Welcome to Xylem's Second Quarter 2022 Earnings Conference Call. All participants are currently in a listen-only mode, and there will be a question-and-answer session after the presentation. I will now hand the call over to Andrea van der Berg, Vice President of Investor Relations.

Good morning everyone and welcome to Xylem's second quarter 2022 earnings conference call. With me today are Chief Executive Officer Patrick Decker and Chief Financial Officer Sandy Rowland. They will provide their insights on Xylem's second quarter 2022 results and discuss the outlook for the third quarter and the full year. After our prepared remarks, we will take questions related to the information shared on the call. As a reminder, this call and our webcast are accompanied by a slide presentation available in the Investors section of our website, www.xylem.com. A replay of today's call will be accessible until midnight on August 9. The replay numbers are +1800-839-5676 and +1402-220-2565. Additionally, the call can be accessed for playback in the Investors section of our website under Investor Events. Please turn to slide two. We will be making some forward-looking statements during today's call, which may reference future events or developments that we expect may occur. These statements are subject to various risks and uncertainties as outlined in Xylem's most recent annual report on Form 10-K and subsequent SEC filings. The company is not obligated to update any forward-looking statements to reflect future events or circumstances, and actual results may vary significantly from our expectations. We have provided a summary of our key performance metrics, including both GAAP and non-GAAP metrics in the appendix. For this call, all references will be on an organic and adjusted basis unless stated otherwise, and non-GAAP financials have been reconciled and are included in the appendix of the presentation. Now, please turn to slide three, and I will now hand the call over to our CEO, Patrick Decker.

Thanks Andrea and good morning, everyone. We're pleased to report that the team delivered a very strong second quarter performance on all key metrics and well ahead of our guidance. But the result builds on the momentum and underlying demand we saw in the first quarter with disciplined operational execution on strong fundamentals and a moderate easing in chip supply constraints. Revenues grew 6% organically, surpassing our guide. The team's commercial performance was outstanding in all segments and supply improvements in M&CS and Water Infrastructure enabled increased conversion of orders into revenue. Geographically, the growth was broad-based, Western Europe was up 9%, and North America at 6%, and emerging markets, excluding China, was up double-digits. While China was down due to COVID lockdowns, backlogs continue to grow on underlying demand. In addition to organic revenue growth, the team posted 6% orders growth. That orders momentum reflects strong performance across each segment. Water Infrastructure set the strongest base, growing orders 21% in the quarter. Our backlogs were up sharply versus last year, with digital solutions comprising more than half the total backlog. EBITDA margin also came in well ahead of our guidance. We delivered strong quarter-on-quarter expansion driven by disciplined execution. All of that good work delivered earnings per share of $0.66, which soundly beat our expectations. As you can see, some incremental improvement in chip supply came earlier than anticipated, and it had a strong positive impact on the quarter. To be clear, we don't believe chip supply will improve much more quickly than previously expected. What we are seeing is a gradual improvement in supply, which provides further confidence in our second half outlook. The team also delivered pricing actions to mitigate inflation across all segments, and I want to give a big shout out to the entire team, including our distribution and channel partners for managing through a dynamic market environment. We combine those disciplined actions with productivity savings from simplifying the way we work and entirely offset inflation in the quarter. We expect demand to remain resilient due to the essential nature of the services our customers need from us. So as you've seen in this morning's release, we are raising our organic revenue guidance to 8% to 10% growth for the full year, and we're raising the bottom end of our EPS range by $0.10. We'll come back and discuss our full review of the macro environment in a few minutes, but let me hand it over now to Sandy for some additional color on the second quarter.

