Edgar Filing: Xylem Inc.

Large accelerated filer

Accelerated filer

Non-accelerated filer

¨ (Do not check if a smaller reporting company)

Smaller reporting company

Document

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, 2016



¨	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) (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 Web site, 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.

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 28, 2016, there were 179,394,836 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, 2016 and 2015 (Unaudited)	3
		Condensed Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2016 and 2015 (Unaudited)	4
		Condensed Consolidated Balance Sheets as of September 30, 2016 and December 31, 2015 (Unaudited)	5
		Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2016 and 2015 (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	28
Item 3	-	Quantitative and Qualitative Disclosures About Market Risk	44
Item 4	-	Controls and Procedures	44
PART II – Other Information
Item 1	-	Legal Proceedings	45
Item 1A	-	Risk Factors	45
Item 2	-	Unregistered Sales of Equity Securities and Use of Proceeds	45
Item 3	-	Defaults Upon Senior Securities	45
Item 4	-	Mine Safety Disclosures	45
Item 5	-	Other Information	45
Item 6	-	Exhibits	45
Signatures			46

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,	2016		2015		2016		2015
Revenue	$	897	$	902	$	2,676	$	2,659
Cost of revenue	540		551		1,621		1,645
Gross profit	357		351		1,055		1,014
Selling, general and administrative expenses	219		207		665		631
Research and development expenses	23		23		75		71
Restructuring charges	6		1		18		5
Operating income	109		120		297		307
Interest expense	16		13		50		41
Other non-operating income, net	2		—		3		—
Gain from sale of businesses	—		—		—		9
Income before taxes	95		107		250		275
Income tax expense	22		19		40		49
Net income	$	73	$	88	$	210	$	226
Earnings per share:
Basic	$	0.41	$	0.48	$	1.17	$	1.25
Diluted	$	0.41	$	0.48	$	1.17	$	1.24
Weighted average number of shares:
Basic	179.3		180.8		179.0		181.5
Diluted	180.3		181.6		179.8		182.3
Dividends declared per share	$	0.1549	$	0.1408	$	0.4647	$	0.4224

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,	2016			2015			2016			2015
Net income	$	73		$	88		$	210		$	226
Other comprehensive (loss) income, before tax:
Foreign currency translation adjustment	(8		)	(39		)	(25		)	(142		)
Foreign currency gain reclassified into net income	—			—			—			(8		)
Net change in derivative hedge agreements:
Unrealized losses	—			—			—			(5		)
Amount of (gain) loss reclassified into net income	(1		)	5			(2		)	17
Net change in postretirement benefit plans:
Amortization of net actuarial loss into net income	3			4			8			12
Other comprehensive loss, before tax	(6		)	(30		)	(19		)	(126		)
Income tax impact related to items of other comprehensive income	(3		)	1			(2		)	4
Other comprehensive loss, net of tax	(3		)	(31		)	(17		)	(130		)
Comprehensive income	$	70		$	57		$	193		$	96

See accompanying notes to condensed consolidated financial statements.

XYLEM INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)

(in millions, except per share amounts)



	September 30, 2016			December 31, 2015

ASSETS
Current assets:
Cash and cash equivalents	$	659		$	680
Receivables, less allowances for discounts and doubtful accounts of $29 and $33 in 2016 and 2015, respectively	792			749
Inventories	488			433
Prepaid and other current assets	153			143
Total current assets	2,092			2,005
Property, plant and equipment, net	440			439
Goodwill	1,621			1,584
Other intangible assets, net	444			435
Other non-current assets	181			194
Total assets	$	4,778		$	4,657
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	341		$	338
Accrued and other current liabilities	438			407
Short-term borrowings and current maturities of long-term debt	62			78
Total current liabilities	841			823
Long-term debt	1,148			1,196
Accrued postretirement benefits	335			335
Deferred income tax liabilities	114			118
Other non-current accrued liabilities	113			101
Total liabilities	2,551			2,573
Commitments and contingencies (Note 17)
Stockholders’ equity:
Common Stock – par value $0.01 per share:
Authorized 750.0 shares, issued 191.3 shares and 190.2 shares in 2016 and 2015, respectively	2			2
Capital in excess of par value	1,871			1,834
Retained earnings	1,011			885
Treasury stock – at cost 11.9 shares and 11.8 shares in 2016 and 2015, respectively	(402		)	(399		)
Accumulated other comprehensive loss	(255		)	(238		)
Total stockholders’ equity	2,227			2,084
Total liabilities and stockholders’ equity	$	4,778		$	4,657

