Edgar Filing: Xylem Inc.

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 March 31, 2019



¨	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, every Interactive Data File required to be submitted 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, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and "emerging growth company" in Rule 12b-2 of the Exchange Act.



Large accelerated filer	þ	Accelerated filer	¨

Non-accelerated filer	¨	Smaller reporting company	¨

		Emerging growth company	¨

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) 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

Securities registered pursuant to Section 12(b) of the Act:



Title of each class	Trading Symbol(s)	Name of each exchange of which registered
Common Stock, par value $0.01 per share	XYL	New York Stock Exchange
2.250% Senior Notes due 2023	XYL23	New York Stock Exchange

As of April 26, 2019, there were 179,933,009 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 Months Ended March 31, 2019 and 2018 (Unaudited)	3
		Condensed Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2019 and 2018 (Unaudited)	4
		Condensed Consolidated Balance Sheets as of March 31, 2019 and December 31, 2018 (Unaudited)	5
		Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2019 and 2018 (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	32
Item 3	-	Quantitative and Qualitative Disclosures About Market Risk	46
Item 4	-	Controls and Procedures	46
PART II – Other Information
Item 1	-	Legal Proceedings	47
Item 1A	-	Risk Factors	47
Item 2	-	Unregistered Sales of Equity Securities and Use of Proceeds	47
Item 3	-	Defaults Upon Senior Securities	47
Item 4	-	Mine Safety Disclosures	47
Item 5	-	Other Information	47
Item 6	-	Exhibits	47
		Signatures	49

PART I

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

XYLEM INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED INCOME STATEMENTS (Unaudited)

(in millions, except per share data)



For the three months ended March 31,	2019		2018
Revenue	$	1,237	$	1,217
Cost of revenue	763		757
Gross profit	474		460
Selling, general and administrative expenses	303		296
Research and development expenses	51		41
Restructuring and asset impairment charges	11		10
Operating income	109		113
Interest expense	18		21
Other non-operating income, net	2		3
Gain from sale of business	1		—
Income before taxes	94		95
Income tax expense	15		16
Net income	$	79	$	79
Earnings per share:
Basic	$	0.44	$	0.44
Diluted	$	0.43	$	0.43
Weighted average number of shares:
Basic	179.7		179.9
Diluted	181.1		181.4

See accompanying notes to condensed consolidated financial statements.

XYLEM INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

(in millions)



For the three months ended March 31,	2019			2018
Net income	$	79		$	79
Other comprehensive income, before tax:
Foreign currency translation adjustment	29			8
Net change in derivative hedge agreements:
Unrealized loss	(9		)	—
Amount of loss (gain) reclassified into net income	2			(1		)
Net change in postretirement benefit plans:
Amortization of prior service credit	(1		)	(1		)
Amortization of net actuarial loss into net income	3			3
Settlement/Curtailment	—			1
Other comprehensive income, before tax	24			10
Income tax expense (benefit) related to items of other comprehensive income	4			(10		)
Other comprehensive income, net of tax	20			20
Comprehensive income	$	99		$	99

See accompanying notes to condensed consolidated financial statements.

XYLEM INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)

(in millions, except per share amounts)



	March 31, 2019			December 31, 2018

ASSETS
Current assets:
Cash and cash equivalents	$	275		$	296
Receivables, less allowances for discounts and doubtful accounts of $28 and $35 in 2019 and 2018, respectively	1,020			1,031
Inventories	617			595
Prepaid and other current assets	169			172
Total current assets	2,081			2,094
Property, plant and equipment, net	653			656
Goodwill	2,988			2,976
Other intangible assets, net	1,219			1,232
Other non-current assets	527			264
Total assets	$	7,468		$	7,222
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	548		$	586
Accrued and other current liabilities	589			546
Short-term borrowings and current maturities of long-term debt	304			257
Total current liabilities	1,441			1,389
Long-term debt	2,044			2,051
Accrued postretirement benefits	394			400
Deferred income tax liabilities	312			303
Other non-current accrued liabilities	469			297
Total liabilities	4,660			4,440
Commitments and contingencies (Note 19)
Stockholders’ equity:
Common Stock – par value $0.01 per share:
Authorized 750.0 shares, issued 193.6 shares and 192.9 shares in 2019 and 2018, respectively	2			2
Capital in excess of par value	1,962			1,950
Retained earnings	1,674			1,639
Treasury stock – at cost 13.7 shares and 13.2 shares in 2019 and 2018, respectively	(526		)	(487		)
Accumulated other comprehensive loss	(316		)	(336		)
Total stockholders’ equity	2,796			2,768
Non-controlling interests	12			14
Total equity	2,808			2,782
Total liabilities and stockholders’ equity	$	7,468		$	7,222

See accompanying notes to condensed consolidated financial statements.