Thanks, Patrick. Please turn to slide 4. The team did a tremendous job over delivering on our commitments with disciplined execution on strong fundamentals and continuing demand. As a result, revenues grew globally high single digits in Western Europe and mid-single digits in the US. In emerging markets, revenue grew low double digits, excluding China, which was slowed by ongoing COVID restrictions. In a moment, I'll detail performance by segment. But in short, utilities was up 2%, led by strength in Western Europe and the US. Industrial grew 12% on increasing activity in all geographies, particularly the US, Western Europe and Latin America. Commercial was down 1%, strength in Western Europe was offset by continued US supply chain challenges. And residential was up 13%, led by commercial execution and backlog conversion in the US. Organic orders were up 6% in the quarter, with water infrastructure up 21% and AWS up 2%, partially offset by M&CS. Global demand continues to be strong, and our book-to-bill ratio was a healthy 1.2 in the quarter. EBITDA margin was 16.6%, well above our guided range, and that reflects a 240 basis point rise sequentially on strong commercial execution and discipline on discretionary costs. Price contributed two points of incremental revenue growth sequentially. As Patrick mentioned, pricing and productivity benefits combined more than offset inflation, and our EPS in the quarter was $0.66, coming in above expectations. Please turn to slide 5, and I'll review the quarter's segment performance in a bit more detail. Water Infrastructure revenue exceeded expectations, growing 9% organically in the quarter. Industrial remained strong, driven by continued backlog conversion, and our US wastewater utility business grew double digits as supply chain constraints improved throughout the quarter. Geographically, the US and Western Europe were also up double digits, driven by robust transport demand in the US and treatment applications in Western Europe, alongside strong dewatering growth. Emerging markets, excluding China, was up high single-digits, driven by strength across Latin America and Africa. These markets were down mid-single digits, including China, due to COVID site access restrictions there. Orders in the second quarter were up 21% organically versus last year, with growth underpinned by strong underlying demand supported by large infrastructure projects in the US and Canada. We also saw sustained demand in our wastewater utility business in North America and Western Europe. EBITDA margin for the segment was up 240 basis points as strong price realization, volume and productivity benefits more than offset inflation and investments. Please turn to Page 6. In the applied water segment, second quarter organic revenues grew 7%, modestly exceeding our expectations. Geographically, the US was up high single-digits with strength across industrial and residential, partially offset by supply chain constraints in the commercial business. Western Europe delivered low double-digit growth with healthy gains across all end markets, led by benefits from new energy-efficient product introductions. Emerging markets was up low single-digits, driven by strong industrial demand. Orders were up 2% organically and continued to outpace revenue with a book-to-bill ratio of 1.1 for the quarter. Segment's EBITDA margin declined 130 basis points compared to the prior year. And while price realization more than offset inflation, volume and mix for the quarter were negative. Despite lower volumes, demand remains robust as seen in our book-to-bill ratio. However, we expect to continue to deliver sequential EBITDA improvement as the benefit of pricing actions comes through our backlog. And now let's turn to Slide 7, and I'll cover our Measurement & Control Solutions business. M&CS exceeded expectations on strong demand and modestly better chip supply with revenue declining 2% organically. We also saw strong growth in our test and pipeline assessment services product lines. Geographically, the US and Western Europe were down mid-single digits and emerging markets was up high single-digits. M&CS orders declined 9% organically in the quarter, due to lapping some large deals in North America and the UK. Underlying demand for our AMI offering remains strong and orders continue to outpace revenue. We recorded a book-to-bill ratio of 1.4 and have built a backlog of over $2 billion. Segment EBITDA margin in the quarter was ahead of expectations, expanding 120 basis points sequentially on improved volumes. As supply chain stability improves and we convert our backlog, we will see strong margin accretion on higher volumes as we have previously discussed. And now let's turn to Slide 8 for an overview of cash flows and our balance sheet. In the second quarter, we generated free cash flow of $67 million, driven by income conversion, partially offset by higher working capital. Our financial position remains strong with $1.1 billion in cash and $1.9 billion of available liquidity. Net debt-to-EBITDA leverage is 1.5 times. Please turn to Slide 9, and I'll hand the call back to Patrick to look forward at the rest of the year.

Thanks, Sandy. As you've seen, the team is delivering strong results in a very dynamic environment. Given the prominence of discussions about macro uncertainty in the economy, it's worth spending a few minutes talking about our confidence in the resilience of underlying demand for Xylem's offerings. The aspect of our sector and our business model that gets most discussed in this context and for good reason is that, our offering is at the core of essential services through the ups and downs of economic cycles. Cities and towns must provide essential water and wastewater services. So, the demand associated with water management tends to be quite resilient. It's also important to understand the dynamics between OpEx versus CapEx across economic cycles, particularly for water utilities. OpEx spending is very stable, given the basic need for day-to-day water services, while CapEx, which represents roughly a third of spending on Xylem's offerings, is focused on infrastructure expansion or refurbishment, and it comes with longer regulatory and funding approvals. So spending against these projects, once approved, historically, has not wavered to a material extent. And this is not just a US dynamic; it applies globally. You see it in Europe, both at the regional level, for example, with the EU's recovery and resilience funding, and at the country level as seen in the UK's AMP process. Similarly, infrastructure funding is embedded in China's five-year planning cycle. And of course, you're all familiar with the recent US federal infrastructure funding and the timelines on which state revolving funds work. Those structural advantages of the sector, however, are only a benefit if our portfolio delivers distinctive value to our customers through the cycle. For many of our customers, value is defined in terms of becoming more efficient. And that means modernizing their infrastructure with digital technologies to make their networks more affordable. Our AMI metrology backlogs offer a proof point about the resilience of that demand. Despite the ongoing chip supply challenges that have dogged the tech sector for the last year, our backlogs have continued to grow. Our distinctive data and communications-driven AMI solutions deliver a step change in both efficiency and resilience for utilities. AMI represents now roughly a third of all water meters in the US, which shows the progress of adoption, but also the potential for future growth. Given the budgetary pressures the utility faces, both to generate revenue and reduce water loss, smart meters will remain a top imperative. One other demand trend that will persist through the cycle and is set to increase is the growing response to climate change. Cities around the world are committing to net zero emissions. At the same time, they are investing in mitigating the impacts of climate change that are already here, like those we've seen this summer in the form of historic and tragic flooding in the US and Asia. These are generational challenges. Innovations and new approaches are absolutely essential to solving them because water management is a significant carbon contributor, accounting for up to 10% of greenhouse gas emissions globally. In commercial and residential markets, cities have begun introducing building regulations to reduce emissions, including efficient water management standards for both regional construction and retrofits, and the utility market, which produces greenhouse gas emissions equal to the entire global shipping industry, is going to be required to reduce its carbon intensity in line with the commitments of their cities, municipalities, and countries. And we at Xylem are an outright leader in this space and are in a unique position to support our customers in their sustainability commitments. You may have seen that we released our annual sustainability report in May. Among all the progress made against our 2025 goals, I'd highlight that we enabled our customers to reduce their carbon footprint by 730,000 metric tons in 2021 alone using our technology. That is the equivalent of taking 160,000 cars off the road. And we're on track to help them reduce their emissions by 2.8 million metric tons by 2025. So stepping back, we're very confident that the macro forces driving our underlying demand will continue. We're also confident that Xylem is better positioned than ever to create value by helping our customers respond to them. So now I'll turn it back over to Sandy for more detail and color on our outlook and guide.