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,	2016			2015
Operating Activities
Net income	$	210		$	226
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation	61			69
Amortization	36			33
Share-based compensation	15			11
Restructuring charges	18			5
Gain from sale of businesses	—			(9		)
Other, net	8			10
Payments for restructuring	(11		)	(11		)
Changes in assets and liabilities (net of acquisitions):
Changes in receivables	(27		)	(32		)
Changes in inventories	(42		)	(15		)
Changes in accounts payable	14			6
Other, net	(8		)	(33		)
Net Cash – Operating activities	274			260
Investing Activities
Capital expenditures	(90		)	(78		)
Acquisition of business, net of cash acquired	(70		)	—
Proceeds from sale of businesses	—			1
Proceeds from the sale of property, plant and equipment	—			1
Other, net	5			2
Net Cash – Investing activities	(155		)	(74		)
Financing Activities
Short-term debt issued	62			—
Short-term debt repaid	(80		)	(3		)
Long-term debt issued	540			—
Long-term debt repaid	(608		)	—
Repurchase of common stock	(3		)	(128		)
Proceeds from exercise of employee stock options	22			14
Dividends paid	(84		)	(77		)
Other, net	1			—
Net Cash – Financing activities	(150		)	(194		)
Effect of exchange rate changes on cash	10			(44		)
Net change in cash and cash equivalents	(21		)	(52		)
Cash and cash equivalents at beginning of year	680			663
Cash and cash equivalents at end of period	$	659		$	611
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest	$	34		$	37
Income taxes (net of refunds received)	$	60		$	57

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 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 agriculture markets. The Applied Water segment’s major products include pumps, valves, heat exchangers, controls and dispensing equipment.

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 intercompany 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, 2015 ("2015 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 2015 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 and indefinite lived intangible impairment testing and contingent liabilities. Actual results could differ from these estimates.

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 October 2016, the Financial Accounting Standards Board (“FASB”) issued guidance amending the accounting for income taxes. Under current guidance the recognition of current and deferred income taxes for an intra-entity asset transfer is prohibited until the asset has been sold to an outside party. The amended guidance eliminates the prohibition against immediate recognition of current and deferred income tax amounts associated with intra-entity transfers of assets other than inventory. This guidance is effective for interim and annual periods beginning

after December 15, 2017 with early adoption permitted as of the beginning of an annual reporting period for which financial statements (interim or annual) have not been issued or made available for issuance. The requirements of the amended guidance should be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. We are evaluating the impact of the guidance on our financial condition and results of operations.

In June 2016, the FASB issued guidance amending the accounting for the impairment of financial instruments, including trade receivables. Under current guidance, credit losses are recognized when the applicable losses are probable of occurring and this assessment is based on past events and current conditions. The amended guidance eliminates the “probable” threshold and requires an entity to use a broader range of information, including forecast information when estimating expected credit losses. Generally, this should result in a more timely recognition of credit losses. This guidance is effective for interim and annual periods beginning after December 15, 2019 with early adoption permitted for interim and annual periods beginning after December 15, 2018. The requirements of the amended guidance should be applied using a modified retrospective approach except for debt securities, which require a prospective transition approach. We are evaluating the impact of the guidance on our financial condition and results of operations.

In February 2016, the FASB issued guidance amending the accounting for leases. Specifically, the amended guidance requires all lessees to record a lease liability at lease inception, with a corresponding right of use asset, except for short-term leases. Lessor accounting is not fundamentally changed. This amended guidance is effective for interim and annual periods beginning after December 15, 2018 using a modified retrospective approach. Early adoption is permitted. We are evaluating the impact of the guidance on our financial condition and results of operations.

In July 2015, the FASB issued guidance regarding simplifying the measurement of inventory. Under prior guidance, inventory is measured at the lower of cost or market, where market is defined as replacement cost, with a ceiling of net realizable value and a floor of net realizable value less a normal profit margin. The amended guidance requires the measurement of inventory at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. This guidance is effective prospectively for interim and annual periods beginning after December 15, 2016 and early application is permitted. We are evaluating the impact of the guidance on our financial condition and 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 interim and annual reporting periods beginning after December 15, 2017 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 permitted for interim and annual reporting periods beginning after December 15, 2016. We are evaluating the impact of the guidance on our financial condition and results of operations.