XYLEM INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(in millions)



For the three months ended March 31,	2019			2018
Operating Activities
Net income	$	79		$	79
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation	29			29
Amortization	35			38
Share-based compensation	9			9
Restructuring and asset impairment charges	11			10
Gain from sale of business	(1		)	—
Other, net	1			(4		)
Payments for restructuring	(4		)	(5		)
Changes in assets and liabilities (net of acquisitions):
Changes in receivables	7			(9		)
Changes in inventories	(25		)	(40		)
Changes in accounts payable	(17		)	6
Other, net	(41		)	(50		)
Net Cash – Operating activities	83			63
Investing Activities
Capital expenditures	(69		)	(61		)
Acquisitions of businesses, net of cash acquired	(5		)	(430		)
Other, net	(3		)	—
Net Cash – Investing activities	(77		)	(491		)
Financing Activities
Short-term debt issued, net	50			371
Repurchase of common stock	(39		)	(33		)
Proceeds from exercise of employee stock options	4			3
Dividends paid	(44		)	(38		)
Other, net	—			(1		)
Net Cash – Financing activities	(29		)	302
Effect of exchange rate changes on cash	2			9
Net change in cash and cash equivalents	(21		)	(117		)
Cash and cash equivalents at beginning of year	296			414
Cash and cash equivalents at end of period	$	275		$	297
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest	$	13		$	14
Income taxes (net of refunds received)	$	18		$	17

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 operates in three segments, Water Infrastructure, Applied Water and Measurement & Control Solutions. See Note 20, "Segment Information" to the condensed consolidated financial statements for further segment background information.

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, 2018 ("2018 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 included in our 2018 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 August 2018, the Financial Accounting Standards Board (“FASB”) issued guidance regarding the accounting for implementation costs of a hosting arrangement that is a service contract. The guidance establishes the requirement to capitalize certain implementation costs incurred in a hosting arrangement that is a service contract, effectively aligning with the requirement to capitalize certain implementation costs incurred to develop or obtain internal-use software. This guidance is effective for interim and annual periods beginning after December 15, 2019 with early adoption permitted. The requirements of the amended guidance may be applied using either a retrospective or prospective approach. 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.

Recently Adopted Pronouncements

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 ("ROU") 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 was permitted. We adopted this guidance as of January 1, 2019 using the modified retrospective approach whereby prior comparative periods were not retrospectively restated in the condensed consolidated financial statements. The adoption of the standard resulted in the recognition of ROU assets and lease liabilities of $267 million and $265 million, respectively, as well as deferred tax assets and deferred tax liabilities of $68 million, as of January 1, 2019, the date of initial application. The guidance did not have a material impact on our Condensed Consolidated Income Statements and Statements of Cash Flow. See Note 9, "Leases" for further details.

Note 3. Acquisitions and Divestitures

2019 Acquisitions

During the three months ended March 31, 2019 we spent approximately $5 million net of cash received on acquisition activity.

2018 Acquisitions and Divestitures

Pure Technologies Ltd.

On January 31, 2018, we acquired all the issued and outstanding shares of Pure Technologies Ltd. (“Pure”), a leader in intelligent leak detection and condition assessment solutions for water distribution networks for approximately $420 million, net of cash received. Acquisition costs of $4 million were reflected as a component of selling, general and administrative expenses in our Condensed Consolidated Income Statement.

Pure’s results of operations were consolidated with the Company effective February 1, 2018 and are reflected in the Measurement & Control Solutions segment.