Thanks, Patrick. Consistent with our previous presentations, we've provided key facts for each end market in the appendix. The outlook across our end markets has broadly improved. We expect healthy underlying demand will continue through the remainder of the year, with improved price/cost mix and modest improvements in supply chain. We now expect our utility business to grow mid-single digits, up from low single digits. On the wastewater side, we now expect mid-single-digit growth, up from low to mid-single-digit growth on improved backlog conversion and resilient global demand. The outlook for longer-term capital project spending and bid activity remains solid globally. For clean water utilities, we now expect mid-single-digit growth, up from flat. The main driver is earlier than expected easing of chip supply constraints. Although supply has improved, lead times continue to remain elevated, and our volumes continue to be constrained. We also expect momentum in our test and pipeline assessment services business to continue, due to increasing focus in our end markets on infrastructure and climate challenges, as evidenced by our strong backlog. Please turn to slide 11. Looking at the industrial end market, we now expect high single-digit to low double-digit growth, up from mid-single-digit growth and increased activity in the US and Europe and strong global demand for our solutions. We continue to expect the commercial end market to deliver mid-single to high single-digit growth on solid replacement activity and new introductions in the US and Europe. In residential, our smallest end market, we now expect healthy demand to drive double-digit growth, up from mid-single digits. As a reminder, the majority of our commercial and residential end market exposure is replacement driven versus new construction. Now let's turn to slide 12, and I'll walk you through our updated guidance. Our outperformance in the second quarter gives us confidence to increase our full year guidance for organic revenue growth and to raise the low end of the adjusted EPS range. We now expect full year organic revenue growth of 8% to 10%, up from 4% to 6%, and we have raised the bottom end of our EPS range by $0.10. The increase in the reported revenue guidance is more modest, as the strength of the dollar offsets roughly half of our operational improvements. We have modified our assumptions on our basket of currency exposure, which is included in the appendix. These changes result in an incremental $0.05 headwind to the full year EPS guide. And this is on top of a $0.10 EPS FX headwind that we discussed last quarter. On slide 13, we've shown how our guidance breaks down by segment. We now expect high single-digit growth in Water Infrastructure, up from mid-single digits and low double-digit growth in Applied Water, up from high single digits, driven by disciplined commercial execution and backlog conversion on continued strong demand in both segments. We now expect Measurement & Control Solutions to be up mid-single digits, up from flat. This reflects the outperformance in the first half from chip supply improving sooner than expected. For 2022, we are raising the bottom end of our adjusted EBITDA margin range, which is now 16.5% to 17% and this yields the adjusted EPS range of $2.50 to $2.70 that I just mentioned. We now expect free cash flow conversion to be approximately 90% of net income. We're carrying about a month of extra inventory to mitigate the risk of supply chain disruptions and provide continuity of service to our customers. We expect to bring conversion back to historical levels as supply chains stabilize, enabling us to return to free cash flow conversion of at least 100%. We have provided you with a number of other full year assumptions on the slide to supplement your models. And now drilling down on the third quarter, we anticipate total company organic revenues will be up 10% to 12%. This includes mid-single-digit growth in Water infrastructure and mid-double-digit growth in Applied Water and M&CS. We expect third quarter adjusted EBITDA margin to be in the range of 16.5% to 17%, a sequential improvement over the prior quarter. And with that, please turn to Slide 14, and I'll turn the call back over to Patrick for closing comments.

Thanks, Sandy. We saw the power of some short-term swings this past quarter. A small improvement in chip supply had a big impact. Currency movements have been offering what you could call a challenging forecasting environment, and the unexpected duration of COVID shutdowns held China back. Just a quick note on China, our team and our customers there have been continuing to serve their communities under very tough conditions, given the extensive restrictions in place to manage COVID; I'm incredibly proud of the team. We expect to see progressive improvement in the market for the second half and have full confidence China will continue to be a source of innovation and growth for the long run. In the context of short-term uncertainty, our job is to navigate through the unexpected. Meeting those challenges is what being a good operator is all about, and the team has certainly been doing that. The team's strong operational execution is built on the same foundation as our 2025 growth and strategic milestones, a consistent story at the heart of our investment thesis. We're building on our leadership position as a technology company with a durable business model. We're benefiting from long-term secular trends of rising demand, driven by water and climate-related challenges. We're driving above-market growth and margin expansion as we digitize our portfolio to serve our customers' imperative to be more efficient. We're successfully putting sustainability at the center of everything we do, across our company, our customers, and our communities. And we'll create additional stakeholder value with disciplined capital allocation as opportunities arise. Strong continued demand and the kind of performance we're seeing from the Xylem team show our ability to deliver on that thesis. And with that, operator, let's open it up for Q&A.

