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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2016
or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from             to             
Commission file number: 1-35229
Xylem Inc.
(Exact name of registrant as specified in its charter)
 
Indiana
  
45-2080495
(State or other jurisdiction of incorporation or
organization)
  
(I.R.S. Employer Identification No.)
1 International Drive, Rye Brook, NY 10573
(Address of principal executive offices) (Zip code)
(914) 323-5700
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes þ   No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  þ    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer
 
þ
 
Accelerated filer
 
¨
 
 
 
 
 
 
Non-accelerated filer
 
¨  (Do not check if a smaller reporting company)
 
Smaller reporting company
 
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes  ¨    No  þ
As of October 28, 2016, there were 179,394,836 outstanding shares of the registrant’s common stock, par value $0.01 per share.
 



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

2


PART I

ITEM 1.             CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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

 
Three Months
 
Nine Months
For the periods ended September 30,
2016
 
2015
 
2016
 
2015
Revenue
$
897

 
$
902

 
$
2,676

 
$
2,659

Cost of revenue
540

 
551

 
1,621

 
1,645

Gross profit
357

 
351

 
1,055

 
1,014

Selling, general and administrative expenses
219

 
207

 
665

 
631

Research and development expenses
23

 
23

 
75

 
71

Restructuring charges
6

 
1

 
18

 
5

Operating income
109

 
120

 
297

 
307

Interest expense
16

 
13

 
50

 
41

Other non-operating income, net
2

 

 
3

 

Gain from sale of businesses

 

 

 
9

Income before taxes
95

 
107

 
250

 
275

Income tax expense
22

 
19

 
40

 
49

Net income
$
73

 
$
88

 
$
210

 
$
226

Earnings per share:
 
 
 
 
 
 
 
Basic
$
0.41

 
$
0.48

 
$
1.17

 
$
1.25

Diluted
$
0.41

 
$
0.48

 
$
1.17

 
$
1.24

Weighted average number of shares:
 
 
 
 
 
 
 
Basic
179.3

 
180.8

 
179.0

 
181.5

Diluted
180.3

 
181.6

 
179.8

 
182.3

Dividends declared per share
$
0.1549

 
$
0.1408

 
$
0.4647

 
$
0.4224

See accompanying notes to condensed consolidated financial statements.


3


XYLEM INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
(in millions)
 
 
Three Months
 
Nine Months
For the periods ended September 30,
2016
 
2015
 
2016
 
2015
Net income
$
73

 
$
88

 
$
210

 
$
226

Other comprehensive (loss) income, before tax:
 
 
 
 
 
 
 
Foreign currency translation adjustment
(8
)
 
(39
)
 
(25
)
 
(142
)
Foreign currency gain reclassified into net income

 

 

 
(8
)
Net change in derivative hedge agreements:
 
 
 
 
 
 
 
Unrealized losses

 

 

 
(5
)
Amount of (gain) loss reclassified into net income
(1
)
 
5

 
(2
)
 
17

Net change in postretirement benefit plans:
 
 
 
 
 
 
 
Amortization of net actuarial loss into net income
3

 
4

 
8

 
12

Other comprehensive loss, before tax
(6
)
 
(30
)
 
(19
)
 
(126
)
Income tax impact related to items of other comprehensive income
(3
)
 
1

 
(2
)
 
4

Other comprehensive loss, net of tax
(3
)
 
(31
)
 
(17
)
 
(130
)
Comprehensive income
$
70

 
$
57

 
$
193

 
$
96

See accompanying notes to condensed consolidated financial statements.

4


XYLEM INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)
(in millions, except per share amounts)
 
 
September 30,
2016
 
December 31,
2015
 
 
 
 
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
659

 
$
680

Receivables, less allowances for discounts and doubtful accounts of $29 and $33 in 2016 and 2015, respectively
792

 
749

Inventories
488

 
433

Prepaid and other current assets
153

 
143

Total current assets
2,092

 
2,005

Property, plant and equipment, net
440

 
439

Goodwill
1,621

 
1,584

Other intangible assets, net
444

 
435

Other non-current assets
181

 
194

Total assets
$
4,778

 
$
4,657

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
341

 
$
338

Accrued and other current liabilities
438

 
407

Short-term borrowings and current maturities of long-term debt
62

 
78

Total current liabilities
841

 
823

Long-term debt
1,148

 
1,196

Accrued postretirement benefits
335

 
335

Deferred income tax liabilities
114

 
118

Other non-current accrued liabilities
113

 
101

Total liabilities
2,551

 
2,573

Commitments and contingencies (Note 17)

 

Stockholders’ equity:
 
 
 
Common Stock – par value $0.01 per share:
 
 
 
Authorized 750.0 shares, issued 191.3 shares and 190.2 shares in 2016 and 2015, respectively
2

 
2

Capital in excess of par value
1,871

 
1,834

Retained earnings
1,011

 
885

Treasury stock – at cost 11.9 shares and 11.8 shares in 2016 and 2015, respectively
(402
)
 
(399
)
Accumulated other comprehensive loss
(255
)
 
(238
)
Total stockholders’ equity
2,227

 
2,084

Total liabilities and stockholders’ equity
$
4,778

 
$
4,657


See accompanying notes to condensed consolidated financial statements.

