Categories Earnings Call Transcripts, Industrials

Xylem Inc (NYSE: XYL) Q1 2020 Earnings Call Transcript

XYL Earnings Call - Final Transcript

Xylem Inc (XYL) Q1 2020 earnings call dated May 05, 2020

Corporate Participants:

Matt Latino — Senior Director, Investor Relation

Patrick Decker — President and Chief Executive Officer

Mark Rajkowski — President and Chief Executive Officer

Anthony Milando — Senior Vice President and Chief Supply Chain Officer

Analysts:

Scott Davis — Melius Research — Analyst

Deane Dray — RBC Capital Markets — Analyst

Ryan Connors — Boenning and Scattergood — Analyst

Nathan Jones — Stifel — Analyst

Mike Halloran — Baird — Analyst

Robert — Cowen — Analyst

Saree Boroditsky — Jefferies — Analyst

Andy Kaplowitz — Citi — Analyst

Pavel Molchanov — Raymond James — Analyst

Presentation:

Operator

Good morning and welcome to the Xylem First Quarter 2020 Earnings Conference Call. [Operator Instructions]

I would now like to turn the call over to Matt Latino, Vice President of Investor Relations. Please go ahead.

Matt Latino — Senior Director, Investor Relation

Thank you, Christie. Good morning, everyone, and welcome to Xylem’s first quarter earnings conference call. With me today are Chief Executive Officer, Patrick Decker; Chief Financial Officer, Mark Rajkowski; and Chief Supply Chain Officer, Tony Milando. They will provide their perspective on Xylem’s first quarter results and our outlook. Following our prepared remarks, we will address questions related to the information covered on the call. [Operator Instructions]

As a reminder, this call and our webcast are accompanied by a slide presentation available in the Investors section of our website at www.xylem.com. A replay of today’s call will be available until midnight on June 6. Please note the replay number is (800) 585-8367, and the confirmation code is 60336487. Additionally, the call will be available for playback via the Investors section of our website under the heading Investor Events. Please turn to slide two. We will make some forward-looking statements on today’s call, including references to future events or developments that we anticipate will or may occur in the future.

These statements are subject to future risks and uncertainties such as those factors described in Xylem’s most recent annual report on Form 10-K and in subsequent reports filed with the SEC, including in Form 10-Q to report results for the period ending March 31, 2020. 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 three. We 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 four, and I will turn the call over to Patrick Decker.

Patrick Decker — President and Chief Executive Officer

Thanks, Matt. Good morning, everyone. Let me start by expressing my sincere hope that you and those close to you are keeping safe and well. Predictably, this earnings call is going to be different than normal. The full team is not here with us. It’s only Matt, Mark and I that are together. And we’re spread rather distantly around a big room. Given the times we’re in, we’re going to keep our prepared remarks brief as it’s especially important we leave more of the call for Q&A. I’ll start by sharing how we’ve guided our COVID-19 response around the world. As you know, we felt the impact of the outbreak early given our sizable business in China. Our anticipation of that impact, in isolation, turned out to be just about right, and our business there has recovered strongly.

Having said that, as the impacts spread across Europe and then the U.S., we saw steeper declines in revenue than we expected, so we moved early to reduce spending and are now finalizing further structural cost actions. We’re privileged to serve markets in which our products and technologies are vital to the continuity of essential services. And having entered this period in a very strong financial position, we’ve been able to maintain and even further enhance our liquidity since then. So looking ahead, economic conditions are evolving too quickly to forecast demand in the near term, so we consider it premature to reset guidance just now. We will, however, share what we’re seeing in our end markets and offer more detail about our outlook.

We’ll address how we see the marketplace responding to the pandemic, including a notable flight to quality. And we’ll share how we’re using that to shape our investments as certain trends accelerate across the sector. In particular, we see COVID-19 shifting how our customers are thinking about sustaining their essential services, and that provides an opportunity to shape both our cost structure and our investment priorities to emerge in a strong position on the other side of the pandemic. Before we get into the results, it’s important to provide some insight into how we’ve responded to the spread of COVID-19. I want to begin by expressing how deeply humbling it is to watch frontline utility operators all around the world step up to serve their communities. They are delivering essential services in extremely difficult circumstances.

I’m also very proud of the Xylem team’s response supporting these folks. When COVID-19 emerged in Wuhan, China, our team activated our business continuity plan. The first priority was to provide for the safety and well-being of our frontline colleagues, our customers and our partners. We then quickly moved to understand our customers’ most urgent needs. It was clear that water, sanitation and hygiene were going to be essential to combating the spread of the disease. So we shored up our supply chains, and we got critical equipment into our customers’ hands so they could keep essential services flowing. We then acted to protect our financial and competitive position. With the China team’s response underway, we activated our corporate pandemic plan to coordinate actions around the world. We put Tony Milando, our Chief Supply Chain Officer, in charge of the global response effort. Tony is with us on the call today to answer any specific questions you may have about that response.

As COVID-19 spread beyond the initial outbreak to major supply hubs like Italy and Germany, and then we dealt with lockdowns across the U.S., India and elsewhere, we applied those same principles modeled first in China. We also significantly reduced our spending, both in the areas of opex and capex. And we put in place a package of employee support to underpin the well-being of our workforce and to make sure they could focus on serving our customers’ mission-critical work. Before passing to Mark to talk about Q1, I also want to mention how rewarding it’s been to partner with our customers to help communities around the world. Through Xylem Watermark, our corporate citizenship program, our employees have found ways, both large and small, to support the sustainability of our communities, working side by side with our customers and our channel partners. And I am so proud of all of them.

Now with that, I’m going to hand it over to Mark to provide detail on the first quarter.

Mark Rajkowski — President and Chief Executive Officer

Thanks, Patrick. Please turn to slide six. First, I’d like to give a big shout-out to our incredible teams working tirelessly to support our customers, whether working remotely, in our factories or in the field. Thanks to all of you. Now let’s turn to first quarter results. Organic revenues declined 8% in the quarter. Of that, we believe COVID-19 ultimately had about a 5% impact on organic revenue growth for the quarter. The market softness we anticipated played out largely as expected until mid-March when we saw a sudden and broad impact as the pandemic spread from China to Europe and North America.