Our first question is from Deane Dray with RBC Capital Markets. Your line is open.

Thank you. Good morning everyone.

Good morning, Deane.

Good morning, Deane.

Hey, maybe we can start with the better news on the chip supply. And we've been hearing that from other manufacturers that it's starting to improve gradually, and your commentary is pretty consistent with that. But just some additional color, what you see in the quarter? And what's that outlook for the second half? How much of the backlog in digital might you be able to sell?

Yes. Good morning, Deane. Thank you for your question. We were definitely pleased to see an improvement in supply throughout the quarter. If we compare this to our lowest revenue point last year in Q4, when we were under $300 million, we have now nearly reached $350 million in the second quarter. This is a greater increase than we expected. As we look toward the second half of the year, we anticipate a more modest increase from Q2 to Q3, followed by another increase in Q4. We believe we will finish the year in line with our projections, benefiting from improved supply earlier in the year. I want to commend the team for staying closely connected with our key suppliers and being proactive in the spot market to ensure we meet our customers' needs.

And I would just add, Deane that – sorry, for my voice that in addition to that, the team has done terrific work, not just on landing chips in the spot market, but a lot of the redesign work that we talked about in previous quarters is nearing completion. And so there was an added cost in the quarter for that, but it was there to really make sure we secured supply for our customers. And we also shipped out more mechanical meters in the interim to bridge that gap while we're waiting on the chip to come through. So there were multiple dynamics, but as Sandy laid out things certainly got better and we feel more confident now about the second half than we did before.

That's real helpful. And just the context of this and I'm not sure if you can give specific numbers, but our expectation is that the profitability of these digitally enhanced products and services is roughly 50% more profitable than the legacy, I don't want to say dumb, but not digitally enabled products and services. Is it still that magnitude of difference in margins on the digital side?

Yes, Deane, the margins are certainly stronger on the digital side, and we noted that in our mix in M&CS during the quarter. We were about 5% less digital this year compared to last year, as we aimed to support our customers by ensuring products were readily available to them. This requirement was more mechanical this time. Looking ahead, we still expect to maintain the margin perspective we outlined during our Investor Day last September.

If anything, the backlog has gotten stronger, especially with some of the large deals that we brought in over the last few quarters and the bidding pipeline remains very robust just given how early we still are in terms of conversion to MI across, especially the US on the water side of things. So we expect that runway to be there for quite some time.

Got it. For Sandy, regarding free cash flow, many companies this earnings season have reduced their free cash flow guidance due to increased working capital commitments caused by supply chain inefficiencies and high demand. How does the expectation of returning to 100% free cash flow relate to the supply chain, and what is the anticipated time frame?

I appreciate the question, Deane. When we established our 2022 plan, we anticipated that supply chains would significantly improve in the latter half of the year. However, we have not yet observed substantial changes. As a result, we believe it is wise to maintain a bit of extra inventory to ensure we can meet our revenue targets and fulfill our backlog. Several factors are at play. Lead times remain extended, and we continue to face issues with missing one or two crucial components, which prevents us from delivering the complete solution. Additionally, inflation is increasing the overall levels of our inventory. However, we do intend to reduce that, and we expect to achieve this by 2023 at the latest. It will be a primary focus for our teams moving forward, and we do not plan to maintain this situation for an extended period.

And from a segment perspective, Deane, it was most notable in Applied Water, where again we've had continued knock-on effects whether be supply chain casings coming out of China due to COVID. Obviously, we expect those to continue somewhat in the second half. And that's why to Sandy's point we brought in an extra month of inventory into that business. So it's very visible. We know exactly what it is. It's totally under control. It's simply a matter of needing to do that to supply customers and maintain that demand.

All right. That was great color. Thank you.

Thank you.

Thank you. We will take our next question from Nathan Jones with Stifel. Your line is open.

Good morning everyone.

Good morning, Nathan.

Good morning, Nath.

Going back to M&CS, I think Dan asked enough questions on the chip supply and how that's progressing. Maybe you could talk a little bit about the expected profitability of that business as we see revenue pick up in the third quarter, and then you've talked about a bigger step-up in the fourth quarter, assuming that it's probably going to continue to improve going into next year. Can you talk about the path to getting back to those profitability targets that you laid out at the Investor Day? Where might we be able to get to in 2023? How quickly can you get to that kind of expected margin level on the business?

Yeah. I think obviously a really important question, Nath. I think one thing I want to call out is we've already seen from the low point in Q4, 300 basis points of margin expansion from Q4 to Q2. And that's evolving because of the higher volumes, partially constrained by some of the things that we referenced earlier in the call, the mechanical mix, the redesign costs on optimal manufacturing flows. But as we look out into the back half of the year, there's not as much of a pickup from a revenue perspective, but we would expect margins to kind of continue along the same trajectory that we've recognized from Q4 to Q2. And I'm not going to give guidance on 2023 on this call. But as we look out to 2024, 2025, we don't see anything structurally different about where margins should land in that time period.

Okay. My follow-up is Europe and Industrial. One of the biggest concerns we hear from investors is Europe and industrial not only are you not seeing that. I think that was one of the stronger areas in terms of growth in the quarter and solid orders there. Maybe you can talk about the trends that you're seeing there? And then, if you can talk about the resilience of the industrial business in general, particularly the lot industrial side of the business, and how you would expect that to react in the potential for a recession in Europe?

