XYL 06.30.2013 10-Q


UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2013
or
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from             to             
Commission file number: 1-35229
Xylem Inc.
(Exact name of registrant as specified in its charter)
 
Indiana
  
45-2080495
(State or other jurisdiction of incorporation or
organization)
  
(I.R.S. Employer Identification No.)
1133 Westchester Avenue, Suite N200, White Plains, NY 10604
(address of principal executive offices and zip code)
(914) 323-5700
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes þ   No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  þ    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer
 
þ
  
Accelerated filer

¨
 
 
 
 
 
 
Non-accelerated filer

¨  (Do not check if a smaller reporting company)
  
Smaller reporting company

¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes  ¨    No  þ
As of July 26, 2013, there were 185,287,683 outstanding shares of the registrant’s common stock, par value $0.01 per share.
 



Xylem Inc.
Table of Contents
ITEM
  
  
PAGE
PART I – Financial Information
 
Item 1
-
 
 
 
 
 
 
 
 
 
 
 
Item 2
-
Item 3
-
Item 4
-
PART II – Other Information
 
Item 1
-
Item 1A
-
Item 2
-
Item 3
-
Item 4
-
Item 5
-
Item 6
-
 

2


PART I

ITEM 1.             CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

XYLEM INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED INCOME STATEMENTS (Unaudited)
(in millions, except per share data)

 
Three Months,
 
Six Months,
For the period ended June 30,
2013
 
2012
 
2013
 
2012
Revenue
$
960

 
$
966

 
$
1,839

 
$
1,891

Cost of revenue
589

 
583

 
1,134

 
1,145

Gross profit
371

 
383

 
705

 
746

Selling, general and administrative expenses
252

 
220

 
488

 
451

Research and development expenses
28

 
28

 
54

 
56

Restructuring charges
20

 

 
25

 

Separation costs
1

 
6

 
2

 
11

Operating income
70

 
129

 
136

 
228

Interest expense
14

 
13

 
27

 
27

Other non-operating income (expense), net
1

 
(1
)
 
(1
)
 
(2
)
Income before taxes
57

 
115

 
108

 
199

Income tax expense
11

 
26

 
21

 
47

Net income
$
46

 
$
89

 
$
87

 
$
152

Earnings per share:
 
 
 
 
 
 
 
Basic
$
0.25

 
$
0.48

 
$
0.47

 
$
0.82

Diluted
$
0.25

 
$
0.48

 
$
0.47

 
$
0.82

Weighted average number of shares:
 
 
 
 
 
 
 
Basic
185.4

 
185.8

 
185.6

 
185.6

Diluted
186.1

 
186.2

 
186.3

 
186.1

Dividends declared per share
$
0.1164

 
$
0.1012

 
$
0.2328

 
$
0.2024

See accompanying notes to condensed consolidated financial statements.


3


XYLEM INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (unaudited)
(in millions)
 
 
Three Months,
 
Six Months,
For the period ended June 30,
2013
 
2012
 
2013
 
2012
Net income
$
46

 
$
89

 
$
87

 
$
152

Other comprehensive income, before tax:
 
 
 
 
 
 
 
Foreign currency translation adjustment
(21
)
 
(70
)
 
(64
)
 
(21
)
Net change in cash flow hedges:
 
 
 
 
 
 
 
Unrealized (losses) gains

 
(2
)
 
(2
)
 
2

Amount of gain reclassified into net income

 
(1
)
 
(1
)
 
(1
)
Net change in postretirement benefit plans:
 
 
 
 
 
 
 
Amortization of net actuarial loss
5

 
3

 
9

 
5

Settlement

 

 

 
2

Other comprehensive loss, before tax
(16
)
 
(70
)
 
(58
)
 
(13
)
Income tax expense related to items of other comprehensive income
1

 
1

 
2

 
3

Other comprehensive loss, net of tax
(17
)
 
(71
)
 
(60
)
 
(16
)
Comprehensive income
$
29

 
$
18

 
$
27

 
$
136

See accompanying notes to condensed consolidated financial statements.

4


XYLEM INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in millions, except per share amounts)
 
 
June 30,
2013
 
December 31,
2012
 
(Unaudited)
 
 
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
360

 
$
504

Receivables, less allowances for discounts and doubtful accounts of $27 and $34 in 2013 and 2012, respectively
792

 
776

Inventories, net
471

 
443

Prepaid and other current assets
113

 
110

Deferred income tax assets
43

 
41

Total current assets
1,779

 
1,874

Property, plant and equipment, net
470

 
487

Goodwill
1,674

 
1,647

Other intangible assets, net
498

 
484

Other non-current assets
190

 
187

Total assets
$
4,611

 
$
4,679

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
311

 
$
332

Accrued and other current liabilities
420

 
443

Short-term borrowings and current maturities of long-term debt
5

 
6

Total current liabilities
736

 
781

Long-term debt
1,199

 
1,199

Accrued postretirement benefits
393

 
400

Deferred income tax liabilities
179

 
173

Other non-current accrued liabilities
52

 
52

Total liabilities
2,559

 
2,605

Commitments and contingencies (Note 17)

 

Stockholders’ equity:
 
 
 
Common Stock – par value $0.01 per share:
 
 
 
Authorized 750.0 shares, issued 186.4 shares and 186.2 shares in 2013 and 2012, respectively
2

 
2

Capital in excess of par value
1,718

 
1,706

Retained earnings
308

 
264

Treasury stock – at cost 1.1 shares and 0.5 shares in 2013 and 2012, respectively
(31
)
 
(13
)
Accumulated other comprehensive income
55

 
115

Total stockholders’ equity
2,052

 
2,074

Total liabilities and stockholders’ equity
$
4,611

 
$
4,679


See accompanying notes to condensed consolidated financial statements.

5


XYLEM INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(in millions)
 
For the six months ended June 30,
2013
 
2012
Operating Activities
 
 
 
Net income
$
87

 
$
152

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation
49

 
44

Amortization
25

 
23

Share-based compensation
12

 
10

Restructuring charges
25

 

Other, net
7

 
(5
)
Payments for restructuring
(11
)
 

Changes in assets and liabilities (net of acquisitions):
 
 
 
Changes in receivables
(31
)
 
(16
)
Changes in inventories
(44
)
 
(44
)
Changes in accounts payable
(4
)
 
12

Other, net
(53
)
 
(51
)
Net Cash – Operating activities
62

 
125

Investing Activities
 
 
 
Capital expenditures
(60
)
 
(57
)
Acquisitions, net of cash acquired
(81
)
 

Proceeds from the sale of property, plant and equipment
3

 
3

Other, net

 
1

Net Cash – Investing activities
(138
)
 
(53
)
Financing Activities
 
 
 
Repurchase of common stock
(18
)
 
(3
)
Proceeds from exercise of employee stock options
1

 
16

Dividends paid
(43
)
 
(39
)
Other, net

 
(5
)
Net Cash – Financing activities
(60
)
 
(31
)
Effect of exchange rate changes on cash
(8
)
 
(1
)
Net change in cash and cash equivalents
(144
)
 
40

Cash and cash equivalents at beginning of year
504

 
318

Cash and cash equivalents at end of period
$
360

 
$
358

Supplemental disclosure of cash flow information:
 
 
 
Cash paid during the period for:
 
 
 
Interest
$
26

 
$
26

Income taxes (net of refunds received)
$
52

 
$
54

See accompanying notes to condensed consolidated financial statements.