From an end-market perspective, industrial, commercial and residential markets each declined double digits, driven somewhat by expected underlying market softness, but more significantly by the impact of COVID-19 as factories, supply chains and customer operations were subject to shutdowns around the world. Utilities end market declined 5% as some project work was delayed, but operations and maintenance spending remained relatively steady. Geographically, all major regions declined in the quarter. Western Europe fared relatively well with growth in several countries in the first two months of the quarter. Emerging markets declined double digits, including a 35% year-over-year decline in China due to mandatory shutdowns. The U.S. was down 7% on broad weakness, with utilities showing the most resilience.

Overall, orders were down 2% with growth in utilities, offset by declines in the other end markets. However, excluding the estimated impact of the spreading pandemic, orders for the company would have grown low single digits in the quarter. Operating margins declined to 6.2% driven mainly by COVID-19-related volume impacts and a warranty charge in the Measurement & Control Solutions segment, which I’ll discuss shortly. Earnings per share was $0.23. This includes roughly $0.09 of impact from the pandemic and $0.07 from the warranty charge. Please turn to slide seven, and I’ll review Q1 results by segment. Water Infrastructure orders in the first quarter were down 1% organically versus last year.

We saw orders growth in utilities markets more than offset by declines in the industrial side of the business. Organic revenues declined 7% in the quarter. The utilities end market was down 4% organically, while industrial was down double digits, led by a 13% decline in dewatering, driven by volume declines in the oil and gas, construction and mining verticals. We consider the Water Infrastructure segment to be a proxy for the wastewater portion of the business, with exposure to sewer collection networks and treatment processes. Historically, we’ve seen most utilities protect their operations and maintenance spending budgets during downturns, and we expect this behavior to continue.

Please turn to slide eight. The Applied Water segment had 5% organic orders decline despite very steady quote activity during the quarter. We’re monitoring this metric very closely with our channel partners as well as order cancellations and project delivery delays. And while we haven’t experienced any order cancellations, we are seeing some delays in project activity as our customers were impacted by construction site closures and distancing mandates. Organic revenue declined 10% as the short-cycle softness we had expected in our industrial and commercial end markets was exacerbated by the significant impact of project delays and construction site closures driven by COVID-19, most notably in China, which was down over 50% versus last year.

Despite the significant impact of lower volumes and absorption from temporary factory closures on operating margins, the team was largely able to offset these impacts with an impressive 460 basis points of productivity and cost savings. Now please turn to slide nine. Measurement & Control Solutions segment revenues were down 7% organically in the quarter, primarily driven by the effects of the pandemic, including water project deployment delays and the impact from supply chain disruptions in our test business. Lower meter replacement demand was also affected beginning in March as physical distancing requirements are impacting utilities’ ability and capacity to perform this work.

Orders within the segment declined 3% organically, along with some softness in our recurring meter replacement revenue. We’re also beginning to see some utilities choose to postpone project bidding or delay issuing decisions on project awards. We’re keeping in close communication with our utility customers and channel partners to understand their operational challenges so we can best support them and effectively manage our supply chain. Segment margins in the quarter were significantly impacted by a $15 million warranty charge. This relates to a specific firmware issue and is contained to a limited number of our North American water customers.

The issue was quickly identified and is now being addressed in partnership with our customers. This charge impacted segment operating margins by roughly 430 basis points in the quarter. The impacts from COVID-19 related to lower demand and the availability of key components was approximately 110 basis points in the quarter. Now please turn to slide 10 for a discussion on the company’s financial position liquidity. We closed the quarter with a cash balance of $739 million. During the quarter, we invested $51 million in capex for critical projects, and we returned $108 million to shareholders through dividends and share repurchases to manage dilution. Our free cash flow performance in the quarter was impacted by lower net income and a higher use of cash for working capital.

While working capital as a percentage of sales improved 70 basis points over the first quarter of 2019, cash used for working capital in the first quarter this year reflects both the timing of accounts payable as well as higher inventories due to lower-than-expected sales. We remain laser-focused on cash flow performance and are tracking cash flows and working capital daily. That said, we do expect increases in past due receivables as we support key customers and channel partners through this period. We continue to have a strong liquidity position with approximately $1.7 billion available. In this past week, we signed two bilateral loan agreements, providing $160 million of borrowing capacity at attractive rates. We’re confident that our strong financial position, our liquidity and focus on cash flow will enable us to effectively manage through this crisis and support the critical investments needed to enable our long-term profitable growth.

And with that, I’ll hand it back to Patrick.

Patrick Decker — President and Chief Executive Officer

Thanks, Mark. Clearly, the impact of the pandemic is continuing, so we are being appropriately cautious, but we’re also in a very strong position. We entered this period on firm foundations, and we are differentiated in ways that position us to outperform over the medium and long term. We have a proven and durable business model that sits at the heart of essential services and critical infrastructure. And we’ve shown the strength of our supply chain to keep customers served. Our market-leading portfolio of technologies positions us well, both with customers and relative to competitors. And our financial strength enables us to deploy capital through the cycle to further differentiate our portfolio in markets that will provide sustainable growth.

Our geographic breadth provides an intrinsic hedge and exposes us to the markets that will recover earliest and the strongest. And we’re privileged to have long-standing relationships with our customers, built on the platform of brands they have trusted for decades. So while everyone is subject to the same unknowns about the pandemic and the economy, we’re very well situated to benefit from the market’s flight to quality and to emerge in an even stronger competitive position. So let’s look ahead. Our customers are already telling us what will be important to them on the other side of this pandemic. Let me take a few moments to share what we’re hearing in our end markets and how we’ll be helping enhance our customers’ resilience.

With our utility customers, the impacts will likely be somewhat different for opex and capex spending. We expect the majority of utility operators’ opex spending to be quite resilient in the short term as they focus on mission-critical applications and maintaining their operational continuity. We’re actually seeing increased opportunity because of their operational pressures. The leaders I speak to say their single biggest COVID-19 challenge is addressing their labor impacts. Whether actual infections or quarantines, they struggle to keep their frontline operators in the field. Conventional modes of working have shown cracks under the strain on their networks and workforce, creating an imperative to be more resilient.