5


XYLEM INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(in millions)
For the nine months ended September 30,
2016
 
2015
Operating Activities
 
 
 
Net income
$
210

 
$
226

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation
61

 
69

Amortization
36

 
33

Share-based compensation
15

 
11

Restructuring charges
18

 
5

Gain from sale of businesses

 
(9
)
Other, net
8

 
10

Payments for restructuring
(11
)
 
(11
)
Changes in assets and liabilities (net of acquisitions):
 
 
 
Changes in receivables
(27
)
 
(32
)
Changes in inventories
(42
)
 
(15
)
Changes in accounts payable
14

 
6

Other, net
(8
)
 
(33
)
Net Cash – Operating activities
274

 
260

Investing Activities
 
 
 
Capital expenditures
(90
)
 
(78
)
Acquisition of business, net of cash acquired
(70
)
 

Proceeds from sale of businesses

 
1

Proceeds from the sale of property, plant and equipment

 
1

Other, net
5

 
2

Net Cash – Investing activities
(155
)
 
(74
)
Financing Activities
 
 
 
Short-term debt issued
62

 

  Short-term debt repaid
(80
)
 
(3
)
Long-term debt issued
540

 

  Long-term debt repaid
(608
)
 

Repurchase of common stock
(3
)
 
(128
)
Proceeds from exercise of employee stock options
22

 
14

Dividends paid
(84
)
 
(77
)
Other, net
1

 

Net Cash – Financing activities
(150
)
 
(194
)
Effect of exchange rate changes on cash
10

 
(44
)
Net change in cash and cash equivalents
(21
)
 
(52
)
Cash and cash equivalents at beginning of year
680

 
663

Cash and cash equivalents at end of period
$
659

 
$
611

Supplemental disclosure of cash flow information:
 
 
 
Cash paid during the period for:
 
 
 
Interest
$
34

 
$
37

Income taxes (net of refunds received)
$
60

 
$
57

See accompanying notes to condensed consolidated financial statements.

6


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

Note 1. Background and Basis of Presentation
Background
Xylem Inc. ("Xylem" or the "Company") is a leading equipment and service provider for water and wastewater applications with a broad portfolio of products and services addressing the full cycle of water, from collection, distribution and use to the return of water to the environment. Xylem was incorporated in Indiana on May 4, 2011.
Xylem operates in two segments, Water Infrastructure and Applied Water. The Water Infrastructure segment focuses on the transportation, treatment and testing of water, offering a range of products including water and wastewater pumps, treatment and testing equipment, and controls and systems. The Applied Water segment serves many of the primary uses of water and focuses on the residential, commercial, industrial and agriculture markets. The Applied Water segment’s major products include pumps, valves, heat exchangers, controls and dispensing equipment.
Except as otherwise indicated or unless the context otherwise requires, "Xylem," "we," "us," "our" and the "Company" refer to Xylem Inc. and its subsidiaries.
Basis of Presentation
The interim condensed consolidated financial statements reflect our financial position and results of operations in conformity with accounting principles generally accepted in the United States of America ("GAAP"). All intercompany transactions between our businesses have been eliminated.
The unaudited interim condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC") and, in the opinion of management, reflect all adjustments (which include normal recurring adjustments) considered necessary for a fair presentation of the financial position and results of operations for the periods presented. Certain information and note disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such SEC rules. We believe that the disclosures made are adequate to make the information presented not misleading. We consistently applied the accounting policies described in our Annual Report on Form 10-K for the year ended December 31, 2015 ("2015 Annual Report") in preparing these unaudited condensed consolidated financial statements, with the exception of accounting standard updates described in Note 2. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in our 2015 Annual Report.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Estimates are revised as additional information becomes available. Estimates and assumptions are used for, but not limited to, postretirement obligations and assets, revenue recognition, income tax contingency accruals and valuation allowances, goodwill and indefinite lived intangible impairment testing and contingent liabilities. Actual results could differ from these estimates.
Our quarterly financial periods end on the Saturday closest to the last day of the calendar quarter, except for the fourth quarter which ends on December 31. For ease of presentation, the condensed consolidated financial statements included herein are described as ending on the last day of the calendar quarter.
Note 2. Recently Issued Accounting Pronouncements
Pronouncements Not Yet Adopted
In October 2016, the Financial Accounting Standards Board (“FASB”) issued guidance amending the accounting for income taxes. Under current guidance the recognition of current and deferred income taxes for an intra-entity asset transfer is prohibited until the asset has been sold to an outside party. The amended guidance eliminates the prohibition against immediate recognition of current and deferred income tax amounts associated with intra-entity transfers of assets other than inventory. This guidance is effective for interim and annual periods beginning