6


XYLEM INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 1. Background and Basis of Presentation
Background
Xylem Inc. ("Xylem" or the "Company") is a leading equipment and service provider for water and wastewater applications with a broad portfolio of products and services addressing the full cycle of water, from collection, distribution and use to the return of water to the environment. Xylem was incorporated in Indiana on May 4, 2011. On October 31, 2011 ITT Corporation ("ITT") completed the spin-off of Xylem, formerly ITT's water equipment and service businesses, and Exelis Inc. ("Exelis"), formerly ITT's defense and service businesses (the "Spin-off").
Xylem operates in two segments, Water Infrastructure and Applied Water. The Water Infrastructure segment focuses on the transportation, treatment and testing of water, offering a range of products including water and wastewater pumps, treatment and testing equipment, and controls and systems. The Applied Water segment serves many of the primary uses of water and focuses on the residential, commercial, industrial and agricultural markets. The Applied Water segment’s major products include pumps, valves, heat exchangers, controls and dispensing equipment.
Hereinafter, except as otherwise indicated or unless the context otherwise requires, "Xylem," "we," "us," "our" and the "Company" refer to Xylem Inc. and its subsidiaries.
Basis of Presentation
The interim condensed consolidated financial statements reflect our financial position and results of operations in conformity with accounting principles generally accepted in the United States of America ("GAAP"). All transactions between our businesses have been eliminated.
The unaudited interim condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC") and, in the opinion of management, reflect all adjustments (which include normal recurring adjustments) considered necessary for a fair presentation of the financial position and results of operations for the periods presented. Certain information and note disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such SEC rules. We believe that the disclosures made are adequate to make the information presented not misleading. We consistently applied the accounting policies described in our Annual Report on Form 10-K for the year ended December 31, 2012 ("2012 Annual Report") in preparing these unaudited condensed consolidated financial statements, with the exception of accounting standard updates described in Note 2. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in our 2012 Annual Report.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Estimates are revised as additional information becomes available. Estimates and assumptions are used for, but not limited to, postretirement obligations and assets, revenue recognition, income tax contingency accruals and valuation allowances, goodwill impairment testing and contingent liabilities. Actual results could differ from these estimates. Additionally, our interim condensed consolidated financial statements may not be indicative of our future performance.
Our quarterly financial periods end on the Saturday closest to the last day of the calendar quarter, except for the fourth quarter which ends on December 31. For ease of presentation, the condensed consolidated financial statements included herein are described as ending on the last day of the calendar quarter.

7


Note 2. Recently Issued Accounting Pronouncements
Pronouncements Not Yet Adopted
In July 2013, the Financial Accounting Standards Board (“FASB”) issued guidance on the financial statement presentation of an unrecognized tax benefit. The guidance requires that an unrecognized tax benefit or a portion of an unrecognized tax benefit, be presented as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward. If an applicable deferred tax asset is not available or a company does not expect to use the applicable deferred tax asset, the unrecognized tax benefit should be presented in an entity's financial statements as a liability and should not be combined with a deferred tax asset. This guidance is effective for fiscal years beginning after December 15, 2013. We are currently evaluating the impact of the guidance on our financial condition and results of operations.

In March 2013, the FASB issued guidance on the release of a cumulative translation adjustment ("CTA") related to an entity's investment in a foreign entity into income. The guidance requires such CTA to be released when there has been a: (1) sale of a subsidiary or group of net assets within a foreign entity and the sale represents the substantially complete liquidation of the investment in the foreign entity, (2) loss of a controlling financial interest in an investment in a foreign entity or (3) step acquisition for a foreign entity. This guidance is effective for fiscal years beginning after December 15, 2013. The impact of the guidance on our financial condition and results of operations will depend on the occurrence and the significance of transactions that meet the criteria described above.

In February 2013, the FASB issued guidance related to the measurement and disclosure of obligations resulting from joint and several liability arrangements. The new guidance requires companies to measure obligations resulting from joint and several liability arrangements as the sum of (1) the amount the company agreed to pay on the basis of its arrangement among co-obligors and (2) any additional amount the company expects to pay on behalf of its co-obligors. Additionally, the new guidance requires the disclosure of a description of the joint and several arrangement and the total outstanding amount of the obligation for all joint parties. This guidance is effective for fiscal years beginning after December 15, 2013. We are currently evaluating the impact of the guidance on our financial condition and results of operations.
Recently Adopted Pronouncements
In February 2013, the FASB issued guidance regarding new disclosures for items reclassified out of accumulated other comprehensive income ("AOCI"). The guidance requires entities to present information about items reclassified out of AOCI by component. Additionally, entities are required to present either on the face of the statement where net income is presented or as a separate disclosure in the notes to the financial statements, significant amounts reclassified out of AOCI by the respective line items of net income. This guidance is effective for fiscal years beginning after December 15, 2012. The adoption of this guidance did not have a material impact on our financial statement presentation and disclosures.
In July 2012, the FASB provided companies with the option to make an initial qualitative evaluation, based on events and circumstances, to determine the likelihood of an impairment of an indefinite-lived intangible asset. The results of this qualitative assessment determine whether it is necessary to perform the currently required quantitative comparison of the indefinite-lived intangible asset's fair value to its carrying amount. If it is more likely than not that the fair value of the intangible asset is less than its carrying amount, a company would be required to perform the quantitative assessment. This guidance is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012 with early adoption permitted. The adoption of the guidance did not have a material impact on our financial condition and results of operations.

8



Note 3. Acquisitions

During the three and six months ended June 30, 2013, we spent $3 million and $84 million ($81 million, net of cash acquired) on acquisitions, respectively. As the acquisitions were not material, individually or in the aggregate, to results of operations, pro forma results of operations reflecting results prior to the acquisitions and certain other disclosure items have not been presented.
 
PIMS

On February 5, 2013 we acquired PIMS Group ("PIMS"), a wastewater services company based in the United Kingdom, for approximately $57 million, including a cash payment of $55 million and the assumption of certain liabilities. PIMS is a supplier of wastewater installation and maintenance services for the private sector, municipal and industrial markets. The company had approximately 220 employees and generated revenue of approximately $38 million for its fiscal year ended April 30, 2012.

Our condensed consolidated financial statements include PIMS' results of operations prospectively from February 5, 2013.

MultiTrode

On March 1, 2013 we acquired MultiTrode Pty Ltd ("MultiTrode"), a water and wastewater technology and services company based in Australia, for approximately $26 million. MultiTrode offers advanced monitoring and control technologies to municipal and private water and waste water authorities as well as industrial clients. The company has approximately 60 employees and generated revenue of approximately $13 million in fiscal 2012.

Our condensed consolidated financial statements include MultiTrode's results of operations prospectively from March 1, 2013.
 
Note 4. Restructuring Charges

During the three and six months ended June 30, 2013, we recognized restructuring charges of $20 million and $25 million, respectively. We incurred these charges primarily in an effort to reorganize our structure in Europe and North America to address declines in sales volumes and optimize our cost structure. The charges relate to the reduction in structural costs, including the elimination of headcount and consolidation of facilities within both our Water Infrastructure and Applied Water segments. There were no restructuring charges recognized during the three and six months ended June 30, 2012.


9


The following table presents the components of restructuring expense for the three and six months ended June 30, 2013 and 2012.
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in millions)
2013
 
2012
 
2013
 
2012
By component:
 
 
 
 
 
 
 
Severance and other charges
$
20

 
$

 
$
25

 
$

Reversal of restructuring accruals

 

 

 

Total restructuring charges
$
20

 
$

 
25

 

 
 
 
 
 
 
 
 
By segment:
 
 
 
 
 
 
 
Water Infrastructure
$
16

 
$

 
$
21

 
$

Applied Water
4

 

 
4

 

Corporate and other

 

 

 



The following table displays a rollforward of the restructuring accruals, presented on our Condensed Consolidated Balance Sheet within accrued and other current liabilities, for the six months ended June 30, 2013 and 2012.

(in millions)
 
2013
 
2012
Restructuring accruals - January 1
 
$
9

 
$
1

Severance and other
 
25

 

Cash payments
 
(11
)
 

Other
 
(1
)
 
(1
)
Restructuring accruals - June 30
 
$
22

 
$

 
 
 
 
 
By segment:
 
 
 
 
Water Infrastructure
 
$
20

 
$

Applied Water
 
2

 

Corporate and other
 

 


The following is a rollforward of employee position eliminations associated with restructuring activities for the six months ended June 30, 2013 and 2012.

 
 
2013
 
2012
Planned reductions - January 1
 
54

 

Additional planned reductions
 
317

 

Actual reductions
 
(233
)
 

Planned reductions - June 30
 
138

 


Total expected costs associated with actions that commenced during the six months ended June 30, 2013 are approximately $25 million for Water Infrastructure and approximately $6 million for Applied Water. These costs primarily comprise severance charges. We currently expect these actions to continue through the first quarter of 2014.