The Pure purchase price allocation as of January 31, 2018 is shown in the following table:



(in millions)	Amount
Cash	$	14
Receivables	23
Inventories	4
Prepaid and other current assets	2
Property, plant and equipment	22
Intangible assets	149
Other long-term assets	1
Accounts payable	(3		)
Accrued and other current liabilities	(12		)
Deferred income tax liabilities	(25		)
Other non-current accrued liabilities	(2		)
Total identifiable net assets	173

Goodwill	261
Total consideration	$	434

The fair values of Pure's assets and liabilities were determined based on estimates and assumptions which management believes are reasonable.

Goodwill arising from the acquisition consists largely of synergies and economies of scale expected from combining the operations of Pure and Xylem. All of the goodwill was assigned to the Measurement & Control Solutions segment and is not deductible for tax purposes.

The estimate of the fair value of Pure identifiable intangible assets was determined primarily using the “income approach,” which requires a forecast of all of the expected future cash flows either through the use of the multi-period excess earnings method or the relief-from-royalty method. Some of the more significant assumptions inherent in the development of intangible asset values include: the amount and timing of projected future cash flows, the discount rate selected to measure the risks inherent in the future cash flows, the assessment of the intangible asset’s life cycle, as well as other factors. The following table summarizes key information underlying identifiable intangible assets related to the Pure acquisition:



Category	Life	Amount (in millions)
Customer Relationships	17 - 18 years	$	84
Technology	3 - 10 years	38
Tradenames	20 years	21
Internally Developed Software	3 years	6
Total		$	149

The following table summarizes, on an unaudited pro forma basis, the condensed combined results of operations of the Company for the three month period ended March 31, 2018 assuming the acquisition of Pure was made on January 1, 2017:



(in millions)	Three Months Ended March 31, 2018
(in millions)	Three Months Ended March 31, 2018
Revenue	$	1,222
Net income	$	76

The foregoing unaudited pro forma results are for informational purposes only and are not necessarily indicative of the actual results of operations that might have occurred had the acquisition occurred on January 1, 2017, nor are they necessarily indicative of future results. The pro forma financial information includes the impact of purchase accounting and other nonrecurring items directly attributable to the acquisition, which include:

•Amortization expense of acquired intangibles


•	Adjustments to the depreciation of property, plant and equipment reflecting the impact of the calculated fair value of those assets in accordance with purchase accounting


•	Adjustments to interest expense to remove historical Pure interest costs and reflect Xylem's current debt profile

•The related tax impact of the above referenced adjustments

The pro forma results do not include any cost savings or operational synergies that may be generated or realized due to the acquisition of Pure.

For the two month period ended March 31, 2018 Pure had revenue and operating loss of $16 million and $3 million, respectively.

Other Acquisition Activity

During the three months ended March 31, 2018 we also spent approximately $10 million net of cash received on other acquisition activity.

Note 4. Revenue

Disaggregation of Revenue

The following table illustrates the sources of revenue:



	Three Months Ended
	March 31,
(in millions)	2019		2018
Revenue from contracts with customers	$	1,178	$	1,162
Lease Revenue	59		55
Total	$	1,237	$	1,217

The following table reflects revenue from contracts with customers by application:



	Three Months Ended
	March 31,
(in millions)	2019		2018
Water Infrastructure
Transport	$	346	$	347
Treatment	77		78

Applied Water
Commercial Building Services	154		137
Residential Building Services	59		57
Industrial Water	166		172

Measurement and Control Solutions
Water	199		172
Energy	73		80
Software as a Service/Other	24		34
Test	80		85

Total	$	1,178	$	1,162

The following table reflects revenue from contracts with customers by geographical region:



	Three Months Ended
	March 31,
(in millions)	2019		2018
Water Infrastructure
United States	$	133	$	113
Europe	160		177
Emerging Markets & Other	130		135

Applied Water
United States	201		188
Europe	94		98
Emerging Markets & Other	84		80

Measurement and Control Solutions
United States	236		206
Europe	72		84
Emerging Markets & Other	68		81

Total	$	1,178	$	1,162

Contract Balances

We receive payments from customers based on a billing schedule as established in our contracts. Contract assets relate to costs incurred to perform in advance of scheduled billings. Contract liabilities relate to payments received in advance of performance under the contracts. Change in contract assets and liabilities are due to our performance under the contract.