As a result of that, we’re seeing new inquiries about remote sensing and automated operations, anything that helps utilities keep delivering essential services even when their networks are put under additional operational and financial pressure. On the capex side, we expect spending to hold up as it did in the period after the global financial crisis of ’08 and ’09. That view is also supported by the multiyear capex funding mechanisms that utilities can access and the government commitments to continued investment that we’re seeing in a number of countries. For that reason, we’re not seeing many project cancellations. We are seeing some projects being delayed momentarily, and that’s likely to lead to a slowing in our order conversion rate in the near term.

Also Read:  KeyCorp (NYSE: KEY) Q4 2019 Earnings Call Transcript

Turning to industrial, commercial and residential. We do expect to see a greater impact from slowed economy. So long as industrial sites are closed, we will see impacts on demand. And specific verticals like marine and beverage dispensing are likely to continue to remain soft as long as stay-at-home orders are in place. Anticipating questions about the specific impact of the depressed oil and gas market, it is worth mentioning that oil and gas activity is less than 2% of our total revenue. Overall, we will expect to see an industrial recovery in line with the broader economy.

Lastly, in commercial, the short term is going to continue to see construction crews off the job or reduced, especially in COVID-19 hotspots, which will limit site activity and delivery of equipment. For now, our backlog remains strong, and we are not seeing cancellations, but we are monitoring quote-to-order conversion very closely. With all that said, we anticipate organic revenues will slow further in the second quarter. Even with China showing early signs of recovery and our factories now operating at near-normal levels, we don’t anticipate a quick global bounce-back.

Given the economic outlook, we expect to see organic revenue declines in the second quarter in the range of 20% to 30%, and we are estimating decremental margins at roughly 50%. That factors in the incremental costs related to our temporary COVID-19 workforce support pay, which are funded by overhead cost reductions. On cost, as it became clear that COVID-19 would have business impacts beyond China, we quickly reduced opex and capex spending by roughly $100 million for the year. We are now also reducing compensation for myself and the senior leadership team on a temporary basis. We will shortly be implementing more permanent structural cost actions.

This will enable our competitiveness in any scenario by applying three principles. First, we’re simplifying our cost structure to be aligned with post-pandemic ways of working, which includes accelerating the reduction of our overhead cost. Second, we’re addressing our business models in the markets most affected by the impacts of COVID-19. And lastly, we’re prioritizing our investments based upon the customer needs that will most likely emerge from the pandemic, and we are reinforcing our position as a water technology leader.

On that last point, as I mentioned above, it is already clear that our customers’ needs will be different coming out of the pandemic. They will be adapting to new operational pressures, and they will have new ways of working. As a technology leader, we bring the tools of adaptation, the solutions that will make our customers more resilient right away and for the future. So our plans prioritize the investments that will reinforce our competitiveness by focusing on the areas where customers will need us most as they adapt through this challenging period and on the other side.

In summary, there’s a reasonable view that in tough times, critical infrastructure is a good business to be in. I would actually rather say it’s a privilege to work in the water sector. Our customers have shown extraordinary resolve in delivering essential services in a time of need. Whether in good times or bad, solving water and natural resource challenges is work that always matters. It’s just now, however, it’s also work at the heart of the world’s public health defense network. The same strengths that give customers confidence in Xylem as their partner in that work also drive our medium- and long-term investment thesis. Our leading market positions, our depth of installed base and our differentiated portfolio underpin our ability to drive sustainable and profitable growth.

Our disciplined delivery and execution enables us to drive sustainable margin expansion. Our financial strength, which customers depend on, especially in difficult times, relies on our robust balance sheet and demonstrated cash flow. Our innovation and anticipating customers’ challenges is underpinned by investment in R&D and capital deployment to further strengthen our portfolio. And lastly, our commitment to create value for all our stakeholders underpins the sustainability of this company, our customers and our communities. With that, I’d like to open up to questions. And just a quick reminder again that in addition to Matt and Mark, we also have Tony Milando on the line as Tony has been leading our COVID-19 response team, and he can provide more color on those specifics.

Operator, let’s open it up for Q&A.

Questions and Answers:

Operator

[Operator Instructions] Your first question is coming from Scott Davis of Melius Research.

Scott Davis — Melius Research — Analyst

Hi, good morning guys.

Patrick Decker — President and Chief Executive Officer

Hey, good morning Scott hope you’re.

Scott Davis — Melius Research — Analyst

Well, thank you. There’s a lot in here, Patrick, and a rough outlook you provided. But maybe we could start off with just the decrementals, the 50%, not a surprise in the short term. But would you expect that to moderate down once you get to 3Q, 4Q? And any best guess of what it might moderate down to?

Patrick Decker — President and Chief Executive Officer

Yes. So I’ll take it first, Scott. Yes, we definitely expect the decrementals to moderate over the course of the back half of the year. Part of the abruptness here in Q2 is the temporary support pay that we’ve got for our folks and some of our communities and customer support. We do expect that will moderate as things return back to some semblance of normalcy. Two, it’s also a mix of business within the quarter that we see. And then third, we’ll have the benefit of the overhead cost reductions that we’re implementing, both temporary right now, but also the permanent structural reductions.

In terms of what it will moderate to, that’s yet to be determined. Although, historically, we’ve talked about decremental margins somewhere more in that 35% kind of range over time. But we won’t see that until more likely the second half of the year.

Mark Rajkowski — President and Chief Executive Officer

Yes. I think in Q2, what we’re seeing, based upon order trends and what we’re hearing from customers, the businesses that are being impacted, unfortunately, are some of the richest in terms of margin profile. So dewatering, for example, is certainly at the top of that list in terms of margins and year-over-year impact. And we’re seeing some of the same in our test business, which is very rich margins, as well as in the North American water side of the business for M&CS. So all of those are very rich in terms of the margin mix. But to Patrick’s point, as what it looks like going forward is a function of that mix volumes, but also, we will see benefit on the cost side that will be reflected.

Scott Davis — Melius Research — Analyst

Okay. That’s helpful. And then since we got Tony on the line, you commented, I think either Patrick or Mark, you commented on the supply chain disruptions and test. What was that specifically? Maybe a little bit of color there?

Patrick Decker — President and Chief Executive Officer

Thank you, Scott. Tony, you on?