10


Note 5. Separation Costs
The components of non-recurring separation costs incurred as a result of the Spin-off are presented below.
(in millions)
Three Months Ended
 
Six Months Ended
June 30,
 
June 30,
2013
 
2012
 
2013
 
2012
Advisory fees and other
$

 
$
2

 
$

 
$
5

Rebranding and marketing costs

 
2

 

 
4

Information and technology costs

 
1

 
1

 
1

Employee retention and hiring costs

 
1

 

 
1

Lease termination and other real estate costs
1

 

 
1

 

Total separation costs in operating income
1

 
6

 
2

 
11

Income tax benefit

 
(2
)
 

 
(3
)
Total separation costs, net of tax
$
1

 
$
4

 
$
2

 
$
8

  

Note 6. Income Taxes
Our quarterly provision for income taxes is measured using an estimated annual effective tax rate, adjusted for discrete items within periods presented. The comparison of our effective tax rate between periods is significantly impacted by the level and mix of earnings and losses by tax jurisdiction, foreign income tax rate differentials and amount of permanent book-to-tax differences.
The income tax provision for the three months ended June 30, 2013 was $11 million at an effective tax rate of 20.3%, compared to $26 million at an effective tax rate of 23.3% for the same period in 2012. The income tax provision for the six months ended June 30, 2013 was $21 million at an effective tax rate of 19.7% compared to $47 million at an effective tax rate of 23.9% for the same period in 2012. The decrease in the effective tax rate for the three and six months ended June 30, 2013 as compared to the same periods in 2012 was primarily due to mix of earnings, including the impact of realignment efforts, and the benefit from a discrete foreign tax refund in the first quarter of 2013.
Unrecognized Tax Benefits
We recognize tax benefits from uncertain tax positions only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized from such positions are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement.
The amount of unrecognized tax benefits at June 30, 2013 was $8 million which, if ultimately recognized, will reduce our annual effective tax rate. We do not believe that the unrecognized tax benefits will significantly change within the next twelve months.
We classify interest relating to unrecognized tax benefits as a component of other non-operating expense, net and tax penalties as a component of income tax expense in our Condensed Consolidated Income Statements. As of June 30, 2013, we had $1 million of interest accrued for unrecognized tax benefits.



11


Note 7. Earnings Per Share
The following is a summary of the calculation of basic and diluted net earnings per share.
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
  
2013
 
2012
 
2013
 
2012
Net income (in millions)
$
46

 
$
89

 
$
87

 
$
152

Shares (in thousands):
 
 
 
 
 
 
 
Weighted average common shares outstanding
185,265

 
185,546

 
185,419

 
185,254

Add: Participating securities (a)
138

 
303

 
186

 
370

Weighted average common shares outstanding — Basic
185,403

 
185,849

 
185,605

 
185,624

Plus incremental shares from assumed conversions: (b)
 
 
 
 
 
 
 
Dilutive effect of stock options
187

 
218

 
183

 
253

Dilutive effect of restricted stock
531

 
181

 
490

 
177

Weighted average common shares outstanding — Diluted
186,121

 
186,248

 
186,278

 
186,054

Basic earnings per share
$
0.25

 
$
0.48

 
$
0.47

 
$
0.82

Diluted earnings per share
$
0.25

 
$
0.48

 
$
0.47

 
$
0.82

(a)
Restricted stock awards containing rights to non-forfeitable dividends that participate in undistributed earnings with common shareholders are considered participating securities for purposes of computing earnings per share.
(b)
Incremental shares from stock options, restricted stock and performance share units are computed by the treasury stock method. The weighted average shares listed below were not included in the computation of diluted earnings per share because to do so would have been anti-dilutive for the periods presented or because they were excluded under the treasury stock method. The treasury stock method calculates dilution assuming the exercise of all in-the-money options and vesting of restricted stock and performance share awards, reduced by the repurchase of shares with the proceeds from the assumed exercises, unrecognized compensation expense for outstanding awards and the estimated tax benefit of the assumed exercises. Performance share units will be included in the treasury stock calculation of diluted earnings per share upon achievement of underlying performance conditions. See Note 15, "Stock-Based Compensation Plans" for further detail on the performance share units.
    
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in thousands)
2013
 
2012
 
2013
 
2012
Stock options
4,481

 
4,510

 
4,306

 
4,408

Restricted stock
862

 
993

 
810

 
918

Performance shares
119

 

 
80

 



Note 8. Inventories
 
(in millions)
June 30,
2013
 
December 31,
2012
Finished goods
$
191

 
$
182

Work in process
32

 
30

Raw materials
248

 
231

Total inventories, net
$
471

 
$
443




12


Note 9. Property, Plant and Equipment

(in millions)
June 30,
2013
 
December 31,
2012
Land, buildings and improvements
$
249

 
$
255

Machinery and equipment
651

 
653

Equipment held for lease or rental
184

 
183

Furniture and fixtures
86

 
90

Construction work in progress
49

 
40

Other
21

 
19

Total property, plant and equipment, gross
1,240

 
1,240

Less accumulated depreciation
770

 
753

Total property, plant and equipment, net
$
470

 
$
487

Depreciation expense of $24 million and $49 million was recognized during the three and six months ended June 30, 2013, respectively, and $21 million and $44 million for the three and six months ended June 30, 2012, respectively.

Note 10. Goodwill and Other Intangible Assets
Changes in the carrying value of goodwill by reportable segment for the six months ended June 30, 2013 are as follows:
 
(in millions)
Water
Infrastructure
 
Applied Water
 
Total
Balance as of January 1, 2013
$
1,085

 
$
562

 
$
1,647

Activity in 2013
 
 
 
 
 
Goodwill acquired (a)
48

 

 
48

Foreign currency and other
(16
)
 
(5
)
 
(21
)
Balance as of June 30, 2013
$
1,117

 
$
557

 
$
1,674

(a) Attributable to the 2013 acquisitions. See Note 3, "Acquisitions" for a description of the acquisitions during 2013.
Based on the results of our latest annual impairment tests, we determined that no impairment of goodwill existed as of the measurement date in 2012. However, future goodwill impairment tests could result in a charge to earnings. We will continue to evaluate goodwill on an annual basis as of the beginning of our fourth quarter and whenever events and changes in circumstances indicate there may be a potential impairment.

13


Other Intangible Assets
Information regarding our other intangible assets is as follows:
 
 
June 30, 2013
 
December 31, 2012
(in millions)
Carrying
Amount
 
Accumulated
Amortization
 
Net
Intangibles
 
Carrying
Amount
 
Accumulated
Amortization
 
Net
Intangibles
Customer and distributor relationships
$
343

 
$
(88
)
 
$
255

 
$
317

 
$
(75
)
 
$
242

Proprietary technology
107

 
(32
)
 
75

 
105

 
(29
)
 
76

Trademarks
33

 
(14
)
 
19

 
33

 
(14
)
 
19

Patents and other
20

 
(17
)
 
3

 
21

 
(17
)
 
4

Indefinite-lived intangibles
146

 

 
146

 
143

 

 
143

 
$
649

 
$
(151
)
 
$
498

 
$
619

 
$
(135
)
 
$
484


Based on the results of our latest annual impairment tests, we determined that no impairment of the indefinite-lived intangibles existed as of the measurement date in 2012. However, future impairment tests could result in a charge to earnings. We will continue to evaluate the indefinite-lived intangible assets on an annual basis as of the beginning of our fourth quarter and whenever events and changes in circumstances indicate there may be a potential impairment.

Amortization expense related to finite-lived intangible assets of $10 million and $19 million was recognized in the three and six months ended June 30, 2013, respectively, and $9 million and $17 million for the three and six months ended June 30, 2012, respectively.