The table below provides contract assets, contract liabilities, and significant changes in contract assets and liabilities:



(in millions)	Contract Assets (a)			Contract Liabilities
Balance at January 1, 2018	$	89		$	107
Additions, net	38			56
Revenue recognized from opening balance	—			(54		)
Billings	(34		)	—
Other	1			1
Balance at March 31, 2018	$	94		$	110

Balance at January 1, 2019	$	96		$	113
Additions, net	39			46
Revenue recognized from opening balance	—			(45		)
Billings	(32		)	—
Other	11			2
Balance at March 31, 2019	$	114		$	116


(a)	Excludes receivable balances which are disclosed on the balance sheet

Performance obligations

Delivery schedules vary from customer to customer based upon their requirements. Typically, large projects require longer lead production cycles and delays can occur from time to time. As of March 31, 2019, the aggregate amount of the transaction price allocated to performance obligations that are unsatisfied or partially unsatisfied for contracts with performance obligations, amount to $314 million. We expect to recognize revenue upon the completion of satisfying these performance obligations in the following 60 months. The Company elects to apply the practical expedient to exclude from this disclosure revenue related to performance obligations that are part of a contract whose original expected duration is less than one year.

Note 5. 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 months ended March 31, 2019, we recognized restructuring charges of $8 million. We incurred these charges primarily as a continuation of our efforts 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 Measurement & Control Solutions and Water Infrastructure segments.

During the three months ended March 31, 2018, we recognized restructuring charges of $10 million. We incurred these charges primarily as a continuation of our efforts 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 Measurement & Control Solutions and Water Infrastructure segments, as well as headcount reductions within our Applied Water segment.

The following table presents the components of restructuring expense and asset impairment charges:



	Three Months Ended
	March 31,
(in millions)	2019		2018
By component:
Severance and other charges	$	7	$	9
Lease related charges	1		1
Total restructuring charges	$	8	$	10
Asset impairment	3		—
Total restructuring and asset impairment charges	$	11	$	10

By segment:
Water Infrastructure	$	4	$	3
Applied Water	—		1
Measurement & Control Solutions	7		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 three months ended March 31, 2019 and 2018:



(in millions)	2019			2018
Restructuring accruals - January 1	$	5		$	7
Restructuring charges	8			10
Cash payments	(4		)	(5		)
Restructuring accruals - March 31	$	9		$	12

By segment:
Water Infrastructure	$	2		$	1
Applied Water	—			1
Measurement & Control Solutions	4			6
Regional selling locations (a)	3			3
Corporate and other	—			1


(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 three months ended March 31, 2019 and 2018 of employee position eliminations associated with restructuring activities:



	2019		2018
Planned reductions - January 1	69		47
Additional planned reductions	158		102
Actual reductions and reversals	(134	)	(45	)
Planned reductions - March 31	93		104

The following table presents expected restructuring spend for actions commenced as of March 31, 2019:



(in millions)	Water Infrastructure		Applied Water		Measurement & Control Solutions		Corporate		Total
Actions Commenced in 2019:
Total expected costs	$	5	$	—	$	6	$	—	$	11
Costs incurred during Q1 2019	3		—		3		—		6
Total expected costs remaining	$	2	$	—	$	3	$	—	$	5

Actions Commenced in 2018:
Total expected costs	$	9	$	1	$	7	$	—	$	17
Costs incurred during 2018	7		1		7		—		15
Costs incurred during Q1 2019	1		—		—		—		1
Total expected costs remaining	$	1	$	—	$	—	$	—	$	1

Actions Commenced in 2017:
Total expected costs	$	16	$	8	$	4	$	—	$	28
Costs incurred during 2017	5		4		2		—		11
Costs incurred during 2018	2		1		1		—		4
Costs incurred during Q1 2019	—		—		1		—		1
Total expected costs remaining	$	9	$	3	$	—	$	—	$	12

The Water Infrastructure, Applied Water, and Measurement & Control Solutions actions commenced in 2019 consist primarily of severance charges and are expected to continue through the end of 2019. The Water Infrastructure, Applied Water, and Measurement & Control Solutions actions commenced in 2018 consist primarily of severance charges and are expected to continue through the third quarter of 2019. The Water Infrastructure, Applied Water and Measurement & Control Solutions actions commenced in 2017 consist primarily of severance charges and are expected to continue through the fourth quarter of 2020.