Recently Adopted Pronouncements

In March 2016, the FASB issued an update on accounting for share-based payments. The guidance simplifies several aspects of the accounting for employee share-based payment transactions, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification of excess tax benefits in the Condensed Consolidated Statements of Cash Flows. This standard is effective for annual reporting periods beginning after December 15, 2016. The Company elected to early adopt this standard in the quarter ended June 30, 2016 retroactively to January 1, 2016. The impact of the early adoption resulted in the following:


•	The Company recorded tax benefits of $1 million and $3 million within income tax expense for the three and nine months ended September 30, 2016, respectively, related to the excess tax benefit on share-based awards. Prior to adoption this amount would have been recorded as an increase of capital in excess of par value. This change could create volatility in the Company's effective tax rate.


•	The Company no longer reflects the cash received from the excess tax benefit within cash flows from financing activities but instead now reflects this benefit within cash flows from operating activities in the

Condensed Consolidated Statements of Cash Flows. The Company elected to apply this change in presentation prospectively and thus prior periods have not been adjusted.


•	The Company elected not to change its policy on accounting for forfeitures and continues to estimate the total number of awards for which the requisite service period will not be rendered.


•	At this time, the Company has not changed its policy on statutory withholding requirements and will continue to allow the employee to withhold up to the Company's minimum statutory withholding requirements.


•	The Company excluded the excess tax benefits from the assumed proceeds available to repurchase shares in the computation of our diluted earnings per share for the three and nine months ended September 30, 2016. This increased diluted weighted average common shares outstanding by less than 50,000 shares for each of the aforementioned periods.

In March 2016, the FASB amended the guidance regarding the use of the equity method to record certain investments. Under current guidance, if an investor increases its level of ownership interest in a company and consequently qualifies for the equity method, the investor must retroactively adjust its investment, results of operations and retained earnings to reflect balances that would have arisen if the equity method had been in effect during all previous periods that the investment was held. The amended guidance eliminates the need to retroactively adjust balances and instead allows for the prospective application of the equity method. This guidance is effective prospectively for interim and annual reporting periods beginning after December 15, 2016. We elected to early adopt this guidance effective the first quarter of 2016. The adoption of this guidance did not impact our financial condition or results of operations.

In March 2016, in response to inconsistency in practice, the FASB issued guidance regarding the ability to maintain hedge accounting for a derivative instruments when one party to the instrument has been replaced by a new party (“a novation”). The new guidance states that a novation does not preclude the continued application of hedge accounting to a derivative assuming all other hedge accounting criteria continue to be met. This guidance is effective using either a prospective or a modified retrospective approach, for interim and annual reporting periods beginning after December 15, 2016. We elected to early adopt this guidance on a prospective basis effective the first quarter of 2016. The adoption of this guidance did not impact our financial condition or results of operations.

In March 2016, the FASB issued guidance clarifying what steps need to be followed when evaluating if call or put options are not clearly and closely related to their debt hosts, and therefore must be accounted for as separate derivatives. The guidance prescribes a four step process to assess whether an event that triggers the ability to exercise a call or put option is clearly and closely related to the debt host. The four step decision sequence requires an entity to consider whether (1) the payoff is adjusted based on changes in an index; (2) the payoff is indexed to an underlying other than interest rates or credit risk; (3) the debt involves a substantial premium or discount; and (4) the call or put option is contingently exercisable. This guidance is effective using a modified retrospective approach, for interim and annual reporting periods beginning after December 15, 2016. We elected to early adopt this guidance effective the first quarter of 2016. The adoption of this guidance did not impact our financial condition or results of operations.

Note 3. Acquisitions and Divestitures

On August 15, 2016, we entered into a Share Purchase Agreement to acquire all of the direct and indirect subsidiaries of Sensus Worldwide Limited (other than Sensus Industries) (“Sensus”), a global leader in smart meters, network technologies and advanced data analytics services for the water, gas and electric industries. The purchase price was agreed at $1.7 billion, net of cash acquired. We completed the acquisition of Sensus on October 31, 2016 pursuant to the terms of the Share Purchase Agreement and an Amendment to the Share Purchase Agreement dated as of October 31, 2016. Sensus, headquartered in Raleigh, North Carolina, has approximately 3,300 employees across 28 locations on six continents.