Note 11. Derivative Financial Instruments
Risk Management Objective of Using Derivatives
We are exposed to certain risks arising from both our business operations and economic conditions and principally manage our exposures to these risks through management of our core business activities. Certain of our foreign operations expose us to fluctuations of foreign interest rates and exchange rates that may impact revenues, expenses, cash receipts and payments. We enter into derivative financial instruments to protect the value or fix the amount of certain cash flows in terms of the functional currency of the business unit with that exposure.
Cash Flow Hedges of Foreign Exchange Risk
We are exposed to fluctuations in various foreign currencies against our functional currencies. We use foreign currency derivatives including currency forward agreements to manage our exposure to fluctuations in the various exchange rates. Currency forward agreements involve fixing the foreign currency exchange rate for delivery of a specified amount of foreign currency on a specified date.
Beginning in 2012, certain business units within our segments with exposure to foreign currency exchange risks have designated certain currency forward agreements as cash flow hedges of forecasted intercompany inventory purchases and sales. The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges of foreign exchange risk is recorded in other comprehensive income and is subsequently reclassified into either revenue or cost of revenue (hedge of sales classified into revenue and hedge of purchases classified into cost of revenue) in the period that the hedged forecasted transaction affects earnings. Any ineffective portion of the change in fair value of the derivative is recognized directly in selling, general and administrative expenses. Our policy is to de–

14


designate cash flow hedges at the time forecasted transactions are recognized as assets or liabilities on a business unit’s balance sheet and report subsequent changes in fair value through selling, general and administrative expenses where the gain or loss due to movements in currency rates on the underlying asset or liability is recorded. If it becomes probable that the originally forecasted transaction will not occur, the gain or loss related to the hedge recorded within other comprehensive income is recognized into net income.
Listed in the table below are the outstanding foreign currency derivatives that were used to hedge foreign exchange risks as of June 30, 2013.
 
(in millions; except number of instruments)
 
 
 
 
Foreign Currency Derivative
 
Number of
Instruments
 
Notional
Sold
 
Sell Notional Currency
 
Notional
Purchased
 
Buy Notional
Currency
Sell AUD/ Buy EUR forward
 
8

 
14.6

 
Australian Dollar (AUD)
 
11.3

 
Euro (EUR)
Sell CAD/ Buy EUR Forward
 
10

 
11.2

 
Canadian Dollar (CAD)
 
8.4

 
Euro (EUR)
Sell GBP/ Buy EUR forward
 
5

 
5.0

 
British Pound Sterling (GBP)
 
5.8

 
Euro (EUR)
Sell USD/ Buy EUR forward
 
5

 
22.5

 
United States Dollar (USD)
 
17.2

 
Euro (EUR)
Buy SEK/ Sell EUR forward
 
5

 
82.8

 
Euro (EUR)
 
705.0

 
Swedish Krona (SEK)
The table below presents the effect of our derivative financial instruments on the Condensed Consolidated Income Statements and Statements of Comprehensive Income.
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in millions)
2013
 
2012
 
2013
 
2012
Derivatives in Cash Flow Hedges
 
 
 
 
 
 
 
Foreign Exchange Contracts
 
 
 
 
 
 
 
Amount of (loss) gain recognized in OCI (a)
$

 
$
(2
)
 
$
(2
)
 
$
2

Amount of (gain) reclassified from OCI into revenue (a)

 

 
(1
)
 

Amount of (gain) reclassified from OCI into cost of revenue (a)

 
(1
)
 

 
(1
)
(a)
Effective portion
As of June 30, 2013, $2 million of the net unrealized losses on cash flow hedges is expected to be reclassified into earnings in the next 12 months. The ineffective portion of the change in fair value of a cash flow hedge is excluded from effectiveness testing and is recognized immediately in selling, general and administrative expenses in the Condensed Consolidated Income Statements. For the three and six months ended June 30, 2013 and 2012, the amounts were not material.



15


The fair values of our foreign exchange contracts currently included in our hedging program were as follows:
 
(in millions)
June 30,
2013
 
December 31,
2012
Derivatives designated as hedging instruments
 
 
 
Assets
 
 
 
Other current assets
$
2

 
$

Liabilities
 
 
 
Other current liabilities
(3
)
 


Note 12. Accrued and Other Current Liabilities
 
(in millions)
June 30,
2013
 
December 31,
2012
Compensation and other employee-benefits
$
191

 
$
201

Customer-related liabilities
59

 
60

Accrued warranty costs
37

 
40

Accrued taxes
20

 
50

Other accrued liabilities
113

 
92

Total accrued and other current liabilities
$
420

 
$
443


Note 13. Credit Facilities and Long-Term Debt
 
(in millions)
June 30,
2013
 
December 31,
2012
Short-term borrowings and current maturities of long-term debt
$
5

 
$
6

 
 
 
 
Long-term debt
 
 
 
3.550% Senior Notes due 2016 (a)
$
600

 
$
600

4.875% Senior Notes due 2021 (a)
600

 
600

Unamortized discount (b)
(1
)
 
(1
)
Long-term debt
$
1,199

 
$
1,199

Total debt
$
1,204

 
$
1,205

(a)
The fair value of our Senior Notes (as defined below) was determined using quoted prices in active markets for identical securities, which are considered Level 1 inputs. The fair value of our Senior Notes due 2016 was $632 million and $639 million as of June 30, 2013 and December 31, 2012, respectively. The fair value of our Senior Notes due 2021 was $636 million and $680 million as of June 30, 2013 and December 31, 2012, respectively.
(b)
The unamortized discount is recognized as a reduction in the carrying value of the Senior Notes (as defined below) in the Condensed Consolidated Balance Sheets and is being amortized to interest expense in our Condensed Consolidated Income Statements over the expected remaining terms of the Senior Notes.

16


Senior Notes
On September 20, 2011, we issued 3.550% Senior Notes of $600 million aggregate principal amount due September 2016 (the "Senior Notes due 2016") and 4.875% Senior Notes of $600 million aggregate principal amount due October 2021 (the "Senior Notes due 2021" and together with the Senior Notes due 2016, the "Senior Notes").

The Senior Notes include covenants which restrict our ability, subject to exceptions, to incur debt secured by liens and engage in sale and lease-back transactions, as well as provide for customary events of default (subject, in certain cases, to receipt of notice of default and/or customary grace and cure periods), including but not limited to: (i) failure to pay interest for 30 days, (ii) failure to pay principal when due, (iii) failure to perform any other covenant for 90 days after receipt of notice from the trustee or from holders of 25% of the outstanding principal amount and (iv) certain events of bankruptcy, insolvency or reorganization. We may redeem the Senior Notes, as applicable, in whole or in part, at any time at a redemption price equal to the principal amount of the Senior Notes to be redeemed, plus a make-whole premium. As of June 30, 2013, we were in compliance with all covenants. If a change of control triggering event (as defined in the Senior Notes indenture) occurs, we will be required to make an offer to purchase the Senior Notes at a price equal to 101% of their principal amount plus accrued and unpaid interest to the date of repurchase.
Interest on the Senior Notes due 2016 is payable on March 20 and September 20 of each year. Interest on the Senior Notes due 2021 is payable on April 1 and October 1 of each year.
Four Year Competitive Advance and Revolving Credit Facility
Effective October 31, 2011, Xylem and its subsidiaries entered into a Four Year Competitive Advance and Revolving Credit Facility (the "Credit Facility") with JPMorgan Chase Bank, N.A., as administrative agent, and a syndicate of lenders. The credit facility provides for an aggregate principal amount of up to $600 million of (i) a competitive advance borrowing option which will be provided on an uncommitted competitive advance basis through an auction mechanism (the "competitive loans"), (ii) revolving extensions of credit (the "revolving loans") outstanding at any time and (iii) the issuance of letters of credit in a face amount not in excess of $100 million outstanding at any time.
At our election, the interest rate per annum applicable to the competitive advances will be based on either (i) a Eurodollar rate determined by reference to LIBOR, plus an applicable margin offered by the lender making such loans and accepted by us or (ii) a fixed percentage rate per annum specified by the lender making such loans. At our election, interest rate per annum applicable to the revolving loans will be based on either (i) a Eurodollar rate determined by reference to LIBOR, adjusted for statutory reserve requirements, plus an applicable margin or (ii) a fluctuating rate of interest determined by reference to the greatest of: (a) the prime rate of JPMorgan Chase Bank, N.A., (b) the U.S. Federal Funds effective rate plus half of 1% or (c) the Eurodollar rate determined by reference to LIBOR, adjusted for statutory reserve requirements, in each case, plus an applicable margin.
In accordance with the terms, we may not exceed a maximum leverage ratio of 3.50 (based on a ratio of total debt to earnings before interest, taxes, depreciation and amortization) throughout the term. As of June 30, 2013, we were in compliance with all covenants. The Credit Facility also contains limitations on, among other things, incurring debt, granting liens, and entering sale and leaseback transactions. In addition, the Credit Facility contains other terms and conditions such as customary representations and warranties, additional covenants and customary events of default.

