Edgar Filing: Xylem Inc.

Large accelerated filer

Accelerated filer

Non-accelerated filer

¨ (Do not check if a smaller reporting company)

Smaller reporting company

XYL 09.30.2014 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 September 30, 2014



	¨	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.)

1 International Drive, Rye Brook, NY 10573

(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):

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 October 24, 2014, there were 181,874,517 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	-	Condensed Consolidated Financial Statements:
		Condensed Consolidated Income Statements for the Three and Nine Months Ended September 30, 2014 and 2013 (Unaudited)	3
		Condensed Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2014 and 2013 (Unaudited)	4
		Condensed Consolidated Balance Sheets as of September 30, 2014 (Unaudited) and December 31, 2013	5
		Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2014 and 2013 (Unaudited)	6
		Notes to the Condensed Consolidated Financial Statements (Unaudited)	7
Item 2	-	Management’s Discussion and Analysis of Financial Condition and Results of Operations	27
Item 3	-	Quantitative and Qualitative Disclosures About Market Risk	42
Item 4	-	Controls and Procedures	42
PART II – Other Information
Item 1	-	Legal Proceedings	43
Item 1A	-	Risk Factors	43
Item 2	-	Unregistered Sales of Equity Securities and Use of Proceeds	43
Item 3	-	Defaults Upon Senior Securities	43
Item 4	-	Mine Safety Disclosure	43
Item 5	-	Other Information	44
Item 6	-	Exhibits	44
Signatures			45

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					Nine Months
For the periods ended September 30,	2014		2013			2014		2013
Revenue	$	963	$	965		$	2,874	$	2,804
Cost of revenue	587		581			1,768		1,715
Gross profit	376		384			1,106		1,089
Selling, general and administrative expenses	222		257			688		747
Research and development expenses	24		24			78		78
Restructuring charges	—		5			18		30
Operating income	130		98			322		234
Interest expense	14		14			41		41
Other non-operating income (expense), net	1		(1		)	1		(2		)
Gain from sale of business	11		—			11		—
Income before taxes	128		83			293		191
Income tax expense	22		10			52		31
Net income	$	106	$	73		$	241	$	160
Earnings per share:
Basic	$	0.58	$	0.39		$	1.31	$	0.86
Diluted	$	0.58	$	0.39		$	1.31	$	0.86
Weighted average number of shares:
Basic	182.2		185.2			183.4		185.5
Diluted	183.4		186.0			184.6		186.2
Dividends declared per share	$	0.1280	$	0.1164		$	0.3840	$	0.3492

See accompanying notes to condensed consolidated financial statements.

XYLEM INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

(in millions)



	Three Months					Nine Months
For the periods ended September 30,	2014			2013		2014			2013
Net income	$	106		$	73	$	241		$	160
Other comprehensive (loss) income, before tax:
Foreign currency translation adjustment	(114		)	68		(113		)	4
Net change in cash flow hedges:
Unrealized (losses) gains	(6		)	2		(14		)	—
Amount of loss reclassified into net income	2			1		1			—
Net change in postretirement benefit plans:
Net gain	10			—		3			—
Amortization of net actuarial loss into net income	2			5		8			14
Other comprehensive (loss) income, before tax	(106		)	76		(115		)	18
Income tax expense related to items of other comprehensive (loss) income	3			2		3			4
Other comprehensive (loss) income, net of tax	(109		)	74		(118		)	14
Comprehensive (loss) income	$	(3	)	$	147	$	123		$	174

See accompanying notes to condensed consolidated financial statements.

XYLEM INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in millions, except per share amounts)



	September 30, 2014			December 31, 2013
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	529		$	533
Receivables, less allowances for discounts and doubtful accounts of $30 and $31 in 2014 and 2013, respectively	804			817
Inventories, net	516			475
Prepaid and other current assets	141			143
Deferred income tax assets	35			41
Total current assets	2,025			2,009
Property, plant and equipment, net	454			488
Goodwill	1,667			1,718
Other intangible assets, net	448			488
Other non-current assets	220			193
Total assets	$	4,814		$	4,896
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	314		$	332
Accrued and other current liabilities	495			479
Short-term borrowings and current maturities of long-term debt	41			42
Total current liabilities	850			853
Long-term debt	1,199			1,199
Accrued postretirement benefits	319			348
Deferred income tax liabilities	183			191
Other non-current accrued liabilities	70			64
Total liabilities	2,621			2,655
Commitments and contingencies (Note 17)
Stockholders’ equity:
Common Stock – par value $0.01 per share:
Authorized 750.0 shares, issued 188.4 shares and 187.6 shares in 2014 and 2013, respectively	2			2
Capital in excess of par value	1,785			1,753
Retained earnings	575			405
Treasury stock – at cost 6.5 shares and 3.0 shares in 2014 and 2013, respectively	(218		)	(86		)
Accumulated other comprehensive income	49			167
Total stockholders’ equity	2,193			2,241
Total liabilities and stockholders’ equity	$	4,814		$	4,896

See accompanying notes to condensed consolidated financial statements.