On February 1, 2016, we acquired Tideland Signal Corporation (“Tideland”), a leading producer of analytics solutions in the coastal and ocean management sectors, for $70 million. Tideland, a privately-owned company headquartered in Texas, has approximately 160 employees. Our condensed consolidated financial statements include Tideland’s results of operations from February 1, 2016 within the Water Infrastructure segment.

There were no divestitures for the three months ended September 30, 2015. For the nine months ended September 30, 2015, we divested two businesses for $1 million, which were not material, individually or in the aggregate, to our results of operations or financial position. The sales resulted in a gain of $9 million, reflected in gain from sale of businesses in our Condensed Consolidated Income Statement.

Note 4. Restructuring Charges

From time to time, the Company will incur costs related to restructuring actions in order to optimize our cost base and more strategically position ourselves based on the economic environment and customer demand. During the three and nine months ended September 30, 2016, we recognized restructuring charges of $6 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 included the reduction of headcount and consolidation of facilities within our Applied Water and Water Infrastructure segments, as well as Corporate headcount reductions.

During the three and nine months ended September 30, 2015, we recognized restructuring charges of $1 million and $5 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 included the reduction of headcount and consolidation of facilities within our Water Infrastructure segment.

The following table presents the components of restructuring expense.



	Three Months Ended					Nine Months Ended
	September 30,					September 30,
(in millions)	2016			2015		2016			2015
By component:
Severance and other charges	$	6		$	1	$	18		$	6
Lease related charges	1			—		1			—
Reversal of restructuring accruals	(1		)	—		(1		)	(1		)
Total restructuring charges	$	6		$	1	$	18		$	5

By segment:
Water Infrastructure	$	5		$	1	$	12		$	5
Applied Water	1			—		4			—
Corporate and other	—			—		2			—

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, 2016 and 2015.



(in millions)	2016			2015
Restructuring accruals - January 1	$	3		$	12
Restructuring charges	18			5
Cash payments	(11		)	(11		)
Foreign currency and other	(1		)	(1		)
Restructuring accruals - September 30	$	9		$	5

By segment:
Water Infrastructure	$	4		$	2
Applied Water	—			—
Regional selling locations (a)	3			3
Corporate and other	2			—


(a)	Regional selling locations consist primarily of selling and marketing organizations that incurred restructuring expense which was allocated to the segments. The liabilities associated with restructuring expense were not allocated to the segments.

The following is a rollforward for the nine months ended September 30, 2016 and 2015 of employee position eliminations associated with restructuring activities.



	2016		2015
Planned reductions - January 1	82		133
Additional planned reductions	364		87
Actual reductions	(296	)	(120	)
Planned reductions - September 30	150		100

Total expected costs associated with actions that commenced during 2016 are approximately $20 million for Water Infrastructure, including $11 million incurred during the nine months ended September 30, 2016. These costs primarily consist of severance charges. We currently expect activity related to these actions to continue through the end of 2017. Total expected costs associated with actions that commenced during 2016 are approximately $6 million for Applied Water, including $4 million incurred during the nine months ended September 30, 2016. These costs primarily consist of severance charges. We currently expect activity related to these actions to continue through the end of 2017. Total expected costs associated with actions that commenced during 2016 are approximately $2 million for Corporate, which we incurred during the nine months ended September 30, 2016. These costs primarily consist of severance charges.

Total expected costs associated with actions that commenced during 2015 are approximately $5 million for Water Infrastructure. Approximately $4 million of the expected cost was incurred in 2015 and $1 million was incurred during the nine months ended September 30, 2016. These costs primarily consist of severance charges and substantially all of the costs associated with these actions have been incurred. Total expected costs associated with actions that commenced during 2015 are approximately $1 million for Applied Water. These costs primarily consist of severance charges and substantially all of the costs associated with these actions were incurred in 2015.

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 discrete items.

