Xylem, Inc. (NYSE:XYL), a leading water technology company I have been covering since March, presented its first-quarter results on May 5. The figures were generally depressed, as revenue slipped while operating income and profit shrunk. Cash from operations was negative. The company also failed to meet Wall Street’s expectations as both adjusted profit and revenue were markedly lower than analysts expected. It appears pundits underestimated the magnitude of the pandemic’s impact both on the top line and margins.
Though 2020 is anticipated to remain bumpy for XYL due to sapping demand in its key cyclical end-markets, analysts are expecting sales may recuperate in 2021 and continue expansion in 2022-2024.
Now let’s take a more in-depth look at the company’s financial performance in Q1.
The top line
In the first quarter, all three Xylem’s segments delivered lackluster sales dynamics due to intuitively evident reasons. Sure, the pandemic and especially lockdowns in China were among the principal culprits of a 9% total GAAP (and 8% adjusted) revenue contraction, bleak operating margin, and 44% reduction in GAAP operating income. Among the key headwinds was the demand contraction in emerging markets (and especially in China), which are at the crux of Xylem’s long-term growth story.
More specifically, Water Infrastructure organic sales were down 7%, Applied Water organic sales dropped by 10%, adjusted revenue of Measurement & Control Solutions fell by 7%. Quite an interesting matter is that despite double-digit revenue decline, the operating margin of the AW division remained the strongest in the overall portfolio and equaled 14.5%.
Total organic revenue from emerging markets was down 19% (the measures governments undertook to stop the spread of infections had taken their toll), while Western Europe was only 2% weaker and the U.S. revenue was down 7%. Organic growth by end-markets was also asymmetric. While Utilities were down only 5% (thanks to its non-cyclical nature), Residential’s revenue tumbled 14%.
For a broader context, I should briefly touch upon the Q1 results of Xylem’s main competitors (a few of them were enumerated in the Form 10-K on pages 7 and 8).
- Pentair plc (NYSE:PNR), one of Xylem’s Applied Water segment’s principal rivals, managed to deliver on its promises and increased both organic and reported sales by 3%. The result was achieved primarily because of strong growth in Consumer Solutions (core sales up 7% vs. 1Q19), while Industrial & Flow Technologies were down 2%. The company suspended 2020 guidance blaming the pandemic-related uncertainty.
- KSB AG (OTC:KSBBF), a German pump and valve manufacturer, noticed some softness in the end-markets and reported a €17 million reduction in Q1 sales revenue to €518 million; Pumps, Valves, and Service segments “all experienced decline.” Order intake in the Pumps segment was down by record 15.4%. The company also mentioned that despite order intake growth in North and South America, the dynamics in other regions were mediocre. After all, it concluded that “reliable predictions regarding future business development” are impossible.
- The Water Systems segment of Franklin Electric Co., Inc. (NASDAQ:FELE) posted a 13% decline in Q1 revenue. Sales in the Asia Pacific were exceptionally lackluster; they fell by 38%. The 2020 guidance was withdrawn.
- On the contrary, the Pumps Equipment segment of Swiss Sulzer Ltd. (OTC:SULZF), which competes with the Water Infrastructure division of XYL, reported a 4.5% increase in organic order intake despite adverse effects of lockdowns in China (see slide 5). The firm did not share any guidance on 2020 sales.
All in all, Xylem’s Q1 performance largely reflected the headwinds the industry has been facing due to lockdowns and the economic downturn; however, some players have fared much better.
Now, given the current economic woes, Xylem expects a 20% to 30% reduction in Q2 organic revenue (see slide 13 of the earnings presentation).
As I have already mentioned above, the Q1 revenue contraction has taken a toll on margins. Despite the reduction in the Cost of Revenue, the gross margin fell by almost 2% to 36.4%. The operating margin declined to 5.4% vs. 8.8% in Q1 2019.
Among other things, I noticed that research & development expenses were reduced by 3.9% to $49 million. I am not a proponent of R&D activities suspension in order to prop up operating earnings and cash flows and, perhaps, secure shareholder rewards during the crisis times. R&D should always remain a company’s paramount priority, especially when it faces tough competition. In Form 10-Q, XYL did not elucidate what actually led to a $2 million decrease in R&D. I hope its product development plans remain on track, and a decline was just a fluctuation, perhaps due to the timing of some activities, or because of a higher share of capitalized software that the company has been developing for sale to external customers. I did not find clarification on that matter in the quarterly report but noticed a $5 million increase in capitalized software included in Other intangible assets on the balance sheet (see page 14).
Importantly, XYL reported a meager income tax expense (an around 10% tax rate), partly because of lower taxes in some jurisdictions. However, the tax rate did not offset the impact of revenue decline; as a result, net income shrunk 2x.
Utterly disappointing cash flow
Regarding cash flows, Xylem had fairly disappointed. Lower net income caused by revenue contraction has taken a toll on cash from operations, which was additionally adversely impacted by inventory build-up and reduction in accounts payable. If we take a quick look at page 14 of the quarterly report, we will find out that finished goods, raw materials, and work in progress on the balance sheet have all increased since the end-2019. Lower revenue is most likely the key culprit.
So, net CFFO plummeted to $(2) million vs. $83 million in 1Q19; that is utterly disappointing, as XYL’s quarterly cash flow (though highly cyclical) has never been negative since at least 2012.
Before working capital movements, gross cash flow was $108 million vs. $159 million in the March quarter of 2019.
So, Xylem’s Q1 profit was not backed by FCF nor by net CFFO. Obviously, negative cash from operations did not cover capital expenditures of $51 million, let alone shareholder rewards. It also goes without saying that the Net income/FCF metric is also of no use here.
Nevertheless, Xylem’s Last Twelve-Month net CFFO is still positive, and we can assess its Cash Return on Total Capital. As of my calculations, LTM CROTC stands at 14.4%. I reckon it is a strong result.
The company ended the March quarter with a solid cash position of $739 million. However, a reader should bear in mind that the company’s liquidity was shored up not by free cash flow, but by the issuance of short-term debt included in cash flow from financing activities.
As of end-March, Debt/Equity was above 88% (short-term debt issuance contributed to the increase). Net Debt/Net CFFO stood at 2.3x. I would not say the company is approaching a default situation (it is definitely not), but if I was a shareholder, I would like to see a reduction in D/E, perhaps close to the 2015 level of 61% or lower.
As it was mentioned in the Form 10-K (see page 42), XYL had $276 million in debt (commercial paper) obligations due to be repaid in 2020. Given the liquidity, I reckon it will have no issues with the repayment of the principal. Nevertheless, if I was a Xylem executive, I would cut the dividend if the net cash flow does not normalize in Q2.
Though Xylem is headed towards a sharp reduction in annual sales, analysts are forecasting revenue to rebound in 2021 to $4.97 billion and edge higher in 2022. The company is a bit overvalued (it has poor Value Grade), but if Enterprise Value/EBITDA dives below 14x, it might become worth considering.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.