XYLEM INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(in millions)



For the nine months ended September 30,	2014			2013
Operating Activities
Net income	$	241		$	160
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation	70			72
Amortization	37			38
Share-based compensation	14			21
Restructuring charges	18			30
Gain from sale of businesses	(11		)	—
Other, net	(2		)	11
Payments for restructuring	(20		)	(24		)
Changes in assets and liabilities (net of acquisitions):
Changes in receivables	(40		)	(71		)
Changes in inventories	(62		)	(59		)
Changes in accounts payable	(2		)	4
Other, net	10			(19		)
Net Cash – Operating activities	253			163
Investing Activities
Capital expenditures	(77		)	(91		)
Acquisitions of businesses, net of cash acquired	—			(81		)
Proceeds from sale of business	30			—
Proceeds from the sale of property, plant and equipment	2			7
Net Cash – Investing activities	(45		)	(165		)
Financing Activities
Issuance of short-term debt	2			—
Principal payments of debt and capital lease obligations	—			(2		)
Repurchase of common stock	(132		)	(44		)
Proceeds from exercise of employee stock options	17			2
Dividends paid	(71		)	(65		)
Excess tax benefit from share based compensation	1			—
Other, net	1			—
Net Cash – Financing activities	(182		)	(109		)
Effect of exchange rate changes on cash	(30		)	1
Net change in cash and cash equivalents	(4		)	(110		)
Cash and cash equivalents at beginning of year	533			504
Cash and cash equivalents at end of period	$	529		$	394
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest	$	36		$	37
Income taxes (net of refunds received)	$	69		$	61

See accompanying notes to condensed consolidated financial statements.

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.

Xylem has two reportable 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, 2013 ("2013 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 2013 Annual Report. Certain prior year amounts have been reclassified to conform to the current year presentation.

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.

Note 2. Recently Issued Accounting Pronouncements

Pronouncements Not Yet Adopted

In June 2014, the Financial Accounting Standards Board (“FASB”) issued guidance related to the recognition of compensation on employee share-based payments in which the terms of the award provide that a performance target that affects vesting could be achieved after the requisite service period. The standard states that the performance target should not be reflected in estimating the grant date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the periods for which the service has already been rendered. If the performance target becomes probable of being achieved before the end of the requisite service period, the remaining unrecognized compensation cost should be recognized prospectively over the remaining requisite service period. This guidance is effective for annual reporting periods beginning after December 15, 2015 with early adoption permitted. The components of the guidance may be applied either (a) prospectively to all awards granted or modified after the effective date or (b) retrospectively to all awards outstanding as of the beginning of the earliest annual period presented in the financial statements and to all new or modified awards thereafter. This guidance is not expected to have an impact on our financial condition or results of operations.

In May 2014, the FASB issued guidance on recognizing revenue from contracts with customers. The guidance outlines a single comprehensive model to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. The core principle of the model is that an entity recognizes revenue to portray the transfer of goods and services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The standard also expands disclosure requirements regarding revenue recognition. This guidance is effective for annual reporting periods beginning after December 15, 2016 and may be applied retrospectively to each prior period presented or with the cumulative effect recognized as of the date of initial application. Early adoption is not permitted. We are currently evaluating the impact of the guidance on our financial condition and results of operations.

In April 2014, the FASB issued guidance related to the reporting of discontinued operations. The guidance states that the disposal of a business or operation is required to be reported as discontinued operations if the disposal represents a strategic shift that will have a major effect on an entity’s operations and financial results. The guidance also expands disclosures about discontinued operations and the disposal of significant businesses that did not qualify for discontinued operations presentation. This standard is effective prospectively, for disposals (or businesses that qualify as “held for sale”) that occur within annual periods beginning on or after December 15, 2014 and interim periods within those years. Early adoption is permitted. The impact of this guidance on our financial condition and results of operations will depend on the occurrence and the significance of disposal transactions that meet the criteria described above.

In January 2014, the FASB issued guidance related to service concession arrangements. A service concession arrangement is an arrangement between a public-sector entity grantor and an operating entity under which the operating entity operates the grantor's infrastructure (for example, airports, roads and bridges). The guidance states that service concession arrangements should not be accounted for under the guidance of Accounting Standards Codification Topic 840, Leases, but rather other guidance as deemed appropriate. This guidance is effective for fiscal years beginning on or after December 15, 2014 with early adoption permitted. Opening retained earnings will be adjusted in the year of adoption to reflect the cumulative historical impact of any arrangements existing at the date of adoption and the new guidance will then be applied to the financial statements on a prospective basis. The adoption of this guidance is not expected to have a material impact on our financial condition or results of operations.

Recently Adopted Pronouncements

In July 2013, the 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. The adoption of this guidance did not have a material impact on our financial condition or 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 adoption of this guidance did not have a material impact on our financial condition or results of operations.

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. The adoption of this guidance did not have a material impact on our financial condition or results of operations.

Note 3. Acquisitions and Divestitures

Divestiture Activity

On July 2, 2014, we divested our Wolverhampton, U.K.-based pneumatic and hydraulic valves business for approximately $30 million. The sale resulted in a gain of $11 million reflected in gain from sale of business in our Condensed Consolidated Income Statement. The business, which was part of our Applied Water segment, provided a wide range of products, primarily to industrial original equipment manufacturer customers in the oil and gas sector. The business reported 2013 annual revenue of approximately $25 million.

Acquisition Activity

During the nine months ended September 30, 2014, we did not make any acquisitions. During the nine months ended September 30, 2013, we spent $84 million ($81 million, net of cash acquired) on acquisitions that were not material individually or in the aggregate to our results of operations or financial position.

Note 4. Restructuring Charges

During the three and nine months ended September 30, 2014, we recognized restructuring charges of less than $1 million and $18 million, respectively. We incurred these charges primarily in an effort to reposition our European and North American businesses to optimize our cost structure and improve our operational efficiency and effectiveness. The charges relate to a reduction in structural costs, including the elimination of headcount and consolidation of facilities within both our Water Infrastructure and Applied Water segments.

During the three and nine months ended September 30, 2013 we recognized restructuring charges of $5 million and $30 million, respectively, which related to the reduction in structural costs, including the elimination of headcount and consolidation of facilities within both our Water Infrastructure and Applied Water segments.