Yeah. I think for us Europe has been a real bright spot. And it's not just in one segment. It's really across the entire portfolio. We've seen good revenues in Europe. We've seen good orders. I know there's a lot of concern about potential recession in Europe, and the industrial market in particular. I think one thing I would call out is that, if you look at our dewatering business, for example, which is more industrial, we've done a lot to diversify the end markets there, much less exposure to oil and gas than we did in the prior recession. I think we're down to about 1% revenue in that end market. And then, of course, there we've also been diversifying from a geographic perspective.

Again, I would just offer up, Nathan, you publicly recall this, but if you go back over time, and look at previous kind of industrial recessions back in kind of the 2015, 2016 timeframe, our European business still held up in terms of growth during that timeframe, because the results are much less cyclical there given the end market exposure that we've got. And also – so for example, I think the numbers in 2016, Europe still grew 3% despite being in the middle of an industrial recession. So, we feel pretty good about that. We think it would be that resilient again. I think as you well know, if we were to first see any softening in orders which we've not seen to this point, it would be – it would be in our short-cycle businesses, which would be more applied water and dewater. And again, we've not seen that yet. Our backlog continues to grow with good book-to-bill, and again, obviously there would be actions that we would take, if we began to see those metrics coming through, as we've done in the past. We can phase investments. We still have further productivity opportunities to go after across the organization, and we're sitting on record backlogs. And the fact that, we've been able to weather the chip supply issue, without losing any business, and those deals and backlog is pretty strong statement about the resilience of our pipeline and the markets that we serve.

Thanks for taking my questions. I’ll pass it on.

Thank you.

We will take our next question from Connor Lynagh with Morgan Stanley. Your line is open.

Yeah. Thanks. Just wanted to talk a little bit about cash flow and capital allocation. So, on the cash flow side, your full year free cash flow guidance does seem to anticipate some pretty good relief on working capital investment in the back half. I'm just thinking through, it looks like you have a CapEx acceleration. Obviously, we can sort of get to the EBITDA number. So – is that because you think that you will be starting to work down inventories, or is that just sort of a seasonal release in working capital that you're anticipating?

Yes. No. Great question. We do have a plan to start working down some of our inventory through the back half of the year. It's nothing dramatic. It's going to take place over the next six months on a very gradual basis. And I think we are – our teams have been doing a good job on the elements around working capital. We are going to continue to lean in hard on collections, and make sure we bring those in, and that – we've seen really good results through the pandemic on our collection front. And similarly, we're doing work around getting better terms from a payable perspective. I may have referenced it on another call. We have a supply chain financing program that's quite active, and it allows our supplier base to take advantage of our credit rating. We're getting more of our supplier base engaged on that program, and that will give us some incremental days from a payables perspective. And I think it ties into being prudent also around cost and discretionary spend, and CapEx spend to make sure we start seeing a better cash conversion in the second half, which lines up with our historical seasonality as well.

Makes sense. And then, I was noticing, it looks like you slowed your cadence of buybacks in the quarter. Is that driven by any concern around the state of the business? Is it because you're starting to see more opportunities emerge on M&A? Just any color on what you're thinking there?

Yeah. So we haven't changed our strategy, our capital allocation strategy. We've typically bought stock back in the first quarter, which is when we have a vesting date in our equity compensation programs. And so this was nothing that we bought back stock in Q1. We wrapped that up at – in the March time frame. And as we look at our M&A funnel, and pipeline, we still see a really – we're really encouraged by the funnel, the range of opportunities, and that remains a higher priority for us than buying back our stock.

Yeah, I would just add to that, if you look at our balance sheet, we've got upwards of about $4 billion in dry powder, and we are not hesitant to do a deal when it needs to be done. But again, that would all be in advance in serving our strategy that we've laid out. As Sandy said, the pipeline is very active, with all different sizes of opportunities in that pipeline. But again, we want to continue to be disciplined and selective with an eye towards significant value creation. And again, as I always say, it takes two to tango.

Right. Makes sense. I'll leave that comment for somebody else to ask about. But – thanks.

We will take our next question from Mike Halloran with Baird. Your line is open.

Hey, good morning, everyone.

Good morning, Mike.

Good morning, Mike.

Many thanks for that. So the – obviously, you guys seem pretty confident in the underlying trends of the end market. I know, you spent a lot of time talking about the – your ability to react as things do so here or there. But obviously, backlog is really strong. Maybe you could talk a little bit about how that visibility from the backlog stretches out here? How does that compare to what that normal visibility looks like? And any color you can around how booked out you are as we get to out years at this point?

Yeah. I think, Mike, really good question. Nothing has changed structurally about our backlog. If you look at our AWS business that has a larger book-to-bill ratio than the other segments, and we're carrying record backlogs across really all three of our segments. And we did see really strong book-to-bill ratios across the portfolio in the quarter from an orders perspective. As we look at our water infrastructure and Xylem's M&CS backlogs, they stretch out for longer periods of time. Water infrastructure is in the middle. We have our transport business, which turns fairly quickly and a treatment business that has projects that stand out for multiple years. And then M&CS is the longest coupled with the supply chain constraints, which don't magically disappear at any one month. We have a $2 billion backlog there. So that's going to take a couple of years plus to work through.

