Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto. This discussion summarizes the significant factors affecting our results of operations and the financial condition of our business during each of the fiscal years in the three-year period ended December 31, 2014. 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 consolidated financial statements to "ITT" or the "former parent" refer to ITT Corporation and its consolidated subsidiaries (other than Xylem Inc.).

Overview

Xylem is a leading equipment and service provider for water and wastewater applications with a broad portfolio of products and services addressing the full cycle of water, from collection, distribution and use to the return of water to the environment. Our business focuses on providing technology-intensive equipment and services. Our product and service offerings are organized into two segments: Water Infrastructure and Applied Water. Our segments are aligned with each of the sectors in the cycle of water, water infrastructure and usage applications. The Water Infrastructure segment focuses on the transportation, treatment and testing of water, offering a range of products including water and wastewater pumps, treatment and testing equipment, and controls and systems. The Applied Water segment serves many of the primary uses of water and focuses on the residential, commercial, industrial and agricultural markets. The segment’s major products include pumps, valves, heat exchangers, controls and dispensing equipment.

•

Water Infrastructure serves the water infrastructure sector with pump systems that transport water from oceans, groundwater, aquifers, lakes, rivers and seas; with filtration, ultraviolet and ozone systems that provide treatment, making the water fit to use; and pumping solutions that move the wastewater to treatment facilities where our mixers, biological treatment, monitoring and control systems provide the primary functions in the treatment process. We provide analytical instrumentation used to measure water quality, flow, and level in wastewater, surface water, and coastal environments.

•

Applied Water serves the usage applications sector with water pressure boosting systems for heating, ventilation and air conditioning and for fire protection systems to the residential and commercial building services markets. In addition, our pumps, heat exchangers, valves and controls provide cooling to power plants and manufacturing facilities, as well as circulation for food and beverage processing. We also provide boosting systems for farming irrigation, pumps for dairy operations, and rainwater reuse systems for small scale crop and turf irrigation.

We sell our equipment and services through direct and indirect channels that serve the needs of each customer type. In the Water Infrastructure segment, we provide the majority of our sales direct to customers with strong application expertise, while the remaining amount was through distribution partners. In the Applied Water segment, we provide the majority of our sales through long-standing relationships with the world’s leading distributors, with the remainder going direct to customers.

Key Performance Indicators and Non-GAAP Measures

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

•	"organic revenue" and "organic orders" defined as revenue and orders, respectively, excluding the impact of foreign currency fluctuations and contributions from acquisitions and divestitures. Divestitures include sales of insignificant portions of our business that did not meet the criteria for classification as a discontinued

operation. The period-over-period change resulting from foreign currency fluctuations assumes no change in exchange rates from the prior period.

•	"constant currency" defined as financial results adjusted for currency translation impacts by translating current period and prior period activity using the same currency conversion rate. This approach is used for countries whose functional currency is not the U.S. dollar.

•	"adjusted net income" and "adjusted earnings per share" defined as net income and earnings per share, respectively, adjusted to exclude non-recurring separation costs from the Spin-off (not excluded after 2012), restructuring and realignment costs, gain on sale of business, special charges and tax-related special items. A reconciliation of adjusted net income is provided below.

(in millions, except per share data)		2014				2013				2012
Net income		$	337			$	228			$	297
Separation costs, net of tax (a)		—				—				16
Restructuring and realignment, net of tax		31				46				17
Special charges, net of tax		—				23				—
Tax-related special items		5				14				—
Gain on sale of business, net of tax		(11		)		—				—
Adjusted net income		$	362			$	311			$	330
Weighted average number of shares - Diluted		184.2				186.0				186.2
Adjusted earnings per share		$	1.97			$	1.67			$	1.77

(a)	Costs of $4 million ($2 million, net of tax) during 2013, associated with non-recurring separation activities are not excluded from adjusted net income.

•	"operating expenses excluding separation, restructuring and realignment costs and special charges" defined as operating expenses, adjusted to exclude non-recurring separation costs from the Spin-off (not excluded after 2012), restructuring and realignment costs and special charges.

•	"adjusted segment operating income" defined as segment operating income, adjusted to exclude non-recurring separation costs from the Spin-off (not excluded after 2012), restructuring and realignment costs, and "adjusted segment operating margin" defined as adjusted segment operating income divided by total segment revenue.

•	“realignment costs” defined as non-recurring costs not included in restructuring costs that are incurred as part of actions taken to reposition our business, including items such as professional fees, relocation, travel and other costs.

•

“special charges" defined as costs incurred by the Company associated with the settlement of legal proceedings with Xylem Group LLC and certain costs incurred for the change in chief executive officer made during the third quarter of 2013, as well as costs incurred in the fourth quarter of 2013 for the contractual indemnification of federal tax obligations to ITT and costs associated with a legal judgment arising from a historical acquisition matter.

•

"free cash flow" defined as net cash provided by operating activities less capital expenditures, as well as adjustments for other significant items that impact current results that management believes are not related to our ongoing operations and performance. Our definition of free cash flow does not consider certain non-discretionary cash payments, such as debt. The following table provides a reconciliation of free cash flow.

(in millions)		2014				2013				2012
Net cash provided by operating activities		$	416			$	324			$	396
Capital expenditures		(119		)		(126		)		(112		)
Separation cash payments (a)		—				—				28
Free cash flow		$	297			$	198			$	312

(a)	Separation cash payments associated with non-recurring separation activities are included in the 2013 free cash flow. Separation cash payments are excluded from free cash flow in 2012 and include capital expenditures associated with the Spin-off of $4 million.

Executive Summary

Xylem reported revenue for 2014 of $3,916 million, an increase of 2.1% from $3,837 million reported in 2013. Significant growth in the industrial and public utility end markets combined with strength in the emerging markets, most notably in China, drove the increase. Continued challenging market conditions limited growth in other regions, Europe, for example, was flat organically year-over-year, while Japan and Australia declined. Operating income for 2014 was $463 million, reflecting an increase of $100 million or 27.5% compared to $363 million in 2013, which was primarily due to savings from lean six sigma activities, global sourcing initiatives and restructuring actions as well as lapping $24 million in non-recurring special charges in 2013, which more than offset headwinds from cost inflation and unfavorable sales mix. Additionally, restructuring and realignment cost actions taken to improve the overall cost base of the business were $43 million in 2014 as compared to $64 million in the prior year.

Additional financial highlights for 2014 include the following:

•	Net income of $337 million, or $1.83 per diluted share ($362 million or $1.97 per diluted share on an adjusted basis)

•	Free cash flow of $297 million, and net cash from operating activities of $416 million

•	Orders of $4,021 million (a 3.9% increase from 2013 on a constant currency basis)

•	We repurchased $130 million in shares under the $250 million share repurchase program approved by our Board of Directors in 2013 as part of our strategy to enhance shareholder return

•	Dividends paid to shareholders increased 10.0% in 2014.