The following table presents the components of restructuring expense for the three and nine months ended September 30, 2014 and 2013.



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(in millions)	2014		2013		2014		2013
By component:
Severance and other charges	$	—	$	4	$	18	$	28
Lease related charges	—		1		—		1
Other restructuring charges	—		—		—		1
Reversal of restructuring accruals	—		—		—		—
Total restructuring charges	$	—	$	5	$	18	$	30

By segment:
Water Infrastructure	$	—	$	3	$	12	$	24
Applied Water	—		2		6		6

The following table displays a rollforward of the restructuring accruals, presented on our Condensed Consolidated Balance Sheets within accrued and other current liabilities, for the nine months ended September 30, 2014 and 2013.



(in millions)	2014			2013
Restructuring accruals - January 1	$	13		$	9
Restructuring charges	18			30
Cash payments	(20		)	(24		)
Other	—			—
Restructuring accruals - September 30	$	11		$	15

By segment:
Water Infrastructure	$	8		$	12
Applied Water	3			3

The following is a rollforward for the nine months ended September 30, 2014 and 2013 of employee position eliminations associated with restructuring activities.



	2014		2013
Planned reductions - January 1	51		54
Additional planned reductions	233		439
Actual reductions	(206	)	(346	)
Planned reductions - September 30	78		147

Total expected costs associated with actions that commenced during the nine months ended September 30, 2014 are approximately $12 million for Water Infrastructure and approximately $9 million for Applied Water. These costs primarily consist of severance charges. Related to these actions, we incurred less than $1 million and $11 million for Water Infrastructure during the three and nine months ended September 30, 2014, respectively, and less than $1 million and $6 million for Applied Water during the three and nine months ended September 30, 2014, respectively. We currently expect activity related to these actions to continue through 2015.

Total expected costs associated with actions that commenced during 2013 are approximately $33 million for Water Infrastructure. Approximately $31 million of the expected cost was incurred in 2013, $0 million and $1 million was incurred during the three and nine months ended September 30, 2014, respectively, and $1 million is expected to be incurred through the end of 2014. Total expected costs associated with actions that commenced during 2013 are approximately $9 million for Applied Water. Approximately $8 million of the expected cost was incurred in 2013 and approximately $1 million is expected to be incurred through the end of 2014.

Note 5. 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 September 30, 2014 was $22 million at an effective tax rate of 17.5%, compared to $10 million at an effective tax rate of 12.1% for the same period in 2013. The income tax provision for the nine months ended September 30, 2014 was $52 million at an effective tax rate of 17.7%, compared to $31 million at an effective tax rate of 16.4% for the same period in 2013. The effective tax rate was lower than the United States Federal statutory rate in each period primarily due to geographic mix of earnings. Additionally, the effective tax rate was higher for the three and nine months ended September 30, 2014 compared to the same periods in 2013 due to the tax impacts from special charges incurred by the Company in 2013 associated with the settlement of legal proceedings with Xylem Group LLC and the impact of one-time costs incurred for the change in chief executive officer.

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 September 30, 2014 was $30 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 expense 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 September 30, 2014, we had $1 million of interest accrued for unrecognized tax benefits.

Note 6. Earnings Per Share

The following is a reconciliation of the shares used in calculating basic and diluted net earnings per share.



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2014		2013		2014		2013
Net income (in millions)	$	106	$	73	$	241	$	160
Shares (in thousands):
Weighted average common shares outstanding	182,196		185,044		183,343		185,294
Add: Participating securities (a)	48		122		46		165
Weighted average common shares outstanding — Basic	182,244		185,166		183,389		185,459
Plus incremental shares from assumed conversions: (b)
Dilutive effect of stock options	646		175		655		180
Dilutive effect of restricted stock	542		661		529		547
Weighted average common shares outstanding — Diluted	183,432		186,002		184,573		186,186
Basic earnings per share	$	0.58	$	0.39	$	1.31	$	0.86
Diluted earnings per share	$	0.58	$	0.39	$	1.31	$	0.86


(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 were otherwise 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 14, "Share-Based Compensation Plans" for further detail on the performance share units.



	Three Months Ended		Nine Months Ended
	September 30,		September 30,
(in thousands)	2014	2013	2014	2013
Stock options	2,709	4,414	2,769	4,342
Restricted stock	534	655	532	758
Performance shares	136	106	114	88

Note 7. Inventories

The components of total inventories, net are summarized as follows:



(in millions)	September 30, 2014		December 31, 2013
Finished goods	$	213	$	189
Work in process	37		31
Raw materials	266		255
Total inventories, net	$	516	$	475

Note 8. Property, Plant and Equipment

The components of total property, plant and equipment, net are as follows:



(in millions)	September 30, 2014		December 31, 2013
Land, buildings and improvements	$	247	$	263
Machinery and equipment	661		685
Equipment held for lease or rental	205		192
Furniture and fixtures	90		93
Construction work in progress	50		49
Other	22		22
Total property, plant and equipment, gross	1,275		1,304
Less accumulated depreciation	821		816
Total property, plant and equipment, net	$	454	$	488

Depreciation expense of $23 million and $70 million was recognized during the three and nine months ended September 30, 2014, respectively, and $23 million and $72 million for the three and nine months ended September 30, 2013, respectively.