Appreciate that. And then the price cost cadence sequential improvement catching up on the price side relative to the inflation pressures. How does that work in the back half of the year on an EBITDA dollar basis when you think your whole? What do you think margins start reflecting the positive pricing you're putting through?

We are really pleased with the pricing developments. We've focused more on pricing due to higher inflation throughout the year. Achieving price cost positivity in the quarter is significant, although it slightly dilutes the rate in Q2. Q3 is expected to have lower revenue compared to Q2 due to the typical seasonal trends in our water infrastructure business. We anticipate remaining price/cost positive on a dollar basis in Q3, likely around 30 basis points, which will be mildly dilutive from a rate perspective. For Q4, we expect to be positive again in dollar terms and neutral in rate terms. Overall, we are making strong progress toward this important milestone across our portfolio.

Thank you.

If I could just go back to your question on visibility and backlog. I think the other dimension that we feel much better about now than we even did in the last industrial downturn is the visibility and the closest we have to our channel partners, our distribution channel partners both here in the US as well as in Europe, where we have meaningful indirect channel business. And we've got much better visibility and coordination with them now than we did back then. So we got hit with a couple of surprises last time around in a quarter or two, we feel much better about that not happening going forward. So they are also our eyes and ears of what's going on in the marketplace at a local level.

Thanks for that Patrick. Thanks, Sandy.

Thanks, Mike.

We will take our next question from Scott Davis with Melius Research. Your line is open.

Hey, good morning everybody.

Hey, good morning, Scott.

Good morning, Scott.

A couple of little things here. I mean, the supply chain issues, I mean, chips we've been talking about for quite some time, have the other supply chain challenges gotten a lot better, the non-chip related stuff getting materials faster, easier?

Yes. Scott another great question. It's a mixed bag. I'd say, supply chain in the aggregate has modestly improved versus Q1, but it really does vary across the three segments. So as we mentioned, chip supply getting a bit better within M&CS, but lead times are still long but they're not worse, they're getting better. And water infrastructure, we have seen improvement in lead times from our European factory into the US. And certainly, what our infrastructure has benefited over the last year by offering more competitive lead times due to better vertical integration that we did within the company. But then I would say as we mentioned earlier, one of the reasons we're carrying an extra month of inventory is because of Applied Water. It's not limited to Applied Water but that's the main driver. And that's really again just knock on effects from China mainly castings, but also we see continued delays in shipping and logistics that we're just having to work through. So I'd say, it's getting marginally better across the board, but it really varies by segment.

And we talked a little bit about China. How does it work? When considering their controlled economy and their capital expenditure budgets, how do they manage the timing of projects, especially with the lockdowns experienced this year? Does that mean projects are pushed to 2023 while the existing 2023 plan stays in place, requiring them to catch up? How does everything get shifted in China?

Sure, it's a significant market, and it varies depending on the sector we are discussing. We have observed that the utility sector is considerably more stable. Currently, our challenge isn't about our plants being operational; we returned to normal staffing levels back in May. However, logistics and transportation have faced disruptions because both customers and colleagues were required to stay home. These delays affect various projects, particularly those funded by the government, but it's not necessarily negative since these projects don't get canceled; they merely get postponed. Historically, we have seen a rapid catch-up once restrictions are lifted. Our factories and distribution partners have the capacity to deliver, but we are waiting for customer job sites and utilities to reopen. We don't anticipate much recovery in the latter half of this year, but we expect a strong rebound in 2023. There are no fundamental changes in our outlook on the attractiveness of China; it's simply a matter of timelines shifting.

Okay. That’s really helpful. Best of luck. Thank you.

Thank you.

We will take our next question from Brian Lee with Goldman Sachs. Your line is now open. Brian, your line is now open.

Hello, this is Miguel standing in for Brian. I have a quick question regarding the chip supply chain. There's been a lot of discussion on this topic, and it seems that the situation is improving for chip supply. However, some of your competitors remain cautious about it. Can you share any specifics about what you are doing that may be giving you an advantage recently compared to your peers?

I can't comment on the situation of our competitors. However, we have been collaborating closely with our suppliers. The way we are positioned as we approach the end of the year aligns well with our expectations. We've made good progress in securing better chip supply earlier than anticipated. Additionally, in our M&CS segment, there are other product lines performing well. The positive outcomes in M&CS are not solely due to chips; we are also witnessing strong results from our test business and some progress in our pipeline assessment services. This wider portfolio is enabling us to exceed our projections for the year.

The only other thing I would add, which I’m cautious to share too much on this because we've got good visibility but it's not perfect because things could change. But I do think, depending upon who you're including in that peer group, it talks about digital, we've got somewhat higher concentration. Therefore we get a bit more leverage with suppliers. And we've got some really strong relationships with our partners, whether it be the direct suppliers from the chips and wafers or whether it be our partnership with Flex, we aggregate our demand and I think it gives us a stronger platform, at least stronger than what would be if we were doing it all on our own. So some of these things it's also just – I mean the number of calls that I and others have been on with the leaders of these companies and you just got – the team has been working it. And we've had to be more patient than we wanted to. But I think those relationships and those investments and relationships are beginning to pay off.