Anthony Milando — Senior Vice President and Chief Supply Chain Officer

I am on. Are we talking about the supply chain disruption as a result of the warranty issue? Or just overall the [Indecipherable]

Patrick Decker — President and Chief Executive Officer

No, no, no. Specifically for analytics test. So that was let me just hit the I mean, there were a number of components coming in from China. Tony, maybe you can give a little bit more color.

Anthony Milando — Senior Vice President and Chief Supply Chain Officer

Yes. Sure. Yes, we did. We had a number of components, particularly in electronics, that came in from China that were disrupted for a short period of time. We also had one COVID case there that shut the factory down for a couple of days. It’s now up and running. That person’s back at work. And we’re that supply chain issue is behind us now.

Scott Davis — Melius Research — Analyst

Okay. Good luck, guys. Thank you.

Anthony Milando — Senior Vice President and Chief Supply Chain Officer

Thank you. I got thank you.

Operator

Our next question is from Deane Dray of RBC Capital Markets.

Deane Dray — RBC Capital Markets — Analyst

Thank you. Good morning, everyone.

Mark Rajkowski — President and Chief Executive Officer

Good morning, Dan.

Deane Dray — RBC Capital Markets — Analyst

Hey, Just want to understand some of the dynamics here on the municipal side. I appreciate some of the differences in the outlook for the second quarter. Within wastewater, seems pretty steady. And it seems like the clean water side has had more of the disruptions. I can only imagine, if you can’t put in any smart meters in homes because they can’t get in, that must mean the Philadelphia project is must be on hold. But can you size for us what the whole disruption is on meter deployments? And maybe we can start there.

Mark Rajkowski — President and Chief Executive Officer

Yes. Deane, it’s Mark. There’s a couple of pieces, too. One is you’ve nailed it, relative to the impact on some of the deployments. And you mentioned one specifically, but there are others out there. And it’s also, to the point you made, having some impact relative to the just the ability to physically go in and do some of that work. And the utilities are really focused on critical repair issues at this point. So not that this isn’t important work and won’t continue, but it’s certainly being pushed out as less essential than some of the other things they need to deal with.

Patrick Decker — President and Chief Executive Officer

Yes. So Deane, this is Patrick. And all of the conversations I’ve had with many, many utility CEOs over the last month, their single biggest challenge right now is obviously keeping their labor force out in the field, whether it be, again, inability to access residential meter, repair, installation or, again, just having the workforce available in general, given the impact of the virus on their workforce. But I do want to be clear, we’ve not seen project cancellations.

And if anything, what the utility CEOs are saying is that they’re actually looking to double down here in the latter half of the year on accelerating implementations, spinning out their capex budgets because of some uncertainty around what the next regulatory approval process might look like in terms of funding. So they’re going to see a surge, in their view, here in the second half of the year. We’ve also continued to see some large international projects that we had been pursuing that are very much remaining on track and even a bit of optimism there in terms of those moving forward. Again, nothing to share right now. So we’ll have more on that later.

Deane Dray — RBC Capital Markets — Analyst

And just as a follow-up to Scott’s question on the decrementals. And Mark, in your answer, I certainly understand there are certain businesses like dewatering that you’re going to see deeper decrementals. And so helping us calibrate the second quarter decrementals, can you kind of size for us the segments and how they would shake out on decrementals?

Mark Rajkowski — President and Chief Executive Officer

I would say, Deane, the I think we really look at it on an end-market basis. And as we think about utilities, we’re expecting to see on the top line down mid-20s, including and that would include the clean water side with M&CS. The in terms of industrial, that’s probably going to be down closer to 30% and think of a big part of that, that’s going to be led by dewatering, okay? And that’s embedded in the transport business in the Water Infrastructure business. And then commercial is going to be close to 20%, 20-plus percent and resi down about 30%. But in terms of the margin by segment, I think Water Infrastructure will probably be the most resilient, I would say, followed by AWS. And with some of the challenges we just talked about on the clean water side, probably M&CS, a little bit more severe.

Patrick Decker — President and Chief Executive Officer

Yes. Directionally, Deane, the decremental margins for Water Infrastructure and for the Applied Water business are going to be pretty similar to what they’ve been historically. They’re going to be in that kind of 30-plus percent range. I think where we’re going to see what we’re expecting in Q2, the larger decremental impact is going to be in M&CS. And that’s because we’ve got a large labor and service piece there that we’re going to hang on to because we don’t want to let them go, and we want to bring them back at this point. And so we’re going to absorb some overhead there. That will be impacting us in Q2. That gets a whole lot better in the second half of the year, although we’re not guiding to that at this point in time. And then lastly, you do have this kind of across the board, temporary employee support package that we built in that is also built into that 50% decrementals.

Deane Dray — RBC Capital Markets — Analyst

Great. That’s exactly what I was looking for, that you’re making that investment in M&CS, and that carries into the second quarter so [Indecipherable]

Mark Rajkowski — President and Chief Executive Officer

Yes. It’s a pretty big cost base.

Deane Dray — RBC Capital Markets — Analyst

Yeah, okay. All right, thank you. Best of luck to everyone.

Mark Rajkowski — President and Chief Executive Officer

Thank you.

Operator

Thank you. Your next question is from Ryan Connors of Boenning and Scattergood.

Ryan Connors — Boenning and Scattergood — Analyst

Great, thanks for taking my question. So I want to just probe a little further on the municipal outlook. I mean obviously, that segment of the market has always been very late cycle in nature. There’s a tendency now to talk about 2Q, 3Q, even 2021. But if you look at the last cycle, really didn’t even bottom out until four or five years out, 2012, 2013. So it’s not the current generation of projects that’s at risk. Those are funded. But it’s really the projects that are at a much earlier stage of exploration that would have been funded next year and beyond that don’t end up happening. And obviously, now we’ve got to talk about the state and local bailout, which is a factor, and we can get your take on that as well. But what do you think about the real intermediate-term outlook, not 2Q, 3Q or even 2021, but ’22, ’23, as we move through all this?

Patrick Decker — President and Chief Executive Officer

Sure. Yes. So it’s a great question. Ryan, I think the what I’m hearing from the utility CEOs as we sit here today, and this is a global conversation, not just a North American conversation, is they’re not calling that. They’re not making that judgment at this point in time that this is going to be like previous financial crises. Even during financial crises in the past, as you well know, that 70% of their spending that is opex remains quite resilient because it’s, again, basic essential services. It really is that 30% that’s capex that can move around.