Note 9. Goodwill and Other Intangible Assets

Changes in the carrying value of goodwill by reportable segment for the nine months ended September 30, 2014 are as follows:



(in millions)	Water Infrastructure			Applied Water			Total
Balance as of January 1, 2014	$	1,149		$	569		$	1,718
Activity in 2014
Goodwill (divested) acquired (a)	—			(6		)	(6		)
Foreign currency and other	(29		)	(16		)	(45		)
Balance as of September 30, 2014	$	1,120		$	547		$	1,667


(a)	On July 2, 2014, we divested our Wolverhampton, U.K.-based pneumatic and hydraulic valves business which had $6 million of goodwill associated with the business.

Based on the results of our latest annual impairment tests, we determined that no impairment of goodwill existed as of the measurement date in 2013. 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.

Other Intangible Assets

Information regarding our other intangible assets is as follows:



	September 30, 2014							December 31, 2013
(in millions)	Carrying Amount		Accumulated Amortization			Net Intangibles		Carrying Amount		Accumulated Amortization			Net Intangibles
Customer and distributor relationships	$	339	$	(118	)	$	221	$	352	$	(104	)	$	248
Proprietary technology	107		(40		)	67		109		(36		)	73
Trademarks	34		(17		)	17		35		(16		)	19
Patents and other	19		(17		)	2		20		(17		)	3
Indefinite-lived intangibles	141		—			141		145		—			145
	$	640	$	(192	)	$	448	$	661	$	(173	)	$	488

Based on the results of our most recent annual impairment tests, we recorded a $2 million charge related to three trade names within our Water Infrastructure segment in the fourth quarter 2013. As of September 30, 2014, no events or circumstances have occurred that indicate an additional impairment has occurred. We will continue to monitor 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 was $9 million and $27 million for the three and nine months ended September 30, 2014, respectively, and $9 million and $28 million for the three and nine months ended September 30, 2013, respectively.

Note 10. 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.

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.

Listed in the table below are the outstanding foreign currency derivatives that were used to hedge foreign exchange risks as of September 30, 2014.



(in millions; except number of instruments)
Foreign Currency Derivative	Number of Instruments	Total Notional Sold	Sell Notional Currency	Total Notional Purchased	Buy Notional Currency
Buy HUF/Sell EUR Forward	7	8	Euro (EUR)	2,423	Hungarian Forint (HUF)
Buy PLN/Sell EUR Forward	14	12	Euro (EUR)	50	Polish Zloty (PLN)
Buy SEK/Sell EUR Forward	15	94	Euro (EUR)	852	Swedish Krona (SEK)
Buy USD/Sell CAD Forward	13	17	Canadian Dollar (CAD)	15	United States Dollar (USD)
Sell AUD/Buy EUR Forward	16	16	Australian Dollar (AUD)	11	Euro (EUR)
Sell AUD/Buy USD Forward	7	5	Australian Dollar (AUD)	5	United States Dollar (USD)
Sell CAD/Buy EUR Forward	17	21	Canadian Dollar (CAD)	14	Euro (EUR)
Sell GBP/Buy EUR Forward	20	25	British Pound Sterling (GBP)	31	Euro (EUR)
Sell USD/Buy EUR Forward	34	89	United States Dollar (USD)	66	Euro (EUR)

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					Nine Months Ended
	September 30,					September 30,
(in millions)	2014			2013		2014			2013
Derivatives in Cash Flow Hedges
Foreign Exchange Contracts
Amount of (loss) gain recognized in Other Comprehensive Income (a)	$	(6	)	$	2	$	(14	)	$	—
Amount of loss (gain) reclassified from Other Comprehensive Income into revenue (a)	1			—		—			(1		)
Amount of loss (gain) reclassified from Other Comprehensive Income into cost of revenue (a)	1			1		1			1


(a)	Effective portion

As of September 30, 2014, $11 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 nine months ended September 30, 2014 and 2013, the amounts were not material.

The fair values of our foreign exchange contracts currently included in our hedging program were as follows:



(in millions)	September 30, 2014			December 31, 2013
Derivatives designated as hedging instruments
Assets
Other current assets	$	1		$	1
Liabilities
Other current liabilities	(9		)	—

Note 11. Accrued and Other Current Liabilities

The components of total accrued and other current liabilities are as follows:



(in millions)	September 30, 2014		December 31, 2013
Compensation and other employee benefits	$	185	$	215
Customer-related liabilities	69		63
Accrued warranty costs	32		36
Accrued taxes	74		45
Other accrued liabilities	135		120
Total accrued and other current liabilities	$	495	$	479

Note 12. Credit Facilities and Long-Term Debt

Total debt outstanding is summarized as follows:



(in millions)	September 30, 2014			December 31, 2013
Short-term borrowings and current maturities of long-term debt	$	41		$	42

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	$	1,240		$	1,241

(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 (as defined below) was $627 million and $635 million as of September 30, 2014 and December 31, 2013, respectively. The fair value of our Senior Notes due 2021 (as defined below) was $652 million and $629 million as of September 30, 2014 and December 31, 2013, respectively.


(b)	The unamortized discount is recognized as a reduction in the carrying value of the Senior Notes 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.

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 leaseback 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). 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 September 30, 2014, 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, the 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 September 30, 2014, 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 September 30, 2014, the Credit Facility remains undrawn.