Understood. Thanks a lot. I’ll pass it on. Appreciate the color.

Thank you.

We will take our next question from Saree Boroditsky with Jefferies. Your line is open.

Good morning. So you highlighted strong growth in dewatering applications across most geographies. Could you talk about the benefit that had on margins during the quarter? And should that continue to be a margin tailwind for the remainder of the year?

Yes. So if you look at our water infrastructure business, we saw a really good margin performance. That business has been the most resilient when we look over the past couple of years. And certainly, the recovery in dewatering is a contributing factor. And so a lot of hard work has gone into our dewatering business both to diversify it from an end market perspective, from a geographic perspective. We've made some purposeful investments in our fleet to make it more modern and current, and we're seeing that upside on the rental side as well. So certainly, dewatering positive seeing good orders momentum there continue in the quarter on a global basis. So certainly helpful to the margin expansion story with the water infrastructure.

Yes, it's one of the shorter cycle businesses we have and it is not immune to cyclical downturns just like it benefits during upturns. We have also gained from a full integration within our commercial team, especially in North America, which has seen enhanced leadership and investment as discussed by Sandy. Furthermore, we are diversifying away from heavy oil, gas, and mining, focusing instead on utility municipal opportunities that show visibility with some of our other portfolio businesses. We are generating good leads by sharing leads with our field services teams. Although it's still early in this process, we've experienced strong growth rates, with orders increasing by double digits in the first half of the year, and we hope to maintain this momentum.

Okay. And then obviously, you've talked a lot about MCS and kind of the strong growth outlook there, but organic colors declined in the quarter. So just wondering, do you expect to see orders turn positive again?

We've experienced a significant increase in orders over the past several quarters. Although the reported numbers for MCS may appear negative, from a dollar perspective, we are still well ahead of our revenue conversion capabilities. In the last quarter, we secured $475 million in orders, which is a solid figure compared to our revenue. Our pipeline remains strong, and we are still in the early stages of the overall AMI conversion process. Currently, about one-third of the industry in North America has transitioned to AMI, indicating that there is plenty of opportunity ahead. We have a unique product that is gaining traction in the market.

Yes. And I think as we said earlier, I know none of us ever like to be talking about difficult year-over-year comps when you have big deals in a quarter last year, but it is there is some element of the nature of that in the business. And we'll certainly be even more transparent going forward as to how big are those deals, what other big deals are coming because it is a big rich pipeline right now that we're bidding on. And so, we have been running hot for the better part of 1.5 years or so, on some big deals big books. So but we were very positive on that pipeline.

Thanks for taking my question.

Thank you.

We will take our next question from Andrew Kaplowitz with Citigroup. Your line is open.

Good morning everyone.

Good morning.

Good morning.

Patrick, could you discuss what you are observing regarding municipal water funding and whether IAG funding is beginning to come in? Have you encountered any of that funding yet, and how are you planning to approach it as we move into 2023?

Yes, we have not seen any significant changes from a funding perspective yet. However, we do see robust demand in utilities, particularly in Europe where the market is stable, in emerging markets, excluding China, and in North America where demand was particularly strong this quarter. We often discuss the infrastructure bill in the US, but as I mentioned earlier, there's also recovery and resilience funding in the EU, the UK's ongoing five-year process, and the infrastructure funding included in Sean's five-year planning cycle, which remains steady. Together, these factors contribute to a strong funding infrastructure for utility spending globally.

Got. That's helpful, Patrick. And I know Sandy, you talked about price cost improving. Obviously, you've mentioned productivity in the past. It seems like it's also improving, but maybe you can talk about that how constrained labor is and you're sort of pushing productivity as you go forward and how that impacts the overall price cost dynamic?

Yes. I believe we experienced positive price cost margins excluding productivity this quarter, which is encouraging. We have a series of ongoing improvement projects across our portfolio. However, this year, our progress has been somewhat limited as we redirected engineers from these improvement initiatives to redesign tasks. As Patrick mentioned earlier, as this redesign work advances and we move through the testing and certification stages, we will be able to reallocate some of our resources back to continuous improvement projects, allowing us to maintain our momentum in productivity. Overall, I think our teams globally are performing well, which is helping to enhance our margins on a quarterly basis.

Appreciate it.

And we will take our next question from Joe Giordano with Cowen. Your line is open.

Hey guys. good morning.

Hey good morning.

Hey Joe.

When you consider M&CS, what do you think were our strengths and what structural changes might we need to make moving forward to adapt to new realities?

That's a great question. From my perspective, I believe we will look back and recognize our success in navigating the chip supply challenges while maintaining team cohesion and morale. Our team dedicated many long hours, including nights and weekends, communicating with suppliers. Our commercial teams worked diligently with customers to keep their support, even when satisfaction was low. The resilience of our team was evident and continues to be so. Additionally, the absence of cancellations in a record backlog is a testament to our efforts, along with the fact that our margins on that backlog have not declined due to chip supply issues. However, we have faced margin impacts due to some recent decisions related to redesign expenditures and selling certain mechanical meters at lower margins compared to our other products. I believe these factors will work in our favor. Looking back, one adjustment I would suggest is that we might have started on the redesign work a bit earlier. While we didn’t miss a critical window, we learned that commencing sooner would have been beneficial since it takes time to progress through that process. Those are my overarching thoughts on this situation, but we still have time to adapt further.