Asset Impairment

During the first quarter of 2019 we determined that certain assets within our Measurement and Control Solutions segment, including a customer relationship, were impaired. Accordingly we recognized an impairment charge of $3 million. Refer to Note 10, "Goodwill and Other Intangible Assets," for additional information.

Note 6. Income Taxes

Our quarterly provision for income taxes is measured using an estimated annual effective tax rate, adjusted for discrete items within periods presented. The comparison of our effective tax rate between periods is significantly impacted by the level and mix of earnings and losses by tax jurisdiction, foreign income tax rate differentials and discrete items.

The income tax provision for the three months ended March 31, 2019 was $15 million resulting in an effective tax rate of 16.6%, compared to $16 million resulting in an effective tax rate of 17.1% for the same period in 2018. The effective tax rate was lower than the U.S. federal statutory rate primarily due to the mix of earnings in jurisdictions, partially offset by the Global Intangible Low-Taxed Income ("GILTI") inclusion.

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 or litigation, 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 resolution. The amount of unrecognized tax benefits at March 31, 2019 was $132 million, as compared to $136 million at December 31, 2018, which if ultimately recognized will reduce our effective tax rate. We believe that it is

reasonably possible that the unrecognized tax benefits will be reduced by approximately $8 million within the next 12 months as a result of the expiration of certain statutes of limitations. 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 March 31, 2019, we had $8 million of interest accrued for unrecognized tax benefits.

Note 7. Earnings Per Share

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



	Three Months Ended
	March 31,
	2019		2018
Net income (in millions)	$	79	$	79
Shares (in thousands):
Weighted average common shares outstanding	179,720		179,858
Add: Participating securities (a)	26		23
Weighted average common shares outstanding — Basic	179,746		179,881
Plus incremental shares from assumed conversions: (b)
Dilutive effect of stock options	835		928
Dilutive effect of restricted stock units and performance share units	532		556
Weighted average common shares outstanding — Diluted	181,113		181,365
Basic earnings per share	$	0.44	$	0.44
Diluted earnings per share	$	0.43	$	0.43


(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 16, "Share-Based Compensation Plans" to the condensed consolidated financial statements for further detail on the performance share units.



	Three Months Ended
	March 31,
(in thousands)	2019	2018
Stock options	1,394	1,218
Restricted stock units	348	294
Performance share units	472	538

Note 8. Inventories

The components of total inventories are summarized as follows:



(in millions)	March 31, 2019		December 31, 2018
Finished goods	$	256	$	248
Work in process	52		45
Raw materials	309		302
Total inventories	$	617	$	595

Note 9. Leases

As discussed in Note 2, “Recently Issued Accounting Pronouncements,” Xylem adopted the new guidance on accounting for leases.

Leasing Arrangements

We lease certain offices, manufacturing buildings, transportation equipment, machinery, computers and other equipment. Our most significant lease liabilities relate to real estate leases. These leases include renewal, termination or purchase options, and we have assessed these to determine whether it is reasonably certain for us to exercise any of the previously mentioned options. All periods relating to options that are reasonably certain to be exercised have been included in the lease term of the respective leases.

We have recorded ROU assets for lease arrangements that are reasonably certain to extend beyond 12 months. ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments under the lease. ROU assets and liabilities are recognized at lease commencement date based on the present value of lease payments over the lease term. The implicit rate within our leases is generally not determinable, and we use our incremental borrowing rate at the lease commencement date to determine the net present value of lease payments. The determination of the appropriate incremental borrowing rate requires judgment. We determine the appropriate incremental borrowing rate for each lease using our current borrowing rate, adjusted for various factors including geographic region, level of collateralization and term, to align with the term of the underlying lease.

Many of our leases are subject to payment adjustments to reflect annual changes in price indexes, such as the Consumer Price Index. While associated lease liabilities are not re-measured as a result of changes in the applicable price indexes, changes to required lease payments are treated as variable lease payments and recognized in the period in which the obligation for those payments was incurred.

