UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

 

FORM 10-Q

 

 

Commission File Number: 1-35229

 

Xylem Inc.
(Exact name of registrant as specified in its charter)

 

 

1133 Westchester Avenue, Suite N200, White Plains, NY 10604
(Address of principal executive office)

 

(914) 323-5700

(Registrant’s telephone number, including area code)

 

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

 

 

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 and (2) has been subject to such filing requirements for the past 90 days. Yes  o  No  þ

 

 

Indicate by check mark whether the registrant has submitted electronically and posted on its web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  þ  No  o

 

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  o   No  þ

 

 

As of November 1, 2011, there were 184,570,429 outstanding shares of common stock ($0.01 par value per share) of the registrant.

 

INDEX

 

 

 

Item 1. CONDENSED COMBINED FINANCIAL STATEMENTS

 

 

The accompanying notes are an integral part of the condensed combined financial statements.

 

The accompanying notes are an integral part of the condensed combined financial statements.

 

The accompanying notes are an integral part of the condensed combined financial statements.

 

The accompanying notes are an integral part of the condensed combined financial statements.

 

THE WATER EQUIPMENT AND SERVICES BUSINESSES OF ITT CORPORATION
NOTES TO CONDENSED COMBINED FINANCIAL STATEMENTS
(Unaudited)

 

 

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 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 encompasses all the uses of water and focuses on the residential, commercial, industrial and agricultural markets. The segment’s major products include pumps, valves, heat exchangers, controls and dispensing equipment. Xylem Inc. (f/k/a ITT WCO, Inc.) was incorporated in Indiana on May 4, 2011. The name of the Company was changed from ITT WCO, Inc. to Xylem Inc. on July 14, 2011.

 

On October 31, 2011, ITT Corporation (“ITT”) completed the previously announced spin-off (the “Spin-off”) of Xylem, formerly ITT’s water equipment and services businesses. Effective as of 12:01 a.m., Eastern time on October 31, 2011 (the “Distribution Date”), the common stock of Xylem was distributed, on a pro rata basis, to ITT’s shareholders of record as of the close of business on October 17, 2011 (the “Record Date”). On the Distribution Date, each of the shareholders of ITT received one share of Xylem common stock for every one share of common stock of ITT held on the Record Date. The Spin-off was completed pursuant to the Distribution Agreement, dated as of October 25, 2011, among ITT, Exelis Inc. (“Exelis”) and Xylem. After the Distribution Date, ITT does not beneficially own any shares of Xylem common stock and, following such date, financial results of Xylem will not be consolidated in ITT’s financial reporting. Xylem’s Registration Statement on Form 10 filed with the U.S. Securities and Exchange Commission (“SEC”) was declared effective on October 6, 2011. Xylem’s common stock began “regular-way” trading on the New York Stock Exchange on November 1, 2011 under the symbol “XYL”.

 

Hereinafter, except as otherwise indicated or unless the context otherwise requires, “Xylem,” “we,” “us,” “our” and “the Company” refer to Xylem Inc. and its subsidiaries. References in the notes to the condensed combined financial statements to “ITT” or “parent” refers to ITT Corporation and its consolidated subsidiaries (other than Xylem Inc.).

 

Carve-out Basis of Presentation

 

The interim condensed combined financial statements presented herein, and discussed below, have been prepared on a standalone basis and are derived from the consolidated financial statements and accounting records of the water equipment and services businesses of ITT. The accompanying unaudited interim condensed combined financial statements reflect our financial position, results of operations and cash flows, as historically managed, in conformity with accounting principles generally accepted in the United States of America (“GAAP”). All intracompany transactions between our businesses have been eliminated. All intercompany transactions between us and ITT have been included in these interim condensed combined financial statements and when the underlying transaction is to be settled in cash with ITT it is considered to be effectively settled for cash in the condensed combined financial statements at

 

the time the transaction is recorded. The total net effect of the settlement of these intercompany transactions is reflected in the Condensed Combined Statements of Cash Flow as a financing activity and in the Condensed Combined Balance Sheets as “Parent company investment.”

 

Our interim condensed combined financial statements include expense allocations for (i) certain corporate functions historically provided by ITT, including, but not limited to, finance, legal, information technology, human resources, communications, ethics and compliance, and shared services, (ii) employee benefits and incentives, and (iii) share-based compensation. These expenses have been allocated to us on the basis of direct usage when identifiable, with the remainder allocated on the basis of revenue, headcount or other measures. Both we and ITT consider the basis on which the expenses have been allocated to be a reasonable reflection of the utilization of services provided to or the benefit received by us during the periods presented. The allocations may not, however, reflect the expense we would have incurred as an independent, publicly traded company for the periods presented. Actual costs that may have been incurred if we had been a standalone company would depend on a number of factors, including the chosen organizational structure, what functions were outsourced or performed by employees and strategic decisions made in areas such as information technology and infrastructure. Following the Spin-off, we will perform these functions using our own resources or purchased services, certain of which may be provided by ITT under the transition services agreement that is expected to extend for a period of 3 to 24 months in most circumstances.

