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Xylem Inc
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Good morning, and welcome to the Xylem Third Quarter 2018 Earnings Conference Call. At this time, all participants have been placed on listen-only mode, and the floor will be open for your questions following the presentation.
I would now like to turn the call over to Matt Latino, Senior Director of Investor Relations. Please go ahead.
Thank you, Christy, and good morning, everyone, and welcome to Xylem's Third Quarter 2018 Earnings Conference Call. With me today are Chief Executive Officer, Patrick Decker; and Chief Financial Officer, Mark Rajkowski. They will provide their perspective on Xylem's third quarter 2018 results and discuss the full year outlook. Following our prepared remarks, we will address questions related to the information covered on the call. I'll ask that you please keep to one question and a follow-up, and then return to the queue.
As a reminder, this call and our webcast are accompanied by a slide presentation available in the Investors section of our website at www.xylem.com. A replay of today's call will be available until midnight on November 30th. Please note, the replay number is 800-585-8367 and the confirmation code is 6079287. Additionally, the call will be available for playback via the Investors section of our website under the heading, Investor Events.
Please turn to slide number 2. We will make some forward-looking statements on today's call, including references to future events or developments that we anticipate will or may occur in the future. These statements are subject to future risks and uncertainties, such as those factors described in Xylem's most recent Annual Report on Form 10-K and in subsequent reports filed with the SEC. Please note that the company undertakes no obligation to update any forward-looking statements publicly to reflect subsequent events or circumstances, and actual events or results could differ materially from those anticipated.
Please turn to slide 3. We have provided you with a summary of our key performance metrics, including both GAAP and non-GAAP metrics. For purposes of today's call, all references will be on an adjusted basis unless otherwise indicated, and non-GAAP financials have been reconciled for you and are included in the appendix section of the presentation.
Now, please turn to slide 4 and I will turn the call over to our CEO, Patrick Decker.
Thanks, Matt, and good morning, everyone. Thanks for joining us today to discuss our third quarter results. Overall, we delivered strong growth in both revenue and earnings in the quarter. The markets we operate in remain robust and our team is leveraging that strength to win more and larger orders. Year-to-date, we've delivered an 8% increase in orders, which sets us up well for continued strong growth. And I continue to be pleased with the price realization that we're achieving. This reflects both the underlying strength in our markets, but also the quality and the breadth of our portfolio. Our ability to deliver even more comprehensive solutions to address our customers' needs has strengthened and we've expanded the value we're bringing to them in meaningful ways.
We also continue to deliver on our productivity initiatives, which enabled us to mitigate the inflationary pressures that we've seen throughout the year. I'm very pleased with the discipline that our teams are demonstrating, truly embedding the continuous improvement mindset into our daily work. That, once again, contributed to our margin expansion and double-digit earnings growth in the quarter.
So let me review a few of the details. In the third quarter, we again delivered strong broad-based orders and revenue growth. As I just mentioned, orders increased 8% in the third quarter, which brings us to four consecutive quarters of high single to double-digit orders growth, a strong indicator of sustained growth ahead. We had strong orders growth across our emerging markets, including a more than 40% increase in India and 10% increase in China. We also saw notable strength in our Measurement & Control Solutions segment, where orders exceeded 30%. It's great to see the momentum building in our Sensus business as well as across the businesses and our new advanced infrastructure analytics platform.
In addition, we're continuing to make progress in the area of revenue synergies. With more significant wins finalized during the third quarter, we've now secured about $100 million in revenue synergy wins year-to-date. Our most recent wins include a large metrology project in India, where we were able to leverage the strong relationship that Xylem already have with the customer to open the door to Sensus solutions. Likewise, we were also able to sell a comprehensive Sensus solution to a Xylem combo utility in Latin America. These two wins alone were worth about $70 million.
Now, these latest wins will largely not start to materialize into revenue until late 2019 and beyond as our teams work with the customers to develop appropriate implementation plans, but these wins further validate our thesis about utilizing the strength of Xylem's global presence to create new opportunities for all of our new solutions across Sensus and our AIA platform and drive growth. We see further opportunities in our larger international deal pipeline, which we're continuing to develop.
Revenue in the quarter grew 8% organically with strength across every end market and region. Revenue in Emerging Markets increased 13% in the quarter with a couple of standout results. Our business in China grew more than 20% in the quarter. There, we continue to see strong investment by utilities to upgrade their facilities to meet new regulatory requirements, particularly those around sewage discharge standards. We also saw strong growth in Latin America, up 20% in the quarter. Our business in this region is smaller relative to our other Emerging Markets, but our team there is building very good momentum with a focus on the most promising opportunities, such as strength in public utilities and mining.
Last quarter, I discussed the strong progress we've made in our price realization efforts. That work has progressed even further as we stay ahead of inflation pressure. In the third and fourth quarters, we announced additional pricing actions and we're already achieving good traction in the marketplace. Again, the health of our end market certainly plays a role in our progress to-date, but our success also reflects the strength of our offering, the value we provide to our customers and the discipline of our sales teams.
As I already mentioned, we continue to deliver on our continuous improvement initiatives. This quarter, we generated $38 million in savings through our productivity and lean initiatives. This helped us drive a 110 basis point increase year-over-year in our adjusted EBITDA margin and 70 basis point expansion of our adjusted operating margin, excluding the impact of purchase accounting. And finally, we delivered an 18% increase in our adjusted earnings per share; so, across the board, another strong quarter.
I'll address our outlook for the year later in the call, but I do want to remind you of the expectations we shared with you at the beginning of the year. We began with an outlook of 4% to 6% organic top line growth and adjusted earnings per share of $2.82 to $2.97. Since that discussion, we have faced inflationary pressures and tariffs, but through the execution of strong productivity initiatives, price realization as well as execution in the marketplace, we have mitigated those challenges.