Also Read:  Clorox Co (NYSE: CLX) Q3 2020 Earnings Call Transcript

And right now, that’s not what we’re hearing from them. I mean we’re keeping a close eye on that, obviously. We don’t want to have deaf ears to that. But they’re viewing this as a bit different from a financial crisis given the human and health nature of this one. They’re not calling for a snapback immediately, but they’re also not calling for a depression situation in terms of not being able to get projects funded because of a number of the bailouts that are being discussed at this point in time and provided at state and local levels. So that’s the best view we have on it right now.

Ryan Connors — Boenning and Scattergood — Analyst

Got it. Okay. And my other one had to do with and you touched on this…

Patrick Decker — President and Chief Executive Officer

And I would add also there I would also add there that, again, the reason I bring up the global component of that is we’ve actually seen a pretty strong snapback already in China and India in terms of building out critical infrastructure there on the water side.

Ryan Connors — Boenning and Scattergood — Analyst

Okay. Good. Then my other one had to do with you touched on this in some of your prepared remarks. But innovation, so core to your strategy, your identity as a company. $100 million is a big number. So presumably, nothing’s immune to the cuts that are going on. But how do you make sure that you continue to maintain that position in terms of not only the dollar spend on R&D, but how disrupted is your ability to sort of feel what the customer is needing in terms of all these trade shows being canceled? I mean in theory, those are you have people out there with their ears to the ground, but they’re not out there. So talk about how all this is impacting that project or that innovation funnel.

Patrick Decker — President and Chief Executive Officer

Yes. That’s a great point. You can be rest assured that we are absolutely committed to preserving our innovation investments. And what I would say is this has allowed us to it’s oftentimes said that it’s not usually brand-new innovations or trends that pop up coming out of a crisis. It accelerates trends that were already there. And that’s certainly what we’re seeing right now, especially within the utility space, but quite frankly, across each one of the verticals. And let me take it in a couple of parts. So we are staying very close to our customers directly, but also, this has afforded us the opportunity to get even closer in discussions with organizations like WEF, the owners of WEFTEC.

They’re talking about how they’re going to be doing things remotely in terms of a trade show. And that led us to having great conversations with them around also how we use them as a conduit for feedback they’re getting from various constituents on innovation themes coming out of this. And so we’re in regular interaction with them in those conversations. So there are themes like, again, remote asset management, again, supporting remote workforce along the way, the issue of affordability in terms of how they become more productive in their opex, but also how they make their capex more affordable going forward has allowed us to actually accelerate the conversations that we had in place on our digital offerings.

And we’ve actually had a significant increase in activity in that type of conversation and request for bids. A number of utilities are now able to action what they refer to as their emergency procurement protocols to be able to move on with that activity that they were otherwise struggling to be able to do. So there are a number of these areas that we actually see as a silver lining as we get through the other side of this pandemic.

Ryan Connors — Boenning and Scattergood — Analyst

Well, thanks for your time this morning.

Patrick Decker — President and Chief Executive Officer

Thank you.

Operator

Thank you. Your next question is from Nathan Jones of Stifel.

Mark Rajkowski — President and Chief Executive Officer

Good morning, everyone.

Nathan Jones — Stifel — Analyst

Hey, good morning. I’d like to go back to some of the cost actions here. You guys talked about $100 million reduction in spend. Can you break that out between capex and P&L costs? And then you talked about some structural cost reductions going forward. Can you give us any idea of what the magnitude of those might be, when they might be implemented, when we might start seeing the benefits from those?

Mark Rajkowski — President and Chief Executive Officer

Yes. Nate, let me start and give you a little bit of color on the $100 million. The that breaks down roughly $40 million of reductions in capex, both less critical as well as just less need for certain capacity because of the demand. But also, we’re focused on taking out roughly $60 million of opex spend. And it’s not so much focused on employees. It’s focused on spending that we’re doing outside, consultants, professional services,etc.

Nathan Jones — Stifel — Analyst

So we’ve seen a lot of companies furloughing workers, reducing work weeks from 40 to 32 hours in order to increase these temporary cost reductions, which are impacting the decrementals in the second quarter. It sounds like you guys have taken a decision not to do that. Can you talk about that decision and what’s led you to that?

Patrick Decker — President and Chief Executive Officer

No. Actually, just to clarify, Nate, we are going to be taking those actions. And so those some of those are underway. Some more of those will be coming here in the immediate term. I don’t want to get into the details on the call here as to what that is, but no, we are going to be taking those temporary actions. But it’s really in service to we’re all in this together. So the faster that we’re able to move on to more permanent structural changes, obviously, the less deep we have to go in the temporary. But we these are all going to be done in service to each other that we’re all in this together as one company.

We are to the latter part of your first question, which was on the permanent structural side, what the size of that is and when would we begin to see the benefits of that, we’re being very purposeful and thoughtful in our approach to those structural actions. We’re not just in a rush to cut. We really have been working feverishly on making sure we have a good understanding as best we can as to what are the structural changes in our customer sets coming out of this pandemic and align ourselves accordingly.

I think we all recognize in this world that we’ve learned the hard way, all of us, to be able to do a lot more with less. And that’s all factoring into our thinking on what the permanent structural changes will be. So more of that to come in our next earnings call. We are going to be taking those actions here in the immediate term. We will see benefits, as I mentioned earlier. It will improve the decremental margins in the second half of the year. It will obviously have an even larger impact and benefit in 2021, just given the fact that we do have approvals that we have to get in works councils and things like that in various parts of the world.

Nathan Jones — Stifel — Analyst

And if I could just slip one in on the industrial side of the business. I would think that is probably the area where you’ve seen the most impact from broad lockdowns and businesses that you would normally service actually being shut down. Do you guys have any visibility into what the impact of the shutdown specifically rather than just general lower industrial activity has been? And I would think you would expect to see that snap back relatively quickly as we start to get global economies open here. Just any commentary you have on that?