As of June 30, 2013, the Credit Facility remains undrawn.


17


Research and Development Facility Agreement

Effective December 14, 2012, we entered into a Risk Sharing Finance Facility Agreement (the "R&D Facility Agreement") with The European Investment Bank ("EIB") in an aggregate principal amount of up to €120 million (approximately $157 million) to finance research projects and research infrastructures in the European Union. The Company's wholly owned subsidiary in Luxembourg, Xylem Holdings S.a.r.l., is the borrower under the R&D Facility Agreement. The funds are made available to finance research and development projects during the period of 2013 through 2016 at the Company's R&D facilities in Sweden, Germany, Italy, the United Kingdom, Austria, Norway and Hungary.

Under the R&D Facility Agreement, the borrower can, starting no later than 18 months from the date of the R&D Facility Agreement, draw loans with a maturity of no longer than 12 years. The R&D Facility Agreement provides for Fixed Rate loans and Floating Rate loans. The interest rate per annum applicable to Fixed Rate loans will be at a fixed percentage rate per annum specified by EIB which includes the applicable margin. The interest rate per annum applicable to Floating Rate loans will be at the rate determined by reference to EURIBOR for loans drawn in Euros and LIBOR for loans drawn in Sterling or U.S. Dollars, plus an applicable spread specified by EIB, which includes the applicable margin. The applicable margin for both Fixed Rate loans and Floating Rate loans shall be determined by reference to the credit rating of the Company.

In accordance with the terms, we may not exceed a maximum leverage ratio of 3.50 (based on a ratio of total debt to earnings before interest, taxes, depreciation and amortization) throughout the term. As of June 30, 2013, we were in compliance with all covenants. The R&D Facility Agreement also contains limitations on, among other things, incurring debt, granting liens, and entering sale and leaseback transactions. In addition, the R&D Facility Agreement contains other terms and conditions such as customary representations and warranties, additional covenants and customary events of default.

As of June 30, 2013, the R&D Facility Agreement remains undrawn.


18


Note 14. Postretirement Benefit Plans

The following table provides the components of net periodic benefit cost and other amounts recognized in other comprehensive income for defined benefit pension plans, disaggregated by domestic and international plans.
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in millions)
2013
 
2012
 
2013
 
2012
Domestic defined benefit pension plans:
 
 
 
 
 
 
 
Net periodic benefit cost:
 
 
 
 
 
 
 
Service cost
$

 
$

 
$
1

 
$
1

Interest cost
1

 
1

 
2

 
2

Expected return on plan assets
(1
)
 
(1
)
 
(2
)
 
(2
)
Amortization of net actuarial loss
1

 
1

 
2

 
1

Net periodic benefit cost
$
1

 
$
1

 
$
3

 
$
2

Other changes in plan assets and benefit obligations recognized in other comprehensive income:
 
 
 
 
 
 
 
Amortization of net actuarial loss
(1
)
 
(1
)
 
(2
)
 
(1
)
Change recognized in other comprehensive income
$
(1
)
 
$
(1
)
 
$
(2
)
 
$
(1
)
International defined benefit pension plans:
 
 
 
 
 
 
 
Net periodic benefit cost:
 
 
 
 
 
 
 
Service cost
$
4

 
$
2

 
$
7

 
$
5

Interest cost
7

 
7

 
14

 
14

Expected return on plan assets
(8
)
 
(7
)
 
(16
)
 
(15
)
Amortization of net actuarial loss
3

 
2

 
6

 
4

Settlement

 

 

 
2

Net periodic benefit cost
$
6

 
$
4

 
$
11

 
$
10

Other changes in plan assets and benefit obligations recognized in other comprehensive income:
 
 
 
 
 
 
 
Amortization of net actuarial loss
(3
)
 
(2
)
 
(6
)
 
(4
)
Settlement

 

 

 
(2
)
Change recognized in other comprehensive income
$
(3
)
 
$
(2
)
 
$
(6
)
 
$
(6
)
Totals:
 
 
 
 
 
 
 
Net periodic benefit cost
$
7

 
$
5

 
$
14

 
$
12

Recognized in other comprehensive income
(4
)
 
(3
)
 
(8
)
 
(7
)
Total recognized in comprehensive income
$
3

 
$
2

 
$
6

 
$
5


19


The total net periodic benefit cost for other postretirement employee benefit plans for the three and six months ended June 30, 2013 was $2 million and $3 million, respectively, including amounts recognized in other comprehensive income of $1 million for both periods. Total net periodic benefit cost for other postretirement benefit plans for the three and six months ended June 30, 2012 was $1 million and $2 million, respectively. Amounts recognized in other comprehensive income were immaterial for the three and six months ended June 30, 2012.
We contributed $21 million and $19 million to postretirement benefit plans during the six months ended June 30, 2013 and 2012, respectively. Additional contributions ranging between approximately $18 million and $28 million are expected during the remainder of 2013.

Note 15. Stock-Based Compensation Plans
Share-based compensation expense was $6 million and $12 million during the three and six months ended June 30, 2013, respectively, and $5 million and $10 million for the three and six months ended June 30, 2012, respectively. The unamortized compensation expense related to our stock options, restricted shares and performance based shares was $14 million, $27 million and $3 million, respectively, at June 30, 2013 and is expected to be recognized over a weighted average period of 1.9, 1.9 and 2.7 years, respectively. The amount of cash received from the exercise of stock options was $1 million and $16 million for the six months ended June 30, 2013 and 2012, respectively. We classify as a financing activity the cash flows attributable to excess tax benefits arising from stock option exercises and restricted stock lapses.
Restricted Stock Grants
The following is a summary of restricted stock activity for the six months ended June 30, 2013: 
(in thousands, except for per share amounts)
Shares
 
Weighted
Average
Grant Date
Fair Value /Share
Outstanding at January 1, 2013
1,588

 
$
26.92

Granted
481

 
$
27.47

Vested
(261
)
 
$
29.48

Forfeited
(36
)
 
$
28.39

Outstanding at June 30, 2013
1,772

 
$
26.64

Performance-Based Share Grants
As part of the annual March 2013 grant under the long-term incentive plan, performance-based shares were granted to all executive officers of the Company. The performance-based shares vest based upon performance by the Company over a three-year period against targets approved by the compensation committee of the Company's Board of Directors prior to the grant date. For the 2013-2015 performance period, the performance-based shares were granted at a target of 100% with actual payout contingent upon the achievement of a pre-set, three-year adjusted Return on Invested Capital and cumulative adjusted net income performance target. Compensation costs resulting from share-based payment transactions are recognized primarily within selling, general and administrative expenses, at fair value over the requisite service period (typically three years) on a straight-line basis. The calculated compensation cost is adjusted based on an estimate of awards ultimately expected to vest and our assessment of the probable outcome of the performance condition. The fair value of performance-based share awards at 100% target is determined using the closing price of our common stock on date of grant.

20


The following is a summary of performance-based share grants for the six months ended June 30, 2013:
(in thousands, except for per share amounts)
Shares
 
Weighted
Average
Grant Date
Fair Value /Share
Outstanding at January 1, 2013

 
$

Granted
119

 
$
27.49

Vested

 
$

Forfeited

 
$

Outstanding at June 30, 2013
119

 
$
27.49

Stock Option Grants
The following is a summary of the changes in outstanding stock options for the six months ended June 30, 2013:
 
(in thousands, except for per share amounts)
Shares
 
Weighted
Average
Exercise
Price /Share
 
Weighted  Average
Remaining
Contractual
Term (Years)
Outstanding at January 1, 2013
4,083

 
$
26.46

 
6.4
Granted
813

 
$
27.43

 
10.0
Exercised
(62
)
 
$
21.00

 
2.5
Forfeited
(187
)
 
$
29.33

 
0.4
Outstanding at June 30, 2013
4,647

 
$
26.54

 
6.8
Options exercisable at June 30, 2013
2,249

 
$
26.29

 
4.7
The aggregate intrinsic value of all outstanding and exercisable stock options as of June 30, 2013 was $8 million and $5 million, respectively. The total intrinsic value of options exercised (which is the amount by which the stock price exceeded the exercise price of the options on the date of exercise) during the six months ended June 30, 2013 was less than $1 million.
Stock Option Fair Value
The fair value of each option grant was estimated on the date of grant using the binomial lattice pricing model which incorporates multiple and variable assumptions over time, including assumptions such as employee exercise patterns, stock price volatility and changes in dividends. The following are weighted-average assumptions for our annual March grants in 2013.
 
