps to position this great company to achieve higher performance in both the short and the long term.

Operator, we are ready for questions now.

(Operator Instructions) Matt Summerville, KeyBanc.

Morning.

Couple questions.

You mentioned heading into the second half of the year you had about $960 million in backlog; 400 ships in 3Q, 200 in 4Q.

In a more normal year what would that dispersion look like?

What I am trying to get a sense of is how much more you still have to go out and get in a tough year like this relative to a normal year.

Does that make sense?

Sure, sure.

I mean our backlog -- when you look at it from a year-over-year perspective, we are up 7% year over year, so we are pulling in with a good backlog, solid backlog.

We still have work to do, because we do have a short-cycle business.

But I would say we feel good about the rate in terms of what we need to achieve as well as the market conditions that we have looked at and adjusted based upon the first half of the year.

Matt, the other thing I would add to that is when we look at that backlog shippable in the second half, we look at it as a percent of the revenue.

If you look back at 2012 as an example, it represented about 30%.

When you look at the backlog, we're entering our second half; it is up at about 33%, so it is a little bit higher.

That is not surprising given the fact that we have seen a decline in the project business, so that is a dynamic that we have adjusted for as we look at that.

I would say the dispersion between the two quarters is pretty typical of what we have seen barring the projects.

Then based on what you are stepping up and doing from a cost standpoint now and what you have previously disclosed, how much in incremental savings should we be thinking about for 2014, assuming you complete everything you have discussed?

Matt, we are working on that today.

We're laying out those actions.

To date, most of the things that we're talking about are -- it is $0.06 to the EPS.

It is $15 million that is baked into our revised guidance.

It is discretionary pullback, taking some costs that we need to out of the business.

As we get a better projection of the 2014 we obviously will share that with you.

Thank you.

Deane Dray, Citi Research.

Good morning.

I've got a -- first question is for Mike.

Take us through the free cash flow, because if I have done my math right you have done a 2% free cash flow conversion so far year-to-date.

So how do you get to a 90% conversion in the second half if you are looking at longer collection periods, higher inventory, and, obviously, higher working capital?

Yes, that's a good question, Deane.

We have taken a hard look at this.

I think from a cash standpoint the one thing you got to keep in perspective is that the cash cost structure is a little bit different than the P&L structure.

For example, we payout bonuses at the beginning of the year and then you are earning yourself back as you go through the year.

So adjusting for those types of items that is why we have revised our working capital projection down, which has had about a 5 point impact on our free cash flow conversion.

When we look at the profitable -- profitability in the contribution to cash, we get pretty comfortable as we look into the back half at the guidance levels that we have.

We have factored in the longer collection cycles, as well as the inventory levels that we have got on hand.

And then, the thing you have to keep in mind is through at least that first-half period we are dealing with a little bit higher cash tax rate given some of the deferrals we had from last year.

Then, obviously, to Gretchen's point, we are looking at investments in the second half, which in terms of the free cash flow conversion, the one area that will be impacted is our capital expenditures.

We see that as being dialed way back from the guidance that we had originally given where we talked about it being at about 3.5 times -- or 3.5% of revenue.

I would look at that number as being closer to 3% or lower in the back half.

Okay.

Then maybe you can talk about how the quarter progressed, because you did say that June came in weaker and that was expected to be seasonally strongest.

The spear of the question is when you see the margin shortfall as severe as it did this quarter, I would like to get a better sense of how proactively did you take out costs this quarter?

And are you trying to manage to a decremental margin?

Because it sounds as though you are making some cost takeouts here, adding only about $10 million to the restructuring.

I thought that maybe I would see more and maybe see more cost take out within the quarter.

So maybe just take us through how the quarter progressed and what cost actions you were taking during the quarter.

So, Deane, let me address that.

As we went through the quarter, as I mentioned, June is a big month for us and it is solid.

So we didn't see that fallout.

We were working our restructuring actions, the $60 million to $70 million that we had in our plan.

If you remember, we had set our plan assuming we were going to be a flat growth rate and we would size our cost base accordingly.

And so we were focused on those areas, so advancing some of our investments around productivity, which was tied to repositioning ourselves in Europe, and also some new product launches.