Patrick Decker — President and Chief Executive Officer

Yes. I think you’ve read it right, Nate. We it is where we’ve seen the single biggest impact in the immediate term, both in Q1 as well as in what we’re looking at in terms of Q2. And I would say there, the impact really is that you’ve got sites that have simply been shut down on the industrial side of the equation. And therefore, if they’re not up and running, they’re not going to be needing our pumps and other ancillary services along the way. We’ve also had some impact within our indirect channel. We sell-through distribution largely into that area. And so they’ve also had their lockdown and kind of work-at-home policies. So it’s as simple as that.

You’re right, I mean, we definitely expect that, as things open up and that might be a little better in Q2 than what we’re calling for. Who knows? We’re we think we’re being prudent right now and cautionary on Q2. But certainly, as things begin to reopen in the second half of the year, then there will be, we would expect to be, a meaningful snapback. And there will probably be some pent-up demand at that point in time that we can benefit from. But it’s too early for us to call that.

Nathan Jones — Stifel — Analyst

Thanks for all the detail, I’ll pass it on.

Patrick Decker — President and Chief Executive Officer

Thank you.

Operator

Thank you. Your next question comes from Mike Halloran of Baird.

Mike Halloran — Baird — Analyst

Good morning, everyone.

Mark Rajkowski — President and Chief Executive Officer

Good morning, Mike.

Mike Halloran — Baird — Analyst

So just first on the kind of offense/defense side on the capital deployment, how are you guys thinking about balancing the liquidity needs in the short term with the fact the cash flow is probably going to be a little softer in the short term with the fact that you have a lot of liquidity and the environment might create a lot of opportunity for you guys on the M&A side over time? And any other things you’re thinking about from a capital usage perspective?

Mark Rajkowski — President and Chief Executive Officer

Sure. Yes. I would start by saying we do enter this with a very, very strong, both cash position, but liquidity broadly. We are going to continue focusing on those areas that are highest-returning, which is continuing to fund the investments we need to grow the business. We talked about that earlier in response to Deane’s question, that it’s important that we maintain those critical investments to grow over the long term. Secondly, given our liquidity position, and there’s not let’s face it. I mean deals are not going to get done in the near term. But we are going to be focused on keeping our ear to the ground. We know where we want to play. We know where we want to participate. And we have our list out there. And at the right time, we think we’ll be well positioned to take advantage of it.

Patrick Decker — President and Chief Executive Officer

And I would just add, Mike, as you and the others well know, I mean, in these times, the strong gets stronger through this. And we’re going to be strategic and continue to be appropriately aggressive to support our long-term strategies that we laid out before. Those remain unchanged. Perhaps maybe some of the things that we invest in from an R&D standpoint get differentiated a little bit more based upon what we learned through the pandemic. And again, that’s just part of us strong getting stronger. Again, I don’t want to overuse the phrase of flight to quality, but there’s clearly going to be a flight to quality here. And we’re confident that, that’s the position that we’re in. And we’re not going to waver from our original commitments.

Mike Halloran — Baird — Analyst

It makes a lot of sense, and agree. And then second one, just some lessons learned from China and what you’re seeing there more specifically. Maybe just talk a little bit about the production ramp versus what you’re seeing on the demand side qualitatively. Obviously, production seems to be coming back online. How is demand tracking relative to that? And what kind of cadence are you seeing?

Patrick Decker — President and Chief Executive Officer

Sure. So Tony if Tony is still on the line, I’m going to hand it over to Tony here just in one second. I would say on the demand side, we have seen a bounce-back in demand in China and India. Again, we’re being prudent and cautious there as to where that’s happening, which product lines, which verticals it’s coming through. But we have seen the snapback in demand. But Tony, do you want to talk about lessons learned on the supply chain and the resilience there?

Anthony Milando — Senior Vice President and Chief Supply Chain Officer

Sure. Yes. So our current capacity globally is about 90%. Our China facility was facilities were down for about 10 days after Chinese New Year before they came back. In the first week, they were back at about half capacity. And now they’re back up to 100%, and they’re fully loaded right now. A lot of pent-up demand, as Patrick mentioned, is coming back into some of the China facilities right now. Some of the lessons that we’ve learned were around communication, around safety. And safety has been a stronghold for us for many years now. We’ve cut our incident rate down by 50% over the last four or five years.

And that this has really been elevated. So temperature checks, PPE, social distancing. And we’ve learned quite a bit from that model, and we’re able to deploy that a lot quicker in Italy, for instance, where we saw really no production downtime. We got low, but we never shut down the facility. And in fact, in our 50 facilities around the world, only one of those is shut down right now, which is in India. In fact, our other Indian facility is actually up and running from last week. So putting those safety measures in place, the communication measures in place, have really helped us keep our employees healthy. And the fact that we’re all deemed essential services almost everywhere has allowed our facilities to stay up and running.

Patrick Decker — President and Chief Executive Officer

I would just add to that. Tony mentioned communications. And I know it may be a little softy for this call, but on the communications front, really for the past several weeks since things really began to spread and it was deemed a pandemic, we’ve leveraged our own internal platforms to every Tuesday, I do an all-hands call with all of our folks around the world. And it’s just kind of ask me anything, kind of what’s on their mind. And then every Thursday, I have a call with our top 400 leaders to hear what’s on their mind and just to kind of pass along critical elements in communications. So I do think although it seems soft, there’s a lot that comes out of that, that keeps us in touch with what’s actually happening. And that further informs what our overall response plan is good.

Also Read:  Vera Bradley Inc. (NASDAQ: VRA) Q1 2021 Earnings Call Transcript

Mark Rajkowski — President and Chief Executive Officer

I would say Tony and his team have done just a tremendous job in terms of the supply chain, making sure we’ve got good visibility into critical components and supply from Tier 1, Tier two suppliers as well. So that’s been.

Mike Halloran — Baird — Analyst

I appreciate everyone, thank you so much.

Mark Rajkowski — President and Chief Executive Officer

Thank you.

Operator

Thank you. Your next question is from Joe Giordano of Cowen.

Robert — Cowen — Analyst

Hey, good morning.This is Robert [Phonetic] in for Joe. Just switching to free cash flow here for a second. I just want to see if you could expand on your expectations for the rest of the year. How does the cadence look? And then as volume goes down, do you think you can translate that into better cash and release some working capital from that and turn that into cash?