Furthermore, we have been managing the impact of a strengthening dollar, which has also weighed modestly on our earnings. Our outlook today, nine months later, is for higher organic revenue growth, now up 7% to 8%, and nearly the same EPS midpoint despite absorbing about $0.05 of negative foreign exchange impact. So I'm very pleased with our team's performance, and we will remain focused on closing out the year strong and delivering on our long-term commitments.
Before I turn over to Mark, I want to touch on a couple of other items of interest; first, the strength of the utilities market. This is a topic that I'm asked about in just about every meeting I have with investors, so let me share my observations.
Utilities remain our largest end market at roughly 50% of our revenue, and we see continued strength here across all of the regions in which we operate. There are a number of drivers which differ by region, from regulatory compliance pressures to the need to strengthen the resiliency of their operations, to the realities of dealing with aging or overstressed infrastructure. Utilities are investing in their operations, and we have the essential solutions they need.
In the U.S., we had a few big projects slip into the fourth quarter, but the market remains strong. Year-to-date, our revenue in the U.S. utilities is up 10%, and our backlog is up double-digits. And globally, our treatment bidding pipeline, a metric we often point to as a leading indicator, increased 11% in the third quarter; so, a very healthy market from our perspective.
Next is innovation; strengthening and accelerating our innovation pipeline has been one of our key strategic priorities. We are progressing this work organically and through acquisitions. As a result, we've made steady progress in growing our vitality index, which now stands at just under 25%. As a reminder, our vitality index is calculated as the sum of new product revenue in the first five years from launch. And over the past three years, our vitality index has increased 600 basis points.
Our new product portfolio is performing well. In fact, the revenue from these products is growing at faster rates and they're generating accretive margins. We are well on track to meeting our 2020 target of a 30% vitality index.
We're in the early stages of building out our offerings in embedded software and network services. We've created an enterprise-wide software center of excellence that's focusing on increasing the value that software and data analytics will provide to future Xylem innovation. This group is integral to developing the strategy and governance of Xylem-wide software and data analytics. Importantly, it's partnering closely with our businesses to ensure that all solutions are developed in alignment with our customers' needs and expectations, and are scalable globally. As I mentioned on our last call, our customers are looking for us to move faster in the development of these new software-enabled solutions. This new center of excellence will help us accelerate this work, capitalizing on our first-mover advantage to bring these margin-accretive solutions to the marketplace.
So now, please turn to slide 5 and Mark will review the quarter results in more detail.
Thanks, Patrick. I'm very proud of our team's performance in the third quarter. Overall, revenues were up 8% year-over-year. This also reflects 8% organic growth as the 2 points of growth we generated from acquisitions were offset by 2 points of foreign exchange headwind. From an organic perspective, this strength in revenue was broad-based across all of our end markets and in all key geographies. We continue to see good momentum in the utilities end market with 9% growth. This was in line with our expectations and driven by strong performance in our Water Infrastructure segment, from transport strength and treatment project deliveries, as well as project deployments in our Measurement & Control Solutions segment. The highest growth was in the U.S. and Asia Pacific regions, which were up 8% and 25%, respectively.
The industrial end market, with growth of 5% year-over-year, continues to perform well and in line with our expectations. Market conditions remain healthy in our dewatering and Applied Water businesses, where saw strength in North America, Europe, and Latin America.
Our commercial end market also had a very strong quarter with 13% growth. This was above our expectations and driven by robust project activity in the U.S. and China markets. Finally, in residential, we were up 4% from growth in Western Europe and the U.S.
Shifting to operational performance, adjusted EBITDA increased 110 basis points to 20.3% in the quarter. This improvement was primarily driven by increased productivity savings, volume leverage from strong organic growth, and price realization, and partially offset by cost inflation, unfavorable mix, investments (12:55) and foreign exchange impacts. Price realization continued to accelerate and improved to 100 basis points in the quarter. We're very encouraged by the strong execution from our commercial teams to mitigate the higher inflation we saw in the quarter.
Adjusted operating margin increased 50 basis points to 14.6%, which includes 20 basis points of non-cash amortization related to purchase accounting for the acquisitions in our advanced infrastructure analytics platform. Our teams continue to execute on our productivity programs and we delivered $38 million in cost savings during the quarter. This 300-basis-point improvement offset inflation, including tariff impacts of about $5 million.
Through our strong revenue performance, improving price realization and solid operational execution, we delivered earnings per share of $0.77, an increase of 18% year-over-year, which was at the high end of our expectations.
Please turn to slide 6 and I'll provide additional details on our segment performance. Water Infrastructure recorded orders of $537 million in the quarter, which was down 1% organically year-over-year. This was primarily due to timing of several large custom transport and treatment orders that we expect to shift into the fourth quarter. Our orders for the year are up mid-single digits, reflective of the overall healthy demand in the utility and industrial markets, which we expect to continue through the fourth quarter and into 2019. We exited the quarter with total backlog for the segment of $659 million, up 10% organically year-over-year.
Water Infrastructure revenue, up $541 million, grew 8% year-over-year on an organic basis. Foreign exchange was an $18 million headwind. Emerging Markets were up 23%, including more than 40% growth in China and roughly 30% growth in Latin America. The majority of the outsized growth we saw in Emerging Markets came from our treatment business, which was up more than 40%, driven both by project deliveries and strong underlying demand.
Canada was a notable pocket of strength this quarter with 24% growth driven by solid demand in our wastewater transport business and increased industrial activity in the construction and oil and gas markets for our dewatering business. We saw modest growth of 2% in Western Europe, which reflected strength in our wastewater transport and dewatering businesses, partly offset by softer treatment performance as we lapped several large project deliveries in the prior year.