When that didn't come through, this was our high-growth margin business and we saw a big drop to the bottom.

Now, going forward, we are going to be resizing the business and taking steps.

I have talked about what is embedded in the revised guidance.

There is more work we need to do and we are looking at all opportunities to see how we can bring our cost base down.

Our end markets are challenged right now.

The underlying fundamentals of our market are going to be -- have an overshadow of the economy and we have got to make sure we have got cushion in our business to be able to still allow us to invest in the growth initiatives that we need, because this is a strong market in the long term and right now we need to be able to get our cost base further down.

And so there will be more action.

As I mentioned, we have put in the $15 million in the revised guidance.

Actions we will be taking for the rest of the year and while we were seven months into the year, we have got five months yet.

Most of those will be savings that will probably play out into 2014 and beyond.

Deane, I think on the decremental question, roughly we are managing to about a 50% decremental and there is a couple dynamics that play in.

While we are taking the cost actions which help us in the second half, one, we are dealing with a revenue decline in our highest margin business where we have a higher cost structure that we are contending with.

So you have got very little erosion in gross margin but you can see the impact at the op line and that is really around that cost structure.

The second dynamic we are contending with is much lower price realization, and as you know, that drops at 100%.

We are obviously not just accepting that; we are pushing the teams.

But in light of the current environment, that certainly places additional pressure on that decremental margin.

So at this point it wants to be close to 60% and we are fighting to get it down closer to about 50%.

Then just one last question for me.

If I heard it correctly, it sounded, Gretchen, like you still had some M&A lined up for the second half.

Are you locked into these acquisitions?

Are they the right ones to be doing at this time?

I know there is a sense that you want to be playing offense here for the long run.

Just how are you weighing that against some of the shorter-term challenges of getting the P&L in order?

Deane, it is a great question, and clearly, as I mentioned, we are dialing back a little from what we had originally said.

There are some key bolt-on strategies that we would like to continue to progress, but our number one priority is to make sure that we get the business in order, we get our performance higher, and making sure that we address taking the costs out that we need to position this Company and moving it forward.

But there are some acquisitions that strategically are nicely positioned to help us ultimately grow.

So, again, that balanced equation is essential.

Take the cost out, position us for cushion, but then be able to invest in those strategic initiatives.

Great, thank you.

Brian Konigsberg, Vertical Research.

Good morning.

I just wanted to touch on the incrementals again, but more sequentially, meaning the second half of the year versus the first half of the year.

So you are looking at a $42 million increase at a midpoint on revenue between H1 and H2 and a $46 million increase in operating profit.

It sounds like maybe $25 million, $26 million or so of that is from incremental restructuring, but it still suggests a fairly significant incremental from the core business.

I think there are some other items, but I was hoping if you could help bridge that gap for us.

Sure.

Yes, there is a little bit of noise in there so let me give you a few of the pieces that I think will help provide that.

If you look at our core volume organically, we are up about $67 million versus the first half.

Foreign exchange is about a $34 million headwind in the second half and then we have got an additional $10 million of acquisitions.

You have to remember, the acquisitions are not contributing at a high drop rate at this point in time and foreign exchange, obviously, has its set of impacts.

So when you look at the core volume increase, less the savings from restructuring, we are looking at about a 50% incremental drop rate, which given where we are at in the business, specifically around Water Infrastructure where we see that sequential improvement, we expect to see that drop rate.

The drop rate then gets enhanced by the incremental $12 million worth of restructuring benefit that we pick up in the back half.

So in my prepared comments I talked about our restructuring in the second quarter was at $4 million.

$3 million of that came from the actions we initiated in 2012; $1 million of that came from the actions we started earlier this there.

We pick up incrementally in the back half another $12 million of restructuring benefit.

Okay.

But the core business dropping at 50%, have you ever had that type of experience before?

Why has that changed now?

Well, there is a couple things.

I think when you look at the Water Infrastructure business, one, we're going to be levering off that cost base.

Two, when you look at the mix that we are anticipating in the second half, specifically on the industrial market as it relates to dewatering, even though we are down on a year-over-year basis, the trends we have seen in terms of some of the fracking that is driving increased volumes to support the rig count increased.