Dividend yield
1.69%
Volatility
31.10%
Risk-free interest rate
1.27%
Expected term (in years)
6.63
Weighted-average fair value / share
$7.58
Expected volatility is calculated based on an analysis of historic and implied volatility measures for a set of peer companies. We use historical data to estimate option exercise and employee termination behavior within the valuation model. Employee groups and option characteristics are considered separately for valuation purposes. The expected term represents an estimate of the period of time options are expected

21


to remain outstanding. The expected term provided above represents the weighted average of expected behavior for certain groups of employees who have historically exhibited different behavior. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of option grant.

Note 16. Accumulated Other Comprehensive Income (Loss)

The following table provides the components of accumulated other comprehensive income for the three months ended June 30, 2013:

(in millions)
Foreign Currency Translation
 
Postretirement Benefit Plans
 
Derivative Instruments
 
Total
Balance at April 1, 2013
$
293

 
$
(219
)
 
$
(2
)
 
$
72

Foreign currency translation adjustment
(21
)
 

 

 
(21
)
Amortization of net actuarial loss on postretirement benefit plans into:
 
 
 
 
 
 
 
Cost of revenue

 
1

 

 
1

Selling, general and administrative expenses

 
3

 

 
3

Other non-operating expense, net

 
1

 

 
1

Income tax expense on amortization of postretirement benefit plan items

 
(1
)
 

 
(1
)
Balance at June 30, 2013
$
272

 
$
(215
)
 
$
(2
)
 
$
55



The following table provides the components of accumulated other comprehensive income for the six months ended June 30, 2013:

(in millions)
Foreign Currency Translation
 
Postretirement Benefit Plans
 
Derivative Instruments
 
Total
Balance at January 1, 2013
$
336

 
$
(222
)
 
$
1

 
$
115

Foreign currency translation adjustment
(64
)
 

 

 
(64
)
Amortization of net actuarial loss on postretirement benefit plans into:
 
 
 
 
 
 
 
Cost of revenue

 
2

 

 
2

Selling, general and administrative expenses

 
5

 

 
5

Other non-operating expense, net

 
2

 

 
2

Income tax expense on amortization of postretirement benefit plan items

 
(2
)
 

 
(2
)
Unrealized loss on foreign exchange agreements

 

 
(2
)
 
(2
)
Reclassification of unrealized gain on foreign exchange agreements into revenue

 

 
(1
)
 
(1
)
Balance at June 30, 2013
$
272

 
$
(215
)
 
$
(2
)
 
$
55



22


Note 17. Commitments and Contingencies
General

From time to time, we are involved in legal proceedings that are incidental to the operation of our businesses, including acquisitions and divestitures, environmental matters, intellectual property matters, product liability and personal injury claims, employment and pension matters, government and commercial contract disputes. Although we cannot predict the outcome of these and other proceedings with certainty, we believe that they will not have a material adverse effect on our condensed consolidated financial position or results of operations.
While very few claims have been asserted against Xylem alleging injury caused by any of our products resulting from asbestos exposure, it is possible that additional claims could be filed in the future. We believe there are numerous legal defenses available for such claims and would defend ourselves vigorously. Pursuant to the Distribution Agreement ("Distribution Agreement") dated October 25, 2011 among ITT, Exelis and Xylem, ITT will indemnify, defend and hold Xylem harmless for asbestos product liability matters, including settlements, judgments, and legal defense costs associated with all pending and future claims that may arise from past sales of ITT’s legacy products. We believe ITT remains a substantial entity with sufficient financial resources to honor its obligations to us.
Although the ultimate outcome of any legal matter cannot be predicted with certainty, based on present information, including our assessment of the merits of the particular claims, we do not expect that any asserted or unasserted legal claims or proceedings, individually or in aggregate, will have a material adverse effect on our results of operations or financial condition.
Indemnifications
As part of the Spin-off, ITT, Exelis and Xylem will indemnify, defend and hold harmless each of the other parties with respect to such parties’ assumed or retained liabilities under the Distribution Agreement and breaches of the Distribution Agreement or related spin agreements. ITT’s indemnification obligations include asserted and unasserted asbestos and silica liability claims that relate to the presence or alleged presence of asbestos or silica in products manufactured, repaired or sold prior to October 31, 2011, the Distribution Date, subject to limited exceptions with respect to certain employee claims, or in the structure or material of any building or facility, subject to exceptions with respect to employee claims relating to Xylem buildings or facilities. The indemnification associated with pending and future asbestos claims does not expire. Xylem has not recorded a liability for material matters for which we will be indemnified by ITT or Exelis through the Distribution Agreement and we are not aware of any claims or other circumstances that would give rise to material payments from us under such indemnifications.

Environmental
In the ordinary course of business, we are subject to federal, state, local, and foreign environmental laws and regulations. We are responsible, or are alleged to be responsible, for ongoing environmental investigation and remediation of sites in various countries. These sites are in various stages of investigation and/or remediation and in many of these proceedings our liability is considered de minimis. We have received notification from the U.S. Environmental Protection Agency, and from similar state and foreign environmental agencies, that a number of sites formerly or currently owned and/or operated by Xylem or for which we are responsible under the Distribution Agreement, and other properties or water supplies that may be or have been impacted from those operations, contain disposed or recycled materials or wastes and require environmental investigation and/or remediation. These sites include instances where we have been identified as a potentially responsible party under federal and state environmental laws and regulations.
Accruals for environmental matters are recorded on a site-by-site basis when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated, based on current law and

23


existing technologies. Our accrued liabilities for these environmental matters represent the best estimates related to the investigation and remediation of environmental media such as water, soil, soil vapor, air and structures, as well as related legal fees. These estimates, and related accruals, are reviewed quarterly and updated for progress of investigation and remediation efforts and changes in facts and legal circumstances. Liabilities for these environmental expenditures are recorded on an undiscounted basis. We have estimated and accrued $10 million and $11 million as of June 30, 2013 and December 31, 2012 for environmental matters, respectively.
It is difficult to estimate the final costs of investigation and remediation due to various factors, including incomplete information regarding particular sites and other potentially responsible parties, uncertainty regarding the extent of investigation or remediation and our share, if any, of liability for such conditions, the selection of alternative remedial approaches, and changes in environmental standards and regulatory requirements. In our opinion, the total amount accrued is reasonable based on existing facts and circumstances.

Warranties
We warrant numerous products, the terms of which vary widely. In general, we warrant products against defect and specific non-performance. The table below provides the changes in our product warranty accrual.
 
(in millions)
2013
 
2012
Warranty accrual – January 1
$
40

 
$
42

Net changes for product warranties in the period
17

 
15

Settlement of warranty claims
(19
)
 
(16
)
Other
(1
)
 
(1
)
Warranty accrual – June 30
$
37

 
$
40


Note 18. Segment Information
Our business is organized into two reportable segments: Water Infrastructure and Applied Water. The Water Infrastructure segment, comprising our Water Solutions and Analytics operating units, focuses on the transportation, treatment and testing of water, offering a range of products including water and wastewater pumps, treatment and testing equipment, and controls and systems. The Applied Water segment serves many of the primary uses of water and focuses on the residential, commercial, industrial and agricultural markets. Corporate and other consists of corporate office expenses including compensation, benefits, occupancy, depreciation, and other administrative costs, as well as charges related to certain matters, such as the Spin-off and environmental matters that are managed at a corporate level and are not included in the business segments in evaluating performance or allocating resources.