The U.S. was flat in the quarter, primarily due to a tough prior-year comparison of 9% growth and the timing of utility project deliveries. We expect U.S. utility growth to be up in the mid-single digits in the fourth quarter with full year growth in the mid- to high-single-digit range. U.S. industrial revenues were up mid-single digits in the third quarter from Water Infrastructure.
Operating margin for the segment increased 110 basis points to 19.2% driven by cost savings from productivity programs, higher volumes and accelerating price realization. This more than offset inflation, growth investments, and unfavorable mix from higher treatment in emerging market projects this year versus last year.
Please turn to slide 7. Our Applied Water segment also had a very good quarter. Orders of $377 million were up 3%, organically. We exited the quarter with backlog of $216 million, which is up 6% organically compared to last year. Revenue for Applied Water was $378 million, up 8% organically versus the prior-year quarter. Foreign exchange was a $4 million headwind. Revenues in the U.S. grew 9% driven by strength across each of the segment's verticals. Commercial and industrial were standouts, up 12% and 10%, respectively.
In commercial, we continue to see strength in the institutional building sector from project activity and modest share gains. Industrial growth was driven by strong project demand as well as growth in our specialty flow business. Residential was up 4% and in line with our expectations.
In Western Europe, we saw growth of 7%, which was also driven by broad-based strength across all verticals. And finally, in the Emerging Markets revenue grew 8%, which primarily reflects strong growth in China in the commercial building sector. There were also pockets of strength in Latin America from industrial activity.
Segment operating margin in the quarter increased 60 basis points to 16.1% year-over-year. The year-over-year margin expansion was driven by cost savings from productivity programs, excellent price realization and higher volume leverage. This more than offset inflation, foreign exchange and unfavorable mix.
Now, let's turn to slide 8 to discuss the performance of Measurement & Control Solutions. Our Measurement & Control Solutions segment continues to build upon its growing momentum in the marketplace. Orders of $442 million in the quarter were up 31%, organically, and were driven primarily by the North American water business. This strong growth increases our confidence in the health of the clean water market and growing opportunities from our broad offerings across this segment.
Segment revenues were $368 million, up 8% on an organic year-over-year basis. Foreign exchange was a $2 million headwind, and the net impact from acquisitions and divestitures added $24 million.
U.S. revenues grew 14%. This was due to strength in our water business, which was up 12% in the quarter, and the deployment of the Nicor Gas contract. The segment's European and Emerging Markets businesses were each down low-single digits in the quarter due to difficult compares against prior-year project deployments.
Adjusted EBITDA margins increased 90 basis points to 19%. Adjusted segment operating margin in the quarter declined 50 basis points to 9.5% year-over-year. The benefits of higher volumes, cost savings and improved price realization were offset by the unfavorable mix from the large gas project deployment, inflation and our investments in strategic growth initiatives. Those investments include our efforts in the areas of networking and software development to support the sizable synergy opportunities we have across our Xylem pipeline, such as the two deals we won this past quarter that Patrick mentioned, as well as investing in commercial resources and capabilities to capture share in the fast-growing infrastructure analytics market, where orders grew 27% in the quarter.
Increased investments, along with purchase accounting amortization, impacted operating margins by 280 basis points year-over-year in the quarter. During the quarter, we also saw ramp-up in the cost of certain electronic component parts, which increased year-over-year inflation on a quarter sequential basis by 70 basis points.
Now, let's turn to slide 9 to discuss cash flows and the company's financial position. We closed the quarter with a cash balance of approximately $400 million (sic) [$404 million]. Despite higher cash earnings and improved working capital efficiency, free cash flow conversion declined to about 100% (sic) [99%] in the quarter. The decrease in free cash flow is primarily driven by the timing of certain capital projects year-over-year as well as higher levels of working capital reflecting the timing of shipments and inventory levels to support higher fourth quarter sales. This quarter also reflected an accelerated pension contribution to optimize our U.S. tax benefit.
We anticipate capital spending and working capital investment to normalize in the fourth quarter, and we continue to expect to deliver our full year target of more than 115% free cash flow conversion. While the amount of working capital investment is higher year-over-year, I'm pleased with our progress on working capital efficiency.
Our teams drove a 170 basis point reduction as we continue to improve our processes and discipline. We remain committed to maintaining our investment grade credit rating and continue to repay the short term debt we use to fund the Pure acquisition, which we expect to completely pay down by the end of this year.
Now, please turn to slide 10 and Patrick will cover our updated outlook.
Thanks, Mark. Let me begin with a look at our end markets. Overall, our end market view for the full year is largely unchanged from the guidance we provided on our last earnings call. We do continue to deliver above our growth expectations in the commercial end market, so we've updated that projection to reflect continued strength.
Let me quickly run through our projections. As I stated earlier, our utility end market continues to show strength, particularly in the U.S. and key Emerging Markets. For full-year 2018, we continue to expect revenue to grow in the high-single-digit range, overall.
Our businesses have performed well in the industrial end market year-to-date. We see continued solid growth in the U.S. and Europe. The heavy industrials in North America have continued to strengthen. In the Emerging Markets, we continue to see stronger conditions in China, India and Latin America, with somewhat softer conditions in parts of the Middle East. We expect industrials to be up mid-single digits for the full year.
Organic growth in the commercial end market has been strong all year. We see continued solid growth in the U.S. and do expect some moderation to occur in Europe. Emerging Markets should continue to benefit from increased government spending, particularly in India and China. We've raised our full-year growth outlook to the high-single-digit range.
Finally, in residential, we had somewhat softer results in the first half of the year, but we're back up 4% in the third quarter. We continue to anticipate full-year 2018 revenue growth in the low-single digit range. Competition in the U.S. market remains high, where demand tends to be replacement-driven. We also anticipate solid demand to continue in China and other Asia Pacific countries as well as Western Europe.