 

On a historical basis, ITT used a centralized approach to cash management and financing of its operations, excluding debt where we are the legal obligor. Prior to the Spin-off, the majority of our cash was transferred to ITT daily and ITT funded our operating and investing activities as needed. Cash transfers to and from ITT’s cash management accounts are reflected in “Parent company investment.”

 

The interim condensed combined financial statements include certain assets and liabilities that have historically been held at the ITT corporate level but are specifically identifiable or otherwise allocable to us. The cash and cash equivalents held by ITT at the corporate level are not specifically identifiable to Xylem and therefore were not allocated to us for any of the periods presented. Cash and cash equivalents in our Condensed Combined Balance Sheets primarily represent cash held locally by entities included in our condensed combined financial statements. Except for debt issued directly by Xylem, ITT third-party debt, and the related interest expense has not been allocated to us for any of the periods presented as we were not the legal obligor of the debt and the ITT borrowings were not directly attributable to our business.

 

The interim condensed combined financial statements exclude the allocation of liabilities, assets, and costs reported by ITT related to asbestos product liability matters. These matters were not allocated to us for any period presented as ITT will continue as the legal obligor for those liabilities, subject to limited exceptions. ITT is expected to pay any associated settlements, judgments, or legal defense costs, subject to limited exceptions with respect to certain employee claims.

 

The unaudited interim condensed combined financial statements have been prepared pursuant to the rules and regulations of the 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, results of operations, and cash flows for the periods presented have been included. Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of

 

America 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 the Information Statement filed as Exhibit 99.1 to our Registration Statement on Form 10 filed with the SEC on October 5, 2011 (the “Information Statement”), in preparing these unaudited financial statements, with the exception of accounting standard updates described in Note 2 adopted on January 1, 2011. These financial statements should be read in conjunction with the combined financial statements and notes thereto as of December 31, 2010 and 2009 and for each of the three years in the period ended December 31, 2010, included in the Registration Statement, filed with the Securities and Exchange Commission on October 5, 2011 as Exhibit 99.1 to our Registration Statement on Form 10.

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect amounts reported in the interim condensed combined financial statements and accompanying notes. Such estimates include, but are not limited to, allowance for doubtful accounts, inventory valuation, warranty accrual, goodwill and intangible asset impairment, postretirement benefits, income taxes and the allocation of purchase price to the assets acquired and liabilities assumed in a business combination. Estimates are revised as additional information becomes available. Additionally, our interim condensed combined financial statements may not be indicative of our future performance and do not necessarily reflect what the results of operations, financial position and cash flows would have been had we operated as an independent, publicly traded company during the periods presented.

 

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 31st. For ease of presentation, the quarterly financial statements included herein are described as ending on the last day of the calendar quarter.

 

Certain prior period amounts in the condensed combined financial statements and related notes have been reclassified to conform to the current period presentation.

 

 

No diluted earnings per share is presented in the table above as no common stock of Xylem was traded in a “regular way” basis prior to November 1, 2011 and the conversion of ITT share-based compensation awards to Xylem awards occurred at separation and are only considered outstanding as of October 31, 2011. See Note 16, Subsequent Events for further details.

 

 

 

Recently Adopted Pronouncements

 

In December 2010, the Financial Accounting Standards Board (“FASB”) issued additional guidance applicable to the testing of goodwill for potential impairment. Specifically, for reporting units with zero or negative carrying amounts, an entity is required to perform the second step of the goodwill impairment test (a comparison between the carrying amount of a reporting unit’s goodwill to its implied fair value) if it is more likely than not that a goodwill impairment exists, considering any adverse qualitative factors. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. As of the date of our most recent goodwill impairment test, none of our reporting units would have been affected by the application of this guidance as each reporting unit had a carrying amount that exceeded zero.

 

In April 2010, the FASB issued authoritative guidance permitting use of the milestone method of revenue recognition for research or development arrangements that contain payment provisions or consideration contingent on the achievement of specified events. On January 1, 2011, we adopted the new guidance on a prospective basis. The adoption of this guidance did not have a material impact on our financial condition, results of operations or cash flows.

 

In October 2009, the FASB issued amended guidance on the accounting for revenue arrangements that contain multiple elements by eliminating the criteria that objective and reliable evidence of fair value for undelivered products or services needs to exist in order to be able to account separately for deliverables and eliminating the use of the residual method of allocating arrangement consideration. The amendments establish a hierarchy for determining the selling price of a deliverable and will allow for the separation of products and services in more instances than previously permitted.

 

We adopted the new multiple element guidance effective January 1, 2011 for new arrangements entered into or arrangements materially modified on or after that date on a prospective basis. In connection with the adoption of the revised multiple element arrangement guidance, we revised our revenue recognition accounting policies. For multiple deliverable arrangements entered into or materially modified on or after January 1, 2011, we recognize revenue for a delivered element based on the relative selling price if the deliverable has stand-alone value to the customer and, in arrangements that include a general right of return relative to the delivered element, performance of the undelivered element is considered probable and substantially in the Company’s control. The selling price for a deliverable is based on vendor-specific objective evidence of selling price (“VSOE”), if available, third-party evidence of selling price (“TPE”), if VSOE is not available, or best estimated selling price (“BESP”), if neither VSOE nor TPE is available.