Mark Rajkowski — President and Chief Executive Officer

Yes. That would certainly be the plan. With some of the impact on volume, we’ll we will release some working capital. But we’re also mindful of the fact that it’s some of our customers are under stress. So we need to be on top of collecting our receivables. Some of our key customers and channel partners are under stress, so we’re going to look to support them. But on the whole, as volumes decline, you’d see some release of working capital for sure.

Patrick Decker — President and Chief Executive Officer

And just to punctuate that, I want to make sure we’re clear here that what we’re talking about in terms of any relief for customers, that’s very targeted and it’s very temporary. It’s very temporary, and we would expect that to normalize and course correct in the second half of the year. So that really is more of a comment on here in the immediate term. That’s not a comment on the year.

Robert — Cowen — Analyst

Okay. That helps. And then just a follow-up would be, just kind of looking at tensions and between the U.S. and China and how political tensions are rising there, is this something that you’re worried about in kind of the longer term, medium term? And can you just provide a little color about how you’re thinking about that situation? Is it starting to kind of emerge and become something that’s being talked about a bit?

Patrick Decker — President and Chief Executive Officer

Yes. Sure. Yes, I’ll this is Patrick. So it’s certainly something that I mean, given that China is our now our second largest market around the world, although it still doesn’t come close to the size of the U.S. market for us, the reality is that we’ve been dealing with these tensions between the U.S. and China for quite some time now. And even though they may be heating up again now and maybe get worse, who knows, the reality is we’re we are seen as such a local company in China. We don’t have a single expat. The look and feel for any of those of you that have been there know that we are very much seen as a local company there that is high quality.

Secondly, the fact that roughly 2/3 or 70% of our business goes into the water infrastructure space, most notably utilities, it’s critical, essential services. And we’ve, to this point, not seen any disruption, even through the previous trade tensions and other discussions along the way. So we feel we’re pretty immune to that. I think the 1/3 of our business that is commercial and industrial, that’s tied more to the broader macroeconomic outlook for China. And we actually see that part of the business is improving right now because there is a return to some level of normality in China, the economy along the way. So we I don’t want to say we’re adept to it, but we’re not concerned about the tensions between the U.S. and China from a business standpoint.

Robert — Cowen — Analyst

That’s great, thank you very much for taking my questions.

Patrick Decker — President and Chief Executive Officer

Thank you.

Operator

Thank you. Our next question is from Saree Boroditsky of Jefferies.

Saree Boroditsky — Jefferies — Analyst

Good morning. I appreciate you remark. COVID-19 impact on organic growth in the quarter. Could you provide some color on how you derive that? Was it operational issues or demand impact?

Mark Rajkowski — President and Chief Executive Officer

Yes. It was really a combination in terms of just customers not being able to continue on with a certain project work, particularly in China because things were shut down. We saw in the U.S. and Europe the demand slow down on certain order and shipments at the end of the second half of March. But we also were impacted on the supply chain side. And I mentioned earlier in our test business, not solely in our test business, but largely there in terms of components that we were not able to get, which impacted our ability to ship.

Patrick Decker — President and Chief Executive Officer

I would just add that the I want to go back to comments that we made in the prepared remarks, and that is I think it’s important for everyone to understand the reason why we were down further in Q1, and at least we’re guiding right now, to be down in a steeper in Q2 is one really needs to follow the virus. It hit first in China. We’ve got a disproportionate amount of business in China relative to other companies in our space. It really didn’t hit fully until really in late March into April, coming out of it now. It then moved to Italy, to Spain, to Germany, where we’ve got major supply points and hubs for not just Europe, but also for some of the product lines that we sell into the U.S. We’re now coming out on the other side of the curve of that, but we’re already halfway through or almost halfway through the quarter.

Then it moves to the U.S., and that’s where we find ourselves in similar situation to competitors and peer companies that have a larger U.S. Concentration. And so one really just doesn’t need to overcomplicate it. You follow the virus in terms of the impact it had on shutdowns, job sites, factories,etc. And that really is how it’s flowing through our impact for Q1 and our outlook for Q2. And then we recover in the second half of the year.

Saree Boroditsky — Jefferies — Analyst

That’s helpful. And I guess on that line, can you provide the cadence of the improvements you saw in demand in China and what the product lines were that bounced back? And is there anything there that you think will apply to the regions as the other regions’ lockdowns get lifted?

Mark Rajkowski — President and Chief Executive Officer

Yes. Yes. Saree, so we saw in the utilities yes, we saw a pretty broad base across China. As mentioned in the prepared remarks, 50% more than 50% in Applied Water, but we saw it in Water Infrastructure, too. You’re now seeing us return to utility activity and quoting bidding activity that’s returned to pre-COVID levels in China. And so that’s an encouraging sign that our teams have seen, albeit they’re working through what life looks like after the pandemic, where those meetings have changed. A lot of it is virtual. A lot of it is less people than previously done. So we’re getting back there. We’re starting to learn what that’s going to look like for even our European and U.S. businesses. But there’s a bit of learning that we’ve had from the China side.

Saree Boroditsky — Jefferies — Analyst

Great, thanks for taking my questions.

Mark Rajkowski — President and Chief Executive Officer

Thank you.

Operator

Our next question is from Andy Kaplowitz of Citi.

Patrick Decker — President and Chief Executive Officer

Good morning, guys.

Andy Kaplowitz — Citi — Analyst

Good morning. Patrick, maybe you could give us some more color on your commercial business. You said the backlog remains robust. But obviously, U.S. nonresi cycle looks like it could be under pressure for a little while. So do you expect a relatively quick snapback in that business as shutdowns end? Or do you worry about a bit of a longer-term overhang in that business?

Patrick Decker — President and Chief Executive Officer

It’s a great question. I think the so what we’ve already seen, and again, I step back globally, I’ll come with US here in a second. As Matt mentioned, we’re already seeing recovery in China. It is lagging the utility side because it’s less essential and critical, but it is returning to normality there. And we expect that to be the case certainly following in Europe and then eventually here in the U.S. The part of our business right now that’s been most heavily impacted is the book-and-ship business in the U.S. that was especially hard hit in the Northeast and California, where you have the hotspots of COVID-19. The rest of the business has actually held up fairly well in that regard, but it’s been very steep in those COVID-19 hotspots.