Now, please turn to slide 11 and I'll address our updated outlook. We're well positioned to deliver on our full-year commitments while continuing to invest in our longer-term growth initiatives. With strong revenue growth year-to-date, we now expect our full-year organic revenue growth to be in the range of 7% to 8%. We expect to continue to generate significant cost savings, which are at $115 million for the third quarter, and to drive price actions to enable us to meet our operating margin expansion targets of 60 basis points to 70 basis points. That results in an adjusted operating margin of 13.9% to 14%. This expansion excludes about 20 basis points of margin dilution from purchase accounting for acquisitions.
Adjusted EBITDA margin is expected to improve by 110 basis points to 130 basis points, which brings the full-year range to between 19.8% to 20%.
At the bottom line, we've narrowed the range of expected adjusted full-year earnings per share to $2.87 to $2.89 after absorbing $0.05 in negative foreign exchange impacts over the course of the year. This excludes integration, restructuring and realignment costs of about $45 million. Adjusted EPS growth is projected to be approximately 20% for the year.
Now, please turn to slide 12 and I'll quickly review our planning assumptions for the fourth quarter. We anticipate overall organic revenue growth in the range of 7% to 8%, reflecting the benefits of continued strength in our underlying markets, our solid commercial performance, and strong backlog entering the fourth quarter. And lastly, our adjusted operating margin for the quarter is expected to be in the range of 15.9% to 16%, and adjusted EBITDA margin of 21.3% to 21.4%.
Now, please turn to slide 13. So to wrap up, we've had another strong quarter and the team continues to execute at a high level. This performance is driving our strong revenue growth, productivity initiatives, and our solid price realization. That's enabling us to continue to expand margins in the near term while also investing in strategically important initiatives that will accelerate our growth and margin expansion in the longer term.
I'm very pleased with the momentum that has been building in the business over the course of the year and will continue to propel us forward.
So with that, operator, we'd be happy to take questions.
Thank you. And your first question comes from Ryan Connors of Boenning & Scattergood.
Great. Thanks for taking my question. I wanted to discuss the channel story in industrial a little bit. There's, I guess, a theory out there making the rounds that a lot of the strength we're seeing in industrial represents sort of a combination of channel stuffing and order pull forward ahead of price increases related to tariffs and et cetera. So – and I guess the implication being that there's a hangover or a pullback at some point. Can you give us your take on that as it relates to your business?
Yeah, Ryan. So we're not really seeing that. I mean, there might have been a tad of that in the last quarter, but we don't really see tariffs having a big impact on our offering and our channels in the market. Having met with – spoken to a number of our channel partners at both WEFTEC as well as other events, recently, and they certainly were not pointing to any of that activity happening in their channel. So that's not something that we are seeing in our business.
Okay. Great.
Yes.
And then, my other one is somewhat bigger picture in nature. You mentioned that Sensus had a nice combo utility sale in the quarter. We seem to be seeing an increased trend of these multi-utility formats; big announcement on that front last week and some talk out there that there might be more to come in the U.S. in terms of multi-utility. How does Sensus view that trend? Is that a positive, a negative? Does it not really matter? What's the view there?
Yeah, we see it very much as a positive trend. And the reason we see that is because we feel that we're even stronger from a competitive position when it's a combo utility because the economics around our FlexNet offering make that much more sense for them; that many more endpoints that they're able to leverage off of that fixed network. And so, we do see that trend continuing and we consider it to be very positive.
Okay. And do you have any – I mean, this is – probably not, but do you have any rough number in terms of what percentage – what portion of Sensus business today is combo utility type formats globally?
Yeah. I don't have – and it would be predominately here in the U.S. I don't have that number off the top of my head, Ryan. We can certainly get it back to you, guys.
Okay. Sure. Thanks for your time.
Thank you.
Thanks, Ryan.
Thank you. Your next question is from Deane Dray with RBC Capital Markets.
Thank you. Good morning, everyone.
Good morning, Deane.
Good morning.
Hey. It's interesting that this quarter there's, across the industrials, lots of hand-wringing about China slowing and you all put up better than 20% growth in China. So, just spend a moment, if you could, about that demand. I know there's really tighter regulatory enforcement about wastewater discharge, but how's that translating into your book of business? What kind of mix are you seeing? Where's backlog and pricing?
Sure. Yeah. So, you're absolutely right, Deane. The drivers there, for the most part, are the fact that water quality and connected treatment continues to be a top policy mandate of the central government there, and we've seen that flow really over the last years. Even whenever people were talking about China being down overall, because two-thirds of our revenue there in China is in the utilities space, we were able to absorb the softness a few years ago on the commercial building industrial side; but, it really is the regulatory drivers.
In terms of mix for us, that's always a favorable mix from a margin standpoint. We've long said that, as we also are building more of a replacement business in China, we're seeing the aftermarket coming through at very attractive margin rates, similar to what we would see around the rest of the world.
Got it. And then, swing over to the advanced infrastructure analytics business, and as you've built out that platform, there were all kinds of discussions about developing a pricing model. And there was some hopes that maybe you'd try to get a percent of savings from non-revenue water, but that didn't look like that was something the market was going to be interested in.
But it sounds like you're focusing more, now, on a Network as a Service model. And maybe – I know it's still early, but if you could share for us how that translates into what kind of margin, what kind of growth rate, and then customer acceptance?
Yeah. So you're right, Deane. So we are still in the early stages of a number of the pilots that we've talked about before where we are trying different pricing models and – whether it be performance-based contracting, value sharing, or strictly subscription-based businesses. And so, we'll have more to say on that as we move along here.
I'd like to keep a little bit close to the chest on competitive dynamics, but nevertheless, the margins we see on that business are very attractive and very accretive, overall, both from a gross margin standpoint and a net operating margin standpoint. We've seen a big pocket in orders here. There are some delays in that converting into revenues, so you will see more of that lift here later in the fourth quarter and into Q1 and Q2 of next year.