Research and Development Facility Agreement

On December 4, 2013, the Company amended and restated its Risk Sharing Finance Facility Agreement (the "R&D Facility Agreement") with The European Investment Bank (the "EIB") to add an additional borrower under the facility. The facility provides an aggregate principal amount of up to €120 million (approximately $153 million) to finance research projects and infrastructure development in the European Union. The Company's wholly owned subsidiaries in Luxembourg, Xylem Holdings S.á r.l. and Xylem International S.á r.l., are the borrowers under the R&D Facility Agreement. The obligations of the borrowers under the R&D Facility Agreement are guaranteed by the Company under an Amended and Restated Deed of Guarantee, dated as of December 4, 2013, in favor of the EIB. The funds are available to finance research and development projects during the period from 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 draw loans on or before June 14, 2015 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 is at a fixed percentage rate per annum specified by the EIB which includes the applicable margin. The interest rate per annum applicable to Floating Rate loans is at the rate determined by reference to EURIBOR for loans drawn in Euros and LIBOR for loans drawn in Pounds Sterling or U.S. Dollars, plus an applicable spread specified by the EIB which includes the applicable margin. The applicable margin for both Fixed Rate loans and Floating Rate loans is determined by reference to the credit rating of the Company.

In accordance with the terms of the R&D Facility Agreement, 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 September 30, 2014, 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 into 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 September 30, 2014, $36 million was outstanding under the R&D Facility Agreement. Although the borrowing term for this arrangement is for five years, we have classified it as short-term debt on our Condensed Consolidated Balance Sheet since we intend to repay this obligation in less than one year.

Note 13. Postretirement Benefit Plans

The following table provides the components of net periodic benefit cost for our defined benefit pension plans, disaggregated by domestic and international plans.



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(in millions)	2014			2013			2014			2013
Domestic defined benefit pension plans:
Service cost	$	1		$	1		$	2		$	2
Interest cost	—			1			2			3
Expected return on plan assets	(1		)	(1		)	(3		)	(3		)
Amortization of net actuarial loss	—			1			1			3
Net periodic benefit cost	$	—		$	2		$	2		$	5
International defined benefit pension plans:
Service cost	$	3		$	3		$	11		$	10
Interest cost	8			7			22			21
Expected return on plan assets	(8		)	(7		)	(25		)	(23		)
Amortization of net actuarial loss	2			3			6			9
Net periodic benefit cost	$	5		$	6		$	14		$	17
Total net periodic benefit cost	$	5		$	8		$	16		$	22

The total net periodic benefit cost for other postretirement employee benefit plans was $1 million and $4 million for the three and nine months ended September 30, 2014, respectively, including amounts recognized in other comprehensive income of less than $1 million and $1 million, respectively. The total net periodic benefit cost for other postretirement employee benefit plans was $2 million and $5 million for the three and nine months ended September 30, 2013, respectively, including amounts recognized in other comprehensive income of $1 million and $2 million, respectively.

We contributed $30 million and $32 million to postretirement benefit plans during the nine months ended September 30, 2014 and 2013, respectively. Additional contributions ranging between approximately $5 million and $10 million are expected during the remainder of 2014.

During the third quarter 2014, we amended one of our international pension plans as well as one of our domestic other postretirement plans. The pension plan amendment froze the accrual of benefits and closed the plan to new entrants. The other postretirement plan amendment modified the accrual of benefits and closed the plan to new entrants. The overall impact of these changes to our third quarter financial statements was a $10 million increase to funded status. This included a net loss of $3 million ($1 million net of tax) and a prior service credit of $13 million ($8 million net of tax) recognized in other comprehensive income.

Note 14. Share-Based Compensation Plans

Share-based compensation expense was $5 million and $14 million during the three and nine months ended September 30, 2014, respectively, and $9 million and $21 million during the three and nine months ended September 30, 2013, respectively. The unamortized compensation expense related to our stock options, restricted stock and performance based shares was $7 million, $20 million and $4 million,

respectively, at September 30, 2014 and is expected to be recognized over a weighted average period of 2.0, 1.8 and 2.2 years, respectively. The amount of cash received from the exercise of stock options was $17 million and $2 million for the nine months ended September 30, 2014 and 2013, respectively.

On March 17, 2014, the Company named Patrick K. Decker as the new President and Chief Executive Officer of Xylem Inc. As part of Mr. Decker's employment agreement, he was awarded 165,584 stock options, 40,342 restricted stock and 40,342 performance-based shares. The award was granted subject to the approval of the Xylem Omnibus Incentive Plan, which was obtained at the annual meeting of shareholders in May 2014. The share and associated expense amounts are included beginning as of the May approval date.

Stock Option Grants

The following is a summary of the changes in outstanding stock options for the nine months ended September 30, 2014:



(shares in thousands)	Shares		Weighted Average Exercise Price / Share		Weighted Average Remaining Contractual Term (Years)
Outstanding at January 1, 2014	3,504		$	26.80	6.4
Granted	543		$	38.16	10.0
Exercised	(617	)	$	27.87	4.4
Forfeited	(70	)	$	25.93	6.0
Outstanding at September 30, 2014	3,360		$	28.47	6.6
Options exercisable at September 30, 2014	1,897		$	26.87	5.3
Vested and expected to vest as of September 30, 2014	3,247		$	28.26	6.5

The aggregate intrinsic value of the outstanding, exercisable, and vested and expected to vest stock options as of September 30, 2014 was $28 million, $18 million and $28 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 nine months ended September 30, 2014 was $6 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 2014 grants:



Dividend yield	1.34		%
Volatility	28.49		%
Risk-free interest rate	1.82		%
Expected term (in years)	5.6
Weighted-average fair value / share	$	9.71

Expected volatility is calculated based on a weighted analysis of historic and implied volatility measures for a set of peer companies and Xylem. 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 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.