The income tax provision for the three months ended September 30, 2016 was $22 million resulting in an effective tax rate of 22.9%, compared to $19 million resulting in an effective tax rate of 17.4% for the same period in 2015. The income tax provision for the nine months ended September 30, 2016 was $40 million resulting in an effective tax rate of 16%, compared to $49 million resulting in an effective tax rate of 17.6% for the same period in 2015. The effective tax rate was lower than the United States federal statutory rate primarily due to geographic mix of earnings in both periods as well as the release of an unrecognized tax benefit in 2016 as a result of the effective settlement of a tax examination offset in part by the establishment of a valuation allowance in 2016.

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 in the condensed consolidated financial statements 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, 2016 was $27 million, which is a reduction of $20 million from the balance as of December 31, 2015, resulting primarily from the effective settlement of a tax examination in 2016. The unrecognized tax benefits, if ultimately recognized will reduce our 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, 2016, we had $2 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,
	2016		2015		2016		2015
Net income (in millions)	$	73	$	88	$	210	$	226
Shares (in thousands):
Weighted average common shares outstanding	179,272		180,815		178,951		181,428
Add: Participating securities (a)	36		30		37		43
Weighted average common shares outstanding — Basic	179,308		180,845		178,988		181,471
Plus incremental shares from assumed conversions: (b)
Dilutive effect of stock options	593		424		462		489
Dilutive effect of restricted stock units and performance share units	409		363		388		376
Weighted average common shares outstanding — Diluted	180,310		181,632		179,838		182,336
Basic earnings per share	$	0.41	$	0.48	$	1.17	$	1.25
Diluted earnings per share	$	0.41	$	0.48	$	1.17	$	1.24


(a)	Restricted stock unit 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 units 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 units and performance share units, reduced by the repurchase of shares with the proceeds from the assumed exercises and unrecognized compensation expense for outstanding awards. Performance share units will be included in the treasury stock calculation of diluted earnings per share upon achievement of underlying performance or market conditions at the end of the reporting period. See Note 14, "Share-Based Compensation Plans" to the condensed consolidated financial statements for further detail on the performance share units.



	Three Months Ended		Nine Months Ended
	September 30,		September 30,
(in thousands)	2016	2015	2016	2015
Stock options	1,701	2,703	2,008	2,712
Restricted stock units	529	747	570	754
Performance share units	414	191	360	187

Note 7. Inventories

The components of total inventories are summarized as follows:



(in millions)	September 30, 2016		December 31, 2015
Finished goods	$	220	$	188
Work in process	46		32
Raw materials	222		213
Total inventories	$	488	$	433

The amounts in the above table of inventory composition as of December 31, 2015 have been revised to appropriately classify as Raw Materials $25 million previously included in Finished Goods.

Note 8. Property, Plant and Equipment

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



(in millions)	September 30, 2016		December 31, 2015
Land, buildings and improvements	$	247	$	240
Machinery and equipment	649		650
Equipment held for lease or rental	225		205
Furniture and fixtures	81		79
Construction work in progress	61		46
Other	19		19
Total property, plant and equipment, gross	1,282		1,239
Less accumulated depreciation	842		800
Total property, plant and equipment, net	$	440	$	439

Depreciation expense of $20 million and $61 million was recognized in the three and nine months ended September 30, 2016, respectively, and $22 million and $69 million for the three and nine months ended September 30, 2015.

Note 9. Goodwill and Other Intangible Assets

Goodwill

Changes in the carrying value of goodwill by reportable segment for the nine months ended September 30, 2016 are as follows:



(in millions)	Water Infrastructure			Applied Water		Total
Balance as of January 1, 2016	$	1,066		$	518	$	1,584
Activity in 2016
Acquired (a)	39			—		39
Foreign currency and other	(2		)			(2		)
Balance as of September 30, 2016	$	1,103		$	518	$	1,621


(a)	On February 1, 2016, we acquired Tideland and recorded $39 million of goodwill. Refer to Note 3, "Acquisitions and Divestitures" for additional information.