Great. And then, just one last clarification. I like how you didn't use this as an excuse whatsoever about some customer order deliveries going from the third quarter into the fourth quarter, but if you could just size for us those orders, that would be helpful. Thanks.
Yeah. So we came in – the orders for Water Infrastructure, overall, came in down 1%. The effect of those order delays – if we would have had those in the quarter, we'd have been about probably 5% to 6% orders growth. So it was about that big of an impact, Deane.
Terrific. Thank you.
Good. Thank you.
Thank you. Your next question is coming from Nathan Jones of Stifel.
Good morning, everyone.
Good morning, Nathan.
Hey. Good morning.
Just start with a higher level question here for you, Patrick. You came into this year saying that you thought the utility cycle was in a multiyear upswing. Has there been anything that's happened this year that has changed your outlook for that, either positively or negatively?
Yeah. So I – not really much has changed in our mind, Nate. When I look at it, I would say, so kind of where are we in the cycle? I mean, I can't give a specific prognosis on where we are, but I can certainly look at leading indicators. I mean, our orders, again, were up 8% through the year. Our backlog is up 10%. Our bid pipeline is up 11% on the treatment side, which is a leading indicator for the rest of the infrastructure business.
And we still think that there is a lot of room for continued convergence in the markets that we serve because of the integrated technology that we're providing here and the whole idea of connected products and software solutions. So we see there being a different dynamic emerging here that we think is going to buoy the growth and the health of this market for some time to come.
Also, as you know, on the wastewater side of the cycle, that historically has grown mid-single digits over a long period of time, just given the nature and the criticality of what the utilities are dealing with there and very hard for them to kick can down the road and neglect spending. So we see that continuing for a long time.
On the clean water side of the market, that can be a little bit lumpier. That's where the utilities can tend to defer projects and spending. We're not seeing that right now because we are continuing to see this heavy conversion towards AMI on metrology and the communications and Software as a Service offering that backs that up. So we still feel that we're in a prolonged healthy cycle here.
Okay. Then on price cost, looking at your overall slide there, you have price up 100 basis points, cost up 300 basis points, and then your productivity restructuring bucket up 300 basis points. If I just look at price cost, your 200 basis points difference there, is it your intention really to neutralize cost with price and productivity? Is there an opportunity to be going a little more aggressively off the price here? I mean, I don't view 100 basis points of price increase in this environment as being particularly aggressive. Is there potential for you to see some margin expansion from maybe being a little more aggressive on price here or do you need to balance that with competitive dynamics?
Yes. So, I'll share a few words here, and then I'd – Mark – like to have Mark jump in here. So we – as we indicated in our commentary, we have just gone back out, again, with another round of price increases across the businesses and, I would say, that will be globally. But I would say we're probably playing a little bit of catch-up in Europe where, again, the whole inflation discussion hasn't been as prominent across Europe. But we believe there's an equal opportunity there to be aggressive on price, so we plan to do so. But – so yeah, we do think we're going to be able to narrow some of that gap, but – Mark, you want to jump in?
Yeah. No. I – Nate, we definitely would agree with that view in terms of the ability to be more aggressive on price, particularly, as you mentioned, we saw a ramp up in terms of the material component of that. That's really what drove the quarter sequential increase, and a lot of it was material; a little bit of freight as well. But when we think about the model, it is really important for us to continue to drive productivity around procurement, but also Lean Six Sigma, continuous improvement. But we need to and we can do a better job in terms of margin expansion by offsetting material cost increases with more price, no doubt.
And we're encouraged, Nate, by the moves that we've seen our competitors make to follow us on price. I'd be more concerned if they weren't. But we have acted like the leader, and we'll continue to act like the leader; and presumably, they will follow as well.
Does the amount of inflation you've seen in the system over the last year or two, and potentially going forward here, have any impact on your 17% to 18% operating margin targets in 2020?
No impact.
Yeah...
Okay.
...just because – Nate, on that, our original assumption when we looked at – when we laid out our target was zero-price, okay? So, yes – and we did expect higher levels of inflation. That's ticked up, certainly, a little bit more material, but we are – that's the whole point about driving harder on price to offset that.
That's very helpful. Thanks very much.
Thank you.
Thank you. Your next question comes from Scott Graham of BMO Capital Markets. And Scott, your line is open.
Hi. Can you hear me now?
Yes, we can.
Yes, Scott.
I'm sorry. I had myself muted, of course. Good morning.
How are you?
Good morning.
Nathan asked a couple of my questions, so I'm going to follow up with a couple different ones. I was just kind of wondering – I know your resi business is not that large, but I was just kind of wondering what you were seeing trend-wise, really, as recently as possible with rates higher and some of these housing-related stocks showing like zero resilience (39:08) and a lot of numbers coming down. Could you talk about, from your perspective, where you see your residential business really both now and like over the next, let's say, six months, if you would?
Sure. Yeah. So, Scott, our resi business is really much more of a replacement business, and so we're not really exposed too much or relying too much on resi expansion because of the installed base we have there. So we've historically called that to be a low-single-digit growth. It bounces around if you get a pop here or there in terms of a distributor buy-in or something of that sort, but we're still calling it for low-single digits and don't see any kind of real snap in that trajectory.
Okay. But nothing has materially changed in the last couple of months with higher rates, from what you see?
No, not that we've seen; and that's the same in discussion with our distributors.
Yeah. Thank you. The next question really is about some of the things that you're doing in industrial, which we've talked about recently. I was just maybe wondering if you could kind of tell us, on the industrial water side, maybe the two or three big opportunities that you're pursuing right now.
Are you – you mean from a commercial standpoint, Scott?
I'm sorry. Yes, commercial, in the commercial line, yes please.