That activity comes at a very high drop rate and is helping us from a mix perspective.

Okay.

Then just moving on to the comments about municipal trends, I think, Gretchen, you said you anticipate the spending to remain weak into 2014.

The orders in the quarter actually maybe showed a little bit of improvement.

Maybe can you just elaborate on that comment?

Is this just a small aberration in orders that you see in the quarter and you anticipate that to drop off again?

Maybe give us some color on that would be helpful.

Yes, so if I step back and I just look at some of the market dynamics that are going on, first of all, in the US you have wastewater spending which is down substantially.

And that doesn't look like it is changing anytime soon.

Now, we all understand the need of water and the demand that is penting up, and we are seeing that in terms of the bid activity.

There is a lot of work in terms of bidding, but the confidence level to actually make that bidding into an order is just not happening.

It is not converting.

And we anticipate going forward in 2014 right now nothing that indicates a significant change there.

Now, if there is public-private partnerships that may move that more aggressively, but when I look at the general dynamics in the market, not only in the US but even globally, the confidence level and the funding streams haven't changed.

When you think about 2014, you need to start getting those orders now versus next year because they typically are 12- to 18-month type of orders.

Brian, I guess what I would add to that is when you look at the 1% order increase that we had in the quarter, a significant portion of that was driven by Applied Water.

The Water Infrastructure business was up about 0.6%.

When you look at that business on a year-to-date basis, because it was down close to 10% in the first quarter, orders are down about 5%.

So back to Gretchen's point, the order funnel really hasn't filled at the level that would support significant growth in 2014.

Thank you very much.

I'll get back in queue.

Chip Moore, Canaccord.

Thanks.

Can you talk a little bit about the signs of bottoming you are seeing to support the outlook in the back half?

It sounds like you are factoring further deterioration in Europe.

Mining has obviously been quite challenged.

Can you just sort of walk us through what you are seeing in some of those markets?

So mining, as you mentioned, is challenged globally.

We have clearly seen the mining industry being challenged and that hit us, as we talked about, in terms of the emerging markets.

But let me talk about it a little bit from the regional perspectives.

In the US, we are seeing positive signs but the industrial market still has not had the confidence level to give us the confidence it is going to pick up in the second half of the year.

In Europe, we are still seeing Europe down.

We saw substantially a decline in Southern Europe more than we anticipated.

While we thought it was down substantially, we didn't think it could go down much further and we have seen that continue.

In the Nordics, positive -- still positive growth there, but not enough to offset what we are seeing in Europe.

And where we are seeing Europe as well is in the public utilities and the industrial markets we anticipate will be weaker as we go into the second half of the year.

Emerging markets, China and Russia we are doing extremely well.

Double-digit growth in both of those regions.

But with the global economy pulling back and confidence levels still being questioned around the growth in China that has had impact in the mining industry and our emerging markets globally, specifically the Middle East and Australia when I look at the Asia-Pacific region.

Okay.

I guess as you look out, if you couple visibility staying challenged in 2014 it sounds like with dialing back the M&A a little bit, maybe you can talk about some of those longer-term assumptions, how we should think about those.

Thanks.

Yes, I think I would say a couple things is what we think is the markets pulling back some.

We are still feeling confident about the product launches that we are launching this year and into next year.

I feel good about some signs of the market picking up.

We are seeing residential commercial picking up.

So what we want to do in terms of -- given the overhang that we have got in some of our markets being industrial and public utility, still stay strong with our customers, work with them as they are challenged in terms of their funding with services and aftermarket.

But we are going to have to adjust ourselves to pull our cost base down.

We are still committed in terms of our long term in our business.

We're taking the right short-term actions to position the cost base, but still being able to position ourselves with the growth initiatives to hold on to our long-term objectives.

David Rose, Wedbush Securities.

Good morning.

I may have missed it, but could you please quantify the impact you think the decline in the dewatering business had on margins and revenues as well?

Dewatering globally has been significantly impacted in the industrial market and very specifically in the US we have seen some decline there.

About $4 million in the US, in Europe $7 million, and in Latin America about another $1 million, so it is down over $10 million in terms of dewatering.

Now let me just talk a little bit about our dewatering strategy.