Other Intangible Assets

Information regarding our other intangible assets is as follows:



	September 30, 2016							December 31, 2015
(in millions)	Carrying Amount		Accumulated Amortization			Net Intangibles		Carrying Amount		Accumulated Amortization			Net Intangibles
Customer and distributor relationships	$	342	$	(159	)	$	183	$	320	$	(140	)	$	180
Proprietary technology and patents	119		(60		)	59		116		(54		)	62
Trademarks	43		(22		)	21		35		(19		)	16
Software	168		(119		)	49		155		(110		)	45
Other	7		(7		)	—		8		(8		)	—
Indefinite-lived intangibles	132		—			132		132		—			132
	$	811	$	(367	)	$	444	$	766	$	(331	)	$	435

Amortization expense related to finite-lived intangible assets was $12 million and $36 million for the three and nine months ended September 30, 2016, respectively, and $11 million and $33 million for the three and nine months ended September 30, 2015, 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 revenue, expenses, cash receipts, cash payments, and the value of our stockholders' equity. 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 and reduce the volatility in stockholders' equity.

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 with exposure to foreign currency exchange risks have designated certain currency forward agreements as cash flow hedges of forecasted intercompany inventory purchases and sales. Our principal currency exposures relate to the Euro, Swedish Krona, British Pound, Canadian Dollar, Polish Zloty and Australian Dollar. We held forward foreign exchange contracts with purchase notional amounts totaling $21 million

and $94 million as of September 30, 2016 and December 31, 2015, respectively. As of September 30, 2016, our most significant foreign currency derivatives include contracts to purchase Swedish Krona and sell Euro, sell Canadian Dollar and purchase US Dollar, sell Canadian Dollar and purchase Euro, and purchase Polish Zloty and sell Euro. The purchased notional amounts associated with these currency derivatives are $14 million, $2 million, $2 million, and $2 million, respectively. As of December 31, 2015, our most significant foreign currency derivatives included contracts to purchase Swedish Krona and sell Euro, sell U.S. Dollar and purchase Euro, and to sell British Pound and purchase Euro. The purchased notional amounts associated with these currency derivatives are $51 million, $24 million and $12 million, respectively.

Hedges of Net Investments in Foreign Operations

We are exposed to changes in foreign currencies impacting our net investments held in foreign subsidiaries.

Cross Currency Swaps

Beginning in 2015, we entered into cross currency swaps to manage our exposure to fluctuations in the Euro-U.S. Dollar exchange rate. The total notional amount of derivative instruments designated as net investment hedges was $419 million and $411 million as of September 30, 2016 and December 31, 2015, respectively.

Foreign Currency Denominated Debt

On March 11, 2016, we issued 2.250% Senior Notes of €500 million aggregate principal amount due March 2023. We designated the entirety of the outstanding balance, or $555 million, net of unamortized discount, as a hedge of a net investment in certain foreign subsidiaries.

Forward Contracts

On September 23, 2016, we entered into forward contacts to manage our exposure to fluctuations in the Euro-U.S. Dollar exchange rate. The total notional amount of derivative instruments designated as net investment hedges was $336 million as of September 30, 2016.

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)	2016			2015		2016			2015
Cash Flow Hedges
Foreign Exchange Contracts
Amount of (loss) recognized in OCI (a)	$	—		$	—	$	—		$	(5	)
Amount of (gain) loss reclassified from OCI into revenue (a)	(1		)	5		(1		)	16
Amount of (gain) loss reclassified from OCI into cost of revenue (a)	—			—		(1		)	1

Net Investment Hedges
Cross Currency Swaps
Amount of (loss) recognized in OCI (a)	$	(7	)	$	—	$	(7	)	$	—
Foreign Currency Denominated Debt
Amount of (loss) recognized in OCI (a)	$	(5	)	$	—	$	(10	)	$	—


(a)	Effective portion

As of September 30, 2016, $1 million of net unrealized losses on cash flow hedges are expected to be reclassified into earnings in the next 12 months. The ineffective portion of a cash flow hedge is recognized immediately in selling, general and administrative expenses in the Condensed Consolidated Income Statements and was not material for the three and nine months ended September 30, 2016 and 2015.

As of September 30, 2016, no gains or losses on the net investment hedges are expected to be reclassified into earnings over their duration. The net investment hedges did not experience any ineffectiveness for the three and nine months ended September 30, 2016.

The fair values of our derivative assets and liabilities are measured on a recurring basis using Level 2 inputs and are determined through the use of models that consider various assumptions including yield curves, time value and other measurements.