Restricted Stock Grants

The following is a summary of restricted stock activity for the nine months ended September 30, 2014:



(shares in thousands)	Shares		Weighted Average Grant Date Fair Value /Share
Outstanding at January 1, 2014	1,275		$	27.67
Granted	377		$	38.35
Vested	(230	)	$	30.98
Forfeited	(79	)	$	29.13
Outstanding at September 30, 2014	1,343		$	30.06

Performance-Based Share Grants

The following is a summary of performance-based share grants for the nine months ended September 30, 2014:



(shares in thousands)	Shares	Weighted Average Grant Date Fair Value /Share
Outstanding at January 1, 2014	52	$	27.49
Granted	84	$	37.87
Vested	—	$	—
Forfeited	—	$	—
Outstanding at September 30, 2014	136	$	33.85

Note 15. Capital Stock

As announced on August 21, 2013, the Board of Directors authorized the repurchase of up to $250 million in shares with no expiration date. The program's objective is to deploy our capital in a manner that benefits our shareholders and maintains our focus on growth. During the three and nine months ended September 30, 2014, we repurchased 0.8 million and 3.4 million shares for $30 million and $130 million, respectively, under this program. There are up to $70 million in shares that may still be purchased under this plan as of September 30, 2014. For both the three and nine months ended September 30, 2013, we repurchased 1.0 million shares for $25 million under this program.

As announced on August 20, 2012, the Board of Directors authorized the repurchase of up to 2.0 million shares of common stock with no expiration date. The program's objective is to offset dilution associated with various Xylem employee stock plans by acquiring shares in the open market from time to time. There were no shares repurchased under this program during the three and nine months ended September 30, 2014. There are up to 1.0 million shares that may still be purchased under this plan as of September 30, 2014. There were no shares repurchased during the three months ended September 30, 2013. For the nine months ended September 30, 2013, there were 0.6 million shares repurchased for $17 million.

Aside from the aforementioned repurchase programs, we repurchased less than 0.1 million shares for less than $1 million during the three months ended September 30, 2014, in relation to settlement of employee tax withholding obligations due as a result of the vesting of restricted stock. We repurchased less than 0.1 million shares for $2 million during the nine months ended September 30, 2014. Likewise, during the three and nine months ended September 30, 2013, we repurchased approximately 0.2 million shares in both periods for $4 million and $6 million, respectively.

Note 16. Accumulated Other Comprehensive Income (Loss)

The following table provides the components of accumulated other comprehensive income (loss) for the three months ended September 30, 2014:



(in millions)	Foreign Currency Translation			Postretirement Benefit Plans			Derivative Instruments			Total
Balance at July 1, 2014	$	352		$	(187	)	$	(7	)	$	158
Foreign currency translation adjustment	(114		)	—			—			(114		)
Changes in postretirement benefit plans	—			10			—			10
Income tax expense on changes in postretirement benefit plans	—			(3		)	—			(3		)
Amortization of net actuarial loss on postretirement benefit plans into:
Cost of revenue	—			1			—			1
Selling, general and administrative expenses	—			1			—			1
Income tax expense on amortization of postretirement benefit plan items	—			(1		)	—			(1		)
Unrealized loss on foreign exchange agreements	—			—			(6		)	(6		)
Income tax benefit on unrealized loss on foreign exchange agreements	—			—			1			1
Reclassification of unrealized loss on foreign exchange agreements into revenue	—			—			1			1
Reclassification of unrealized loss on foreign exchange agreements into cost of revenue	—			—			1			1
Balance at September 30, 2014	$	238		$	(179	)	$	(10	)	$	49

The following table provides the components of accumulated other comprehensive income (loss) for the nine months ended September 30, 2014:



(in millions)	Foreign Currency Translation			Postretirement Benefit Plans			Derivative Instruments			Total
Balance at January 1, 2014	$	351		$	(186	)	$	2		$	167
Foreign currency translation adjustment	(113		)	—			—			(113		)
Changes in postretirement benefit plans	—			3			—			3
Income tax expense on changes in postretirement benefit plans	—			(1		)	—			(1		)
Amortization of net actuarial loss on postretirement benefit plans into:
Cost of revenue	—			3			—			3
Selling, general and administrative expenses	—			5			—			5
Income tax expense on amortization of postretirement benefit plan items	—			(3		)	—			(3		)
Unrealized loss on foreign exchange agreements	—			—			(14		)	(14		)
Income tax benefit on unrealized loss on foreign exchange agreements	—			—			1			1
Reclassification of unrealized loss on foreign exchange agreements into cost of revenue	—			—			1			1
Balance at September 30, 2014	$	238		$	(179	)	$	(10	)	$	49

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, intellectual property matters, product liability and personal injury claims, employment and pension matters, government and commercial contract disputes.

On October 1, 2014, the court approved a settlement agreement with respect to a purchase price dispute with the minority shareholders arising from one of our historical acquisitions. All outstanding claims have been settled and the court proceedings have been terminated. The settlement has been reflected on the September 30, 2014 Condensed Consolidated Balance Sheet and is consistent with what had been previously accrued.

From time to time, claims may be asserted against Xylem alleging injury caused by any of our products resulting from asbestos exposure. 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 Corporation ("ITT" or "former parent"), Exelis Inc. and Xylem, the former parent has an obligation to 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 the former parent’s legacy products. We believe the former parent 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. We have estimated and accrued $17 million for these general legal matters as of both September 30, 2014 and December 31, 2013.

Indemnifications

As part of our 2011 spin-off from our former parent, ITT, Exelis Inc. 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. The former parent’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 expect to be indemnified by the former parent or Exelis Inc. 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 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 $6 million and $8 million as of September 30, 2014 and December 31, 2013 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. We believe 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)	2014			2013
Warranty accrual – January 1	$	37		$	40
Net changes for product warranties in the period	19			24
Settlement of warranty claims	(23		)	(26		)
Foreign currency and other	(1		)	—
Warranty accrual - September 30	$	32		$	38

Note 18. Segment Information

Our business has two reportable segments: Water Infrastructure and Applied Water. The Water Infrastructure segment, comprising our Water Solutions and Analytics operating segments, 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 encompasses the uses of water and focuses on the residential, commercial, industrial and agricultural markets offering a wide range of products, including pumps, valves and heat exchangers. 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 environmental matters that are managed at a corporate level and are not included in the business segments in evaluating performance or allocating resources.