7


after December 15, 2017 with early adoption permitted as of the beginning of an annual reporting period for which financial statements (interim or annual) have not been issued or made available for issuance. The requirements of the amended guidance should be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. We are evaluating the impact of the guidance on our financial condition and results of operations.
In June 2016, the FASB issued guidance amending the accounting for the impairment of financial instruments, including trade receivables. Under current guidance, credit losses are recognized when the applicable losses are probable of occurring and this assessment is based on past events and current conditions. The amended guidance eliminates the “probable” threshold and requires an entity to use a broader range of information, including forecast information when estimating expected credit losses. Generally, this should result in a more timely recognition of credit losses. This guidance is effective for interim and annual periods beginning after December 15, 2019 with early adoption permitted for interim and annual periods beginning after December 15, 2018. The requirements of the amended guidance should be applied using a modified retrospective approach except for debt securities, which require a prospective transition approach. We are evaluating the impact of the guidance on our financial condition and results of operations.
In February 2016, the FASB issued guidance amending the accounting for leases. Specifically, the amended guidance requires all lessees to record a lease liability at lease inception, with a corresponding right of use asset, except for short-term leases. Lessor accounting is not fundamentally changed. This amended guidance is effective for interim and annual periods beginning after December 15, 2018 using a modified retrospective approach. Early adoption is permitted. We are evaluating the impact of the guidance on our financial condition and results of operations.
In July 2015, the FASB issued guidance regarding simplifying the measurement of inventory. Under prior guidance, inventory is measured at the lower of cost or market, where market is defined as replacement cost, with a ceiling of net realizable value and a floor of net realizable value less a normal profit margin. The amended guidance requires the measurement of inventory at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. This guidance is effective prospectively for interim and annual periods beginning after December 15, 2016 and early application is permitted. We are evaluating the impact of the guidance on our financial condition and results of operations.
In May 2014, the FASB issued guidance on recognizing revenue from contracts with customers. The guidance outlines a single comprehensive model to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. The core principle of the model is that an entity recognizes revenue to portray the transfer of goods and services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The standard also expands disclosure requirements regarding revenue recognition. This guidance is effective for interim and annual reporting periods beginning after December 15, 2017 and may be applied retrospectively to each prior period presented or with the cumulative effect recognized as of the date of initial application. Early adoption is permitted for interim and annual reporting periods beginning after December 15, 2016. We are evaluating the impact of the guidance on our financial condition and results of operations.
Recently Adopted Pronouncements
In March 2016, the FASB issued an update on accounting for share-based payments.  The guidance simplifies several aspects of the accounting for employee share-based payment transactions, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification of excess tax benefits in the Condensed Consolidated Statements of Cash Flows. This standard is effective for annual reporting periods beginning after December 15, 2016. The Company elected to early adopt this standard in the quarter ended June 30, 2016 retroactively to January 1, 2016. The impact of the early adoption resulted in the following:
The Company recorded tax benefits of $1 million and $3 million within income tax expense for the three and nine months ended September 30, 2016, respectively, related to the excess tax benefit on share-based awards. Prior to adoption this amount would have been recorded as an increase of capital in excess of par value. This change could create volatility in the Company's effective tax rate.
The Company no longer reflects the cash received from the excess tax benefit within cash flows from financing activities but instead now reflects this benefit within cash flows from operating activities in the

8


Condensed Consolidated Statements of Cash Flows. The Company elected to apply this change in presentation prospectively and thus prior periods have not been adjusted.
The Company elected not to change its policy on accounting for forfeitures and continues to estimate the total number of awards for which the requisite service period will not be rendered.
At this time, the Company has not changed its policy on statutory withholding requirements and will continue to allow the employee to withhold up to the Company's minimum statutory withholding requirements.
The Company excluded the excess tax benefits from the assumed proceeds available to repurchase shares in the computation of our diluted earnings per share for the three and nine months ended September 30, 2016. This increased diluted weighted average common shares outstanding by less than 50,000 shares for each of the aforementioned periods.
In March 2016, the FASB amended the guidance regarding the use of the equity method to record certain investments. Under current guidance, if an investor increases its level of ownership interest in a company and consequently qualifies for the equity method, the investor must retroactively adjust its investment, results of operations and retained earnings to reflect balances that would have arisen if the equity method had been in effect during all previous periods that the investment was held. The amended guidance eliminates the need to retroactively adjust balances and instead allows for the prospective application of the equity method. This guidance is effective prospectively for interim and annual reporting periods beginning after December 15, 2016. We elected to early adopt this guidance effective the first quarter of 2016. The adoption of this guidance did not impact our financial condition or results of operations.
In March 2016, in response to inconsistency in practice, the FASB issued guidance regarding the ability to maintain hedge accounting for a derivative instruments when one party to the instrument has been replaced by a new party (“a novation”). The new guidance states that a novation does not preclude the continued application of hedge accounting to a derivative assuming all other hedge accounting criteria continue to be met. This guidance is effective using either a prospective or a modified retrospective approach, for interim and annual reporting periods beginning after December 15, 2016. We elected to early adopt this guidance on a prospective basis effective the first quarter of 2016. The adoption of this guidance did not impact our financial condition or results of operations.
In March 2016, the FASB issued guidance clarifying what steps need to be followed when evaluating if call or put options are not clearly and closely related to their debt hosts, and therefore must be accounted for as separate derivatives. The guidance prescribes a four step process to assess whether an event that triggers the ability to exercise a call or put option is clearly and closely related to the debt host. The four step decision sequence requires an entity to consider whether (1) the payoff is adjusted based on changes in an index; (2) the payoff is indexed to an underlying other than interest rates or credit risk; (3) the debt involves a substantial premium or discount; and (4) the call or put option is contingently exercisable. This guidance is effective using a modified retrospective approach, for interim and annual reporting periods beginning after December 15, 2016. We elected to early adopt this guidance effective the first quarter of 2016. The adoption of this guidance did not impact our financial condition or results of operations.
Note 3. Acquisitions and Divestitures
On August 15, 2016, we entered into a Share Purchase Agreement to acquire all of the direct and indirect subsidiaries of Sensus Worldwide Limited (other than Sensus Industries) (“Sensus”), a global leader in smart meters, network technologies and advanced data analytics services for the water, gas and electric industries. The purchase price was agreed at $1.7 billion, net of cash acquired. We completed the acquisition of Sensus on October 31, 2016 pursuant to the terms of the Share Purchase Agreement and an Amendment to the Share Purchase Agreement dated as of October 31, 2016. Sensus, headquartered in Raleigh, North Carolina, has approximately 3,300 employees across 28 locations on six continents. 