2015 Business Outlook

In 2015, we are anticipating organic revenue growth of low single digits. The projected organic growth excludes an expected negative foreign exchange translation impact on growth of high single digits, primarily driven by a weaker Euro to U.S. dollar. We expect continued strength in the United States industrial markets, but a modest deceleration in emerging market growth and weakness in the oil and gas markets to result in low single digit growth overall for the industrial end market. We expect public utilities to also increase at low single digits where emerging market infrastructure investments continue to bolster growth and we see improving market conditions in the United States. In the commercial market, we anticipate growth of low to mid-single digits as the United States appears to continue to slowly recover and emerging markets continue to be strong, which we expect will be partially offset by soft European markets. We believe the residential markets will be flat to down low single digits as the United States markets moderate and Europe continues to be negative. Finally, the agriculture markets, which is our smallest end market, we expect will likely be relatively flat compared to 2014 as we are expecting slower growth in the United States from lapping of a strong 2014 combined with stabilization in Europe and continued strength in emerging markets.

We will continue to execute restructuring and realignment actions to reposition our European and North American business to optimize our cost structure and improve our operational efficiency and effectiveness. During 2014, we incurred $26 million and $17 million in restructuring and realignment costs, respectively. As a result of the restructuring actions in 2014, we realized $13 million of net savings. In 2015, we expect to incur approximately $20 million in restructuring and realignment costs. We expect to realize approximately $16 million of incremental net savings in 2015 from actions initiated in 2014, and an additional $2 million of net savings from our 2015 actions. Additional strategic actions we are taking include strategic initiatives to drive above-market growth, advance continuous improvement activities to increase productivity, focus on improving cash performance and drive a disciplined capital deployment strategy.

Results of Operations

(in millions)		2014				2013				2012				2014 v. 2013			2013 v. 2012
Revenue		$	3,916			$	3,837			$	3,791			2.1	%		1.2	%
Gross profit		1,513				1,499				1,502				0.9	%		(0.2	)%
Gross margin		38.6		%		39.1		%		39.6		%		(50	)bp		(50	)bp
Operating expenses excluding separation, restructuring and realignment costs and special charges (a)		1,007				1,048				1,013				(3.9	)%		3.5	%
Expense to revenue ratio		25.7		%		27.3		%		26.7		%		(160	)bp		60	bp
Restructuring and realignment costs		43				64				24				(32.8	)%		166.7	%
Separation costs (a)		—				—				22				—	%		NM
Special charges		—				24				—				NM			NM
Total operating expenses		1,050				1,136				1,059				(7.6	)%		7.3	%
Operating income		463				363				443				27.5	%		(18.1	)%
Operating margin		11.8		%		9.5		%		11.7		%		230	bp		(220	)bp
Interest and other non-operating expense (income), net		53				65				55				(18.5	)%		18.2	%
Gain on sale of business		11				—				—				NM			—	%
Income tax expense		84				70				91				20.0	%		(23.1	)%
Tax rate		19.8		%		23.5		%		23.4		%		(370	)bp		10	bp
Net income		$	337			$	228			$	297			47.8	%		(23.2	)%

(a)	Separation costs of $4 million ($2 million, net of tax) during 2013 are included within the $1,048 million of operating expenses.

NM Not Meaningful

2014 versus 2013

Revenue

Revenue generated for 2014 was $3,916 million, an increase of $79 million, or 2.1%, compared to $3,837 million in 2013. On a constant currency basis, revenue grew 3.3%. The following table illustrates the impact on 2014 revenue from organic growth, recent acquisitions, and fluctuations in foreign currency.

(in millions)	$ Change				% Change
2013 Revenue	$	3,837
Organic Growth	134				3.5	%
Acquisitions/(Divestitures)	(6		)		(0.2	)%
Constant Currency	128				3.3	%
Foreign currency translation (a)	(49		)		(1.3	)%
Total change in revenue	79				2.1	%
2014 Revenue	$	3,916

(a)	Foreign currency impact primarily due to weakness in the value of the Canadian Dollar, Australian Dollar, Argentine Peso, Swedish Krona and Norwegian Krone against the U.S. Dollar, partially offset by strength in the value of the British Pound against the U.S. Dollar.

The following table summarizes revenue by segment for 2014 and 2013:

(in millions)	2014				2013				As Reported Change			Constant Currency Change
Water Infrastructure	$	2,442			$	2,384			2.4	%		4.4	%
Applied Water	1,474				1,453				1.4	%		1.6	%
Total	$	3,916			$	3,837			2.1	%		3.3	%

Water Infrastructure

Water Infrastructure’s revenue increased $58 million, or 2.4% in 2014 (4.4% on a constant currency basis). The 4.4% constant currency increase reflects growth within the industrial water and public utility end markets and $6 million of incremental revenue from our 2013 acquisitions.

Organic revenue increased $99 million or 4.2% during the year, which was substantially due to higher volumes in transport, test and treatment applications. Revenue from transport applications grew primarily from increased industrial dewatering applications in the United States from oil and gas market-related rental activities. Transport also grew organically from public utility pump and aftermarket demand. Revenue from test applications increased due to significant strength in the United States from increased government spending coupled with the continued success of new products and cross-selling of our European technologies. Revenue from treatment applications grew from the delivery of several large projects in the emerging markets, particularly in Latin America, partially offset by lower deliverable project backlog in the United States and European markets.

Applied Water

Applied Water’s revenue increased $21 million, or 1.4% in 2014 (a 1.6% increase on a constant currency basis). The growth on a constant currency basis is driven primarily by organic revenue growth of $35 million, or 2.4% versus the prior year due to strength in the commercial building services, industrial water and agriculture end markets, which more than offset declines in the residential building services. The increase in the current year was partially offset by the absence of revenue from our Wolverhampton valves business following its divestiture in the third quarter of 2014 as compared to $12 million of revenue for the comparative period in 2013.

Organic revenue increased $35 million or 2.4% for the year due primarily to commercial building recovery in the United States institutional building market, including distributor restocking and promotional activity. Also contributing to the organic growth was industrial water application strength across all regions, particularly from projects in the Middle East and Latin America. Irrigation application revenue also grew, driven by the timing of project shipments and increased demand for vertical turbines. A decline in European demand for residential applications partially offset organic growth.

Orders/Backlog

Orders received during 2014 increased by $109 million, or 2.8% to $4,021 million (a 3.9% increase on a constant currency basis). Organic order growth increased $153 million or 3.9% for the year.

Water Infrastructure segment orders increased $68 million, or 2.8% to $2,511 million (4.4% growth on a constant currency basis), including $8 million from acquisitions. Organic order growth of 4.1% was primarily due to higher industrial demand within transport for wastewater pumps in the United States and Europe as well as strength within the dewatering business for rental and equipment sales into oil and gas markets. Orders for test applications also bolstered the growth for the segment from large orders in the United States. The strength in transport and test offset declines in treatment from project delays in the United States and Europe.

Orders increased in our Applied Water segment $41 million, or 2.8% to $1,510 million (3.0% growth on a constant currency basis). Organic growth of 3.6% was driven by strong performance in the commercial building services and industrial water markets in the United States, as well as continued strength in China. The growth was partially offset by weakness in the residential markets of Europe.

Delivery schedules vary from customer to customer based upon their requirements. Typically, large projects require longer lead production cycles, and delays can occur from time to time. Total backlog was $740 million at December 31, 2014 and $707 million at December 31, 2013. We anticipate that more than 85% of the backlog at December 31, 2014 will be recognized as revenue during 2015.

Gross Margin

Gross margins as a percentage of consolidated revenue declined to 38.6% in 2014 from 39.1% in 2013. The decrease is primarily attributable to lower margin sales within the Water Infrastructure segment caused by higher mix sold to emerging markets, which have lower margins, in conjunction with foreign exchange headwinds as well as unfavorable product sales mix. These negative impacts were partially mitigated by benefits from restructuring savings and cost-saving initiatives through lean six sigma and global sourcing across both segments.