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



(in millions)	September 30, 2016			December 31, 2015
Derivatives designated as hedging instruments
Assets
Cash Flow Hedges
Other current assets	$	—		$	2
Liabilities
Cash Flow Hedges
Other current liabilities	$	(1	)	$	—
Net Investment Hedges
Other non-current liabilities	$	(30	)	$	(18	)

The fair value of our long-term debt, due in 2023, designated as a net investment hedge was $608 million as of September 30, 2016.

Note 11. Accrued and Other Current Liabilities

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



(in millions)	September 30, 2016		December 31, 2015
Compensation and other employee benefits	$	163	$	156
Customer-related liabilities	70		64
Accrued warranty costs	35		33
Accrued taxes	67		64
Other accrued liabilities	103		90
Total accrued and other current liabilities	$	438	$	407

Note 12. Credit Facilities and Debt

Total debt outstanding is summarized as follows:



(in millions)	September 30, 2016			December 31, 2015
3.550% Senior Notes due 2016	$	—		$	600
4.875% Senior Notes due 2021 (a)	600			600
2.250% Senior Notes due 2023 (a)	560			—
Commercial paper	20			—
Research and development facility agreement	42			76
Other	—			2
Debt issuance costs and unamortized discount (b)	(12		)	(4		)
Total debt	1,210			1,274
Less: short-term borrowings and current maturities of long-term debt	62			78
Total long-term debt	$	1,148		$	1,196


(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 2021 was $654 million and $640 million as of September 30, 2016 and December 31, 2015, respectively. The fair value of our Senior Notes due 2023 was $608 million as of September 30, 2016.


(b)	The debt issuance costs and unamortized discount are recognized as a reduction in the carrying value of the Senior Notes in the Condensed Consolidated Balance Sheets and are 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"). On March 11, 2016, we issued 2.250% Senior Notes of €500 million aggregate principal amount due March 2023 (the "Senior Notes due 2023" and together with the Senior Notes due 2016 and 2021, 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. We may redeem all or a portion of the Senior Notes due 2023 at our option at any time on or after December 11, 2022 (three months prior to their maturity), at a redemption price equal to 100% of the principal amount, plus accrued and unpaid interest to the redemption date. We may also redeem all, but not part, of the Senior Notes due 2023 in the event of specified tax events as described in the applicable Senior Notes indenture. If a change of control triggering event (as defined in the applicable 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. As of September 30, 2016, we were in compliance with all covenants for the Senior Notes.

Interest on the Senior Notes due 2016 was 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. Interest on the Senior Notes due 2023 is payable on March 11 of each year.

On April 11, 2016, our Senior Notes due 2016 were settled for a total of $607 million which included make-whole interest expense of $7 million. The Company recorded this loss on extinguishment of the debt in the second quarter of 2016 as interest expense.

Bridge Facility

On August 15, 2016, we entered into a $1.3 billion senior unsecured bridge facility (the “Bridge Facility”). The Bridge Facility was put in place to finance the Sensus acquisition and to pay the related fees and expenses to the extent we were unable to finance the Sensus acquisition through available cash on hand, a new term loan and the

issuance of the Notes (refer to Note 15 for further information on the issuance of the Notes). The Bridge Facility was terminated on October 31, 2016 in connection with the Sensus acquisition.

Five-Year Revolving Credit Facility

Effective March 27, 2015, Xylem entered into a Five-Year Revolving Credit Facility (the "Credit Facility") with Citibank, 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) revolving extensions of credit (the "revolving loans") outstanding at any time and (ii) the issuance of letters of credit in a face amount not in excess of $100 million outstanding at any time. The Credit Facility provides for increases of up to $200 million for a possible maximum total of $800 million in aggregate principal amount at our request and with the consent of the institutions providing such increased commitments.

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 Citibank, 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 of an amendment to the Credit Facility dated August 30, 2016, we may not exceed a maximum leverage ratio of 4.00 to 1.00 (based on a ratio of total debt to earnings before interest, taxes, depreciation and amortization) for a period of 12-months following the Sensus acquisition and a maximum leverage ratio of 3.50 to 1.00 through the rest of the term. The Credit Facility also contains limitations on, among other things, incurring secured debt, granting liens, entering into sale and leaseback transactions, mergers, consolidations, liquidations, dissolutions and sales of assets. 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, 2016, we were in compliance with all covenants.

As of September 30, 2016, the Credit Facility was undrawn.