Yeah. So I'd say, again there, one of the benefits we've gotten this year and, certainly, last year was some of the revenue synergies that we've gotten from having finalized the integration of our commercial team in the Americas. That was the last region to come together and act as one integrated commercial team. We'd already done that in Europe and had done that in Emerging Markets. And we're seeing a sizable amount of revenue synergies there across all of the Americas commercial team, and certainly a meaningful piece of that is in the industrial space.
I would say, secondly, you have also seen that we are getting the benefits of some of our NPD pipeline and new product that we've launched in the marketplace, and have a number of those that are scheduled here for the fourth quarter and Q1 of next year that we think is going to help us continue to gain some share there.
I would say we're seeing some more industrial treatment opportunities as well as we grow our Wedeco offering because of some of this integration together.
Got it. And if I can just sneak in a third – a final one here and it's a piggyback on the prior question. Are you in a position to give us what you think will be the pricing exit rate for fourth quarter?
Yeah. We're not going to try to predict that. A lot of it is a function of negotiations and ultimate realization. What I would tell you, Scott, is that we've got good acceleration. And just to give you the ramp in the quarter and as a reminder, we got 20 basis points in Q1, 60 basis points in Q2, and then in July ramped up to 80 basis points. We were at 100 basis points in August, 110 basis points in September. So, we've got good momentum moving into the fourth quarter. But it is a function of not just the price increases, but also what you realize; but, we feel that there's good momentum there.
That's hugely helpful. Thank you.
Okay. You're welcome.
Thank you. Your next question comes from Joe Giordano with Cowen.
Hey, guys. Good morning.
Good morning, Joe.
And you kind of touched on this already, but like in your 2020 bridge, I mean, there's obviously a lot built in on sourcing and that part of the business. And if we kind of extrapolate what's happening now, forward a couple of years and we talk about an inflationary environment, like what's your confidence that prices – is it just prices you offset or are there other areas that you target to kind of offset that impact?
Yeah. So, Joe, the – so certainly, price is a big piece of this and we're going to continue to be driving hard on that, but it's not the only lever that we're focusing on. So we do still have – obviously, we're benefiting in the procurement space from higher volumes, so we get more volume leverage there in terms of our purchasing power negotiation. Two, we're also doing a lot of work right now in what we call value optimized design. Some people call it VAVE, but value optimized design is really about taking products that are a little bit longer in the tooth in terms of age, maybe slower growth rates, margins that may be challenged. We don't have a lot of those in the portfolio, but those that we do, we're doing a lot of work to redesign those products to spur the growth rate and improve the margins; and, we see that being a substantial contributor to our margin expansion from a gross margin standpoint.
And then, of course, the third lever that we've talked about is the introduction of Global Business Services, which we're in the early phases of right now. That really is about simplifying our back office and a number of those functions. We're working with Cognizant as our outside partner, and we don't really expect those benefits to start ramping in until 2019 and 2020. And that's predominantly going to be hitting the G&A line where we still – we think we're still about 200 basis points, at least, above where we need and can be at the end of that GBS implementation.
Okay. That's fair. And then, can you give us a little bit more color on the electronics tightness for Sensus? Has that mitigated a little bit over the last couple of months, or is that accelerating, and what kind of – are you buying, double ordering to kind of take care of that? How are you guys dealing with it?
Yeah, Joe, it's Mark. Yeah. This has been a challenge for us throughout the course of the year. The team has been managing it extremely well. We do benefit from having a really good partner in terms of contract manufacturer that brings their scale to the play. But nevertheless, the demand for these components has continued to increase. And what we've done is, really, we tried to get out ahead of it where we can in terms of bringing on inventory to make sure we have enough to meet our demand. But also, where we need to, we get more aggressive on price so we can get more of our fair share of those components in. And that's really what you saw in the third quarter with that ramp up in inflation in M&CS.
And I think, Joe, that really the only reason we highlighted it in our commentary was really just the impact it had on the Measurement & Control Solutions margin, which was 70 basis points. It's not really significant overall Xylem. But as we're going through segment-by-segment commentary, we felt the need to kind of call that out. It's not that we're downplaying them. The teams are all over this. And as Mark commented, we have a great contract manufacturing partner that's able to really leverage their scale to make sure we get access to supply. So the teams continue to work it. We're having to pay a little extra to get it, but we're going hard on the price angle in other areas to offset.
And then, last from me, we're starting to see some, at least on the public side, valuations come in. As you look at your balance sheet and you've already kind of delineated key areas that you look for more strategic deployment, how the – are you guys sharpening pencils a little bit here, or are you getting a little bit more aggressive with wanting to deploy as valuations come down?
I think – I mean, certainly, Joe, to your point, I mean, we do have a really attractive, healthy pipeline. And so, we will continue to deploy capital on what we think is a great pipeline of assets. Certainly, we keep an eye on valuations that are out there, whether it be public or privately held. But I wouldn't foreshadow anything here in the near-term that we're going to go jump on something just because of valuations being where they are.
While valuations matter, of course, there's also the discussions around what cost of capital is. And we always take a long-term view on cost of capital as opposed to where it may be at any point in the cycle. So we're going to continue to be disciplined on how we evaluate these opportunities, and evaluate and monitor.
Great. Thanks.
Thank you.
And your next question is from John Walsh of Credit Suisse.
Hi. Good morning.
Good morning, John.
Hey, John.
Hey, wondering – piggybacking off that question, you're going to pay down some short-term debt here. You're going to generate a lot of cash Q4 and into next year. Can you level set us on what your actual capacity is remaining within an investment grade credit rating as you see it today?
Yeah, John, I mean, it definitely will ramp up as we move through the fourth quarter, which is a big cash flow quarter for us. And part of it is a function of how much EBITDA you're acquiring and what you're ultimately paying. Right now, we're at about 3 times leverage. That will continue to decline into 2019. And part of it is a function of maintaining our investment grade rating. But as we've done in the past, we can lever up a little bit more with the clear confidence that we're going to be able to pay this down and get back into our target range. So, we are going to be building more – certainly more firepower as we move into the third – fourth quarter this year and into 2019.