24


The accounting policies of each segment are the same as those described in the summary of significant accounting policies (see Note 1 in the 2012 Annual Report). The following tables contain financial information for each reportable segment.
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(in millions)
2013
 
2012
 
2013
 
2012
Revenue:
 
 
 
 
 
 
 
Water Infrastructure
$
596

 
$
609

 
$
1,147

 
$
1,193

Applied Water
381

 
373

 
726

 
728

Eliminations
(17
)
 
(16
)
 
(34
)
 
(30
)
Total
$
960

 
$
966

 
$
1,839

 
$
1,891

Operating Income:
 
 
 
 
 
 
 
Water Infrastructure
$
41

 
$
93

 
$
83

 
$
167

Applied Water
45

 
52

 
85

 
92

Corporate and other
(16
)
 
(16
)
 
(32
)
 
(31
)
Total
$
70

 
$
129

 
$
136

 
$
228

Depreciation and Amortization:
 
 
 
 
 
 
 
Water Infrastructure
$
28

 
$
24

 
$
56

 
$
50

Applied Water
6

 
7

 
14

 
14

Corporate and other
3

 
2

 
4

 
3

Total
$
37

 
$
33

 
$
74

 
$
67

Capital Expenditures:
 
 
 
 
 
 
 
Water Infrastructure
$
21

 
$
21

 
$
38

 
$
41

Applied Water
8

 
3

 
19

 
13

Corporate and other
2

 
2

 
3

 
3

Total
$
31

 
$
26

 
$
60

 
$
57


The following table contains the total assets for each reportable segment.
 
 
Total Assets
(in millions)
June 30,
2013
 
December 31,
2012
Water Infrastructure
$
2,908

 
$
2,844

Applied Water
1,290

 
1,253

Corporate and other
413

 
582

Total
$
4,611

 
$
4,679


Corporate and other consists of items pertaining to our corporate headquarters function, which principally consist of cash, deferred tax assets, pension assets and certain property, plant and equipment.


25


ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This report contains information that may constitute "forward-looking statements." Forward-looking statements by their nature address matters that are, to different degrees, uncertain. Generally, the words "anticipate," "estimate," "expect," "project," "intend," "plan," "believe," "target" and similar expressions identify forward-looking statements, which generally are not historical in nature. However, the absence of these words or similar expressions does not mean that a statement is not forward-looking.
These forward-looking statements include, but are not limited to, statements about the separation of Xylem Inc. ("Xylem" or the "Company") from ITT Corporation in 2011, capitalization of the Company, future strategic plans and other statements that describe the Company’s business strategy, outlook, objectives, plans, intentions or goals, and any discussion of future operating or financial performance. All statements that address operating performance, events or developments that we expect or anticipate will occur in the future — including statements relating to orders, sales, operating margins and earnings per share growth, and statements expressing general views about future operating results — are forward-looking statements.
Caution should be taken not to place undue reliance on any such forward-looking statements because they involve risks, uncertainties and other factors that could cause actual results to differ materially from those expressed or implied in, or reasonably inferred from, such statements. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In addition, forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from the Company’s historical experience and our present expectations or projections. For a more detailed discussion of these factors, see the information under the heading "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2012 ("2012 Annual Report") and with subsequent filings we make with the Securities and Exchange Commission.
The following discussion should be read in conjunction with the condensed consolidated financial statements, including the notes thereto, included elsewhere in this report. Except as otherwise indicated or unless the context otherwise requires, "Xylem," "we," "us," "our" and the "Company" refer to Xylem Inc. and its subsidiaries. References in the condensed consolidated financial statements to "ITT" or "parent" refer to ITT Corporation and its consolidated subsidiaries (other than Xylem Inc.).
Our quarterly financial periods end on the Saturday closest to the last day of the calendar quarter, except for the fourth quarter which ends on December 31. For ease of presentation, the reporting periods included herein are described as ending on the last day of the calendar quarter.
On October 31, 2011 ITT completed the spin-off of Xylem, formerly ITT's water equipment and service businesses, and Exelis Inc. ("Exelis"), formerly ITT's defense and service businesses (the "Spin-off").

Overview

Xylem is a leading equipment and service provider for water and wastewater applications with a broad portfolio of products and services addressing the full cycle of water, from collection, distribution and use to the return of water to the environment. Our business focuses on providing technology-intensive equipment and services. Our product and service offerings are organized into two segments: Water Infrastructure and Applied Water. Our segments are aligned with each of the sectors in the cycle of water, supply infrastructure and usage applications. The Water Infrastructure segment focuses on the transportation, treatment and testing of water, offering a range of products including water and wastewater pumps, treatment and testing equipment, and controls and systems. The Applied Water segment serves many of the primary uses of water and focuses on the residential, commercial, industrial and agricultural markets. The segment’s major products include pumps, valves, heat exchangers, controls and dispensing equipment.

26



Water Infrastructure serves the supply infrastructure sector with pump systems that transport water from aquifers, lakes, rivers and seas; with filtration, ultraviolet and ozone systems that provide treatment, making the water fit to use; and pumping solutions that move the wastewater to treatment facilities where our mixers, biological treatment, monitoring, and control systems provide the primary functions in the treatment process. We provide analytical instrumentation used to measure water quality, flow, and level in wastewater, surface water, and coastal environments.

Applied Water serves the usage applications sector with water pressure boosting systems for heating, ventilation and air conditioning and for fire protection systems to the residential and commercial building services markets. In addition, our pumps, heat exchangers, valves and controls provide cooling to power plants and manufacturing facilities, as well as circulation for food and beverage processing. We also provide boosting systems for farming irrigation, pumps for dairy operations, and rainwater reuse systems for small scale crop and turf irrigation.

We sell our equipment and services via direct and indirect channels that serve the needs of each customer type. In the Water Infrastructure segment for the year ended 2012, we provided more than 70% direct sales with strong application expertise, with the remaining amount going through distribution partners. In the Applied Water segment, we provided more than 85% of our sales in 2012 through long-standing relationships with the world’s leading distributors, with the remainder going direct to customers. We believe the total market opportunity for this equipment and services portion of the water industry supply chain is estimated at $280 billion.
Executive Summary
Xylem reported revenue for the second quarter 2013 of $960 million, a decrease of 0.6% compared to $966 million during the second quarter of 2012. Revenue declined 1.0% on a constant currency basis, driven by sales volume declines across most applications, partially offset by the benefits from the launch of new products. The 2012 and 2013 acquisitions within our Water Infrastructure segment contributed $23 million of incremental revenue for the second quarter 2013. Operating income for the second quarter 2013 was $70 million, reflecting a decrease of $59 million or 45.7% compared to $129 million in the second quarter of 2012 primarily due to the sales volume decline, costs incurred from our restructuring and realignment actions, continued investment in the business, and foreign currency exchange headwinds, partially offset by savings from our cost reduction initiatives and our restructuring activities in 2012 and 2013.

Additional financial highlights for the quarter ended June 30, 2013 include the following:
 
Orders of $1,009 million, or 4% growth from $970 million in the second quarter of the prior year
Net income of $46 million, or $0.25 per diluted share ($0.36 on an adjusted basis) for the second quarter of 2013
Cash flow from operating activities of $62 million for the six months ended June 30, 2013

Key Performance Indicators and Non-GAAP Measures
Management reviews key performance indicators including revenue, gross margin, segment and total operating income and margins, earnings per share, orders growth, working capital, free cash flow and backlog, among others. In addition, we consider certain measures to be useful to management and investors evaluating our operating performance for the periods presented, and to provide a tool for evaluating our ongoing operations, liquidity and management of assets. This information can assist investors in assessing our financial performance and measures our ability to generate capital for

27


deployment among competing strategic alternatives and initiatives, including, but not limited to, dividends and acquisitions, share repurchases and debt repayment. These metrics, however, are not measures of financial performance under accounting principles generally accepted in the United States of America ("GAAP") and should not be considered a substitute for revenue, operating income, net income, earnings per share (basic and diluted) or net cash from operations as determined in accordance with GAAP. We consider the following non-GAAP measures, which may not be comparable to similarly titled measures reported by other companies, to be key performance indicators:
 
"organic revenue" and "organic orders" defined as revenue and orders, respectively, excluding the impact of foreign currency fluctuations, intercompany transactions and contributions from acquisitions and divestitures. Divestitures include sales of insignificant portions of our business that did not meet the criteria for classification as a discontinued operation. The period-over-period change resulting from foreign currency fluctuations assumes no change in exchange rates from the prior period.