Commercial Paper

Our commercial paper program generally serves as a means of short-term funding and has a combined outstanding limit of $600 million inclusive of the Five-Year Revolving Credit Facility. As of September 30, 2016, $20 million of the Company’s $600 million commercial paper program was outstanding at a weighted average interest rate of 0.75%. We will periodically borrow under this program and may borrow under it in future periods.

Research and Development Facility Agreement

On December 3, 2015, the Company amended and restated its Risk Sharing Finance Facility Agreement (the "R&D Facility Agreement") with The European Investment Bank (the "EIB") to amend the maturity date. The facility provides an aggregate principal amount of up to €120 million (approximately $135 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 during the period from 2013 through 2016 at the Company's facilities in Sweden, Germany, Italy, the United Kingdom, Austria, Norway and Hungary.

Under the R&D Facility Agreement, the borrower was able to draw loans on or before March 31, 2016 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 to 1.00 (based on a ratio of total debt to earnings before interest, taxes, depreciation and amortization) throughout the term. 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, 2016, we were in compliance with all covenants.

As of September 30, 2016 and December 31, 2015, $42 million and $76 million was outstanding, respectively, under the R&D Facility Agreement. Although the borrowing term for this arrangement is up to five years, we have classified it as short-term debt on our Condensed Consolidated Balance Sheets since we intend to repay this obligation in less than a year.

Note 13. Postretirement Benefit Plans

The components of net periodic benefit cost for our defined benefit pension plans are as follows:



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(in millions)	2016			2015			2016			2015
Domestic defined benefit pension plans:
Service cost	$	1		$	1		$	2		$	2
Interest cost	1			1			3			3
Expected return on plan assets	(2		)	(2		)	(4		)	(4		)
Amortization of net actuarial loss	1			1			2			2
Net periodic benefit cost	$	1		$	1		$	3		$	3
International defined benefit pension plans:
Service cost	$	3		$	3		$	8		$	9
Interest cost	6			6			18			18
Expected return on plan assets	(8		)	(8		)	(25		)	(25		)
Amortization of net actuarial loss	2			3			6			10
Net periodic benefit cost	$	3		$	4		$	7		$	12
Total net periodic benefit cost	$	4		$	5		$	10		$	15

The total net periodic benefit cost for other postretirement employee benefit plans was less than $1 million and $2 million including amounts recognized in other comprehensive income ("OCI") of less than $1 million for both the three and nine months ended September 30, 2016, respectively. The total net periodic benefit cost for other postretirement employee benefit plans was $1 million and $3 million including amounts recognized in OCI of less than $1 million for both the three and nine months ended September 30, 2015, respectively.

We contributed $22 million and $21 million to our defined benefit plans during the nine months ended September 30, 2016 and 2015, respectively. Additional contributions ranging between approximately $6 million and $10 million are expected during the remainder of 2016.

Note 14. Share-Based Compensation Plans

Share-based compensation expense was $5 million and $15 million during the three and nine months ended September 30, 2016, respectively, and $3 million and $11 million during the three and nine months ended September 30, 2015, respectively. The unrecognized compensation expense related to our stock options, restricted stock units and performance share units was $6 million, $19 million and $10 million, respectively, at September 30, 2016 and is expected to be recognized over a weighted average period of 1.9, 1.8 and 2.2 years, respectively. The amount of cash received from the exercise of stock options was $22 million and $14 million for the nine months ended September 30, 2016 and 2015, respectively.

Stock Option Grants

The following is a summary of the changes in outstanding stock options for the nine months ended September 30, 2016.



	Shares (in thousands)		Weighted Average Exercise Price / Share		Weighted Average Remaining Contractual Term (Years)	Aggregate Intrinsic Value (in millions)
Outstanding at January 1, 2016	2,561		$	31.16	6.8
Granted	463		37.90
Exercised	(797	)	27.91
Forfeited and expired	(44	)	35.55
Outstanding at September 30, 2016	2,183		$	33.68	7.2	$	41
Options exercisable at September 30, 2016	1,222		$	29.40	5.9	$	26
Vested and expected to vest as of September 30, 2016	2,098		$	33.53	7.1	$	40

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, 2016 was $12 million.

Stock Option Fair Value

The fair value of each option grant was estimated on the date of grant using the binomial lattice pricing