 

The deliverables in our arrangements with multiple elements include various products and may include related services, such as installation and start-up services. For multiple element arrangements entered into or materially modified after adoption of the revised multiple element arrangement guidance, we allocate arrangement consideration based on the relative selling prices of the separate units of accounting determined in accordance with the hierarchy described above. For deliverables that are sold separately, we establish VSOE based on the price when the deliverable is sold separately. We establish TPE, generally for services, based on prices similarly situated customers pay for similar services from third party vendors. For those deliverables for which we are unable to establish VSOE or TPE, we estimate the selling price considering various

 

factors including market and pricing trends, geography, product customization, and profit objectives. Revenue allocated to products and services is generally recognized as the products are delivered and the services are performed, provided all other revenue recognition criteria have been satisfied. The adoption of the new multiple element guidance did not result in a material change in either the units of accounting or the pattern or timing of revenue recognition. Additionally, the adoption of the revised multiple element arrangement guidance did not have a material impact on our financial condition, results of operations or cash flows.

 

Pronouncements Not Yet Adopted

 

In September 2011, the FASB provided companies with the option to make an initial qualitative evaluation, based on the entity’s events and circumstances, to determine the likelihood of goodwill impairment. The results of this qualitative assessment determine whether it is necessary to perform the currently required two-step impairment test. If it is more likely than not that the fair value of a reporting unit is less than its carrying amount, a company would be required to perform the two-step impairment test. This guidance is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. The Company could apply the option to any goodwill impairment test performed after December 31, 2011. The amendments are not expected to have any effect on the Company’s consolidated financial statements.

 

In May 2011, the FASB issued guidance intended to achieve common fair value measurements and related disclosures between U.S. GAAP and international accounting standards. The amendments primarily clarify existing fair value guidance and are not intended to change the application of existing fair value measurement guidance. However, the amendments include certain instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. This guidance is effective for the periods beginning after December 15, 2011 and early application is prohibited. We will adopt these amendments on January 1, 2012; however, the requirements are not expected to have a material effect on the Company’s consolidated financial statements.

 

 

On September 1, 2011, we acquired 100% of the outstanding shares of YSI Incorporated (“YSI”) for a purchase price of $309 million, net of cash acquired. YSI, which reported 2010 revenue of $101 million, is a leading developer and manufacturer of sensors, instruments, software, and data collection platforms for environmental water monitoring. YSI employs 390 people at facilities in the United States, Europe and Asia. Our financial statements include YSI’s results of operations and cash flows prospectively from September 1, 2011 within the Water Infrastructure segment; however, the acquisition was not material to results of operations for the three or nine months ended September 30, 2011 and accordingly, pro forma results of operations reflecting YSI’s results prior to acquisition have not been presented.

 

The purchase price for YSI was allocated to the net tangible and intangible assets acquired and liabilities assumed based on their preliminary fair values as of September 1, 2011. The excess of the purchase price over the preliminary assets acquired and liabilities assumed was recorded as goodwill. The purchase price allocation is based upon a preliminary valuation and our estimates and assumptions are subject to change within the measurement period. The primary areas of the purchase price allocation that are not yet finalized relate to the fair values of certain

 

environmental matters, intangible assets, income taxes, working capital balances, and residual goodwill. A charge in the amount of $3 million is included in selling, general and administrative expense related to acquisition-related costs.

 

The following table presents the allocation of the purchase price to the assets acquired and liabilities assumed, based on their fair values (in millions):

 

 

Goodwill of $192 million arising from the acquisition consists largely of the planned expansion of YSI to new geographic markets, synergies and economies of scale is not expected to be deductible for income tax purposes. In addition, of the $124 million that was allocated to intangible assets, $40 million was assigned to customer relationships and will be amortized on a straight line basis over the estimated useful life of 19 years; $35 million was assigned to proprietary technology and will be amortized on a straight line basis over the weighted average useful life of 19 years; and the remaining $49 million of acquired intangible assets was assigned to trademarks, which is not subject to amortization as they were determined to have indefinite useful lives.

 

During the first six months of 2010, we spent $391 million, net of cash acquired. The substantial majority of the first six months of 2010 aggregate purchase price pertained to the acquisition of Nova Analytics Corporation (“Nova”) on March 23, 2010 for $385 million. Nova provides us with analytical instrumentation brands and technologies and was combined with the Water & Waste Water Division of the Water Infrastructure segment.

 

Additionally, in the third quarter of 2010, we completed the acquisitions of Godwin Pumps of America, Inc. and Godwin Holdings Limited (collectively referred to as Godwin) for $580 million. Godwin is a supplier and servicer of automatic self-priming and on-demand pumping solutions serving the global industrial, construction, mining, municipal, oil and gas dewatering markets. The Godwin acquisition expands our dewatering market presence in the United States. The results of operations and cash flows from our 2010 acquisitions have been included in our Condensed Combined Financial Statements prospectively from their date of acquisition.