The accounting policies of each segment are the same as those described in the summary of significant accounting policies (see Note 1 in the 2013 Annual Report). The following tables contain financial information for each reportable segment.



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(in millions)	2014			2013			2014			2013
Revenue:
Water Infrastructure	$	619		$	619		$	1,823		$	1,766
Applied Water	362			360			1,105			1,086
Eliminations	(18		)	(14		)	(54		)	(48		)
Total	$	963		$	965		$	2,874		$	2,804
Operating Income:
Water Infrastructure	$	94		$	88		$	217		$	171
Applied Water	52			40			145			125
Corporate and other	(16		)	(30		)	(40		)	(62		)
Total	$	130		$	98		$	322		$	234
Depreciation and Amortization:
Water Infrastructure	$	27		$	27		$	81		$	83
Applied Water	7			7			21			21
Corporate and other	1			2			5			6
Total	$	35		$	36		$	107		$	110
Capital Expenditures:
Water Infrastructure	$	19		$	18		$	50		$	57
Applied Water	8			7			21			26
Corporate and other	2			5			6			8
Total	$	29		$	30		$	77		$	91

The following table contains the total assets for each reportable segment.



	Total Assets
(in millions)	September 30, 2014		December 31, 2013
Water Infrastructure	$	2,918	$	2,989
Applied Water	1,333		1,340
Corporate and other (a)	563		567
Total	$	4,814	$	4,896


(a)	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.



ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the condensed consolidated financial statements, including the notes thereto, included elsewhere in this report on Form 10-Q (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 the "former parent" refer to ITT Corporation and its consolidated subsidiaries (other than Xylem Inc.).

This Report contains “forward-looking statements” within the meaning of the Private Securities Litigation Act of 1995 that are based on our current expectations and assumptions. Forward-looking statements by their nature address matters that are, to different degrees, uncertain. Generally, the words “anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,” “strategy,” “may,” “will,” “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.

Forward-looking statements include, but are not limited to, statements about the capitalization of the Company, the Company's restructuring and realignment, our 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 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, cash flows, 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 its present expectations or projections. These risks and uncertainties include, but are not limited to, those set forth under the heading "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2013 ("2013 Annual Report") and with subsequent filings we make with the Securities and Exchange Commission.

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.

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 reportable segments: Water Infrastructure and Applied Water. Our segments are aligned with each of the sectors in the cycle of water, water infrastructure and usage applications.

•

Water Infrastructure serves the water 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. In the Water Infrastructure segment, we provide the majority of our sales direct to customers with strong application expertise, while the remaining amount is through distribution partners.

•

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. In the Applied Water segment, we provide the majority of our sales through long-standing relationships with the world’s leading distributors, with the remainder going direct to customers.

Executive Summary

Xylem reported revenue for the third quarter of 2014 of $963 million, a decrease of 0.2% compared to $965 million during the third quarter of 2013. Revenue was flat on a constant currency basis due to organic growth of 0.7% offset by the impact of our divestiture of our Wolverhampton valves business. The organic growth was driven by strength from emerging markets and the United States which was offset by weakness in the European markets. Operating income for the third quarter of 2014 was $130 million, reflecting an increase of $32 million or 32.7% compared to $98 million in the third quarter of 2013, primarily due to savings from lean six sigma activities, global sourcing initiatives and restructuring actions as well as $20 million in non-recurring special charges in the prior year, which more than offset headwinds from cost inflation and unfavorable price and sales mix. Additionally, restructuring and realignment cost actions taken to improve the overall cost base of the business were $4 million in the third quarter of 2014 as compared to $12 million in the prior year.

Additional financial highlights for the quarter ended September 30, 2014 include the following:


•	Orders of $1,027 million, or 7.5% growth from $955 million in the prior year


•	Earnings per share of $0.58, up 48.7% from prior year ($0.53 on an adjusted basis, up 8.2%)


•	Cash flow from operating activities of $253 million for the nine months ended September 30, 2014, up 55.2% from prior year, and free cash flow of $176 million as compared to $72 million in the prior year.

Key Performance Indicators and Non-GAAP Measures

Management reviews key performance indicators including revenue, gross margin, segment 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 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 deployment among competing strategic alternatives and initiatives, including, but not limited to, dividends, 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 restructuring and realignment costs, gain on sale of business, special charges and tax-related special items. A reconciliation of adjusted net income is provided below.



	Three Months Ended					Nine Months Ended
	September 30,					September 30,
(In millions, except for per share data)	2014			2013		2014			2013
Net income	$	106		$	73	$	241		$	160
Restructuring and realignment, net of tax	3			7		23			36
Special charges, net of tax	—			12		—			12
Tax-related special items	(1		)	—		(5		)	—
Gain on sale of business, net of tax	(11		)	—		(11		)	—
Adjusted net income	$	97		$	92	$	248		$	208
Weighted average number of shares - Diluted	183.4			186.0		184.6			186.2
Adjusted earnings per share	$	0.53		$	0.49	$	1.35		$	1.12


•	"operating expenses excluding restructuring and realignment costs" defined as operating expenses, adjusted to exclude restructuring and realignment costs and special charges.