"constant currency" defined as financial results adjusted for currency translation impacts by translating current period and prior period activity using the same currency conversion rate. This approach is used for countries whose functional currency is not the U.S. dollar.

"adjusted net income" and "adjusted earnings per share" defined as net income and earnings per share, respectively, adjusted to exclude non-recurring separation costs from the Spin-off (not excluded in 2013), restructuring and realignment costs and tax-related special items. A reconciliation of adjusted net income is provided below.
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(In millions, except for per share data)
2013
 
2012
 
2013
 
2012
Net income
$
46

 
$
89

 
$
87

 
$
152

Separation costs, net of tax (a)

 
4

 

 
8

Restructuring and realignment, net of tax
20

 

 
29

 

Tax-related special items

 
(1
)
 

 
(1
)
Adjusted net income
$
66

 
$
92

 
$
116

 
$
159

Weighted average number of shares - Diluted
186.1

 
186.2

 
186.3

 
186.1

Adjusted earnings per share
$
0.36

 
$
0.49

 
$
0.62

 
$
0.85


(a)
Costs of $1 million ($1 million, net of tax) and $2 million ($2 million, net of tax) for the three and six months ended June 30, 2013, respectively, associated with non-recurring separation activities are not excluded from adjusted net income.

"operating expenses excluding separation, restructuring and realignment costs" defined as operating expenses, adjusted to exclude non-recurring separation costs from the Spin-off (not excluded in 2013), restructuring and realignment costs.

"adjusted segment operating income" defined as segment operating income, adjusted to exclude non-recurring separation costs from the Spin-off (not excluded in 2013), restructuring and realignment costs and "adjusted segment operating margin" defined as adjusted segment operating income divided by total segment revenue.

"free cash flow" defined as net cash provided by operating activities less capital expenditures, as well as adjustments for other significant items that impact current results that management believes are not related to our ongoing operations and performance. Our definition of free cash

28


flow does not consider certain non-discretionary cash payments, such as debt. The following table provides a reconciliation of free cash flow.
 
Six Months Ended
 
June 30,
(In millions)
2013
 
2012
Net cash provided by operating activities
$
62

 
$
125

Capital expenditures
(60
)
 
(57
)
Separation cash payments (a)

 
18

Free cash flow
$
2

 
$
86

 
(a)
Separation cash payments associated with non-recurring separation activities are included in the 2013 free cash flow. Separation cash payments are excluded from free cash flow in 2012 and include capital expenditures associated with the Spin-off of $2 million.

“realignment costs” defined as non-recurring costs not included in restructuring costs that are incurred as part of actions taken to reposition our business, including items such as professional fees, relocation, travel and other costs.


2013 Outlook

The current global market conditions, particularly the economic conditions within Europe and the United States, have continued to negatively impact the Company. We continue to be impacted by the adverse economic environment in Europe, and difficult market conditions have inhibited growth during the first half of 2013. In the United States, market uncertainty, combined with delays in government funding, have resulted in weaker performance in the industrial markets and delays in public utility projects. These economic conditions are expected to continue to be significantly challenging for the remainder of 2013. We are continuing to execute restructuring and realignment actions to reposition our European business to optimize our cost structure and improve our operational efficiency and effectiveness. During the second quarter of 2013, we incurred $20 million and $8 million in restructuring and realignment costs, respectively. We expect to incur approximately $40 to $50 million in restructuring costs, and approximately $20 to $30 million in realignment costs for the full year. As a result of the actions started in 2013, we continue to anticipate approximately $13 to $15 million of net savings to be realized during 2013. Additional strategic actions we are taking include investing in growth platforms and new product development, as well as drawing operating efficiencies through lean six sigma and global sourcing initiatives.

Additionally, we currently generate nearly two-thirds of our revenue outside the U.S., which is impacted by changes in foreign currency exchange rates, particularly the Euro, Swedish Krona, British Pound, Australian Dollar, Canadian Dollar, South African Rand, Polish Zloty, and Hungarian Forint. Upon consolidation, as exchange rates vary, our revenue and other operating results may differ from expectations. In this uncertain economy, significant fluctuations in foreign exchange rates may continue.


29


Results of Operations
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(In millions)
2013
 
2012
 
Change
 
2013
 
2012
 
Change
Revenue
$
960

 
$
966

 
(0.6
)
%
 
$
1,839

 
$
1,891

 
(2.7
)
%
Gross Profit
371

 
383

 
(3.1
)
%
 
705

 
746

 
(5.5
)
%
Gross Margin
38.6
%
 
39.6
%
 
(100
)
bp 
 
38.3
%
 
39.5
%
 
(120
)
bp 
Operating expenses excluding separation, restructuring and realignment costs (a)
273

 
248

 
10.1

%
 
529

 
507

 
4.3

%
Expense to revenue ratio
28.4
%
 
25.7
%
 
270

bp 
 
28.8
%
 
26.8
%
 
200

bp 
Restructuring and realignment costs
28

 

 
NM*

 
 
40

 

 
NM*

 
Separation costs (a)

 
6

 
NM*

 
 

 
11

 
NM*

 
Total operating expenses
301

 
254

 
18.5

%
 
569

 
518

 
9.8

%
Operating Income
70

 
129

 
(45.7
)
%
 
136

 
228

 
(40.4
)
%
Operating Margin
7.3
%
 
13.4
%
 
(610
)
bp 
 
7.4
%
 
12.1
%
 
(470
)
bp 
Interest and other non-operating expense, net
13

 
14

 
(7.1
)
%
 
28

 
29

 
(3.4
)
%
Income tax expense
11

 
26

 
(57.7
)
%
 
21

 
47

 
(55.3
)
%
Tax rate
20.3
%
 
23.3
%
 
(300
)
bp 
 
19.7
%
 
23.9
%
 
(420
)
bp 
Net Income
$
46

 
$
89

 
(48.3
)
%
 
$
87

 
$
152

 
(42.8
)
%
(a) Separation costs of $1 million and $2 million for the three and six months ended June 30, 2013, respectively, are included within the $273 million and $529 million of operating expenses.
* NM - Not meaningful percentage change
Revenue
Revenue generated during the three and six months ended June 30, 2013 was $960 million and $1,839 million, respectively, reflecting a decrease of $6 million or 0.6% and $52 million or 2.7%, respectively, compared to the same prior year periods. On a constant currency basis, revenue fell 1.0% and 2.9% for the three and six months ended June 30, 2013, respectively.

30


The following table illustrates the impact from organic growth, recent acquisitions and fluctuations in foreign currency in relation to revenue during the three and six months ended June 30, 2013:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(In millions)
Change
 
% Change
 
Change
 
% Change
2012 Revenue
$
966

 
 
 
$
1,891

 
 
Organic growth
(33
)
 
(3.4
)%
 
(100
)
 
(5.3
)%
Acquisitions
23

 
2.4
 %
 
46

 
2.4
 %
Constant Currency
(10
)
 
(1.0
)%
 
(54
)
 
(2.9
)%
Foreign currency translation (a)
4

 
0.4
 %
 
2

 
0.1
 %
Total change in revenue
(6
)
 
(0.6
)%
 
(52
)
 
(2.7
)%
2013 Revenue
$
960

 
 
 
$
1,839

 
 

(a)
Foreign currency impact primarily due to fluctuations in the value of the Euro, British Pound, Swedish Krona and South African Rand against the U.S. Dollar.

The following table summarizes revenue by segment:
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
(In millions)
2013
 
2012
 
As  Reported
Change
 
Constant  Currency
Change
 
2013
 
2012
 
As  Reported
Change
 
Constant Currency
Change
Water Infrastructure
$
596

 
$
609

 
(2.1
)%
 
(2.5
)%
 
$
1,147

 
$
1,193

 
(3.9
)%
 
(3.9