Leases with a lease term of 12 months or less, including renewal options that are reasonably certain to be exercised, that also do not include an option to purchase the underlying asset that is reasonably certain of exercise, are not recorded on the balance sheet. Instead, lease payments for these leases are recognized as a lease cost on a straight-line basis over the lease term.

We elected the package of practical expedients, which among other things, does not require reassessment of lease classification. Additionally, we have made an accounting policy election whereby we chose not to separate non-lease components from lease components in agreements in all leases which we are the lessee.

We did not identify any events or conditions during the quarter ended March 31, 2019 to indicate that a reassessment or re-measurement of our existing leases was required. There were also no impairment indicators identified during the quarter ended March 31, 2019 that required an impairment test for the Company’s ROU assets or other long-lived assets in accordance with ASC 360-10.

Our current lease liabilities of $62 million are included in Accrued and other current liabilities and our non-current lease liabilities of $193 million are included in Other non-current accrued liabilities as of March 31, 2019. Our ROU asset balances are included in Other non-current assets. The net balance of our ROU assets as of March 31, 2019 was $256 million. These balances include an immaterial amount related to finance leases.

The components of our lease cost were as follows:



(in millions)	Three Months Ended March 31, 2019
Lease cost
Operating lease cost	$	18
Short-term lease cost	1
Variable lease cost	8
Total lease cost	$	27

The supplemental cash flow information related to leases are as follows:



(in millions)	Three Months Ended March 31, 2019
Cash paid for amounts included in the measurement of lease liabilities:
Operating cash flows from operating leases	$	18

Right-of-use assets obtained in exchange for lease obligations:
Operating leases	$	7

Information relating to the lease term and discount rate are as follows:



	Three Months Ended March 31, 2019
Weighted-average remaining lease term (years)
Operating leases	6 Years

Weighted-average discount rate
Operating leases	2.79%

As of March 31, 2019, the maturities of operating lease liabilities were as follows:



(in millions)
2019	$	52
2020	57
2021	41
2022	30
2023	23
2024	18
Thereafter	56
Total lease payments	277
Less: Imputed interest	(23		)
Total	$	254

Disclosures related to periods prior to adoption of the New Lease Standard as reported in our December 31, 2018 Form 10-K.

As of December 31, 2018, we were obligated to make minimum future rental payments under operating leases which are as follows:



(in millions)
2019	$	76
2020	61
2021	43
2022	33
2023	22
Thereafter	64
Total lease payments	299

Lessor arrangements

In addition to manufacturing and selling equipment, we also lease out equipment to customers in exchange for consideration. These arrangements are generally short term in nature and predominantly involve the rental of pumps and accessories within the Water Infrastructure segment. Rental arrangements generally do not provide the customer the right to purchase the equipment as Xylem’s strategy is to rent these items over their useful lives. Customers may be billed based on daily, weekly or monthly rates depending on the expected rental period. We assessed that these arrangements constitute a lease under ASC 842, and have recognized them as operating leases. In situations where arrangements contain both the sale of products and a leasing component, contract consideration is allocated based on relative standalone selling price.

Total revenue from lease arrangements was $59 million for the three months ended March 31, 2019. Our gross assets available for rent and related accumulated amortization were $255 million and $163 million, respectively, as of March 31, 2019. Depreciation expense for these assets was $7 million for the three months ended March 31, 2019.

Note 10. Goodwill and Other Intangible Assets

Goodwill

Changes in the carrying value of goodwill by reportable segment for the three months ended March 31, 2019 are as follows:



(in millions)	Water Infrastructure		Applied Water			Measurement & Control Solutions		Total
Balance as of January 1, 2019	$	653	$	516		$	1,807	$	2,976
Activity in 2019
Divested/Acquired	—		—			8		8
Foreign currency and other	1		(1		)	4		4
Balance as of March 31, 2019	$	654	$	515		$	1,819	$	2,988

Other Intangible Assets

Information regarding our other intangible assets is as follows:



	March 31, 2019							December 31, 2018
(in millions)	Carrying Amount		Accumulated Amortization			Net Intangibles		Carrying Amount		Accumulated Amortization			Net Intangibles
Customer and distributor relationships	$	947	$	(301	)	$	646	$	951	$	(286	)	$	665
Proprietary technology and patents	200		(97		)	103		198		(93		)	105
Trademarks	148		(43		)	105		148		(41		)	107
Software	371		(173		)	198		355		(164		)	191
Other	20		(19		)	1		24		(19		)	5
Indefinite-lived intangibles	166		—			166		159		—			159
Other Intangibles	$	1,852	$	(633	)	$	1,219	$	1,835	$	(603	)	$	1,232

Amortization expense related to finite-lived intangible assets was $35 million and $38 million for the three months ended March 31, 2019 and 2018, respectively.