•	"adjusted segment operating income" defined as segment operating income, adjusted to exclude restructuring and realignment costs, and "adjusted segment operating margin" defined as adjusted segment operating income divided by total segment revenue.


•	“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.


•	"special charges" defined as costs incurred by the Company associated with the settlement of legal proceedings with Xylem Group LLC, as well as certain costs incurred for the change in chief executive officer made during the third quarter of 2013.

•

"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 flow does not consider certain non-discretionary cash payments, such as debt. The following table provides a reconciliation of free cash flow.



	Nine Months Ended
	September 30,
(In millions)	2014			2013
Net cash provided by operating activities	$	253		$	163
Capital expenditures	(77		)	(91		)
Free cash flow	$	176		$	72

2014 Outlook

We continue to expect a modest recovery in the United States industrial markets combined with continued strength in the emerging markets. We are monitoring the European market conditions and expect marginal improvement in performance in our industrial end markets there. Globally, while our industrial markets are improving in production and capital outlay, continued mixed geographical performance in mining is expected. We expect public utilities to be flat to up slightly for the remainder of 2014, but at a lower rate than we experienced in the first half of 2014 and lower compared to the second half of 2013, which was particularly strong. We expect marginal growth for the remainder of 2014 within commercial building applications from an improved outlook in the U.S. institutional building sector, which will be reinforced by incremental growth from new products and strength in emerging markets, partially offset by mixed European market conditions. We expect flat to slightly negative revenue growth from residential building applications over the balance of the year from continued strength in the United States markets tempered by weakness in Europe. We are continuing to execute restructuring and realignment actions, including our organizational redesign and repositioning of our European and North American businesses to optimize our cost structure and improve our operational efficiency and effectiveness. In 2014, we continue to expect to incur approximately $30 to $35 million in restructuring costs, and approximately $10 to $15 million in realignment costs. We expect to realize approximately $25 million of incremental net savings in 2014 from restructuring actions initiated in 2013, and an additional $15 to $17 million of net savings from our 2014 actions. Additional strategic actions we have undertaken include investing in a customer relationship management system, growth platforms and new product development, as well as executing operating efficiencies through lean six sigma and global sourcing initiatives. We also will continue to focus on the Xylem Management System, which integrates our key business processes.

Additionally, in the fourth quarter of 2014 we expect to finalize the implementation of our revised measurement system related to the organizational redesign we previously initiated whereby we shifted within geographical regions from marketing and sales organizations tied to specific business units to an integrated approach across the Xylem portfolio of products.

Results of Operations



	Three Months Ended									Nine Months Ended
	September 30,									September 30,
(In millions)	2014			2013			Change			2014			2013			Change
Revenue	$	963		$	965		(0.2	)	%	$	2,874		$	2,804		2.5		%
Gross Profit	376			384			(2.1	)	%	1,106			1,089			1.6		%
Gross Margin	39.0		%	39.8		%	(80	)	bp	38.5		%	38.8		%	(30	)	bp
Operating expenses excluding restructuring and realignment costs and special charges	242			254			(4.7	)	%	753			783			(3.8	)	%
Expense to revenue ratio	25.1		%	26.3		%	(120	)	bp	26.2		%	27.9		%	(170	)	bp
Restructuring and realignment costs	4			12			(66.7	)	%	31			52			(40.4	)	%
Special charges	—			20			NM			—			20			NM
Total operating expenses	246			286			(14.0	)	%	784			855			(8.3	)	%
Operating Income	130			98			32.7		%	322			234			37.6		%
Operating Margin	13.5		%	10.2		%	330		bp	11.2		%	8.3		%	290		bp
Interest and other non-operating expense, net	13			15			(13.3	)	%	40			43			(7.0	)	%
Gain on sale of business	11			—			NM			11			—			NM
Income tax expense	22			10			120.0		%	52			31			67.7		%
Tax rate	17.5		%	12.1		%	540		bp	17.7		%	16.4		%	130		bp
Net Income	$	106		$	73		45.2		%	$	241		$	160		50.6		%

NM - Not meaningful percentage change

Revenue

Revenue generated during the three and nine months ended September 30, 2014 was $963 million and $2,874 million, respectively, reflecting a decrease of $2 million or 0.2% and an increase of $70 million or 2.5%, respectively, compared to the same prior year periods. On a constant currency basis, revenue was flat and increased 2.5% for the three and nine months ended September 30, 2014, respectively. The flat performance included organic growth of 0.7% driven by strong growth from emerging markets and the United States which was offset by weakness in the European markets and also offset by the impact of our divestiture of our Wolverhampton valves business as of the beginning of the third quarter of 2014. The 2.5% increase reflected organic growth across most regions partially offset by declines in Europe.

The following table illustrates the impact from organic growth, recent acquisitions and divestitures, and fluctuations in foreign currency in relation to revenue during the three and nine months ended September 30, 2014:



	Three Months Ended					Nine Months Ended
	September 30,					September 30,
(In millions)	Change			% Change		Change			% Change
2013 Revenue	$	965				$	2,804
Organic growth	7			0.7	%	70			2.5	%
Acquisitions/(Divestitures)	(7		)	(0.7	)%	(1		)	—	%
Constant Currency	—			—	%	69			2.5	%
Foreign currency translation (a)	(2		)	(0.2	)%	1			—	%
Total change in revenue	(2		)	(0.2	)%	70			2.5	%
2014 Revenue	$	963				$	2,874


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

The following table summarizes revenue by segment:

Three Months Ended

Nine Months Ended

September 30,

(In millions)

2014

2013

As Reported

Change

Constant Currency

Change

2014

2013

As Reported

Change

Constant

Currency

Change

Water Infrastructure

619