So we do expect and again, as I mentioned earlier, it’s not necessarily in all cases where we go direct. It’s also the impact it’s had on our channel partners and their ability to be at work. And the feedback that we get from them is that they do still see quoting activity continuing on jobs. It is happening remotely, similar to what we see in China. I think we all can kind of relate to that. So that always slows things down a little bit in terms of jobs getting completed, in terms of bid, but we do expect there to be a reasonably strong recovery.

But I do think it’s going to be prolonged for some period as things just take a little bit longer to get done as people are working remotely. So I don’t think it’s going to be a big snapback. It’s not going to be a V shape, at least we’re not guiding that way at this point. But I just want to make sure everybody understands. It is very much isolated to certain hotspots around the U.S. It’s not a broad-based commentary on commercial channel.

Mark Rajkowski — President and Chief Executive Officer

And backlogs are up.

Patrick Decker — President and Chief Executive Officer

And backlogs are up.

Andy Kaplowitz — Citi — Analyst

Got it. And then, Patrick and Mark, maybe you could just give us a little more color on the MCS warranty charge. I mean you addressed it in the prepared remarks, but what happened? And is there any risk of further issues moving forward?

Mark Rajkowski — President and Chief Executive Officer

Yes. It’s as I said, it’s a it was a firmware issue. It’s very contained. It’s really in a relatively small part of our business. It’s in our AMR side, which is the vast majority of our business is AMI, FlexNet and other things. So it does not impact FlexNet customers, international business. It’s not electric or gas. So fairly contained. They’ve identified the issue, and they’re working it through with customers right now. So it’s very much contained.

Patrick Decker — President and Chief Executive Officer

And we the approach we took on this was to get on it. As soon as we heard about it, get on it, nail it, get it behind us, do what we got to do to take care of those customers and move on. And that’s why we took the charge in the quarter. And we’re confident that, as Mark said, it’s very contained. It’s an isolated piece of the business, certain number of end points. And our customers have responded very positively in terms of the way that we’ve gotten on it.

Andy Kaplowitz — Citi — Analyst

Thank you.

Operator

Your next question is from Pavel Molchanov of Raymond James.

Pavel Molchanov — Raymond James — Analyst

Thanks for taking my question. First, on your in-house manufacturing, you referenced India. I think that’s the strictest lockdown that you have direct exposure to. As India begins to reopen, I believe, this week, what’s the latest on that manufacturing site?

Patrick Decker — President and Chief Executive Officer

Yes. Tony, are you still on?

Anthony Milando — Senior Vice President and Chief Supply Chain Officer

Yes. So first of all, we have two facilities in India. One of the facilities is we’ve been able to get it deemed an essential service, and that actually opened up last week. I think the latest lockdown actually has pushed it out to May 15. And so our other facility will remain shut down through May 15. But the first facility, our larger facility actually, was opened up last week.

Pavel Molchanov — Raymond James — Analyst

Got it.

Patrick Decker — President and Chief Executive Officer

And one of the things and one of the learnings that we had coming out of China that I think we didn’t mention in our prepared remarks and I don’t think Tony mentioned earlier was, as we saw, again, following the virus, as we saw things moving around the world, one of the things that we did was go ahead and begin to build up inventory in certain factories to get ahead of it, to make sure that we can at least try to minimize supply disruption and just absorb demand slowing, but be able to be prepared for that. And that certainly was also the case in our India factories, the two that we have there.

Pavel Molchanov — Raymond James — Analyst

My follow-up question is on the M&A. You said that no one is going to be doing deals in the near term. But playing devil’s advocate, if there are some distressed M&A situations in water tech, which we have not seen for years and years, given how hot the space has been, would you opportunistically look at those?

Patrick Decker — President and Chief Executive Officer

Yes. Yes. I mean I think our comment there really I think the intention of Mark’s comment was not that there wouldn’t be a deal to be done or there won’t be activity at all. I think it just it always moves things out a little bit more to the right as people try to figure out kind of what is the appropriate valuation for their assets.

Mark Rajkowski — President and Chief Executive Officer

Just to do diligence.

Patrick Decker — President and Chief Executive Officer

And then you can take the time to do the diligence, as Mark pointed. So we’re not rushing out. But at the same time, we are very open. Again, our strategy remains unchanged there. We’ll be smart about it, both in terms of the pace and the valuations. But you’re absolutely right. Again, there’s a flight to quality. And again, the strong gets stronger in these time frames.

Pavel Molchanov — Raymond James — Analyst

Thank you.

Patrick Decker — President and Chief Executive Officer

Thank you.

Operator

Thank you. We have reached our allotted time for questions. I will turn the call back over to Patrick Decker for any additional or closing remarks.

Patrick Decker — President and Chief Executive Officer

Thank you. Thanks, everybody, for joining. Again, as we like to say here, stay safe, stay strong, stay focused. We appreciate your time here with us today and look forward to getting back in touch with you.

Operator

[Operator Closing Remarks]

Disclaimer

This transcript is produced by AlphaStreet, Inc. While we strive to produce the best transcripts, it may contain misspellings and other inaccuracies. This transcript is provided as is without express or implied warranties of any kind. As with all our articles, AlphaStreet, Inc. does not assume any responsibility for your use of this content, and we strongly encourage you to do your own research, including listening to the call yourself and reading the company’s SEC filings. Neither the information nor any opinion expressed in this transcript constitutes a solicitation of the purchase or sale of securities or commodities. Any opinion expressed in the transcript does not necessarily reflect the views of AlphaStreet, Inc.

© COPYRIGHT 2020, AlphaStreet, Inc. All rights reserved. Any reproduction, redistribution or retransmission is expressly prohibited.

Most Popular

MongoDB (MDB) has what it takes to end the losing streak. Here’s why

An innovative product portfolio that is capable of outshining the legacy databases has helped MongoDB (NASDAQ: MDB) stay largely unaffected by the market turmoil so far. Of late, the database

Macy’s (M) confirms Q1 loss; expects gradual sales recovery

Retailer Macy's (NYSE: M) posted mixed results for its first quarter of 2020. While the topline missed the market's estimates, bottom line topped the targets. There were no change in

STZ Earnings: Key quarterly highlights that you need to know from Constellation Brands Q1 financial results

Constellation Brands (NYSE: STZ) today announced its first quarter financial results for the period ended May 31, 2020. First quarter net loss was $177.9 million, or $0.94 per share, compared

Top