That’s good color. Thank you, Pat. And then maybe I'll ask one about some of your more international products, you've been hearing this from some other companies. Have you seen increased international competition from like maybe competitors who are selling in USD but have a fully local currency cost basis, so they don't really need to raise prices? I guess their margins are benefiting and you guys are in a comparably tougher situation. Are you seeing any of that?

Joe, we're really not seeing anything meaningful on that front. We're seeing across our end markets with our competitors that they are also taking price increases. I mean nobody has been immune to inflation in this market. And so we have been the price leader where we have a competitive advantage. And so...

We have a somewhat different structure compared to some of our peers and other companies you may follow. Our competitive base products, particularly those we sell out of Europe, mainly face competition from European companies. We have a strong presence in countries like Italy, Sweden, and the UK, and we have successfully reduced lead times for shipping these products to the US. In North America, most of our competitors are based in the US, so we don’t face a significant structural disadvantage compared to them. We share similar challenges with our competitors, and we are continuously seeking ways to further localize, reduce costs, and decrease lead times.

Thanks.

We will take our next question from John Walsh with Credit Suisse. Your line is now open.

Hi, good morning and wanted to say nice quarter.

Thank you.

Thank you.

A lot of ground covered, question around price cost. One, just wondering, if you could talk about what you're seeing sequentially with some of the big cost buckets be it materials, logistics, etc. And then, I know you've done some structural pricing initiatives. Just how much of the price you think is structural? And how much might be tied to surcharges? Thank you.

Thank you for the question, John. I'll address the last part first. From a pricing standpoint, we have not implemented surcharges; instead, we have enacted more permanent price increases. We've seen a significant increase in our price realization from Q1 to Q2, and we expect that to stabilize in the second half of the year, as we began implementing price increases in that period last year. It will likely even out a bit during the latter half. Additionally, I want to highlight that while there have been some reports of moderation in commodity prices, we are still experiencing inflation across various categories, including freight, labor, and overhead. Overall, we anticipate being in a better position in the second half of the year compared to the first half.

Great. And then maybe just as a follow-on, any color you can provide kind of last time we saw commodity deflation and experience that. I mean, obviously, as you just noted it's more than commodities, but just curious historically, the ability of the price.

Yes. For instance, during the period of heavy tariffs, when some of those tariffs were removed, we did not reduce the price increases we had implemented because our customers recognized the value we were providing. Historically, when there has been a decrease in material inflation, we have had a strong track record of maintaining our price increases. I believe we have been largely successful in doing so, although there may be a few exceptions. However, in general, those headline numbers do not revert.

Great. Thanks for fitting me in and taking the questions. Appreciate it.

We will take our next question from Pavel Molchanov with Raymond James. Your line is open.

Thanks for taking my questions. Obviously supply chain problems affect everybody and probably touched on this a quarter ago. Are you seeing any situations where some of the smaller middle market players that could be prospective acquisition targets for you, are struggling disproportionately and perhaps creating kind of an opportunistic situation for you to look at M&A?

No, it's an interesting question. It was perhaps raised earlier in the previous quarter when we were more focused on supply chain challenges. We have not really considered it that way. The companies we analyze are high-quality and may not always operate on a large scale, but they manage their supply chains effectively. They tend to concentrate on specific product lines or a few offerings. That said, I believe, as Joe mentioned earlier, that we all now view supply chain management as one of the most important competitive advantages a company can possess. Whether it’s chip supply or another issue down the line, the world has become highly interdependent. We have improved significantly ourselves, but there is still room for growth. I think it could lead to new synergies in the future, although it is not a major focus in our current pipeline considerations.

Understood. A follow-up about the U.K. specifically. There was a report from one of the government experts the other day saying that without the implementation of smart water metering, the U.K. would be experiencing outright water scarcity by the end of this decade, pretty striking headline. Just thought, I'd get your perspective on that.

Yeah. So I won't prognosticate on the prediction. But what I can reinforce is, the lead of late which is the office of water in the U.K. they regulate the 17 or so utilities that serve the U.K. And that five-year AMP cycle they go through there is a preempt piece to that where they all have to come for with their proposals in order to get their funding approvals, their rate cases approved. And all that is published very visibly as to what are the top three priorities that each utility is focusing on; they're mandated to have that. And we can confirm that in this last cycle, unlike any cycle before, virtually every one of utilities when you look at what they were trying to solve for, it was things around scarcity. It was things around water losses and how they do all that in an affordable, efficient way. So that common theme was a big deal. And then also in some cases, climate change impact in terms of flood prevention and building more resilient infrastructure. So there is a lot there. It makes it a very attractive market. So hopefully that was helpful.

Thank you very much.

Thank you.

We have reached our allotted time for questions. I would now like to turn the call back over to Patrick Decker for any additional or closing remarks.

Well, thanks everyone for your time today for your continued support. I know we've run a bit long here. I appreciate the questions and the interest. I trust you'll all have a very safe and enjoyable remainder of the year summer. I know you're a need even earnings season. So we appreciate your time and your attention. And I look forward to hearing to you again.

Thank you. This does conclude today's Xylem's Second Quarter 2022 Earnings Conference Call. Please disconnect your lines at this time. And have a wonderful day.