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

9


There were no divestitures for the three months ended September 30, 2015. For the nine months ended September 30, 2015, we divested two businesses for $1 million, which were not material, individually or in the aggregate, to our results of operations or financial position. The sales resulted in a gain of $9 million, reflected in gain from sale of businesses in our Condensed Consolidated Income Statement.
Note 4. Restructuring Charges
From time to time, the Company will incur costs related to restructuring actions in order to optimize our cost base and more strategically position ourselves based on the economic environment and customer demand. During the three and nine months ended September 30, 2016, we recognized restructuring charges of $6 million and $18 million, respectively. We incurred these charges primarily in an effort to reposition our European and North American businesses to optimize our cost structure and improve our operational efficiency and effectiveness. The charges included the reduction of headcount and consolidation of facilities within our Applied Water and Water Infrastructure segments, as well as Corporate headcount reductions.
During the three and nine months ended September 30, 2015, we recognized restructuring charges of $1 million and $5 million, respectively. We incurred these charges primarily in an effort to reposition our European and North American businesses to optimize our cost structure and improve our operational efficiency and effectiveness. The charges included the reduction of headcount and consolidation of facilities within our Water Infrastructure segment.
The following table presents the components of restructuring expense.
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in millions)
2016
 
2015
 
2016
 
2015
By component:
 
 
 
 
 
 
 
Severance and other charges
$
6

 
$
1

 
$
18

 
$
6

Lease related charges
1

 

 
1

 

Reversal of restructuring accruals
(1
)
 

 
(1
)
 
(1
)
Total restructuring charges
$
6

 
$
1

 
$
18

 
$
5

 
 
 
 
 
 
 
 
By segment:
 
 
 
 
 
 
 
Water Infrastructure
$
5

 
$
1

 
$
12

 
$
5

Applied Water
1

 

 
4

 

      Corporate and other

 

 
2

 



10


The following table displays a rollforward of the restructuring accruals, presented on our Condensed Consolidated Balance Sheets within accrued and other current liabilities, for the nine months ended September 30, 2016 and 2015.
(in millions)
 
2016
 
2015
Restructuring accruals - January 1
 
$
3

 
$
12

Restructuring charges
 
18

 
5

Cash payments
 
(11
)
 
(11
)
Foreign currency and other
 
(1
)
 
(1
)
Restructuring accruals - September 30
 
$
9

 
$
5

 
 
 
 
 
By segment:
 
 
 
 
Water Infrastructure
 
$
4

 
$
2

Applied Water
 

 

Regional selling locations (a)
 
3

 
3

Corporate and other
 
2

 


(a)
Regional selling locations consist primarily of selling and marketing organizations that incurred restructuring expense which was allocated to the segments. The liabilities associated with restructuring expense were not allocated to the segments.
The following is a rollforward for the nine months ended September 30, 2016 and 2015 of employee position eliminations associated with restructuring activities.
 
 
2016
 
2015
Planned reductions - January 1
 
82

 
133

Additional planned reductions
 
364

 
87

Actual reductions
 
(296
)
 
(120
)
Planned reductions - September 30
 
150

 
100


Total expected costs associated with actions that commenced during 2016 are approximately $20 million for Water Infrastructure, including $11 million incurred during the nine months ended September 30, 2016. These costs primarily consist of severance charges. We currently expect activity related to these actions to continue through the end of 2017. Total expected costs associated with actions that commenced during 2016 are approximately $6 million for Applied Water, including $4 million incurred during the nine months ended September 30, 2016. These costs primarily consist of severance charges. We currently expect activity related to these actions to continue through the end of 2017. Total expected costs associated with actions that commenced during 2016 are approximately $2 million for Corporate, which we incurred during the nine months ended September 30, 2016. These costs primarily consist of severance charges.
Total expected costs associated with actions that commenced during 2015 are approximately $5 million for Water Infrastructure. Approximately $4 million of the expected cost was incurred in 2015 and $1 million was incurred during the nine months ended September 30, 2016. These costs primarily consist of severance charges and substantially all of the costs associated with these actions have been incurred. Total expected costs associated with actions that commenced during 2015 are approximately $1 million for Applied Water. These costs primarily consist of severance charges and substantially all of the costs associated with these actions were incurred in 2015.
Note 5. Income Taxes
Our quarterly provision for income taxes is measured using an estimated annual effective tax rate, adjusted for discrete items within periods presented. The comparison of our effective tax rate between periods is significantly impacted by the level and mix of earnings and losses by tax jurisdiction, foreign income tax rate differentials and discrete items.

11


The income tax provision for the three months ended September 30, 2016 was $22 million resulting in an effective tax rate of 22.9%, compared to $19 million resulting in an effective tax rate of 17.4% for the same period in 2015. The income tax provision for the nine months ended September 30, 2016 was $40 million resulting in an effective tax rate of 16%, compared to $49 million resulting in an effective tax rate of 17.6% for the same period in 2015. The effective tax rate was lower than the United States federal statutory rate primarily due to geographic mix of earnings in both periods as well as the release of an unrecognized tax benefit in 2016 as a result of the effective settlement of a tax examination offset in part by the establishment of a valuation allowance in 2016.
Unrecognized Tax Benefits
We recognize tax benefits from uncertain tax positions only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the condensed consolidated financial statements from such positions are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement.
The amount of unrecognized tax benefits at September 30, 2016 was $27 million, which is a reduction of $20 million from the balance as of December 31, 2015, resulting primarily from the effective settlement of a tax examination in 2016. The unrecognized tax benefits, if ultimately recognized will reduce our effective tax rate. We do not believe that the unrecognized tax benefits will significantly change within the next twelve months.
We classify interest expense relating to unrecognized tax benefits as a component of other non-operating expense, net, and tax penalties as a component of income tax expense in our Condensed Consolidated Income Statements. As of September 30, 2016, we had $2 million of interest accrued for unrecognized tax benefits.
Note 6. Earnings Per Share
The following is a reconciliation of the shares used in calculating basic and diluted net earnings per share.
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2016
 