That is not just our Godwin business, but it is our Flygt business that supports some of the mining industry, so it is a combination of the two.

Okay.

I'm sorry, I wasn't clear.

That is the -- what is the operating impact on the business?

Well, David, it is a high drop rate business.

The majority of where we have seen the pullback is around the rental market.

As you know, that is a high-margin business and that has played into, frankly, where we are dialing back from a capital expenditure standpoint as we size that fleet accordingly.

We don't typically get into the specific breakouts, but there is, obviously, within the Water Infrastructure business, dewatering being a relatively large component of that, an impact from that pullback in the rental revenue.

Okay.

Then, lastly, I think when we last spoke your sense was that your assumptions basically would hold -- this is back in June -- provided that you didn't see deterioration in Europe.

Most indications is Europe is not deteriorating.

Is there some elements in your business that you see different than your competitors or you are more vulnerable than your competitors?

David, it's a great question.

It is obviously something we sit back and we looked at the data and analyzed it, but I still feel very confident about the issue that we are facing is the market dynamic.

It is the underlying market overhang that we are seeing, specifically in the public utilities, very specifically around CapEx.

And then also the pullback very specifically in the mining and the industrial market, just the confidence of not being able to go spend.

When I look at our win/loss data we look at data in the industry trade.

Our share -- we think we are holding our share.

We feel very good about where we are going.

Now, of course, what is important to that is to make sure we continue to launch new products and we stay close to our customers.

But I do not believe this is a share issue; it is a market dynamic.

David, I guess I just -- I would point out a couple things.

If you look at our peers, specifically around the wastewater side of our pumping business where we are down about 6% in the public utilities, I think you will see pretty similar characteristics in those results.

And then on the commercial and resi side, where we are up 9% and 8.2%, respectively, I think that is very strong relative to the peer group, although it is a small part of our business.

Those two components make up just under 20% of our revenue.

Okay.

Then, lastly, general commentary was MROs is up.

Is that the same for you or not?

Our repair and overhaul or our service revenue was up in the quarter.

When you exclude the effect of our PIMS acquisition, we were up just over 1%.

So that is pretty consistent with what we have seen coming out of the operational side of the public utilities and even the industrial market, where folks are still continuing to spend on repairing and maintaining the existing equipment.

Okay, great.

Thank you very much.

Ryan Connors, Janney Montgomery.

Good morning.

I had a question on -- I wanted to continue on this topic of competitive dynamics.

Specifically, Mike, you mentioned price and the fact that I think you mentioned you are pushing the [seams] to try to maintain that and so forth.

Could you just give us a little more color around that side of things?

How the market weakness that you are seeing is impacting your strategic pricing initiative, and then just broadly price across the market?

Then, relatedly, I will throw my follow-on there.

Relatedly, do you believe industry capacity overall is where it needs to be or are we at risk here of somewhat of an overcapacity situation?

And an impact on price there would impact the end-market weakness percent?

Thank you.

So, Ryan, let me talk about pricing.

The pricing dynamics that we are really seeing is in the industrial and public utility markets, that is the markets that we have seen down, and also across the board.

It is a competitive market.

The market is slow and so everyone is going after competitively to win the bids that are out there.

Now we have got a good process in place and we have been driving price and have seen up and through last year a positive price value gap.

We want to continue to drive that, but we also do not want to lose share in our core positions.

And that is what we have done is we have pulled back to make sure that we can get the position that we need.

I would say just beyond a price perspective, though, our commercial excellence initiatives that we have been driving drive more than just price.

It is about talking to our customers about our value proposition around really thinking about our key accounts and making sure that we are driving our growth with those accounts.

So I feel good about our strategy and we are continuing to drive for profitable growth.

That is key to us, but we will make sure that we don't lose share in the marketplace.

Ryan, I made a comment in my prepared remarks in terms of we saw about 30 basis points of favorable margin impact in the second quarter, which was down pretty significantly from what we had in the first.

We think that is indicative of where we will be for the balance of the year, so we were anticipating when we originally gave guidance that we would be around 1% pricing.

We now see the effect of revenue is about 40 basis points of positive pricing and that flows through to margin with about 30 basis points.

So pretty similar to what you saw in the second quarter holding for the balance of the year.