 

 

 

 

Our current estimate of the after-tax cash impact of the remaining activities associated with the separation ranges from approximately $30 million to $50 million, primarily attributable to tax, accounting, and other professional advisory fees, and information technology costs

 

 

Effective Tax Rate

 

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

 

The income tax provision for the three months ended September 30, 2011 was $5 million or 6.3% of income before taxes, compared to $19 million or 16.7% for the three months ended September 30, 2010. The decrease in the third quarter of 2011 tax provision is primarily due to the effective settlement of an international tax examination and a reduction in tax separation costs offset, in part, by separation costs and a deferred tax adjustment recognized during the three months ended September 30, 2011. The tax provision for the third quarter of 2010 was favorably impacted by a tax benefit resulting from the repatriation of foreign earnings net of foreign tax credits.

 

For the nine months ended September 30, 2011, we recorded an income tax provision of $72 million at an effective tax rate of 24.0% compared to $45 million at an effective tax rate of 16.2% for the

 

nine months ended September 30, 2010. The 2011 effective tax rate was decreased by the effective settlement of an international tax examination and more than offset by tax separation costs, separation costs, and deferred tax adjustments. The 2010 effective tax rate was favorably impacted by a tax benefit resulting from the repatriation of foreign earnings net of foreign tax credits.

 

Uncertain Tax Positions

 

We recognize a tax benefit from an uncertain tax position 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. As of September 30, 2011 and December 31, 2010, we recorded $30 million and $43 million of total unrecognized tax benefits principally all of which would affect the effective tax rate.

 

As agreed upon as part of the separation, ITT is primarily liable for all income taxes up to a certain amount for all pre- separation period combined or consolidated income tax returns, and, as such, approximately $27 million of our unrecognized tax benefits will be assumed by ITT at the time of the separation. Related interest will be reduced accordingly.

 

We classify interest relating to tax matters as a component of interest expense and tax penalties as a component of income tax expense in our Combined Condensed Income Statement. We had $4 million of interest accrued for tax matters as of September 30, 2011 and $5 million as of December 31, 2010.

 

 

 

Depreciation expense of $25 million and $72 million was recognized in the three and nine months periods ended September 30, 2011, respectively and $20 million and $48 million for the three and nine month periods ended September 30, 2010, respectively.

 

 

In connection with the YSI acquisition, the excess of the preliminary purchase price over the fair value of net assets acquired was $192 million (which is not expected to be deductible for income tax purposes). The goodwill arising from the acquisition consists largely of the planned expansion of the YSI footprint to new geographic markets, synergies and economies of scale.

 

Based on the results of our annual impairment tests, we determined that no impairment of goodwill existed as of our measurement date in 2010. However, future goodwill impairment tests could result in a charge to earnings. We will continue to evaluate goodwill on an annual basis as of the beginning of our fourth fiscal quarter and whenever events and changes in circumstances indicate there may be a potential impairment.

 

 

In connection with the YSI acquisition, $124 million was allocated to intangible assets, of which $40 million was assigned to customer relationships and will be amortized on a straight line basis over the estimated useful life of 19 years; $35 million was assigned to proprietary technology and will be amortized on a straight line basis over the weighted average useful life of 19 years; and

 

the remaining $49 million of acquired intangible assets was assigned to trademarks which were determined to have indefinite useful lives and therefore are not subject to amortization.

 

Based on the results of our annual impairment tests, we determined that no impairment of the indefinite-lived intangibles existed as of our measurement date in 2010. However, future impairment tests could result in a charge to earnings. We will continue to evaluate the indefinite-lived intangible assets on an annual basis as of the beginning of our fourth fiscal quarter and whenever events and changes in circumstances indicate there may be a potential impairment.

 

Amortization expense related to finite-lived intangible assets for the nine months ended September 30, 2011 and 2010 was $23 million and $14 million, respectively. Estimated amortization expense for the remaining three months of 2011 and each of the five succeeding years is as follows (in millions):

 

 

 

We have adjusted certain balances in the above table as of December 31, 2010 by immaterial amounts to reflect them within the appropriate categories.

 

 

 

Senior Notes

 

On September 20, 2011, we issued 3.55% Senior Notes of $600 million aggregate principal amount due September 2016 and 4.875% Senior Notes of $600 million aggregate principal amount due October 2021 (together, the “Senior Notes”). The issuance resulted in gross proceeds of $1.2 billion, offset by $9 million in debt issuance costs which were capitalized and are included within other assets. The Senior Notes include covenants which restrict our ability, subject to exceptions, to incur debt secured by liens and engage in sale and lease-back transactions as well as provide for customary events of default (subject, in certain cases, to receipt of notice of default and/or customary grace and cure periods), including but not limited to, (i) failure to pay interest for 30 days, (ii) failure to pay principal when due, (iii) failure to perform any other covenant for 90 days after receipt of notice from the trustee or from holders of 25% of the outstanding principal amount and (iv) certain events of bankruptcy, insolvency or reorganization. We may redeem the Senior Notes, as applicable, in whole or in part, at any time at a redemption price equal to the principal amount of the Senior Notes to be redeemed, plus a make-whole premium. As of September 30, 2011, we were in compliance with all covenants. If a change of control triggering event occurs, we will be required to make an offer to purchase the Senior Notes at a price equal to 101% of their principal amount plus accrued and unpaid interest to the date of repurchase.