During the first quarter of 2019 we determined that the intended use of a finite lived customer relationship within our Measurement and Control Solutions segment had changed. Accordingly we recorded a $3 million impairment charge. The charge was calculated using income approach, which is considered a Level 3 input for fair value measurement, and is reflected in “Restructuring and asset impairment charges” in our Condensed Consolidated Income Statements.

Note 11. Derivative Financial Instruments

Risk Management Objective of Using Derivatives

We are exposed to certain risks arising from both our business operations and economic conditions, and principally manage our exposures to these risks through management of our core business activities. Certain of our foreign operations expose us to fluctuations of foreign interest rates and exchange rates that may impact 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 had foreign exchange contracts with purchased notional amounts totaling $370 million and $506 million as of March 31, 2019 and December 31, 2018, respectively. As of March 31, 2019, our most significant foreign currency derivatives included contracts to sell U.S. Dollar and purchase Euro, purchase Swedish Krona and sell Euro, sell British Pound and purchase Euro, purchase Polish Zloty and sell Euro, purchase US Dollar and sell Canadian Dollar, and to sell Canadian Dollar and Purchase Euro. The purchased notional amounts associated with these currency derivatives are $142 million, $120 million, $38 million, $27 million, $22 million and $16 million, respectively. As of December 31, 2018, the purchased notional amounts associated with these currency derivatives were $191 million, $168 million, $52 million, $37 million, $29 million and $22 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 $421 million and $426 million as of March 31, 2019 and December 31, 2018, 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 $559 million and $566 million as of March 31, 2019 and December 31, 2018, respectively, net of unamortized discount, as a hedge of a net investment in certain foreign subsidiaries.

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
	March 31,
(in millions)	2019			2018
Cash Flow Hedges
Foreign Exchange Contracts
Amount of (loss) recognized in OCI (a)	$	(9	)	$	—
Amount of (gain) loss reclassified from OCI into revenue (a)	1			(1		)
Amount of loss reclassified from OCI into cost of revenue (a)	1			—

Net Investment Hedges
Cross Currency Swaps
Amount of gain (loss) recognized in OCI (a)	$	7		$	(23	)
Amount of income recognized in Interest Expense	3			—
Foreign Currency Denominated Debt
Amount of gain (loss) recognized in OCI (a)	$	7		$	(23	)


(a)	Effective portion

As of March 31, 2019, $8 million of net 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 months ended March 31, 2019 and 2018.

As of March 31, 2019, 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 months ended March 31, 2019.

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)	March 31, 2019			December 31, 2018
Derivatives designated as hedging instruments
Assets
Cash Flow Hedges
Other current assets	$	1		$	3
Liabilities
Cash Flow Hedges
Other current liabilities	$	(8	)	$	(1	)
Net Investment Hedges
Other non-current accrued liabilities	$	(38	)	$	(46	)

The fair value of our long-term debt, due in 2023, designated as a net investment hedge was $602 million and $599 million as of March 31, 2019 and December 31, 2018, respectively.

Note 12. Accrued and Other Current Liabilities

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



(in millions)	March 31, 2019		December 31, 2018
Compensation and other employee benefits	$	170	$	194
Customer-related liabilities	130		129
Accrued taxes	79		85
Lease liabilities	62		—
Accrued warranty costs	40		44
Other accrued liabilities	108		94
Total accrued and other current liabilities	$	589	$	546

Note 13. Credit Facilities and Debt

Total debt outstanding is summarized as follows:



(in millions)	March 31, 2019		December 31, 2018
4.875% Senior Notes due 2021 (a)	$	600