Okay.

And on the issue of capacity, do you believe that from an industry perspective the situation is significant enough in terms of end-market weakness that it needs to be a curtailment of capacity industry-wide?

And if so, is that happening or is that not the right way to frame it?

Well, I would say from this perspective -- the capacity issue, when you look at our equipment and our technology is positioned in the marketplace, as long as the factories are up and running and so forth our equipment is being utilized.

I would say in the mines -- they are not opening the mines.

That industry has pulled back, but still we have got a good position in the marketplace.

As I mentioned earlier, though, some of the dynamics in the marketplace in terms of inventory in the markets is not there, pulled back.

So if there is a growth cycle that may be an opportunity for us in terms of quick turnarounds, but right now I don't think capacity is a big driver for us.

You know, Ryan, I think we look at it in short- and long-term views.

I think in the short term we all know the distribution channel has pretty well destocked to a level that when growth is restored we think that will, obviously, serve as an opportunity.

And I think so as we look over the longer term we don't see that as being a capacity issue.

Great.

Well, thanks for the help.

Brent Thielman, D. A. Davidson.

Good morning.

You talked about pressure from sequestration on the test category, which I know provides some nice margins for you guys.

About what percentage of that business is impacted by those sorts of issues?

So if you take our Analytics business, it is really the YSI business here in the US.

They typically do work with the USGS and, of course, with some universities that typically get their funding coming from the government.

It is probably 40% of that business, roughly.

Now the one thing I would say is, while sequestration is having an impact, there has not been significant reductions in terms of budgets, but the pullback of funding and the confidence to go ahead with certain projects is clearly stalled in the market.

So we are watching that closely.

We feel pretty confident about our position and our relationship with those end customers.

And our hope is that will get released over time.

I think it is also important to point out, as we did in our remarks, that Europe was up about 5%, which is strong performance in light of the current environment.

And I would even say, even in the US, in our wastewater analytics business we saw positive signs as well.

Sure.

Then on the commercial side of things, looks like you saw some gains there.

I know it is smaller, but any sense how much of that is market growth this quarter versus sort of market share gains or any of your positioning you have done with that business?

I would say it is a little bit of both.

We have spent some time investing in new product launches and the team has done a great job in getting out, being able to show the value proposition announce.

As a lot of companies or businesses are upgrading their commercial buildings, our new products are nicely positioned to do retrofits and so forth.

So I think it is a combination of growing with the market as well as taking some share.

Okay, thank you.

Michael Gaugler, Brean Capital.

You had mentioned in earlier prepared remarks Europe municipals and industrials as weak end-markets.

As you look to future acquisitions, are you looking to exclude these areas and end-markets?

So let me address it; in general, it is a tough question to answer.

I mean I would prefer an acquisition that is going to give us nice position to the emerging markets, which are the growing markets.

But depending upon the technology and how that complements our position and being able to serve our customers more effectively, you've got to look at the technology and potentially the channel to the market as we go forward.

So it is more of a strategic direction.

Okay.

Then my apologies if you covered this previously.

In your Infrastructure segment, how is your aftersales service business performing and what percentage of the sales mix is it now?

So right now in the second quarter our aftermarket Water Infrastructure was up about 8%, but that includes the effects of the PIMS acquisition.

We were up about 2% organically and that constitutes just under about 20% of our revenue coming out of that segment.

Okay.

That's all I had.

Thank you.

There appear to be no further questions at this time.

I would now like to turn the floor back over to Gretchen McClain for any closing remarks.

Well, let me just summarize with, as we reported today, we are not happy with our performance.

We know we have work to do.

Our markets are challenged.

However, we do have some very positive signs that are taking place on the business and we're going to continue to push forward with our new products.

We are going to make sure that we are staying close with our customers and make sure that we are driving the top line.

At the same time, we're going to make sure that we are positioning this company with cushion for the challenging markets that we know are still there.

And we are focused on our long-term objectives and making sure that we are putting the actions in place that we can assure the long term still plays out.

This is a strong market, the macro conditions are still there, and we have the right technologies and the right talent to be able to lead the market.

Thank you.

Thank you.

This concludes today's conference call.

You may now disconnect.