 

Interest on the Senior Notes accrues from September 20, 2011. Interest on the 2016 Notes is payable on March 20 and September 20 of each year, commencing on March 20, 2012. Interest on the 2021 Notes is payable on April 1 and October 1 of each year, commencing on April 1, 2012.

 

The net proceeds received from the offering of the Senior Notes was used to pay a special cash dividend to ITT, to repay indebtedness incurred to fund the Company’s acquisition of YSI and for general corporate purposes.

 

On September 20, 2011, ITT and Xylem entered into a registration rights agreement with respect to the Senior Notes (“the Xylem Registration Rights Agreement”). ITT and Xylem agreed to (i) file a registration statement on an appropriate registration form with respect to a registered offer to exchange the Senior Notes for new notes, with terms substantially identical in all material respects and (ii) cause the registration statement to be declared effective under the Securities Act.

 

If the exchange offer is not completed within 365 days after the issue date, we will use our reasonable best efforts to file and to have declared effective a shelf registration statement relating to the resale of the Senior Notes.

 

If we fail to satisfy this obligation (a registration default) under the Xylem Registration Rights Agreement, the annual interest rate on the Senior Notes will increase by 0.25% and increase by an additional 0.25% for each subsequent 90-day period during which the registration default continues, up to a maximum additional interest rate of 1.00% per year. If the registration default is corrected, the applicable interest rate will revert to the original level.

 

In the event that we must pay additional interest, it will pay to the holders of the Senior Notes in cash on the same dates that it makes other interest payments on the Senior Notes until the registration default is corrected.

 

Four Year Competitive Advance and Revolving Credit Facility

 

Effective October 31, 2011, Xylem and its subsidiaries entered into a Four Year Competitive Advance and Revolving Credit Facility (the “Credit Facility”) with JPMorgan Chase Bank, N.A., as agent, and a syndicate of lenders. Refer to Note 16, Subsequent Events for further details.

 

 

We contributed approximately $6 million and $1 million to our various plans during the nine months ended September 30, 2011 and 2010, respectively. Additional contributions ranging between $6 million and $8 million are expected during the remainder of 2011.

 

Certain company employees participate in defined benefit pension and other postretirement benefit plans sponsored by ITT, which include participants of other ITT subsidiaries. We recorded approximately $19 million and $15 million of expense related to such plans during the nine months ended September 30, 2011 and 2010, respectively.

 

 

 

ITT maintained several share-based and long term incentive plans for the benefit of certain officers, directors, and employees, including Xylem employees. Share-based awards issued to employees include non-qualified stock options, restricted stock awards and a target cash award. Nonqualified stock options (“NQO”) and equity-settled restricted stock awards are accounted for as equity-based compensation. The target cash award and certain restricted stock awards are cash settled and accounted for as liability-based compensation. These compensation costs are recognized primarily within selling, general and administrative expenses.

 

As of September 30, 2011, there were approximately 0.6 million NQO and 0.2 million restricted stock shares outstanding related to Xylem specific employees. Total share-based compensation and long-term incentive plan costs recognized was $7 million and $5 million for the nine months ended September 30 2011, and 2010, respectively. A significant component of these charges relates to costs allocated to Xylem for ITT employees as well as other ITT employees not solely dedicated to Xylem. These awards and related amounts are not necessarily indicative of awards and amounts that would have been granted if we were an independent, publicly traded company for the periods presented. Refer to Note 16, Subsequent Events for further details. The following table provides further detail related to share-based compensation expense.

 

 

 

The interim condensed combined financial statements have been prepared on a standalone basis and are derived from the consolidated financial statements and accounting records of ITT.

 

During the nine months ended September 30, 2011 and 2010, we sold inventory to other ITT businesses in the aggregate amount of $9 million and $6 million, respectively which is included in revenue in our Condensed Combined Income Statement.

 

We also purchase inventories from other ITT businesses. During each of the nine months ended September 30, 2011 and 2010, we recognized cost of revenue from the inventory purchased from ITT of $8 million. The aggregate inventory on hand of purchases from other ITT businesses as of September 30, 2011 and December 31, 2010 was not significant.

 

Allocation of General Corporate Expenses

 

The condensed combined financial statements include expense allocations for certain functions provided by ITT as well as other ITT employees not solely dedicated to Xylem, including, but not limited to, general corporate expenses related to finance, legal, information technology, human resources, communications, ethics and compliance, shared services, employee benefits and incentives, and share-based compensation. These expenses have been allocated to us on the basis of direct usage when identifiable, with the remainder allocated on the basis of revenue, headcount or other measure. We were allocated $43 million and $107 million of general corporate expenses incurred by ITT which is included within selling, general and administrative expenses in the Condensed Combined Income Statements for the three and nine months period ended September 30, 2011, respectively, and $28 million and $80 million for the comparable periods in 2010.