Operating Expenses

(in millions)	2014				2013				Change
Selling, General and Administrative (SG&A)	$	920			$	986			(6.7	)%
SG&A as a % of revenue	23.5		%		25.7		%		(220	)bp
Research and Development (R&D)	104				104				—	%
R&D as a % of revenue	2.7		%		2.7		%		—
Restructuring and asset impairment charges	26				42				(38.1	)%
Separation Costs	—				4				NM
Operating expenses	$	1,050			$	1,136			(7.6	)%
Expense to revenue ratio	26.8		%		29.6		%		(280	)bp

NM Not meaningful percentage change

Selling, General and Administrative Expenses

SG&A decreased by $66 million or 6.7% to $920 million, or 23.5% of revenue in 2014, as compared to $986 million or 25.7% of revenue in 2013. The decrease in SG&A expenses as a percentage of revenue is due primarily to savings from restructuring actions combined with lapping the impacts from non-recurring special charges in 2013 of $24 million, which comprise the legal settlement with Xylem Group LLC, costs incurred for the change in our chief executive officer, costs incurred for the contractual indemnification of federal tax obligations to ITT and costs associated with a legal judgment arising from a historical acquisition matter. The decrease was also driven by $7 million less realignment costs in 2014, which were costs incurred by the Company to reposition our European business in an effort to optimize our cost structure and improve our operational efficiency and effectiveness as well as implement our new organizational structure.

Research and Development Expenses

R&D spending was flat at $104 million or 2.7% of revenue in both 2014 and 2013.

Restructuring and Asset Impairment Charges

During 2014, we incurred restructuring costs of $19 million, $6 million and $1 million in our Water Infrastructure and Applied Water segments, and Corporate and other, respectively. These charges were incurred primarily in an effort to realign our organizational structure in Europe and North America to optimize our cost structure. The charges relate to the reduction in structural costs, including a decrease in headcount and consolidation of facilities. During 2013, we recognized restructuring costs of $31 million and $9 million in our Water Infrastructure and Applied Water segments, respectively. These charges were incurred primarily in an effort to realign our organizational structure in Europe and North America to address declines in sales volumes and optimize our cost structure. The charges relate to the reduction in structural costs, including a decrease in headcount and consolidation of facilities.

Total expected costs associated with actions that commenced during 2014 are approximately $22 million for Water Infrastructure, approximately $10 million for Applied Water and approximately $1 million for Corporate and other. These costs primarily comprise severance charges. The Water Infrastructure and Applied Water actions are expected to continue through 2015. The Corporate and other actions are complete. As a result of these actions initiated in 2014, we achieved savings of approximately $13 million in 2014 and estimate annual future net savings beginning in 2015 of approximately $29 million.

Additionally, in the fourth quarter of 2013, we recorded a $2 million impairment charge related to three trade names in our Water Infrastructure segment associated with acquired businesses within our Analytics operating unit, reflecting a decline in their value since being acquired. Refer to Note 11, “Goodwill and Other Intangible Assets,” for additional information.

Operating Income

We generated operating income of $463 million during 2014, a $100 million or 27.5% increase from the prior year operating income of $363 million, primarily reflecting cost-saving initiatives and savings from restructuring actions. These benefits were partially offset by cost inflation combined with unfavorable impacts from our geographic and product sales mix described above. Another driving factor in the year-over-year improvement was the absence of the aforementioned special charges in 2013 within SG&A, which did not recur as well as lower restructuring and realignment costs. The following table illustrates operating income results by business segments for 2014 and 2013.

(in millions)	2014				2013				Change
Water Infrastructure	$	321			$	263			22.1	%
Applied Water	193				175				10.3	%
Segment operating income	514				438				17.4	%
Corporate and other	(51		)		(75		)		(32.0	)%
Total operating income	$	463			$	363			27.5	%
Operating margin
Water Infrastructure	13.1		%		11.0		%		210	bp
Applied Water	13.1		%		11.6		%		150	bp
Total Xylem	11.8		%		9.5		%		230	bp

The table included below provides a reconciliation from segment operating income to adjusted operating income, and a calculation of the corresponding adjusted operating margin.

(in millions)	2014				2013				Change
Water Infrastructure
Operating income	$	321			$	263			22.1	%
Restructuring and realignment costs	29				48				(39.6	)%
Special charges	—				4				NM
Adjusted operating income	$	350			$	315			11.1	%
Adjusted operating margin	14.3		%		13.2		%		110	bp
Applied Water
Operating income	193				175				10.3	%
Restructuring and realignment costs	13				16				(18.8	)%
Adjusted operating income	$	206			$	191			7.9	%
Adjusted operating margin	14.0		%		13.1		%		90	bp
Total Xylem
Operating income	$	463			$	363			27.5	%
Restructuring and realignment costs	43				64				(32.8	)%
Special charges	—				24				NM
Adjusted operating income	$	506			$	451			12.2	%
Adjusted operating margin	12.9		%		11.8		%		110	bp

NM Not meaningful percentage change

Water Infrastructure

Operating income for our Water Infrastructure segment increased $58 million or 22.1% (increased $35 million or 11.1% on an adjusted basis) compared with the prior year. The 11.1% increase was primarily driven by higher volume, restructuring savings and cost reduction initiatives, such as global sourcing and lean six sigma. The increase was partially offset by cost inflation, unfavorable sales mix and price.

Applied Water

Operating income for our Applied Water segment increased $18 million or 10.3% (increased $15 million or 7.9% on an adjusted basis) compared to the prior year. The 7.9% increase was driven by lean six sigma initiatives, global sourcing and restructuring savings combined with modest price realization. The increase was partially offset by cost inflation and unfavorable foreign exchange headwinds.

Interest Expense

Interest expense was $54 million and $55 million for 2014 and 2013, respectively, primarily related to interest expense on $1.2 billion aggregate principal amount of our senior notes. Refer to Note 14, “Credit Facilities and Long-Term Debt,” for further details.

Income Tax Expense

The income tax provision for 2014 was $84 million at an effective tax rate of 19.8% compared to $70 million at an effective tax rate of 23.5% in 2013. The 2014 effective tax rate is lower than 2013 due primarily to geographic mix of earnings.

Other Comprehensive Income/(Loss)

Other comprehensive loss before tax of $284 million in 2014 as compared to income of $74 million in 2013 was primarily due to a $221 million foreign currency translation impact due to a weakening of the Euro, British Pound and Swedish Krona against the U.S. dollar. Further contributing to the year-over-year decline was a $110 million net loss in postretirement benefit plans in 2014 as compared to a net gain of $34 million in 2013 due to a decrease in discount rates, partially mitigated by actual gains on plan assets in excess of the assumed long-term rate of return. The effective tax rate on other comprehensive income decreased as compared to 2013 due primarily to the shift in comprehensive earnings from foreign currency translation, which is not taxable, as well as from a change in the jurisdictional mix of net gains and losses from postretirement benefit plans.

2013 versus 2012

Revenue

Revenue generated for 2013 was $3,837 million, an increase of $46 million, or 1.2%, compared to $3,791 million in 2012. On a constant currency basis, revenue grew 1.1%. The following table illustrates the impact from organic growth, recent acquisitions, and fluctuations in foreign currency, in relation to revenue during 2013.