And I think, to Mark's point on leverage with the rating agencies, I think we've – the team's done a great job in building a lot of credibility with the agencies. So, we've got more leverage there probably than we would have had in the past just because we've demonstrated that we've acquired high-quality businesses with great cash flow profile and paid things down faster than what we've committed to the agencies.
Got you. Understood. And then, maybe just a quick follow-up here, can you maybe just size the specific U.S. municipal business for us, and then if you're seeing any impact from at least discussions in the market around the Water Infrastructure bill? I mean, obviously it's a positive, but a lot of that stuff does get funded more at the state and local level, but it seems like it would at least be a tailwind relative to something not being done in Washington.
Yeah. So our rough exposure there would be about, just roughly, $1.5 billion of revenue. And again, as I mentioned earlier, I mean, we just continue to see broad-based health there. As I mentioned earlier, historically, our biggest exposures had been on the wastewater side. And then, of course, when we acquired Sensus, and now Pure, we've kind of leveled that out now where we're about half exposed to wastewater, about half exposed to what we call the clean drinking water distribution network.
And we're seeing – and then, within those pieces on the wastewater side, about 70% of that spending is OpEx versus CapEx. And because we've got such a large installed base there, we tend to benefit in a rising tide in terms of share gain on break and fix and repair and replacement side, which we're certainly seeing right now. And we're seeing that we're still in a healthy space on the CapEx side of the equation as well.
Great. Thank you.
Okay. Thank you.
Thank you. Your next question is from Brian Lee of Goldman Sachs.
Hey, guys. Good morning.
Good morning, Brian.
Good morning, Brian.
Yes. First off, the 30% order growth, I think that's the best we've seen in MCS since you bought Sensus and it sounds like it's in North American watering, which is encouraging. Can you give us some sense of how broad-based the order strength was and if it's tied to just a few large projects, or just how we should be thinking about the sustainability here?
Yeah. It was pretty broad based. And we see that the market in that business continuing to grow in about the mid-single digits in terms of overall spend. So certainly, there were a couple of projects that helped pop that number, but the growth was pretty broad-based both in terms of product line, but also geographically.
And within our advanced infrastructure analytics business as well, while it's a smaller piece of the segment, that was almost 30% orders growth in the quarter as well.
Okay. Great. No, that's helpful. I guess, a follow-up question, just shifting gears a little bit to the commercial end market, I felt like that was maybe one of the bigger changes here in terms of directional trend positive. Where are you seeing most of that strength coming from? And then, can you guys kind of speak to where you think we are in terms of the cycle for that end market relative to some of your bigger end markets, like utilities and industrial?
Yeah, Brian. Yeah, we had two regions where we saw really strong growth. One was in the U.S. where we had kind of been talking about this. If you go back a year or so, we had tremendous amount of activity in our pipeline and there were a lot of projects that we were bidding on and they weren't getting released. Well, they're starting to get released. And we saw that, particularly, in the institutional building segment in the U.S. It was really, really strong and we think there's some room to run there. And then, the other driver of that growth was in China with a number of key customers where we had very, very strong growth; but very, very good growth in price, some room to run in the U.S. for sure.
Yeah. So I would just offer a couple of notes here. One, we've guided up to high-single digit for the full year just based upon where we are cumulative through the third quarter and what we expect for, certainly, the fourth quarter. I think our view on what that growth outlook looks like over the 2020 planning timeframe really remains unchanged. I'd say it likely moderates back down to kind of mid-single-digit level, so I wouldn't get too attached to that high-single digit running forever.
Having said that, just to punctuate, in China, one of the team – one of the things our team over there did as a great reaction to the downturn a few years ago was to diversify in terms of across a broader customer set, and that broader key account approach is certainly paying dividends now in that growth rate where Asia Pac was up 40% in the quarter from a revenue standpoint.
Okay. Great. Thanks, guys.
Thank you.
Thank you. Your next question is from Walter Liptak with Seaport Global.
Hi. Thanks. Good morning, guys.
Good morning, Walter.
Hey, Walter.
I wanted to ask about the weather, and there were a couple of big storms in the quarter. I wonder if there was any impact from that. And then, in the fourth quarter, any projects that are building in the pipeline because of any storm-related damage?
Yeah. We haven't seen – we got a little bit of a benefit in the quarter and a little bit here in Q4. But I think overall, the team's estimating it gets probably around $1.5 million, maybe $2 million on the high end of revenue. I mean, it's high-calorie revenue, but not a big bottom line impact. Part of that is just the nature of these storms and where they occur. And so, where there tends to be natural runoff, the dewatering applications are not as critical as it was, perhaps, maybe in Sandy, where we really were involved in dewatering and de-flooding a lot of underground infrastructure. We are – we will see some benefit in the quarter that we've built into our outlook as there is some repair of utility infrastructure in certain areas, but we don't expect that to be a big number for us in the quarter.
Okay. All right. Great. And then, just on the bucket with purchase accounting and strategic investment, I just wanted to ask about the purchase accounting. When do we clear those from the comps – from the income statement? And the strategic investment, it looks like most of that's in M&C. Is that an ongoing offset to the profit improvement? How should we (56:40)?
Yeah, Walter. So on the purchase accounting, that's – it's really a function of largely Pure. There have been a couple of smaller deals that we've done, but as we anniversary that, really beginning of the first quarter of next year, that goes away.
And the investments, it was – we've been investing both in terms of building out capability to support some of these international deals, both some technical as well as commercial, but also taking advantage of first-mover in our AIA platform, both in terms of commercial resources, but support on the ground, too, to deliver these projects.