 

The expense allocations have been determined on a basis that we consider to be a reasonable reflection of the utilization of services provided or the benefit received by us during the periods presented. The allocations may not, however, reflect the expense we would have incurred as an independent, publicly traded company for the periods presented. Actual costs that may have been incurred if we had been a standalone company would depend on a number of factors, including the chosen organizational structure, what functions were outsourced or performed by employees and strategic decisions made in areas such as information technology and infrastructure.

 

Parent Company Equity

 

On a historical basis, ITT used a centralized approach to cash management and financing of its operations, excluding debt directly incurred by any of its businesses, such as debt assumed in an acquisition. The majority of our domestic cash is transferred to ITT daily and ITT funds our operating and investing activities as needed. The condensed combined financial statements also include the push down of certain assets and liabilities that have historically been held at the ITT corporate level but which are specifically identifiable or otherwise allocable to us. The cash and cash equivalents held by ITT at the corporate level were not allocated to us for any of the periods presented. Cash and equivalents in our combined balance sheets primarily represent cash held locally by entities included in our combined financial statements. Transfers of cash to and from ITT’s cash management system are reflected as a component of Parent company investment on the combined balance sheets.

 

All significant intercompany transactions between us and ITT have been included in these condensed combined financial statements and are considered to be effectively settled for cash in the combined financial statements at the time the transaction is recorded when the underlying transaction is to be settled in cash by ITT. The total net effect of the settlement of these intercompany transactions is reflected in the combined statements of cash flow as a financing activity and in the combined balance sheets as parent company investment.

 

 

Our business is organized into 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 encompasses all the uses of water and focuses on the residential, commercial, industrial and agricultural markets. Corporate and Other consists of

 

corporate office expenses including compensation, benefits, occupancy, depreciation, and other administrative costs, as well as charges related to certain matters, such as the Spin-off and environmental matters that are managed at a corporate level and are not included in the business segments in evaluating performance or allocating resources.

 

 

 

 

 

 

General

 

From time to time we are involved in legal proceedings that are incidental to the operation of our businesses. Some of these proceedings seek remedies relating to environmental matters, product liability, personal injury claims, employment and pension matters, and commercial or contractual

 

disputes, sometimes related to acquisitions or divestitures. We will continue to defend vigorously against all claims.

 

While no claims have been asserted against Xylem alleging injury caused by our products resulting from asbestos exposure, it is possible that claims could be filed in the future. Should asbestos product liability claims be asserted against Xylem in the future, we believe there are numerous legal defenses available and would defend ourselves vigorously against such a claim. As part of the separation, ITT will indemnify Xylem for asbestos product liability matters, subject to limited exceptions with respect to certain employee claims, including settlements, judgments, and legal defense costs associated with all pending and future claims that may arise from past revenue of ITT’s legacy products. We believe ITT remains a substantive entity with sufficient financial resources to honor its obligations to us.

 

Although the ultimate outcome of any legal matter cannot be predicted with certainty, based on present information, including our assessment of the merits of the particular claim, we do not expect that any asserted or unasserted legal claims or proceedings, individually or in the aggregate, will have a material adverse effect on our cash flow, results of operations, or financial condition.

 

Indemnifications

 

As part of the Spin-off, ITT, Exelis and Xylem will indemnify each of the other parties with respect to such parties’ assumed or retained liabilities under the Distribution Agreement and breaches of the Distribution Agreement or related spin agreements. ITT’s indemnification obligations include asserted and unasserted asbestos and silica liability claims that relate to the presence or alleged presence of asbestos or silica in products manufactured, repaired or sold prior to the Distribution Date, subject to limited exceptions with respect to certain employee claims, or in the structure or material of any building or facility, subject to exceptions with respect to employee claims relating to Xylem buildings or facilities. The indemnifications are absolute in accordance with their terms and indefinite. The indemnification associated with pending and future asbestos claims does not expire. Xylem has not recorded a liability for matters for which we will be indemnified by ITT or Exelis through the Distribution Agreement and we are not aware of any claims or other circumstances that would give rise to material payments from us under such indemnifications.

 

Environmental

 

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

 

Accruals for environmental matters are recorded on a site by site basis when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated, based on current law and existing technologies. Our accrued liabilities for these environmental matters

 

represent the best estimates related to the investigation and remediation of environmental media such as water, soil, soil vapor, air and structures, as well as related legal fees. These estimates, and related accruals, are reviewed quarterly and updated for progress of investigation and remediation efforts and changes in facts and legal circumstances. Liabilities for these environmental expenditures are recorded on an undiscounted basis. We have estimated and accrued $10 million and $8 million as of September 30, 2011 and December 2010, respectively, for environmental matters.

 

It is difficult to estimate the final costs of investigation and remediation due to various factors, including incomplete information regarding particular sites and other potentially responsible parties, uncertainty regarding the extent of investigation or remediation and our share, if any, of liability for such conditions, the selection of alternative remedial approaches, and changes in environmental standards and regulatory requirements. In our opinion, the total amount accrued is reasonable based on existing facts and circumstances.