2015
 
2016
 
2015
Net income (in millions)
$
73

 
$
88

 
$
210

 
$
226

Shares (in thousands):
 
 
 
 
 
 
 
Weighted average common shares outstanding
179,272

 
180,815

 
178,951

 
181,428

Add: Participating securities (a)
36

 
30

 
37

 
43

Weighted average common shares outstanding — Basic
179,308

 
180,845

 
178,988

 
181,471

Plus incremental shares from assumed conversions: (b)
 
 
 
 
 
 
 
Dilutive effect of stock options
593

 
424

 
462

 
489

Dilutive effect of restricted stock units and performance share units
409

 
363

 
388

 
376

Weighted average common shares outstanding — Diluted
180,310

 
181,632

 
179,838

 
182,336

Basic earnings per share
$
0.41

 
$
0.48

 
$
1.17

 
$
1.25

Diluted earnings per share
$
0.41

 
$
0.48

 
$
1.17

 
$
1.24

(a)
Restricted stock unit awards containing rights to non-forfeitable dividends that participate in undistributed earnings with common shareholders are considered participating securities for purposes of computing earnings per share.
(b)
Incremental shares from stock options, restricted stock units and performance share units are computed by the treasury stock method. The weighted average shares listed below were not included in the computation of diluted earnings per share because to do so would have been anti-dilutive for the periods presented or were otherwise excluded under the treasury stock method. The treasury stock method calculates dilution assuming the exercise of all in-the-money options and vesting of restricted stock units and performance share units, reduced by the repurchase of shares with the proceeds from the assumed exercises and unrecognized compensation expense for outstanding awards. Performance share units will be included in the treasury stock calculation of diluted earnings per share upon achievement of underlying performance or market conditions at the end of the reporting period. See Note 14, "Share-Based Compensation Plans" to the condensed consolidated financial statements for further detail on the performance share units.

12


 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in thousands)
2016
 
2015
 
2016
 
2015
Stock options
1,701

 
2,703

 
2,008

 
2,712

Restricted stock units
529

 
747

 
570

 
754

Performance share units
414

 
191

 
360

 
187


Note 7. Inventories
The components of total inventories are summarized as follows: 
(in millions)
September 30,
2016
 
December 31,
2015
Finished goods
$
220

 
$
188

Work in process
46

 
32

Raw materials
222

 
213

Total inventories
$
488

 
$
433


The amounts in the above table of inventory composition as of December 31, 2015 have been revised to appropriately classify as Raw Materials $25 million previously included in Finished Goods.
Note 8. Property, Plant and Equipment
The components of total property, plant and equipment, net are as follows:
(in millions)
September 30,
2016
 
December 31,
2015
Land, buildings and improvements
$
247

 
$
240

Machinery and equipment
649

 
650

Equipment held for lease or rental
225

 
205

Furniture and fixtures
81

 
79

Construction work in progress
61

 
46

Other
19

 
19

Total property, plant and equipment, gross
1,282

 
1,239

Less accumulated depreciation
842

 
800

Total property, plant and equipment, net
$
440

 
$
439


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

13


Note 9. Goodwill and Other Intangible Assets
Goodwill    
Changes in the carrying value of goodwill by reportable segment for the nine months ended September 30, 2016 are as follows:
(in millions)
Water
Infrastructure
 
Applied Water
 
Total
Balance as of January 1, 2016
$
1,066

 
$
518

 
$
1,584

Activity in 2016
 
 
 
 
 
Acquired (a)
39

 

 
39

Foreign currency and other
(2
)
 


 
(2
)
Balance as of September 30, 2016
$
1,103

 
$
518

 
$
1,621


(a)
On February 1, 2016, we acquired Tideland and recorded $39 million of goodwill. Refer to Note 3, "Acquisitions and Divestitures" for additional information.
Other Intangible Assets
Information regarding our other intangible assets is as follows:
 
September 30, 2016
 
December 31, 2015
(in millions)
Carrying
Amount
 
Accumulated
Amortization
 
Net
Intangibles
 
Carrying
Amount
 
Accumulated
Amortization
 
Net
Intangibles
Customer and distributor relationships
$
342

 
$
(159
)
 
$
183

 
$
320

 
$
(140
)
 
$
180

Proprietary technology and patents
119

 
(60
)
 
59

 
116

 
(54
)
 
62

Trademarks
43

 
(22
)
 
21

 
35

 
(19
)
 
16

Software
168

 
(119
)
 
49

 
155

 
(110
)
 
45

Other
7

 
(7
)
 

 
8

 
(8
)
 

Indefinite-lived intangibles
132

 

 
132

 
132

 

 
132

 
$
811

 
$
(367
)
 
$
444

 
$
766

 
$
(331
)
 
$
435


Amortization expense related to finite-lived intangible assets was $12 million and $36 million for the three and nine months ended September 30, 2016, respectively, and $11 million and $33 million for the three and nine months ended September 30, 2015, respectively.
Note 10. Derivative Financial Instruments
Risk Management Objective of Using Derivatives
We are exposed to certain risks arising from both our business operations and economic conditions, and principally manage our exposures to these risks through management of our core business activities. Certain of our foreign operations expose us to fluctuations of foreign interest rates and exchange rates that may impact revenue, expenses, cash receipts, cash payments, and the value of our stockholders' equity. We enter into derivative financial instruments to protect the value or fix the amount of certain cash flows in terms of the functional currency of the business unit with that exposure and reduce the volatility in stockholders' equity.
Cash Flow Hedges of Foreign Exchange Risk
We are exposed to fluctuations in various foreign currencies against our functional currencies. We use foreign currency derivatives, including currency forward agreements, to manage our exposure to fluctuations in the various exchange rates. Currency forward agreements involve fixing the foreign currency exchange rate for delivery of a specified amount of foreign currency on a specified date.
Certain business units with exposure to foreign currency exchange risks have designated certain currency forward agreements as cash flow hedges of forecasted intercompany inventory purchases and sales. Our principal currency exposures relate to the Euro, Swedish Krona, British Pound, Canadian Dollar, Polish Zloty and Australian Dollar. We held forward foreign exchange contracts with purchase notional amounts totaling $21 million

14


and $94 million as of September 30, 2016 and December 31, 2015, respectively. As of September 30, 2016, our most significant foreign currency derivatives include contracts to purchase Swedish Krona and sell Euro, sell Canadian Dollar and purchase US Dollar, sell Canadian Dollar and purchase Euro, and purchase Polish Zloty and sell Euro. The purchased notional amounts associated with these currency derivatives are $14 million, $2 million, $2 million, and $2 million, respectively. As of December 31, 2015, our most significant foreign currency derivatives included contracts to purchase Swedish Krona and sell Euro, sell U.S. Dollar and purchase Euro, and to sell British Pound and purchase Euro. The purchased notional amounts associated with these currency derivatives are $51 million, $24 million and $12 million, respectively.
Hedges of Net Investments in Foreign Operations
We are exposed to changes in foreign currencies impacting our net investments held in foreign subsidiaries.
Cross Currency Swaps
Beginning in 2015, we entered into cross currency swaps to manage our exposure to fluctuations in the Euro-U.S. Dollar exchange rate. The total notional amount of derivative instruments designated as net investment hedges was $419 million and $411 million as of September 30, 2016 and December 31, 2015, respectively.
Foreign Currency Denominated Debt
On March 11, 2016, we issued 2.250% Senior Notes of €500 million aggregate principal amount due March 2023. We designated the entirety of the outstanding balance, or $555 million, net of unamortized discount, as a hedge of a net investment in certain foreign subsidiaries.
Forward Contracts
On September 23, 2016, we entered into forward contacts to manage our exposure to fluctuations in the Euro-U.S. Dollar exchange rate. The total notional amount of derivative instruments designated as net investment hedges was $336 million as of September 30, 2016.
The table below presents the effect of our derivative financial instruments on the Condensed Consolidated Income Statements and Statements of Comprehensive Income. 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in millions)
2016
 
2015
 
2016
 
2015
Cash Flow Hedges
 
 
 
 
 
 
 
Foreign Exchange Contracts
 
 
 
 
 
 
 
Amount of (loss) recognized in OCI (a)
$

 
$

 
$

 
$
(5
)
Amount of (gain) loss reclassified from OCI into revenue (a)
(1
)
 
5

 
(1
)
 
16

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

 

 
(1
)
 
1

 
 
 
 
 
 
 
 
Net Investment Hedges
 
 
 
 
 
 
 
Cross Currency Swaps
 
 
 
 
 
 
 
Amount of (loss) recognized in OCI (a)
$
(7
)
 
$

 
$
(7
)
 
$

Foreign Currency Denominated Debt
 
 
 
 
 
 
 
Amount of (loss) recognized in OCI (a)
$
(5
)
 
$

 
$
(10
)
 
$

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

15


As of September 30, 2016, no gains or losses on the net investment hedges are expected to be reclassified into earnings over their duration. The net investment hedges did not experience any ineffectiveness for the three and nine months ended September 30, 2016.
The fair values of our derivative assets and liabilities are measured on a recurring basis using Level 2 inputs and are determined through the use of models that consider various assumptions including yield curves, time value and other measurements.
The fair values of our foreign exchange contracts currently included in our hedging program designated as hedging instruments were as follows:
(in millions)
September 30,
2016
 
December 31,
2015
Derivatives designated as hedging instruments
 
 
 
Assets
 
 
 
Cash Flow Hedges
 
 
 
  Other current assets
$

 
$
2

Liabilities
 
 
 
Cash Flow Hedges
 
 
 
  Other current liabilities
$
(1
)
 
$

Net Investment Hedges
 
 
 
Other non-current liabilities
$
(30
)
 
$
(18
)

The fair value of our long-term debt, due in 2023, designated as a net investment hedge was $608 million as of September 30, 2016.
Note 11. Accrued and Other Current Liabilities
The components of total accrued and other current liabilities are as follows:
(in millions)
September 30,
2016
 
December 31,
2015
Compensation and other employee benefits
$
163

 
$
156

Customer-related liabilities
70

 
64

Accrued warranty costs
35

 
33

Accrued taxes
67

 
64

Other accrued liabilities
103

 
90

Total accrued and other current liabilities
$
438

 
$
407



16


Note 12. Credit Facilities and Debt
Total debt outstanding is summarized as follows:
(in millions)
September 30,
2016
 
December 31,
2015
3.550% Senior Notes due 2016
$

 
$
600

4.875% Senior Notes due 2021 (a)
600

 
600

2.250% Senior Notes due 2023 (a)
560

 

Commercial paper
20

 

Research and development facility agreement
42

 
76

Other

 
2

Debt issuance costs and unamortized discount (b)
(12
)
 
(4
)
Total debt
1,210

 
1,274

Less: short-term borrowings and current maturities of long-term debt
62

 
78

Total long-term debt
$
1,148

 
$
1,196

(a)
The fair value of our Senior Notes (as defined below) was determined using quoted prices in active markets for identical securities, which are considered Level 1 inputs. The fair value of our Senior Notes due 2021 was $654 million and $640 million as of September 30, 2016 and December 31, 2015, respectively. The fair value of our Senior Notes due 2023 was $608 million as of September 30, 2016.
(b)
The debt issuance costs and unamortized discount are recognized as a reduction in the carrying value of the Senior Notes in the Condensed Consolidated Balance Sheets and are being amortized to interest expense in our Condensed Consolidated Income Statements over the expected remaining terms of the Senior Notes.
Senior Notes
On September 20, 2011, we issued 3.550% Senior Notes of $600 million aggregate principal amount due September 2016 (the "Senior Notes due 2016") and 4.875% Senior Notes of $600 million aggregate principal amount due October 2021 (the "Senior Notes due 2021"). On March 11, 2016, we issued 2.250% Senior Notes of €500 million aggregate principal amount due March 2023 (the "Senior Notes due 2023" and together with the Senior Notes due 2016 and 2021, the "Senior Notes").
The Senior Notes include covenants which restrict our ability, subject to exceptions, to incur debt secured by liens and engage in sale and leaseback transactions, as well as provide for customary events of default (subject, in certain cases, to receipt of notice of default and/or customary grace and cure periods). We may redeem the Senior Notes, as applicable, in whole or in part, at any time at a redemption price equal to the principal amount of the Senior Notes to be redeemed, plus a make-whole premium. We may redeem all or a portion of the Senior Notes due 2023 at our option at any time on or after December 11, 2022 (three months prior to their maturity), at a redemption price equal to 100% of the principal amount, plus accrued and unpaid interest to the redemption date.  We may also redeem all, but not part, of the Senior Notes due 2023 in the event of specified tax events as described in the applicable Senior Notes indenture. If a change of control triggering event (as defined in the applicable Senior Notes indenture) occurs, we will be required to make an offer to purchase the Senior Notes at a price equal to 101% of their principal amount plus accrued and unpaid interest to the date of repurchase. As of September 30, 2016, we were in compliance with all covenants for the Senior Notes.
Interest on the Senior Notes due 2016 was payable on March 20 and September 20 of each year. Interest on the Senior Notes due 2021 is payable on April 1 and October 1 of each year. Interest on the Senior Notes due 2023 is payable on March 11 of each year.
On April 11, 2016, our Senior Notes due 2016 were settled for a total of $607 million which included make-whole interest expense of $7 million. The Company recorded this loss on extinguishment of the debt in the second quarter of 2016 as interest expense.
Bridge Facility
On August 15, 2016, we entered into a $1.3 billion senior unsecured bridge facility (the “Bridge Facility”). The Bridge Facility was put in place to finance the Sensus acquisition and to pay the related fees and expenses to the extent we were unable to finance the Sensus acquisition through available cash on hand, a new term loan and the

17


issuance of the Notes (refer to Note 15 for further information on the issuance of the Notes). The Bridge Facility was terminated on October 31, 2016 in connection with the Sensus acquisition.
Five-Year Revolving Credit Facility
Effective March 27, 2015, Xylem entered into a Five-Year Revolving Credit Facility (the "Credit Facility") with Citibank, N.A., as administrative agent, and a syndicate of lenders. The Credit Facility provides for an aggregate principal amount of up to $600 million of: (i) revolving extensions of credit (the "revolving loans") outstanding at any time and (ii) the issuance of letters of credit in a face amount not in excess of $100 million outstanding at any time. The Credit Facility provides for increases of up to $200 million for a possible maximum total of $800 million in aggregate principal amount at our request and with the consent of the institutions providing such increased commitments.
At our election, the interest rate per annum applicable to the revolving loans will be based on either (i) a Eurodollar rate determined by reference to LIBOR, adjusted for statutory reserve requirements, plus an applicable margin or (ii) a fluctuating rate of interest determined by reference to the greatest of: (a) the prime rate of Citibank, N.A., (b) the U.S. Federal funds effective rate plus half of 1% or (c) the Eurodollar rate determined by reference to LIBOR, adjusted for statutory reserve requirements, in each case, plus an applicable margin.
In accordance with the terms of an amendment to the Credit Facility dated August 30, 2016, we may not exceed a maximum leverage ratio of 4.00 to 1.00 (based on a ratio of total debt to earnings before interest, taxes, depreciation and amortization) for a period of 12-months following the Sensus acquisition and a maximum leverage ratio of 3.50 to 1.00 through the rest of the term. The Credit Facility also contains limitations on, among other things, incurring secured debt, granting liens, entering into sale and leaseback transactions, mergers, consolidations, liquidations, dissolutions and sales of assets. In addition, the Credit Facility contains other terms and conditions such as customary representations and warranties, additional covenants and customary events of default. As of September 30, 2016, we were in compliance with all covenants.
As of September 30, 2016, the Credit Facility was undrawn.
Commercial Paper
Our commercial paper program generally serves as a means of short-term funding and has a combined outstanding limit of $600 million inclusive of the Five-Year Revolving Credit Facility. As of September 30, 2016, $20 million of the Company’s $600 million commercial paper program was outstanding at a weighted average interest rate of 0.75%. We will periodically borrow under this program and may borrow under it in future periods.
Research and Development Facility Agreement
On December 3, 2015, the Company amended and restated its Risk Sharing Finance Facility Agreement (the "R&D Facility Agreement") with The European Investment Bank (the "EIB") to amend the maturity date. The facility provides an aggregate principal amount of up to 120 million (approximately $135 million) to finance research projects and infrastructure development in the European Union. The Company's wholly owned subsidiaries in Luxembourg, Xylem Holdings S.á r.l. and Xylem International S.á r.l., are the borrowers under the R&D Facility Agreement.  The obligations of the borrowers under the R&D Facility Agreement are guaranteed by the Company under an Amended and Restated Deed of Guarantee, dated as of December 4, 2013, in favor of the EIB. The funds are available during the period from 2013 through 2016 at the Company's facilities in Sweden, Germany, Italy, the United Kingdom, Austria, Norway and Hungary.
Under the R&D Facility Agreement, the borrower was able to draw loans on or before March 31, 2016 with a maturity of no longer than 12 years. The R&D Facility Agreement provides for Fixed Rate loans and Floating Rate loans. The interest rate per annum applicable to Fixed Rate loans is at a fixed percentage rate per annum specified by the EIB which includes the applicable margin. The interest rate per annum applicable to Floating Rate loans is at the rate determined by reference to EURIBOR for loans drawn in Euros and LIBOR for loans drawn in Pounds Sterling or U.S. Dollars, plus an applicable spread specified by the EIB which includes the applicable margin. The applicable margin for both Fixed Rate loans and Floating Rate loans is determined by reference to the credit rating of the Company.

18


In accordance with the terms of the R&D Facility Agreement, we may not exceed a maximum leverage ratio of 3.50 to 1.00 (based on a ratio of total debt to earnings before interest, taxes, depreciation and amortization) throughout the term. The R&D Facility Agreement also contains limitations on, among other things, incurring debt, granting liens, and entering into sale and leaseback transactions. In addition, the R&D Facility Agreement contains other terms and conditions, such as customary representations and warranties, additional covenants and customary events of default. As of September 30, 2016, we were in compliance with all covenants.
As of September 30, 2016 and December 31, 2015, $42 million and $76 million was outstanding, respectively, under the R&D Facility Agreement. Although the borrowing term for this arrangement is up to five years, we have classified it as short-term debt on our Condensed Consolidated Balance Sheets since we intend to repay this obligation in less than a year.
Note 13. Postretirement Benefit Plans
The components of net periodic benefit cost for our defined benefit pension plans are as follows:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in millions)
2016
 
2015
 
2016
 
2015
Domestic defined benefit pension plans:
 
 
 
 
 
 
 
Service cost
$
1

 
$
1

 
$
2

 
$
2

Interest cost
1

 
1

 
3

 
3

Expected return on plan assets
(2
)
 
(2
)
 
(4
)
 
(4
)
Amortization of net actuarial loss
1

 
1

 
2

 
2

Net periodic benefit cost
$
1

 
$
1

 
$
3

 
$
3

International defined benefit pension plans:
 
 
 
 
 
 
 
Service cost
$
3

 
$
3

 
$
8

 
$
9

Interest cost
6

 
6

 
18

 
18

Expected return on plan assets
(8
)
 
(8
)
 
(25
)
 
(25
)
Amortization of net actuarial loss
2

 
3

 
6

 
10

Net periodic benefit cost
$
3

 
$
4

 
$
7

 
$
12

Total net periodic benefit cost
$
4

 
$
5

 
$
10

 
$
15


The total net periodic benefit cost for other postretirement employee benefit plans was less than $1 million and $2 million including amounts recognized in other comprehensive income ("OCI") of less than $1 million for both the three and nine months ended September 30, 2016, respectively. The total net periodic benefit cost for other postretirement employee benefit plans was $1 million and $3 million including amounts recognized in OCI of less than $1 million for both the three and nine months ended September 30, 2015, respectively.
We contributed $22 million and $21 million to our defined benefit plans during the nine months ended September 30, 2016 and 2015, respectively. Additional contributions ranging between approximately $6 million and $10 million are expected during the remainder of 2016.
Note 14. Share-Based Compensation Plans
Share-based compensation expense was $5 million and $15 million during the three and nine months ended September 30, 2016, respectively, and $3 million and $11 million during the three and nine months ended September 30, 2015, respectively. The unrecognized compensation expense related to our stock options, restricted stock units and performance share units was $6 million, $19 million and $10 million, respectively, at September 30, 2016 and is expected to be recognized over a weighted average period of 1.9, 1.8 and 2.2 years, respectively. The amount of cash received from the exercise of stock options was $22 million and $14 million for the nine months ended September 30, 2016 and 2015, respectively.

19


Stock Option Grants
The following is a summary of the changes in outstanding stock options for the nine months ended September 30, 2016. 
 
Shares             (in thousands)
 
Weighted
Average
Exercise
Price / Share
 
Weighted  Average
Remaining
Contractual
Term (Years)
 
Aggregate Intrinsic Value (in millions)
Outstanding at January 1, 2016
2,561

 
$
31.16

 
6.8
 
 
Granted
463

 
37.90

 
 
 
 
Exercised
(797
)
 
27.91

 
 
 
 
Forfeited and expired
(44
)
 
35.55

 
 
 
 
Outstanding at September 30, 2016
2,183

 
$
33.68

 
7.2
 
$
41

Options exercisable at September 30, 2016
1,222

 
$
29.40

 
5.9
 
$
26

Vested and expected to vest as of September 30, 2016
2,098

 
$
33.53

 
7.1
 
$
40


The total intrinsic value of options exercised (which is the amount by which the stock price exceeded the exercise price of the options on the date of exercise) during the nine months ended September 30, 2016 was $12 million.
Stock Option Fair Value
The fair value of each option grant was estimated on the date of grant using the binomial lattice pricing mode