So, we expect the investments to continue, certainly, probably through mid-2019. And that's a combination of, again, building the platform and capabilities around the new analytics platform with the acquisition of Pure and the other smaller deals that we've done, but also investing in these large international deals from a business development standpoint.
The thing about those deals is they're likely going to have decisions on them sometime in mid to, probably, mid- to late-2019. And so, those are binary outcomes. If you win them, then it more than pays for the investments you made. And if you don't win them, you stop investing in the deal. So, we expect that to really be a bit of a cliff in the middle part of next year.
Okay. Got it. All right. Thank you.
Thank you.
Thank you. Your next question is from Pavel Molchanov of Raymond James.
Thanks for taking the question.
Sure.
On the M&A front, we've seen a very wide range of buyers in the market for water tech deals, everything from private equity to large strategics, to kind of smaller strategics. And I'm curious, as one of the most active consolidators, what are you seeing on valuations and how has the competitive landscape from the buy-side perspective changed in your view, maybe, over the last 12 months?
Sure. Yeah. There's certainly been some uptick in valuation expectations on the part of the potential sellers. I think that for the most part, we've seen people be fairly disciplined in terms of what they ultimately are purchasing something for. We certainly are going to be disciplined. We tend – other than any of the things that you see on the public side, we tend to cultivate a lot of opportunities that are privately owned, either family owned or they're owned by PE. We tend to focus on those areas where we know that we're going to have a lot of very natural high-competence cost synergies and as well, obviously, revenue synergies that we don't build into our model for valuation. We only count on the cost synergies.
And as a result of that, we tend to cultivate these relationships over a very long timeframe and try to take them off the market without them becoming competitive along the way. So we're not always successful in doing that, but I'm very proud of our M&A and corporate development team here in terms of how disciplined and well-connected they are.
Thanks. That's helpful. And then, just a quick one on tariffs. Are all of the tariff-related headwinds in the value chain kind of incorporated into what Q3 was like in terms of margin, or do you think there is more impact that has yet to be felt?
Yeah. So we think we have it pretty well reflected in our Q3 results and what the outlook is for Q4. To put it in perspective, we had a modest impact in Q3 of about $5 million, both on the direct and the indirect impacts of tariffs. We think that it might increase modestly going forward, but not meaningful. The teams continue to be on top of it. We're, again, focusing on the execution on the productivity side.
We talked about price realization. But also, I think one of the things that many investors are now beginning to probably understand that's a bit unique about us is the impact of our product localization strategy, which we started really about four years or so ago. Whenever I certainly joined, there was some work already happening on that front, but we've really ramped that up. That helps mitigate a lot of the pressure here, because it's not just localization in the Emerging Markets. We import very little of our product offerings into the U.S. from, say, China. We have one small business line that we do, and we're dealing with that in our supply chain right now in terms of mitigating that.
But then, even within China and the trade market concerns there really doesn't have much, if any, impact on our business because the largest portion of our revenue there, 90%-plus, is localized. And so, again, we tend to talk about localization from a cost management and getting the right things fit for purpose in a market for growth, but what we're really seeing now is the benefits, when you're in this kind of trade environment, that it does help tremendously to be localized.
And we have some good flexibility in our supply chain, too, both through our contract manufacturer as well as some of our own capacity to make some of those changes where that's – where we need to.
Thank you very much.
Thank you.
Thank you. Our final question is coming from Andrew Buscaglia of Berenberg. Andrew, your line is open.
Sorry about that. Thanks for taking my question, guys.
Sure.
So I just wanted to touch on – so your orders in your Water Infrastructure segment were up double digits and you commented on the decline in – a 1% decline for orders. What is the – can you just dig in to that a little bit more? I know you mentioned there was a delay or something like that into the next quarter, but just give us some more details around that.
I missed the first part of your question. Was the first part of the question you're reconciling the revenue growth versus the order growth?
You say your backlog in Water Infrastructure is up double digits...
Okay.
...and orders declined about a percent.
Sure. Yeah. Like I said before, it was just simply timing of a few large projects that if you would have – if we would have had those in Q3, it would have taken us from being down a point to being up about 5% to 6% in orders. Year-to-date, we are up 6% in order growth there. So, the backlog itself, that's really a function of the lead times on some of these projects and when they convert into hard form orders.
Okay. Okay. Then – yeah, I hate to belabor the point on these tariffs and impacts on inflationary costs, but a competitor of yours in the Water Infrastructure segment is seeing supply chain disruptions really influenced by tariffs. Indirectly – it doesn't seem like you guys have changed your view much at all from last quarter regarding this, but indirectly, though, why wouldn't you guys see an impact, but some of your peers are?
Well, I think, again – I think, predominantly is the fact that we're localized. We're much more localized than many of our competitive peers are in terms of the percent of our revenue that is coming from cross-border movement. And I think, secondly, it is the benefits of scale and depending upon which channel you're talking about and which product lines that we're referring to.
So, look, we don't take it lightly. We're just sticking with the facts here in terms of what we see. And I think it's also – again, not knowing, particularly, which competitor you may be referring to, we've also seen the benefits here of having created this global procurement team that we didn't have in place up until about three and a half, four years ago. And a lot of work they're doing is managing these impacts by leveraging our scale, but also working very close with our commercial teams on what are the supply chain management moves that we can make to better optimize our manufacturing network.
We've got adequate capacity there and they're moving these things on a regular basis to get ahead of it. They're also the ones that are working heavily with our legal teams on trying to get exceptions, depending upon the categories that are being laid out. So, it's a multi-prong effort.
Okay. All right. Thanks, guys.
Thank you.
Thank you. I'll now turn the floor back over to Patrick for any additional or closing remarks.
Well, great. Thank you very much. Appreciate you all hanging on to the call with us. Appreciate your continued support and interest. Safe travels, happy holidays and we'll be back in touch with you in our next earnings call. Thank you.
Thank you. This does conclude today's conference call. You may now disconnect.