 

As of September 30, 2011, our estimate of reasonably possible losses in excess of amounts accrued for environmental and legal matters was approximately $23 million.

 

 

 

Impact of Assets and Liabilities Contributed by ITT Corporation

 

As of October 31, 2011, the Distribution Date, ITT transferred to Xylem Inc. certain assets and liabilities with a total net liability of approximately $29 million, primarily consisting of certain defined benefit pension and other postretirement benefit plans offset by adjustments to deferred income taxes. As the newly designated plan sponsor, we assumed all assets and liabilities associated with such plans. The net liabilities associated with such plans assumed were approximately $85 million, excluding net deferred tax assets of approximately $22 million.

 

The final parent net investment is subject to customary closing adjustments based upon the Distribution Agreement through October 31, 2011. We currently estimate that ITT’s final parent net investment will be approximately $1.7 billion.

 

Also in connection with the Spin-off, the Board of Directors agreed to award options and restricted stock grants pursuant to the Xylem Inc. 2011 Omnibus Incentive Plan of approximately 1.3 million options and 425,000 restricted stock to certain employees and directors of the Company.

 

Agreements with ITT and Exelis Related to the Separation

 

On October 25, 2011, ITT, Exelis, and Xylem executed the various agreements that will govern the ongoing relationships between the three companies after the distribution and provide for the allocation of employee benefits, income taxes, and certain other liabilities and obligations attributable to periods prior to the Distribution. The executed agreements include the Distribution Agreement, Benefits and Compensation Matters Agreement, Tax Matters Agreement, and Master Transition Services Agreement and a number of on-going commercial relationships. The Distribution Agreement also provides for certain indemnifications and cross-indemnifications among ITT, Exelis, and Xylem. The indemnifications address a variety of subjects, including asserted and unasserted product liability matters (e.g., asbestos claims, product warranties), which relate to products sold prior to the Distribution Date. The indemnifications are absolute in accordance with their terms and indefinite. The indemnification associated with pending and future asbestos claims does not expire. Effective upon the Distribution, certain intercompany work orders and/or informal intercompany commercial arrangements are being converted into third-party contracts based on standard business terms and conditions.

 

Four Year Competitive Advance and Revolving Credit Facility

 

Effective October 31, 2011, Xylem and its subsidiaries entered into a Four Year Competitive Advance and Revolving Credit Facility (the “Credit Facility”) with JPMorgan Chase Bank, N.A., as agent, and a syndicate of lenders. The credit facility provides for an aggregate principal amount of up to $600 million of (i) a competitive advance borrowing option which will be provided on an uncommitted competitive advance basis through an auction mechanism (the “competitive loans”), (ii) revolving extensions of credit (the “revolving loans”) outstanding at any time and (iii) the issuance of letters of credits in a face amount not in excess of $100 million outstanding at any time.

 

At our election, the interest rate per annum applicable to the competitive advances will be based on either (i) a Eurodollar rate determined by reference to LIBOR, plus an applicable margin offered by the lender making such loans and accepted by us or (ii) a fixed percentage rate per annum specified by the lender making such loans. At our election, interest rate per annum applicable to the revolving loans will be based on either (i) a Eurodollar rate determined by reference to LIBOR, adjusted for statutory reserve requirements, plus an applicable margin or (ii) a fluctuating rate of interest

 

determined by reference to the greatest of (a) the prime rate of JPMorgan Chase Bank, N.A., (b) the federal funds effective rate plus half of 1% or (c) the Eurodollar rate determined by reference to LIBOR, adjusted for statutory reserve requirements, in each case, plus an applicable margin.

 

In accordance with the terms, we may not exceed a maximum leverage ratio of 3.50 (based on a ratio of total debt to EBITDA) throughout the term. The Credit Facility also contains limitations on, among other things, incurring debt, granting liens, and entering sale and leaseback transactions. In addition, the Credit Facility contains other terms and conditions such as customary representations and warranties, additional covenants and customary events of default.

 

Board Declares Fourth Quarter Dividend

 

On November 2, 2011, the Board of Directors of Xylem declared a fourth quarter dividend of $0.1012 per share to shareholders of record on November 16, 2011. The cash dividend will be payable December 31, 2011.

 

This Report contains forward-looking statements made pursuant to the safe harbor within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”) relating to our operations, results of operations and other matters. Forward-looking statements in this Report are indicated by words such as “anticipates,” “expects,” “believes,” “intends,” “plans,” “estimates,” “projects” and similar expressions. These statements represent our expectations based on current information and assumptions and are inherently subject to risks and uncertainties. Our actual results could differ materially from those which are anticipated or projected as a result of certain risks and uncertainties, including, but not limited to, our significant leverage; economic and market conditions (including access to credit and financial markets); the performance of the aftermarket and original equipment service markets; changes in business relationships with our major customers and in the timing, size and continuation of our customers’ programs; changes in the product mix and distribution channel mix; the ability of our customers to achieve their projected revenue; competitive product and pricing pressures; increases in production or material costs that cannot be recouped in product pricing; successful integration of acquired businesses; our ability to achieve cost savings from our restructuring initiatives; product liability and environmental matters; as well as other risks and uncertainties. For a more detailed discussion of these factors, see the information under the heading “Risk Factors” in our Registration Statement on Form 10 and with other filings we make with the SEC. Forward-looking statements are made only as of the date hereof, and the Company undertakes no obligation to update or revise the forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In addition, historical information should not be considered as an indicator of future performance.