(in millions)	$ Change				% Change
2012 Revenue	$	3,791
Organic Growth	(39		)		(1.0	)%
Acquisitions	82				2.2	%
Constant Currency	43				1.1	%
Foreign currency translation (a)	3				0.1	%
Total change in revenue	46				1.2	%
2013 Revenue	$	3,837

(a)	Foreign currency impact primarily due to strength in the value of the Euro and Swedish Krona against the U.S. Dollar, partially offset by weakness in the value of the Australian Dollar, South African Rand, Canadian Dollar and British Pound against the U.S. Dollar.

The following table summarizes revenue by segment for 2013 and 2012:

(in millions)	2013				2012				As Reported Change			Constant Currency Change
Water Infrastructure	$	2,384			$	2,349			1.5	%		1.7	%
Applied Water	1,453				1,442				0.8	%		0.3	%
Total	$	3,837			$	3,791			1.2	%		1.1	%

Water Infrastructure

Water Infrastructure’s revenue increased $35 million, or 1.5% in 2013 (1.7% on a constant currency basis). Our 2012 and 2013 acquisitions contributed $82 million of incremental revenue in 2013.

Organic revenue decreased $43 million or 1.8% during the year, which was due substantially to lower volumes across the transport, treatment and test applications. The significant declines were caused primarily by weakness in the Europe, Middle East and Africa treatment markets and declines in transport in the Asia Pacific markets from less mining activity. Organic revenue performance improved year-over-year in the third and fourth quarters of 2013 driven by increases in transport revenue, which reflected modest market recovery in northern and central Europe as well as the United States. Treatment negatively impacted organic growth for the year as revenue decreased from 2012 due substantially to non-recurring large custom projects shipped in the prior year as well as project delays from government funding uncertainties. Additionally, test applications, which had flat organic revenue in 2013, experienced lower revenue for the year from delays in orders and the government sequestration in the United States during the first half of 2013, which were offset by revenue growth in the second half of the year, specifically in Europe, as well as incremental revenue from price increases, new products and cross-branding initiatives.

Applied Water

Applied Water’s revenue increased $11 million, or 0.8% in 2013 (a 0.3% increase on a constant currency basis). The growth on a constant currency basis was driven by organic revenue growth predominately due to irrigation and industrial water applications.

Organic revenue increased $4 million or 0.3% for the year due primarily to irrigation application revenue caused by drought conditions in the United States. Strength in the industrial water application also bolstered revenue, particularly within China from large fire pump projects as well as in northern Europe from increased industrial multistage pump revenue. These revenue increases were partially offset by weakness in Europe, particularly within the residential and commercial building services markets of southern Europe, combined with sluggish industrial and commercial building service markets in the United States and Latin America.

Orders/Backlog

Orders received during 2013 increased by $130 million, or 3.4% to $3,912 million (a 3.4% increase on a constant currency basis). These amounts include a benefit of $87 million from acquisitions. Organic order growth was $43 million for the year.

The Water Infrastructure segment orders increased $79 million, or 3.3% to $2,443 million (3.6% growth on a constant currency basis), including $87 million from acquisitions. Orders increased slightly on a constant currency basis due primarily to a strong second half of 2013 driven by higher transport volume from Europe public utilities and the dewatering business, combined with healthy growth in emerging markets. Orders increased in our Applied Water segment $51 million, or 3.6% to $1,469 million (3.2% growth on a constant currency basis), driven by strong performance in the commercial building services and industrial water markets in China as well as orders within the residential building services and agriculture markets in the United States during 2013, partially offset by weakness in Southern Europe across all end markets.

Delivery schedules vary from customer to customer based upon their requirements. Typically, large projects require longer lead production cycles and delays can occur from time to time. Total backlog was $707 million at December 31, 2013 and $647 million at December 31, 2012.

Gross Margin

Gross margins as a percentage of consolidated revenue declined to 39.1% in 2013 from 39.6% in 2012. The decrease is attributable to negative price realization, geographic sales mix and additional costs associated with recent acquisitions. These negative impacts were partially mitigated by benefits from restructuring savings and cost saving initiatives such as lean six sigma and global sourcing.

Operating Expenses

(in millions)	2013				2012				Change
Selling, General and Administrative (SG&A)	$	986			$	914			7.9	%
SG&A as a % of revenue	25.7		%		24.1		%		160bp
Research and Development (R&D)	104				106				(1.9	)%
R&D as a % of revenue	2.7		%		2.8		%		(10)bp
Restructuring and asset impairment charges	42				17				147.1	%
Separation Costs	4				22				(81.8	)%
Operating expenses	$	1,136			$	1,059			7.3	%
Expense to revenue ratio	29.6		%		27.9		%		170bp

Selling, General and Administrative Expenses

SG&A increased by $72 million or 7.9% to $986 million or 25.7% of revenue in 2013, as compared to $914 million or 24.1% of revenue in 2012. The increase in SG&A expenses as a percentage of revenue is primarily due to the combined impacts from the legal settlement with Xylem Group LLC and costs incurred for the change in our chief executive officer of $20 million. The increase was also driven by realignment costs of $17 million during 2013 incurred by the Company to reposition our European business in an effort to optimize our cost structure and improve our operational efficiency and effectiveness. Acquisitions, increased pension costs and investments in growth platforms also contributed to the increase.

Research and Development Expenses

R&D spending decreased $2 million or 1.9% to $104 million or 2.7% of revenue for 2013 as compared to $106 million or 2.8% of revenue in 2012.

Restructuring and Asset Impairment Charges

During 2013, we incurred restructuring costs of $31 million and $9 million in our Water Infrastructure and Applied Water segments, respectively. These charges were incurred primarily in an effort to realign our organizational structure in Europe and North America to address declines in sales volumes and optimize our cost structure. The charges relate to the reduction in structural costs, including a decrease in headcount and consolidation of facilities. During 2012, we recognized restructuring charges of $17 million related to restructuring related severance payments for manufacturing reduction in force initiatives primarily within our Water Infrastructure segment.

Total expected costs associated with actions that commenced during 2013 are approximately $32 million for Water Infrastructure and approximately $8 million for Applied Water. These costs primarily comprise severance charges. These actions are substantially complete. As a result of actions initiated during 2013, we achieved net savings of approximately $13 million in 2013 and annual future net savings beginning in 2014 of approximately $36 million.

Additionally, in the fourth quarter of 2013 we recorded a $2 million impairment charge related to three trade names in our Water Infrastructure segment associated with acquired businesses within our Analytics operating unit, reflecting a decline in their value since being acquired. Refer to Note 11, “Goodwill and Other Intangible Assets,” for additional information.

Separation Costs

We had non-recurring separation costs related to our Spin-off from ITT as presented below.

(in millions)	2013				2012
Rebranding and marketing costs	$	—			$	8
Advisory and professional fees	—				7
Information and technology costs	2				3
Employee retention and hiring costs	—				1
Lease termination and other real estate costs	2				1
Other	—				2
Total separation costs in operating income	4				22
Income tax benefit	(2		)		(6		)
Total separation costs, net of tax	$	2			$	16

Operating Income

We generated operating income of $363 million during 2013, an $80 million or 18.1% decrease from the prior year operating income of $443 million, primarily reflecting higher operating expenses as increased SG&A, and restructuring and asset impairment charges more than offset reductions from lower separation costs and savings from restructuring activities. The following table illustrates operating income results by business segments for 2013 and 2012.

(in millions)	2013				2012				Change
Water Infrastructure	$	263			$	334			(21.3	)%
Applied Water	175				178				(1.7	)%
Segment operating income	438				512				(14.5	)%
Corporate and other	(75		)		(69		)		8.7	%
Total operating income	$	363			$	443			(18.1	)%
Operating margin
Water Infrastructure	11.0		%		14.2		%		(320)bp
Applied Water	12.0		%		12.3		%		(30)bp
Total Xylem	9.5		%		11.7		%		(220)bp

The table included below provides a reconciliation from segment operating income to adjusted operating income, and a calculation of the corresponding adjusted operating margin.

(in millions)	2013				2012				Change
Water Infrastructure
Operating income	$	263			$	334			(21.3	)%
Separation costs	—				4				NM
Restructuring and realignment costs	48				19				152.6	%
Special charges	4				—				NM
Adjusted operating income	$	315			$	357			(11.8	)%
Adjusted operating margin	13.2		%		15.2		%		(200)bp
Applied Water
Operating income	175				178				(1.7	)%
Separation costs	—				2				NM
Restructuring and realignment costs	16				5				220.0	%
Adjusted operating income	$	191			$	185			3.2	%
Adjusted operating margin	13.1		%		12.8		%		30bp
Total Xylem
Operating income	$	363			$	443			(18.1	)%
Separation costs*	—				22				NM
Restructuring and realignment costs	64				24				166.7	%
Special charges	24				—				NM
Adjusted operating income*	$	451			$	489			(7.8	)%
Adjusted operating margin*	11.8		%		12.9		%		(110)bp

NM Not meaningful percentage change

*	Costs associated with non-recurring separation activities of $4 million ($2 million, net of tax) during 2013 are not excluded from adjusted operating income.

Water Infrastructure

Operating income for our Water Infrastructure segment decreased $71 million or 21.3% (decreased $42 million or 11.8% on an adjusted basis) compared with the prior year. The 11.8% decrease was driven by lower volume, inflation, unfavorable foreign exchange impacts, costs associated with the establishment of our European headquarters and investments in growth platforms, specifically acquisitions and new product launches. The decrease was partially offset by restructuring savings and cost reduction initiatives, such as global sourcing and lean six sigma.

Applied Water

Operating income for our Applied Water segment decreased $3 million or 1.7% (increased $6 million or 3.2% on an adjusted basis) compared to the prior year. The 3.2% increase was driven by lean initiatives, global sourcing and price realization partially offset by inflation and new product development.

Interest Expense

Interest expense was $55 million for both 2013 and 2012, reflecting the same full year of interest expense related to the issuance of $1.2 billion aggregate principal amount of our senior notes. Refer to Note 14, “Credit Facilities and Long-Term Debt,” for further details.

Income Tax Expense

The income tax provision for 2013 was $70 million at an effective tax rate of 23.5% compared to $91 million at an effective tax rate of 23.4% in 2012. The 2013 effective tax rate is higher than 2012 due to an increase in foreign repatriations partially offset by mix of earnings.

Other Comprehensive Income/(Loss)

Other comprehensive income before tax of $74 million in 2013 compared to a loss of $30 million in 2012, an improvement of $104 million, was primarily due to a $34 million net gain in 2013 as compared to a net loss of $84 million in 2012 related to postretirement benefit plans. The net gain in 2013 was due to an increase in discount rates as well as actual gains on plan assets in excess of the assumed long-term rate of return as compared to the net loss in 2012 which was due to a reduction in discount rates, partially mitigated by actual gains on plan assets in excess of the assumed long-term rate of return. This year-over-year improvement was partially offset by a $33 million reduction in foreign currency translation benefit primarily due to the Euro, Swedish Krona and British Pound strengthening against the U.S. dollar. The effective tax rate on other comprehensive income decreased as compared to 2012 due primarily to the shift in comprehensive earnings from foreign currency translation, which is not taxable, as well as from a change in the jurisdictional mix of net gains and losses from postretirement benefit plans.

Liquidity and Capital Resources

The following table summarizes our sources and uses of cash:

	Year Ended December 31,
(in millions)	2014				2013				2012
Operating activities	$	416			$	324			$	396
Investing activities	(86		)		(199		)		(147		)
Financing activities	(147		)		(100		)		(74		)
Foreign exchange (a)	(53		)		4				11
Total	$	130			$	29			$	186

(a)	2014 impact is primarily due to the weakness of the Euro against the US Dollar.

Sources and Uses of Liquidity

Operating Activities

During 2014, net cash provided by operating activities was $416 million, compared to $324 million in 2013. The $92 million year-over-year increase was driven by an increase in income, as well as a modest improvement in working capital performance. Reductions in payments made for restructuring and postretirement plan contributions in 2014 were largely offset by an increase in tax payments. Also contributing to the increase was a refund of value-added tax in the current year that had been paid during 2013.

During 2013, net cash provided by operating activities was $324 million, compared to $396 million in 2012. The $72 million year-over-year decrease was driven by an increase in the use of working capital in both segments, due to increased accounts receivable primarily from longer collection times in Europe, and increased inventories to support a higher backlog as well as to be able to support shorter lead times. Additionally, revenue volume declines during the first half of 2013 reduced cash inflow from income. Payments made for restructuring and realignment activities in 2013 also contributed to the decline, largely offset by lower tax payments.

Investing Activities

Cash used in investing activities was $86 million for 2014, compared to $199 million in 2013. The decrease of $113 million was primarily driven by a decrease in acquisition activity as there were no acquisitions in 2014, whereas we spent $81 million for the acquisitions during 2013. Also contributing to the decrease was the receipt of $30 million in 2014 for the sale of a business. Capital expenditures were also lower in 2014, with a $7 million reduction primarily due to a decrease in the spending on post Spin-off information technology investments and the relocation of our corporate headquarters.

Cash used in investing activities was $199 million in 2013 compared to $147 million in 2012. The changes in investing activities are driven almost entirely by acquisitions activity and, to a lesser extent, from changes in spending on capital expenditures. Cash used for acquisitions was $81 million in 2013 compared to $41 million during 2012. Capital expenditures were $126 million in 2013 and $112 million in 2012. The increase in capital expenditures were primarily due to information technology investments within both the Applied Water segment and Corporate as a result of system requirements subsequent to the Spin-off in addition to capital expenditures required for the relocation of our corporate headquarters as required by the Spin-off from ITT.

Financing Activities

Cash used by financing activities was $147 million, $100 million and $74 million during 2014, 2013 and 2012, respectively. The increases in cash used for financing activities was primarily driven by an increase in share repurchase activity and dividend payments. In 2014, share repurchase activity increased $61 million and dividend payments increased $7 million compared to 2013. Additionally, there was an increase in short-term debt for borrowings under the European Investment Bank facility of $50 million in 2014 versus $38 million in 2013. In 2013, increases in share repurchase activity and dividend payments were $60 million and $12 million, respectively, compared to 2012. The 2013 share repurchase activity was impacted by $50 million of repurchases under a new share repurchase program approved on August 20, 2013 by the Board of Directors to repurchase up to $250 million in shares.

Funding and Liquidity Strategy

Our ability to fund our capital needs depends on our ongoing ability to generate cash from operations, and access to the bank and capital markets.

Our global funding requirements are continually monitored with appropriate strategies executed to ensure liquidity needs are met cost effectively. Based on our current global cash positions, cash flows from operations and access to the commercial paper markets, we believe there is sufficient liquidity to meet our funding requirements. In addition, our existing committed credit facilities and access to the public debt markets would provide further liquidity if required.

Historically, we have generated operating cash flow sufficient to fund our primary cash needs centered on operating activities, working capital, capital expenditures, and strategic investments. If our cash flows from operations are less than we expect, we may need to incur debt or issue equity. From time to time, we may need to access the long-term and short-term capital markets to obtain financing. Our access to, and the availability of, financing on acceptable terms and conditions in the future will be impacted by many factors, including: (i) our credit ratings or absence of a credit rating, (ii) the liquidity of the overall capital markets, and (iii) the current state of the economy. There can be no assurance that we will continue to have access to the capital markets on terms acceptable to us or that financing will be available at all.

We anticipate that our present sources of funds, including funds from operations, will provide us with sufficient liquidity and capital resources to meet our global liquidity and capital needs over the next twelve months.

Senior Notes

On September 20, 2011, we issued 3.550% Senior Notes of $600 million aggregate principal amount due September 2016 (the "Senior Notes due 2016") and 4.875% Senior Notes of $600 million aggregate principal amount due October 2021 (the "Senior Notes due 2021" and together with the Senior Notes due 2016, the "Senior Notes").

The Senior Notes include covenants which restrict our ability, subject to exceptions, to incur debt secured by liens and engage in sale and leaseback transactions, as well as provide for customary events of default (subject, in certain cases, to receipt of notice of default and/or customary grace and cure periods). We may redeem the Senior Notes, as applicable, in whole or in part, at any time at a redemption price equal to the principal amount of the Senior Notes to be redeemed, plus a make-whole premium. If a change of control triggering event (as defined in the Senior Notes) 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 December 31, 2014, we were in compliance with all covenants.

Interest on the Senior Notes due 2016 is payable on March 20 and September 20 of each year. Interest on the Senior Notes due 2021 is payable on April 1 and October 1 of each year.

Four Year Competitive Advance and Revolving Credit Facility

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

At our election, the interest rate per annum applicable to the competitive advances will be based on either (i) a Eurodollar rate determined by reference to LIBOR, plus an applicable margin offered by the lender making such loans and accepted by us or (ii) a fixed percentage rate per annum specified by the lender making such loans. At our election, interest rate per annum applicable to the revolving loans will be based on either (i) a Eurodollar rate determined by reference to LIBOR, adjusted for statutory reserve requirements, plus an applicable margin or (ii) a fluctuating rate of interest determined by reference to the greatest of: (a) the prime rate of JPMorgan Chase Bank, N.A., (b) the U.S. Federal Funds effective rate plus half of 1% or (c) the Eurodollar rate determined by reference to LIBOR, adjusted for statutory reserve requirements, in each case, plus an applicable margin.

In accordance with the terms, we may not exceed a maximum leverage ratio of 3.50 (based on a ratio of total debt to earnings before interest, taxes, depreciation and amortization) throughout the term. The Credit Facility also contains limitations on, among other things, incurring debt, granting liens, and entering sale and leaseback transactions. In addition, the Credit Facility contains other terms and conditions such as customary representations and warranties, additional covenants and customary events of default. As of December 31, 2014, we were in compliance with all covenants.

As of December 31, 2014, this credit facility remains undrawn. Our intention is to renew the Credit Facility in 2015.

Research and Development Facility Agreement

On December 4, 2013, the Company amended and restated its Risk Sharing Finance Facility Agreement (the "R&D Facility Agreement") with The European Investment Bank (the "EIB") to add an additional borrower under the facility. The facility provides an aggregate principal amount of up to €120 million (approximately $146 million) to finance research projects and infrastructure development in the European Union. The Company's wholly-owned subsidiaries in Luxembourg, Xylem Holdings S.á.r.l. and Xylem International S.á.r.l., are the borrowers under the R&D Facility Agreement. The obligations of the borrowers under the R&D Facility Agreement are guaranteed by the Company under an Amended and Restated Deed of Guarantee, dated as of December 4, 2013, in favor of the EIB. The funds are available to finance research and development projects during the period from 2013 through 2016 at the Company's R&D facilities in Sweden, Germany, Italy, the United Kingdom, Austria, Norway and Hungary.

Under the R&D Facility Agreement, the borrower can draw loans on or before June 14, 2015 with a maturity of no longer than 12 years. The R&D Facility Agreement provides for Fixed Rate loans and Floating Rate loans. The interest rate per annum applicable to Fixed Rate loans will be 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 will be 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 shall be determined by reference to the credit rating of the Company.

In accordance with the terms of the R&D Facility Agreement, we may not exceed a maximum leverage ratio of 3.50 (based on a ratio of total debt to earnings before interest, taxes, depreciation and amortization) throughout the term. 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 December 31, 2014, we were in compliance with all covenants.

As of December 31, 2014, $84 million was outstanding under the R&D Facility Agreement. Although the borrowing term for this arrangement is for five years, we have classified it as short-term debt on our Consolidated Balance Sheet since we intend to repay this obligation in less than one year.

Non-U.S. Operations

For both 2014 and 2013, we generated 62% of our revenue from non-U.S. operations. As we continue to grow our operations in the emerging markets and elsewhere outside of the United States, we expect to continue to generate significant revenue from non-U.S. operations and we expect our cash will be predominately held by our foreign subsidiaries. We expect to manage our worldwide cash requirements considering available funds among the many subsidiaries through which we conduct business and the cost effectiveness with which those funds can be accessed. We may transfer cash from certain international subsidiaries to the U.S. and other international subsidiaries when it is cost effective to do so. Our intent is to indefinitely reinvest all but $65 million of these funds outside of the United States. However, we continually review our domestic and foreign cash profile, expected future cash generation and investment opportunities that support our current designation of these funds as being indefinitely reinvested and reassess whether there is a demonstrated need to repatriate funds held internationally to support our U.S. operations. If, as a result of our review, it is determined that all or a portion of the funds may be needed for our operations in the United States, we would be required to accrue U.S. taxes related to future tax payments associated with the repatriation of these funds. As of December 31, 2014, our foreign subsidiaries were holding $537 million in cash or marketable securities.

As of December 31, 2014, our excess of financial reporting over the tax basis of investments in certain foreign subsidiaries totaled $1.9 billion. We have not asserted that $65 million of our excess basis difference will be indefinitely reinvested and have therefore provided for United States or additional foreign withholding taxes for that portion. Generally, such amounts become subject to U.S. taxation upon the remittance of dividends and under certain other circumstances.

Contractual Obligations

The following table summarizes our contractual commitments as of December 31, 2014:

(in millions)	2015				2016 - 2017				2018 - 2019				Thereafter				Total
Debt and capital lease obligations (1)	$	89			$	600			$	—			$	600			$	1,289
Interest payments (2)	51				80				59				58				248
Operating lease obligations	63				81				37				25				206
Purchase obligations (3)	54				7				—				—				61
Other long-term obligations reflected on the balance sheet	1				2				2				21				26
Total commitments	$	258			$	770			$	98			$	704			$	1,830

In addition to the amounts presented in the table above, we have recorded liabilities for uncertain tax positions of $44 million. These amounts have been excluded from the contractual obligations table due to an inability to reasonably estimate the timing of such payments in individual years. Further, benefit payments which reflect expected future service related to the Company's pension and other postretirement employee benefit obligations are presented in Note 15, “Postretirement Benefit Plans” and not included in the above table. Finally, estimated environmental payments are excluded from the table above. We estimate, based on historical experience, that we will spend approximately $1 million to $2 million per year on environmental investigation and remediation. At December 31, 2014, we had estimated and accrued $5 million related to environmental matters.

(1)	Refer to Note 14, “Credit Facilities and Long-Term Debt,” in the notes to the consolidated financial statements for discussion of the use and availability of debt and revolving credit agreements. Amounts represent principal payments of long-term debt including current maturities and exclude unamortized discounts.

(2)	Amounts represent estimate of future interest payments on long-term debt outstanding as of December 31, 2014.

(3)	Represents unconditional purchase agreements that are enforceable and legally binding and that specify all significant terms to purchase goods or services, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase agreements that are cancellable without penalty have been excluded.

Off-Balance Sheet Arrangements

As of December 31, 2014, we have issued guarantees for the debt and other obligations of consolidated subsidiaries in the normal course of business. We have determined that none of these arrangements has a material current effect or is reasonably likely to have a material future effect on our consolidated financial statements, liquidity, capital expenditures or capital resources.

Critical Accounting Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and the disclosure of contingent liabilities. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.

Significant accounting policies used in the preparation of the Consolidated Financial Statements are discussed in Note 1, “Summary of Significant Accounting Policies,” in the notes to the consolidated financial statements. Accounting estimates and assumptions discussed in this section are those that we consider most critical to an understanding of our financial statements because they are inherently uncertain, involve significant judgments, include areas where different estimates reasonably could have been used, and changes in the estimate that are reasonably possible could materially impact the financial statements. Management believes that the accounting estimates employed and the resulting balances are reasonable; however, actual results in these areas could differ from management’s estimates under different assumptions or conditions.

Revenue Recognition. We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collectability of the sales price is reasonably assured. For product sales, delivery does not occur until the products have been shipped, risk of loss has been transferred to the customer and the contractual terms have been fulfilled. In instances where contractual terms include a provision for customer acceptance, revenue is recognized when either (i) we have previously demonstrated that the product meets the specified criteria based on either seller- or customer-specified objective criteria or (ii) upon formal acceptance received from the customer where the product has not been previously demonstrated to meet customer-specified objective criteria. Revenue on service and repair contracts is recognized after services have been agreed to by the customer and rendered.

We enter into contracts to sell our products and services, and while the majority of our sales agreements contain standard terms and conditions, certain agreements contain multiple elements or non-standard terms and conditions. Where sales agreements contain multiple elements or non-standard terms and conditions, judgment is required to determine the appropriate accounting, including whether the deliverables specified in these agreements should be treated as separate units of accounting for revenue recognition purposes, and, if so, how the transaction price should be allocated among the elements and when to recognize revenue for each element. When a sale involves multiple deliverables, the total revenue from the arrangement is allocated to each unit of accounting based on the relative selling price of the deliverable to all other deliverables in the contract. Revenue for multiple element arrangements is recognized when the appropriate revenue recognition criteria for the individual deliverable have been satisfied. The allocation of sales price between elements may impact the timing of revenue recognition, but will not change the total revenue recognized on the arrangement. For delivered elements accounted for as separate units of accounting in a multiple element arrangement, revenue is recognized only when the delivered elements have standalone value, there are no uncertainties regarding customer acceptance and there are no customer-negotiated refund or return rights affecting the sales recognized.

We record a reduction in revenue at the time of sale for estimated product returns, rebates and other allowances, based on historical experience and known trends.

Warranty Accrual. Accruals for estimated expenses related to warranties are made at the time products are sold or services are rendered and are recorded as a component of cost of revenue. These accruals are established using historical information on the nature, frequency and average cost of warranty claims and consider any factors that may cause differences in expected future warranty costs as compared to historical claim experience. While we engage in extensive product quality programs and processes, we base our estimated warranty obligation on product warranty terms offered to customers, ongoing product failure rates, material usage and service delivery costs incurred in correcting a product failure, as well as specific product class failures outside of our baseline experience. We also record a warranty liability for specific matters. We assess the adequacy of our recorded warranty liabilities quarterly and adjust amounts as necessary.

Income Taxes. Deferred tax assets and liabilities are determined based on temporary differences between the financial reporting and tax bases of assets and liabilities, applying enacted tax rates in effect for the year in which we expect the differences will reverse. Based on the evaluation of available evidence, we recognize future tax benefits, such as net operating loss carryforwards, to the extent that we believe it is more likely than not we will realize these benefits. We periodically assess the likelihood that we will be able to recover our deferred tax assets

and reflect any changes to our estimate of the amount we are more likely than not to realize in the valuation allowance, with a corresponding adjustment to earnings or other comprehensive income, as appropriate.

In assessing the need for a valuation allowance, we look to the future reversal of existing taxable temporary differences, taxable income in carryback years and the feasibility of tax planning strategies and estimated future taxable income. The valuation allowance can be affected by changes to tax laws, changes to statutory tax rates and changes to future taxable income estimates.

Our effective tax rate reflects the impact of certain undistributed foreign earnings for which we have not provided U.S. taxes because we plan to reinvest such earnings indefinitely outside the United States. We plan foreign earnings remittance amounts based on projected cash flow needs, as well as the working capital and long-term investment requirements of our foreign subsidiaries and our domestic operations. Based on these assumptions, we estimate the amount we will distribute to the United States and provide the U.S. federal taxes due on these amounts. Material changes in our estimates of cash, working capital and long-term investment requirements in the various jurisdictions in which we do business could impact our effective tax rate.

The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations in a multitude of jurisdictions across our global operations. We recognize potential liabilities and record tax liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether, and to the extent to which, additional taxes will be due. Furthermore, we recognize the 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. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement.

We adjust our liability for uncertain tax positions in light of changing facts and circumstances; however, due to the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from our current estimate of the tax liabilities. If our estimate of tax liabilities proves to be less than the ultimate assessment, an additional tax expense would result. If a payment of these amounts ultimately proves to be less than the recorded amounts, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary.

Goodwill and Intangible Assets. We review goodwill and indefinite-lived intangible assets for impairment annually and whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. We also review the carrying value of our finite-lived intangible assets for potential impairment when impairment indicators arise. We conduct our annual impairment test as of the first day of the fourth quarter. We perform a two-step impairment test for goodwill. In the first step, we compare the estimated fair value of each reporting unit to its carrying value. If the estimated fair value of the reporting unit exceeds the carrying value of the net assets assigned to that reporting unit, goodwill is not impaired and we are not required to perform further testing. If the carrying value of the net assets assigned to the reporting unit exceeds its fair value, then we must perform the second step of the impairment test in order to measure the impairment loss to be recorded, if any. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then we record an impairment loss equal to the difference. In our annual impairment test for indefinite-lived intangible assets, we compare the fair value of those assets to their carrying value. We recognize an impairment loss when the estimated fair value of the indefinite-lived intangible asset is less than its carrying value. We estimate the fair value of our reporting units and intangible assets with indefinite lives using an income approach. Under the income approach, we calculate fair value based on the present value of estimated future cash flows.

Determining the fair value of a reporting unit or an indefinite-lived intangible asset is judgmental in nature and involves the use of significant estimates and assumptions, particularly related to future operating results and cash flows. These estimates and assumptions include, but are not limited to, revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, assumed royalty rates, future economic and market conditions and identification of appropriate market comparable data. In addition, the identification of reporting units and the allocation of assets and liabilities to the reporting units when determining the carrying value of each reporting unit also require judgment. Goodwill is tested for impairment at either the operating segment identified in Note 21, “Segment and Geographic Data,” of the consolidated financial statements, or one level below. The fair value of our reporting units and indefinite-lived intangible assets is based on estimates and assumptions that are believed to be reasonable. Significant changes to these estimates and assumptions could adversely impact our conclusions. Actual future results may differ from those estimates.

During the fourth quarter of 2014, we performed our annual impairment assessment and determined that the estimated fair values of our goodwill reporting units were substantially in excess of each of their carrying values. However, future goodwill impairment tests could result in a charge to earnings. We will continue to evaluate goodwill on an annual basis as of the beginning of our fourth quarter and whenever events and changes in circumstances indicate there may be a potential impairment.

We determined that no impairment of the indefinite-lived intangibles existed as of the measurement date in 2014. During the fourth quarter of 2013 we performed our annual impairment test of our indefinite-lived intangibles assets which resulted in an impairment charge of $2 million related to trade names within our Water Infrastructure segment. Refer to Note 11, “Goodwill and Other Intangible Assets,” for additional information.

Postretirement Plans. Company employees around the world participate in numerous defined benefit plans. The determination of projected benefit obligations and the recognition of expenses related to these plans are dependent on various assumptions. These major assumptions primarily relate to discount rates, expected long-term rates of return on plan assets, rate of future compensation increases, mortality, health care inflation and years of service (some of which are disclosed in Note 15, “Postretirement Benefit Plans,” in the notes to the consolidated financial statements) and other factors. Actual results that differ from our assumptions are accumulated and amortized on a straight-line basis only to the extent they exceed 10% of the higher of the market-related value or projected benefit obligation, over the average remaining service period of active plan participants, or for plans with all or substantially all inactive participants, over the average remaining life expectancy.

Significant Assumptions

Management develops each assumption using relevant Company experience, in conjunction with market-related data for each individual country in which such plans exist. All assumptions are reviewed annually with third-party consultants and adjusted as necessary. The table included below provides the weighted average assumptions used to estimate our defined benefit pension obligations and costs as of and for the years ended 2014 and 2013.

	2014						2013
	U.S.			Int’l			U.S.			Int’l
Benefit Obligation Assumptions
Discount rate	4.01	%		3.14	%		4.79	%		4.23	%
Rate of future compensation increase	NM			3.34	%		NM			3.48	%
Net Periodic Benefit Cost Assumptions
Discount rate	4.79	%		4.23	%		4.13	%		4.04	%
Expected long-term return on plan assets	8.00	%		7.30	%		8.00	%		7.33	%
Rate of future compensation increase	NM			3.48	%		4.50	%		3.50	%

NM	Not meaningful. During 2013, an amendment to one of the Company's U.S business unit's pension plans modified the benefit formula. Similar to all other U.S. pension plans, pension benefits for future service was changed to be based on years of service and not be impacted by future compensation increases.

We determine the expected long-term rate of return on plan assets by evaluating both historical returns and estimates of future returns. Specifically, the Company analyzes the estimated future returns based on independent estimates of asset class returns and evaluates historical broad market returns over long-term timeframes based on the strategic asset allocation, which is detailed in Note 15, “Postretirement Benefit Plans,” in the notes to the consolidated financial statements.

Based on the approach described above, the chart below shows weighted average actual returns versus the weighted average expected long-term rates of return for our pension plans that were utilized in the calculation of the net periodic pension cost for each respective year.

	2014			2013			2012
Expected long-term rate of return on plan assets	7.38	%		7.40	%		7.42	%
Actual rate of return on plan assets	18.13	%		10.17	%		10.09	%

For the recognition of net periodic pension cost, the calculation of the expected return on plan assets is generally derived by applying the expected long-term rate of return to the market-related value of plan assets. The market-

related value of plan assets is based on average asset values at the measurement date over the last five years. The use of fair value, rather than a calculated value, could materially affect net periodic pension cost. Our weighted average expected long-term rate of return on plan assets for all pension plans, effective January 1, 2015 is 7.38%. We estimate that every 25 basis point change in the expected return on plan assets impacts the expense by $1 million.

The discount rate reflects our expectation of the present value of expected future cash payments for benefits at the measurement date. A decrease in the discount rate increases the present value of benefit obligations and increases pension expense. We base the discount rate assumption on current investment yields of high-quality fixed income investments during the retirement benefits maturity period. The pension discount rate was determined by considering an interest rate yield curve comprising AAA/AA bonds, with maturities between zero and 30 years, developed by the plan’s actuaries. Annual benefit payments are then discounted to present value using this yield curve to develop a single-point discount rate matching the plan’s characteristics. Our weighted average discount rate for all pension plans effective January 1, 2015, is 3.23%. We estimate that every 25 basis point change in the discount rate impacts the expense by $1 million.

The rate of future compensation increase assumption reflects our long-term actual experience and future and near-term outlook. Effective January 1, 2015, our expected rate of future compensation is 3.34% for all pension plans. The estimated impact of a 25 basis point change in the expected rate of future compensation is less than $1 million.

The assumed rate of future increases in the per capita cost of health care (the health care trend rate) is 6.88% for 2015, decreasing ratably to 5.00% in 2020. An increase or decrease in the health care trend rates by one percent per year would impact the aggregate annual service and interest components by less than $1 million, and impact the benefit obligation by approximately $4 million.

We currently anticipate making contributions to our pension and postretirement benefit plans in the range of $24 million to $34 million during 2015, of which $7 million is expected to be made in the first quarter.

Funded Status

Funded status is derived by subtracting the respective year-end values of the projected benefit obligations from the fair value of plan assets. We estimate that every 25 basis point change in the discount rate impacts the funded status by approximately $30 million.

Fair Value of Plan Assets

The plan assets of our pension plans comprise a broad range of investments, including domestic and foreign equity securities, interests in private equity and hedge funds, fixed income investments, insurance contracts, and cash and cash equivalents.

A portion of our pension benefit plan assets portfolio comprises investments in private equity and hedge funds. The private equity and hedge fund investments are generally measured at net asset value. However, in certain instances, the values reported by the asset managers were not current at the measurement date. Accordingly, we made estimate adjustments to the last reported value where necessary to measure the assets at fair value at the measurement date. These adjustments consider information received from the asset managers, as well as general market information. The adjustment recorded at December 31, 2014 and 2013 for these assets represented less than one percent of total plan assets in each respective year. Asset values for other positions were generally measured using market observable prices. We estimate that a 5% change in asset values will impact funded status by approximately $27 million.

New Accounting Pronouncements

See Note 2, “Recently Issued Accounting Pronouncements,” in the notes to the consolidated financial statements for a complete discussion of recent accounting pronouncements.