 

The following discussion should be read in conjunction with the unaudited consolidated financial statements, including the notes thereto, included elsewhere in this Report. Except as otherwise indicated or unless the context otherwise requires, “Xylem,” “we,” “us,” “our” and “the Company” refer to Xylem Inc. and its subsidiaries. References to the condensed combined financial statements to “ITT” or “parent” refers to ITT Corporation and its consolidated subsidiaries (other than Xylem Inc.).

 

Separation from ITT Corporation

 

On October 31, 2011, ITT Corporation (“ITT”) completed the previously announced spin-off (the “Spin-off”) of Xylem, formerly ITT’s water equipment and services businesses. Effective as of 12:01 a.m., Eastern time on October 31, 2011 (the “Distribution Date”), the common stock of Xylem was distributed, on a pro rata basis, to ITT’s shareholders of record as of the close of business on October 17, 2011 (the “Record Date”). On the Distribution Date, each of the shareholders of ITT received one share of Xylem common stock for every one share of common stock of ITT held on the Record Date. The Spin-off was completed pursuant to the Distribution Agreement, dated as of October 25, 2011, among ITT, Exelis Inc. and Xylem. After the Distribution Date, ITT does not beneficially own any shares of Xylem common stock and, following such date, financial results of Xylem will not be consolidated in ITT’s financial reporting. Xylem’s Registration Statement on Form 10 filed with U.S. Securities and Exchange Commission was declared effective on October 6, 2011. Xylem’s common stock began “regular-way” trading on the New York Stock Exchange on November 1, 2011 under the symbol “XYL”.

Business Overview

 

Our Company is a world leader in the design, manufacturing, and application of highly engineered technologies for the water industry. We are 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, and we have leading market positions among equipment and service providers in the core application areas of the water equipment industry: transport, treatment, test, building services, industrial processing and irrigation. Our Company’s brands, such as Bell & Gossett and Flygt, are well known throughout the industry and have served the water market for many years. Over the years, we have leveraged our heritage strength in wastewater pumping technologies to expand into wastewater treatment, and later into clean water treatment and water quality analysis. We believe we are strongly positioned to use our deep applications expertise and offer our customers a full spectrum of service offerings in the transportation, treatment and testing of water.

 

We operate 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. Key brands in this segment include Flygt, Wedeco, Godwin Pumps, WTW, Sanitaire, AADI and Leopold. The Applied Water segment encompasses all the uses of water and focuses on the residential, commercial, industrial and agricultural markets. The segment’s major products include pumps, valves, heat exchangers, controls and dispensing equipment. Key brands in this segment include Goulds Water Technology, Bell & Gossett, AC Fire, Standard, Flojet, Lowara, Jabsco and Flowtronex. In both our segments, we benefit from a large and growing installed base of products driving growth in aftermarket revenue for replacement parts and services.

 

We serve a global customer base across diverse end markets while offering localized expertise. We sell our products in more than 150 countries through a balanced distribution network consisting of our direct sales force and independent channel partners.

 

Executive Summary

 

Xylem reported revenue for the third quarter 2011 of $939 million, an increase of 16.5% compared to $806 million during the comparable quarter in 2010, primarily due to strong dewatering performance in our Water Infrastructure segment and strength in light industrial, agricultural and residential markets in our Applied Water segment. Operating income for the third quarter of 2011, excluding costs of $46 million incurred in connection with the Spin-off, was $125 million, reflecting an increase of $18 million or 16.8% compared to $107 million in the third quarter of 2010.

 

Additional highlights for the third quarter of 2011 include the following:

 

 

 

Known Trends and Uncertainties

 

There has been no material change in the information concerning known trends and uncertainties in our Information Statement.

 

Key Performance Indicators and Non-GAAP Measures

 

Management reviews key performance indicators including revenue, segment operating income and margins, earnings per share, orders growth, and backlog, among others. In addition, we consider certain measures to be useful to management and investors evaluating our operating performance for the periods presented, and provide a tool for evaluating our ongoing operations, liquidity and management of assets. This information can assist investors in assessing our financial performance and measures our ability to generate capital for deployment among competing strategic alternatives and initiatives, including, but not limited to, dividends, acquisitions, share repurchases and debt repayment. These metrics, however, are not measures of financial performance under accounting principles generally accepted in the United States of America (“GAAP”) and should not be considered a substitute for revenue, operating income, income from continuing operations, income from continuing operations per diluted share or net cash from continuing operations as determined in accordance with GAAP. We consider the following non-GAAP measures, which may not be comparable to similarly titled measures reported by other companies, to be key performance indicators: