filings.toolsItem 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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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, 2018*. Except as otherwise indicated or unless the context otherwise requires, “Xylem,” “we,” “us,” “our” and “the Company” refer to Xylem Inc. and its subsidiaries.*
Overview
Xylem is a leading global water technology company. We design, manufacture and service highly engineered products and solutions ranging across a wide variety of critical applications in utility, industrial, residential and commercial building services settings. Our broad portfolio of solutions addresses customer needs across the water cycle, from the delivery, measurement and use of drinking water to the collection, test and treatment of wastewater to the return of water to the environment. Our product and service offerings are organized into three reportable segments that are aligned around the critical market applications they provide: Water Infrastructure, Applied Water and Measurement & Control Solutions.
| • | Water Infrastructure serves the water infrastructure sector with pump systems that transport water from 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 also provide sales and rental of specialty dewatering pumps and related equipment and services. Additionally, our offerings use monitoring & control, smart and connected technologies to allow for remote monitoring of performance and enable products to self-optimize pump operations maximizing energy efficiency and minimizing unplanned downtime and maintenance for our customers. In the Water Infrastructure segment, we provide the majority of our sales directly to customers along with strong applications expertise, while the remaining amount is through distribution partners. |
| • | 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 and controls provide cooling to power plants and manufacturing facilities, circulation for food and beverage processing, as well as boosting systems for agricultural irrigation. In the Applied Water segment, we provide the majority of our sales through long-standing relationships with many of the leading independent distributors in the markets we serve, with the remainder going directly to customers. |
| • | Measurement & Control Solutions primarily serves the utility infrastructure solutions and services sector by delivering communications, smart metering, measurement and control technologies and critical infrastructure technologies that allow customers to more effectively use their distribution networks for the delivery, monitoring and control of critical resources such as water, electricity and natural gas. We also provide analytical instrumentation used to measure water quality, flow and level in clean water, wastewater, surface water and coastal environments. Additionally, we offer software and services including cloud-based analytics, remote monitoring and data management, leak detection, condition assessment, asset management and pressure monitoring solutions. We also offer smart lighting solutions that improve efficiency and public safety efforts across communities. In the Measurement & Control Solutions segment, we generate our sales through a combination of long-standing relationships with leading distributors and dedicated channel partners as well as direct sales depending on the regional availability of distribution channels and the type of product. |
Key Performance Indicators and Non-GAAP Measures
Management reviews key performance indicators including revenue, gross margins, segment operating income and margins, orders growth, working capital and backlog, among others. In addition, we consider certain non-GAAP (or "adjusted") 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. Excluding revenue, Xylem provides guidance only on a non-GAAP basis due to the inherent difficulty in forecasting certain amounts that would be included in GAAP earnings, such as discrete tax items, without unreasonable effort. These adjusted metrics are consistent with how management views our business and are used to make financial, operating and planning decisions. These metrics, however, are not measures of financial performance under GAAP and should not be considered a substitute for revenue, operating income, net income, earnings per share (basic and diluted) or net cash from operating activities 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 fluctuations in foreign currency translation 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 translation impacts is determined by translating current period and prior period activity using the same currency conversion rate. |
| • | "constant currency" defined as financial results adjusted for foreign 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 restructuring and realignment costs, Sensus acquisition related costs, special charges, tax-related special items and gains and losses from the sale of businesses, as applicable. A reconciliation of adjusted net income is provided below. |
| (in millions, except per share data) | 2018 | 2017 | 2016 | |||||||||
| Net income attributable to Xylem | $ | 549 | $ | 331 | $ | 260 | ||||||
| Earnings per share - diluted | $ | 3.03 | $ | 1.83 | $ | 1.45 | ||||||
| Restructuring and realignment, net of tax of $12, $13 and $13, respectively | 36 | 28 | 34 | |||||||||
| Sensus acquisition related costs, net of tax of $8 and $15, respectively | — | 14 | 38 | |||||||||
| Special charges, net of tax of $1, $4 and $7, respectively | 12 | 8 | 11 | |||||||||
| Tax-related special items | (75 | ) | 40 | 21 | ||||||||
| Loss (gain) from sale of businesses, net of tax benefit of $2 | — | 12 | — | |||||||||
| Adjusted net income | $ | 522 | $ | 433 | $ | 364 | ||||||
| Adjusted earnings per share | $ | 2.88 | $ | 2.40 | $ | 2.03 |
| ▪ | "adjusted operating expenses" and "adjusted gross profit" defined as operating expenses and gross profit, respectively, adjusted to exclude restructuring and realignment costs, Sensus acquisition related costs and special charges. |
| ▪ | "adjusted operating income" defined as operating income, adjusted to exclude "adjusted operating expenses", and "adjusted operating margin" defined as adjusted operating income divided by total revenue. |
| ▪ | “realignment costs” defined as costs not included in restructuring costs that are incurred as part of actions taken to reposition our business, including items such as professional fees, severance, relocation, travel, facility set-up and other costs. |
| ▪ | "Sensus acquisition related costs" defined as costs incurred by the Company associated with the acquisition of Sensus that are being reported within operating income. These costs include integration costs, acquisition |
costs, costs related to the recognition of the backlog intangible asset amortization recorded in purchase accounting.
| ▪ | “special charges" defined as costs incurred by the Company, such as acquisition and integration related costs not included in "Sensus acquisition related costs", non-cash impairment charges, due diligence costs and other special non-operating items. |
| ▪ | "tax-related special items" defined as tax items, such as tax return versus tax provision adjustments, tax exam impacts, tax law change impacts, significant reserves for cash repatriation, excess tax benefits/losses and other discrete tax adjustments. |
| ▪ | "free cash flow" defined as net cash from operating activities less capital expenditures. Free cash flow is further adjusted for other significant items that impact current results which 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) | 2018 | 2017 | 2016 | |||||||||
| Net cash provided by operating activities | $ | 586 | $ | 686 | $ | 497 | ||||||
| Capital expenditures | (237 | ) | (170 | ) | (124 | ) | ||||||
| Free cash flow | $ | 349 | $ | 516 | $ | 373 | ||||||
| Cash paid for Sensus acquisition related costs | 1 | 28 | 13 | |||||||||
| Free cash flow, excluding Sensus acquisition related costs | $ | 350 | $ | 544 | $ | 386 |
| ▪ | “EBITDA” defined as earnings before interest, taxes, depreciation and amortization expense and "Adjusted EBITDA" reflects the adjustment to EBITDA to exclude share-based compensation, restructuring and realignment costs, Sensus acquisition related costs, special charges and gain or loss from sale of businesses. |
| (in millions) | 2018 | 2017 | 2016 | |||||||||
| Net Income | $ | 549 | $ | 330 | $ | 260 | ||||||
| Income tax expense | 36 | 136 | 80 | |||||||||
| Interest expense (Income), net | 78 | 79 | 68 | |||||||||
| Depreciation | 117 | 109 | 87 | |||||||||
| Amortization | 144 | 125 | 64 | |||||||||
| EBITDA | $ | 924 | $ | 779 | $ | 559 | ||||||
| Share-based compensation | 30 | 21 | 18 | |||||||||
| Restructuring and realignment | 47 | 41 | 47 | |||||||||
| Sensus acquisition related costs | — | 14 | 46 | |||||||||
| Special charges | 12 | 13 | 5 | |||||||||
| Loss (gain) from sale of business | — | 10 | — | |||||||||
| Adjusted EBITDA | $ | 1,013 | $ | 878 | $ | 675 |
Executive Summary
Xylem reported revenue of $5,207 million for 2018, an increase of $500 million, or 10.6%, from $4,707 million reported in 2017. On a constant currency basis, revenue increased by $477 million, or 10.1%, primarily consisting of organic revenue growth of $390 million, or 8.3%, driven by growth in all end markets, as well as across all major geographic regions. Acquisition revenue of $111 million also contributed to the increase, partially offset by revenue related to divestitures of $24 million.
Operating income for 2018 was $654 million, reflecting an increase of $102 million, or 18.5%, compared to $552 million in 2017. Operating margin was 12.6% for 2018 versus 11.7% for 2017, an increase of 90 basis points. The increase in operating income and margin included favorable impacts from decreased Sensus acquisition related costs of $22 million, partially offset by an increase in restructuring and realignment costs of $7 million and increased special charges of $1 million. Excluding the impact of these items, adjusted operating income was $714 million, with an adjusted operating margin of 13.7% in 2018 as compared to adjusted operating income of $626 million with an adjusted operating margin of 13.3% in 2017. The increase in adjusted operating margin was primarily due to cost reductions from our global procurement and productivity initiatives, favorable volume impacts and price realization, which were partially offset by cost inflation, increased spending on strategic investments and unfavorable mix. Purchase accounting and currency impacts also negatively affected operating margin.
Additional financial highlights for 2018 include the following:
| • | Net income attributable to Xylem of $549 million, or $3.03 per diluted share ($522 million or $2.88 per diluted share on an adjusted basis, up 20.6% from 2017) |
| • | Cash from operating activities of $586 million, and free cash flow, excluding Sensus acquisition related costs, of $350 million down 35.7% from 2017 |
| • | Orders of $5,437 million, up 11.7% from $4,868 million in 2017 (up 9.3% on an organic basis) |
| • | Dividends paid to shareholders increased 17% in 2018. |
2019 Business Outlook
We anticipate total revenue growth in the range of 2% to 4% in 2019, with organic revenue growth anticipated to be in the range of 4% to 6%. The following is a summary of our 2018 organic revenue performance and 2019 organic revenue outlook by end market.
| • | Utilities increased approximately 10% for 2018 on an organic basis driven by strength across all regions globally, particularly in North America and Asia Pacific. For 2019, we expect organic growth in the mid-single-digit range driven by healthy water and wastewater spending in the U.S., smart meter and infrastructure analytics growth opportunities and mixed but stable low-single-digit growth in Europe. We also anticipate a healthy infrastructure investment focus in the emerging markets will continue in China and India. |
| • | Industrial increased by roughly 6% for 2018 on an organic basis driven by strength in North America, western Europe and Latin America, partially offset by weakness in Asia Pacific. For 2019, we expect organic growth in the low to mid-single-digits driven by continued solid industrial conditions in the U.S. as the oil and gas markets begin to stabilize after a strong 2018. We also anticipate mixed emerging market conditions with strength in India and Latin America, offset by softness in the Middle East and slowing growth in China. |
| • | In the commercial markets, organic growth was approximately 11% for 2018 primarily driven by strength in the United States and Asia Pacific. For 2019, we expect organic growth in the low to mid-single-digit range as the overall market will begin to moderate after two years of strong performance. Organic growth will be driven by continued strength in the U.S., especially during the first half of the year, and the emerging markets led by initiatives in the China and India building markets. |
| • | In residential markets, organic growth was approximately 2% in 2018 primarily driven by strength in western Europe which was partially offset by weakness in Asia Pacific. For 2019, we expect low-single-digit growth primarily driven by continued competition in the U.S. replacement market as the housing market begins to stabilize. We also anticipate stability in Europe and modest growth opportunities in China and other Asia Pacific countries for secondary clean water sources. |
We will continue to strategically execute restructuring and realignment actions primarily to reposition our European and North American businesses in an effort to optimize our cost structure and improve our operational efficiency and effectiveness. During 2018, we incurred $20 million and $28 million in restructuring and realignment costs,
respectively. We realized approximately $13 million of incremental net savings in 2018 from actions initiated in 2017, and an additional $3 million of net savings from our 2018 actions. As a result of our 2017 and 2018 actions we expect to realize approximately $8 million of incremental net savings in 2019 and beyond. During 2019, we currently expect to incur approximately $30 million in restructuring and realignment costs.
We plan to continue to take actions and focus spending in 2019 on actions that allow us to make progress on our top strategic priorities. The priority of accelerating profitable growth encompasses our initiatives to drive commercial excellence, grow in emerging markets and strengthen innovation and technology through creation of new centers of excellence, a streamlined approach to product development and strategic acquisitions. The priority of driving continuous improvement is an area where we will continue to work to create new opportunities to unlock savings by eliminating waste and increasing efficiencies, which is supported by efforts to expand and further deepen our talent pool. We plan to continue to deploy capital in smart, disciplined ways to develop and acquire solutions to address our customers’ challenges. Finally, we continue to work to improve cash performance and generate capital to return to our shareholders.
Results of Operations
| (in millions) | 2018 | 2017 | 2016 | 2018 v. 2017 | 2017 v. 2016 | |||||||||||||
| Revenue | $ | 5,207 | $ | 4,707 | $ | 3,771 | 10.6 | % | 24.8 | % | ||||||||
| Gross profit | 2,026 | 1,847 | 1,462 | 9.7 | % | 26.3 | % | |||||||||||
| Gross margin | 38.9 | % | 39.2 | % | 38.8 | % | (30 | )bp | 40 | bp | ||||||||
| Restructuring and realignment costs | 5 | 3 | 3 | 66.7 | % | — | % | |||||||||||
| Sensus acquisition related charges | — | 8 | 26 | NM | (69.2 | )% | ||||||||||||
| Adjusted gross profit | 2,031 | 1,858 | 1,491 | 9.3 | % | 24.6 | % | |||||||||||
| Adjusted gross margin | 39.0 | % | 39.5 | % | 39.5 | % | (50 | )bp | — | |||||||||
| Total operating expenses | 1,372 | 1,295 | 1,054 | 5.9 | % | 22.9 | % | |||||||||||
| Expense to revenue ratio | 26.3 | % | 27.5 | % | 28.0 | % | (120 | )bp | (50 | )bp | ||||||||
| Restructuring and realignment costs | (43 | ) | (38 | ) | (44 | ) | 13.2 | % | (13.6 | )% | ||||||||
| Sensus acquisition related charges | — | (14 | ) | (27 | ) | NM | (48.1 | )% | ||||||||||
| Special charges | (12 | ) | (11 | ) | (5 | ) | 9.1 | % | 120.0 | % | ||||||||
| Adjusted operating expenses | 1,317 | 1,232 | 978 | 6.9 | % | 26.0 | % | |||||||||||
| Adjusted operating expense to revenue ratio | 25.3 | % | 26.2 | % | 25.9 | % | (90 | )bp | 30 | bp | ||||||||
| Operating income | 654 | 552 | 408 | 18.5 | % | 35.3 | % | |||||||||||
| Operating margin | 12.6 | % | 11.7 | % | 10.8 | % | 90 | bp | 90 | bp | ||||||||
| Interest and other non-operating expense (income), net | 69 | 76 | 68 | (9.2 | )% | 11.8 | % | |||||||||||
| (Loss)/gain from sale of businesses | — | (10 | ) | — | NM | NM | ||||||||||||
| Income tax expense | 36 | 136 | 80 | (73.5 | )% | 70.0 | % | |||||||||||
| Tax rate | 6.1 | % | 29.2 | % | 23.5 | % | (2,310 | )bp | 570 | bp | ||||||||
| Net income | $ | 549 | $ | 330 | $ | 260 | 66.4 | % | 26.9 | % |
NM Not Meaningful
2018 versus 2017
Revenue
Revenue generated for 2018 was $5,207 million, an increase of $500 million, or 10.6%, compared to $4,707 million in 2017. On a constant currency basis, revenue grew 10.1% during 2018. This increase in revenue at constant currency was primarily driven by an increase in organic revenue of $390 million reflecting strong organic growth across all major regions, with the vast majority of growth coming from North America, the emerging markets, particularly in China and Latin America, as well as in western Europe. Acquisition revenue of $111 million also contributed to the increase, partially offset by a reduction in revenue related to divestitures of $24 million during the period.
The following table illustrates the impact on 2018 revenue from organic growth, recent acquisitions and divestitures, and foreign currency translation in relation to revenue:
| Water Infrastructure | Applied Water | Measurement & Control Solutions | Total Xylem | ||||||||||||||||||||
| (in millions) | $ Change | % Change | $ Change | % Change | $ Change | % Change | $ Change | % Change | |||||||||||||||
| 2017 Revenue | $ | 2,004 | $ | 1,421 | $ | 1,282 | $ | 4,707 | |||||||||||||||
| Organic Growth | 176 | 8.8 | % | 113 | 8.0 | % | 101 | 7.9 | % | 390 | 8.3 | % | |||||||||||
| Acquisitions/(Divestitures) | — | — | % | (10 | ) | (0.7 | )% | 97 | 7.6 | % | 87 | 1.8 | % | ||||||||||
| Constant Currency | 176 | 8.8 | % | 103 | 7.2 | % | 198 | 15.4 | % | 477 | 10.1 | % | |||||||||||
| Foreign currency translation (a) | (4 | ) | (0.2 | )% | 10 | 0.7 | % | 17 | 1.3 | % | 23 | 0.5 | % | ||||||||||
| Total change in revenue | 172 | 8.6 | % | 113 | 8.0 | % | 215 | 16.8 | % | 500 | 10.6 | % | |||||||||||
| 2018 Revenue | $ | 2,176 | $ | 1,534 | $ | 1,497 | $ | 5,207 |
| (a) | Foreign currency translation impact for the year primarily due to strength in the value of the Euro, British Pound, Chinese Yuan and various other currencies against the U.S. Dollar. This impact was partially offset by the weakening in value of the Argentine Peso, Indian Rupee, Swedish Krona and Australian dollar against the U.S. Dollar. |
Water Infrastructure
Water Infrastructure’s revenue increased $172 million, or 8.6%, in 2018 (8.8% increase on a constant currency basis) compared to 2017. Revenue was negatively impacted by $4 million of foreign currency translation, with the change at constant currency coming entirely from organic growth during the year of $176 million, or 8.8%. Organic growth for the year was driven by strength in the utility end market across all geographic regions, with particularly strong growth coming from the emerging markets, especially China, as well as from the United States. Organic growth during the year was also driven by strength in the industrial end market, primarily in North America and Europe, while emerging market industrial strength in Latin America was partially offset by declines in Asia Pacific due to the lapping of a large ozone project delivery in China last year.
From an application perspective, organic revenue growth for the year was largely attributable to our transport application. The transport application grew due to strength across all geographic regions. Growth in North America was driven by modest share gains and continued focus by utility customers on improving infrastructure, as well as strong dewatering rental sales and oil and gas growth. Project deliveries in western Europe and product localization in China also contributed to the transport application growth during the period with China having 35.6% organic growth for the year. Organic revenue from our treatment application also contributed significantly to the segment's growth across all regions, particularly from strong utility project deliveries in China, with 42.1% growth for the year.
Applied Water
Applied Water’s revenue increased $113 million, or 8.0%, in 2018, with revenue benefiting from $10 million of foreign currency translation during the year. The revenue growth at constant currency was $103 million, or 7.2%, and consisted of organic growth of $113 million, or 8.0%, partially offset by $10 million of reduction in revenue related to divestitures. Organic growth for the year was driven primarily by strength in the commercial and industrial end markets, primarily in the United States and Asia Pacific, as well as modest growth in the residential end market.
From an application perspective, commercial building services revenue was primarily driven by distributor strength and commercial building construction growth, coupled with price realization, in the United States and project deployments in China and India. Organic revenue growth in the industrial water application was driven primarily by recovery in large project business and healthy general industrial demand in the United States, as well as strong strength in the emerging markets, particularly China and Latin America. Residential building services also had modest organic growth, primarily from strength in western Europe, partially offset by declines in Asia Pacific.
Measurement & Control Solutions
Measurement & Control Solutions revenue increased $215 million, or 16.8%, in 2018 (15.4% increase on a constant currency basis), with revenue benefiting from $17 million of foreign currency translation during the year. Revenue growth at constant currency consisted of revenue contributed by acquisitions of $111 million and organic revenue growth of $101 million, or 7.9%, which was partially offset by $14 million of reduction in revenue related to divestitures during the year. Organic revenue growth for the year was primarily driven by strength in the utility end market in North America.
From an application perspective, organic revenue from the gas application contributed the most organic growth for the segment, driven entirely by large project deployments in North America. The water application also drove organic growth, with large project deployments and increased water shipments in the Unites States and Asia Pacific, partially offset by declines in Europe. Software as a service & other also had significant growth from large deployments in the United States and the United Kingdom. Additional organic revenue growth came from the test application, which saw growth in both the utility and industrial end markets, primarily in western Europe and the United States, partially offset by declines in the emerging markets. The electric application also had modest organic growth in North America during the year.
Orders/Backlog
| Water Infrastructure | Applied Water | Measurement & Control Solutions | Total Xylem | ||||||||||||||||||||
| (in millions) | $ Change | % Change | $ Change | % Change | $ Change | % Change | $ Change | % Change | |||||||||||||||
| 2017 Orders | $ | 2,112 | $ | 1,476 | $ | 1,280 | $ | 4,868 | |||||||||||||||
| Organic Growth | 140 | 6.6 | % | 83 | 5.6 | % | 231 | 18.0 | % | 454 | 9.3 | % | |||||||||||
| Acquisitions/(Divestitures) | — | — | % | (12 | ) | (0.8 | )% | 100 | 7.8 | % | 88 | 1.8 | % | ||||||||||
| Constant Currency | 140 | 6.6 | % | 71 | 4.8 | % | 331 | 25.9 | % | 542 | 11.1 | % | |||||||||||
| Foreign currency translation (a) | 3 | 0.1 | % | 10 | 0.7 | % | 14 | 1.1 | % | 27 | 0.6 | % | |||||||||||
| Total change in revenue | 143 | 6.8 | % | 81 | 5.5 | % | 345 | 27.0 | % | 569 | 11.7 | % | |||||||||||
| 2018 Orders | $ | 2,255 | $ | 1,557 | $ | 1,625 | $ | 5,437 |
| (a) | Foreign currency translation impact for the year primarily due to strength in the value of the Euro, British Pound, Chinese Yuan and various other currencies against the U.S. Dollar. This impact was partially offset by the weakening in value of the Argentine Peso, Indian Rupee, Swedish Krona and Australian dollar against the U.S. Dollar. |
Orders received during 2018 increased by $569 million, or 11.7%, to $5,437 million (11.1% increase on a constant currency basis). Order growth was favorably impacted by $27 million of foreign currency translation during the year. The order increase on a constant currency basis included organic order growth of $454 million, or 9.3%, over the prior year. Orders from acquisitions of $115 million also contributed to the growth at constant currency, partially offset by a reduction in orders related to divestitures of $27 million during the year.
Water Infrastructure segment orders increased $143 million, or 6.8%, to $2,255 million (6.6% increase on a constant currency basis). Orders growth for the segment benefited from $3 million of foreign currency translation for the year. The order increase on a constant currency basis consisted entirely of an increase in organic orders. Organic orders grew in both of the segment applications. The treatment application had very strong order intake, driven by orders in China, the United States and India. Transport order growth was driven by increased strength in North America, primarily from dewatering rental and equipment orders along with overall strong market conditions, and order strength in Europe. Transport order growth during the year was partially offset by custom pump project timing in India.
Orders increased in our Applied Water segment by $81 million, or 5.5%, to $1,557 million (4.8% increase on a constant currency basis). Orders growth for the segment benefited from $10 million of foreign currency translation for the year. The order increase on a constant currency basis included organic order growth of $83 million, or 5.6%, driven by strong commercial and industrial performance in the United States, as well as modest strength in Europe and the emerging markets, partially offset by the reduction in orders from divestitures of $12 million.
Orders increased in our Measurement & Control Solutions segment by $345 million, or 27.0%, to $1,625 million (25.9% increase on a constant currency basis). Orders growth for the segment benefited from $14 million of foreign currency translation for the year. The order increase on a constant currency basis included orders from recent acquisitions of $115 million, partially offset by the reduction of orders from divestitures of $15 million, and organic order growth of $231 million, or 18.0%. Organic order growth primarily driven by orders within the water application in North America and a large order in India. The gas and software as a service & other applications also had strong organic order growth in North America as well as Asia Pacific, while electric orders were only slightly up for the year.
Backlog includes contractual customer commitments as well as orders on hand as of the end of the period. Delivery schedules vary from customer to customer based upon their requirements. Annual or multi-year contracts are subject to rescheduling and cancellation by customers due to the long-term nature of the contracts. As such, beginning total backlog, plus orders, minus revenues will not equal ending total backlog due to contract adjustments, foreign currency fluctuations and other factors. Typically, large projects require longer lead production cycles and deployment schedules, and delays can occur from time to time. Total backlog was $1,689 million at December 31, 2018 and $1,513 million at December 31, 2017, an increase of 11.6%. This year over year increase in backlog of $176 million includes approximately $42 million of backlog from 2018 acquisitions. We anticipate that approximately 65% of our total backlog at December 31, 2018 will be recognized as revenue during 2019.
Gross Margin
Gross margins as a percentage of consolidated revenue decreased 30 basis points to 38.9% in 2018 as compared to 39.2% in 2017. The gross margin decrease was primarily driven by the negative impact of cost inflation, unfavorable mix, increased amortization of external sale software, net negative currency impacts and purchase accounting impacts. These unfavorable impacts were partially offset by cost reductions from global procurement and productivity improvement initiatives, price realization, and reductions in Sensus acquisition related costs and realignment costs.
Operating Expenses
| (in millions) | 2018 | 2017 | Change | |||||||
| Selling, general and administrative expenses ("SG&A") | $ | 1,161 | $ | 1,089 | 6.6 | % | ||||
| SG&A as a % of revenue | 22.3 | % | 23.1 | % | (80 | )bp | ||||
| Research and development expenses ("R&D") | 189 | 181 | 4.4 | % | ||||||
| R&D as a % of revenue | 3.6 | % | 3.8 | % | (20 | )bp | ||||
| Restructuring and asset impairment charges | 22 | 25 | (12.0 | )% | ||||||
| Operating expenses | $ | 1,372 | $ | 1,295 | 5.9 | % | ||||
| Expense to revenue ratio | 26.3 | % | 27.5 | % | (120 | )bp |
Selling, General and Administrative Expenses
SG&A increased by $72 million (increase of 6.6%) to 22.3% of revenue in 2018, as compared to 23.1% of revenue in 2017. The improvement in SG&A as a percent of revenue for the year was primarily driven by favorable volume impacts, partially offset by the absence of Sensus acquisition related charges that did not recur in 2018. Additional SG&A from recent acquisitions also added to the increase in SG&A expenses as compared to the prior year.
Research and Development Expenses
R&D spending was $189 million, or 3.6% of revenue, in 2018 as compared to $181 million, or 3.8% of revenue, in 2017. Additionally, we capitalized R&D on external sale software of $60 million in 2018 as compared to $46 million in 2017. Our increased spending on R&D is driven by our continued commitment to innovation and technology development.
Restructuring Charges and Asset Impairment
Restructuring Charges
During 2018, we incurred restructuring costs of $9 million, $2 million and $9 million in our Water Infrastructure, Applied Water and Measurement & Control Solutions segments, respectively. We incurred these charges related to actions taken in 2018 primarily as a continuation of our efforts to reposition our European and North American businesses to optimize our cost structure and improve our operational efficiency and effectiveness. The charges included the reduction of headcount and consolidation of facilities within our Measurement & Control Solutions and Water Infrastructure segments, as well as headcount reductions within our Applied Water segment.
During 2017, we recognized restructuring costs of $7 million, $8 million and $5 million in our Water Infrastructure, Applied Water and Measurement & Control Solutions, 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 included the reduction of headcount and consolidation of facilities within our Applied Water and Water Infrastructure segments, as well as headcount reductions within our Measurement & Control Solutions segment.
The following table presents expected restructuring spend:
| (in millions) | Water Infrastructure | Applied Water | Measurement & Control Solutions | Corporate | Total | |||||||||||||||
| Actions Commenced in 2018: | ||||||||||||||||||||
| Total expected costs | $ | 9 | $ | 1 | $ | 7 | $ | — | $ | 17 | ||||||||||
| Costs incurred during 2018 | 7 | 1 | 7 | — | 15 | |||||||||||||||
| Total expected costs remaining | $ | 2 | $ | — | $ | — | $ | — | $ | 2 | ||||||||||
| Actions Commenced in 2017: | ||||||||||||||||||||
| Total expected costs | $ | 18 | $ | 12 | $ | 3 | $ | — | $ | 33 | ||||||||||
| Costs incurred during 2017 | 5 | 4 | 2 | — | 11 | |||||||||||||||
| Costs incurred during 2018 | 2 | 1 | 1 | — | 4 | |||||||||||||||
| Total expected costs remaining | $ | 11 | $ | 7 | $ | — | $ | — | $ | 18 | ||||||||||
| Actions Commenced in 2016: | ||||||||||||||||||||
| Total expected costs | $ | 13 | $ | 14 | $ | 10 | $ | 2 | $ | 39 | ||||||||||
| Costs incurred during 2016 | 11 | 10 | 6 | 2 | 29 | |||||||||||||||
| Costs incurred during 2017 | 2 | 4 | 3 | — | 9 | |||||||||||||||
| Costs incurred during 2018 | — | — | 1 | — | 1 | |||||||||||||||
| Total expected costs remaining | $ | — | $ | — | $ | — | $ | — | $ | — |
The Water Infrastructure, Applied Water, and Measurement & Control Solutions actions commenced in 2018 consist primarily of severance charges and are expected to continue through the third quarter of 2019. The Water Infrastructure, Applied Water, and Measurement & Control Solutions actions commenced in 2017 consist primarily of severance charges and are expected to continue through the second quarter of 2020. The Water Infrastructure, Applied Water, Measurement & Control Solutions and Corporate actions commenced in 2016 consist primarily of severance charges and are complete. As a result of the actions initiated in 2018, we achieved savings of approximately $2 million in 2018 and estimate annual future net savings beginning in 2019 of approximately $7 million, resulting in $5 million of incremental savings from the 2018 actions.
Asset Impairment Charges
During the fourth quarter of 2018 we determined that certain software assets within our Water Infrastructure segment were impaired. Accordingly we recognized an impairment charge of $2 million.
During the first quarter of 2017 we determined that certain assets within our Applied Water segment, including a tradename, were impaired. Accordingly we recognized an impairment charge of $5 million. Refer to Note 11, "Goodwill and Other Intangible Assets," for additional information.
Operating Income
We generated operating income of $654 million (operating margin of 12.6%) for 2018, reflecting an increase of $102 million, or 18.5%, when compared to operating income of $552 million (operating margin of 11.7%) during the prior year. The increase in operating margin was primarily due to cost reductions resulting from our global procurement and productivity initiatives, favorable volume impacts and price realization and a decrease in Sensus acquisition related costs. These favorable impacts on operating margin were partially offset by cost inflation increases, increased spending on strategic investments, unfavorable mix, an increase in restructuring and realignment costs and an increase in special charges. Purchase accounting impacts also negatively affected operating margin.
Adjusted operating income was $714 million (adjusted operating margin of 13.7%) for 2018, reflecting an increase of $88 million, or 14.1%, when compared to adjusted operating income of $626 million (adjusted operating margin of 13.3%) during the prior year. The increase in adjusted operating margin was mostly due to the same factors impacting operating income, except for the decrease in Sensus acquisition related costs, the increase in restructuring and realignment costs and the increase in special charges as these costs were not included in adjusted operating income.
The table below provides a reconciliation of total and each segment's operating income to adjusted operating income, and a calculation of the corresponding adjusted operating margin:
| (In millions) | 2018 | 2017 | Change | ||||||||
| Water Infrastructure | |||||||||||
| Operating income | $ | 359 | $ | 312 | 15.1 | % | |||||
| Operating margin | 16.5 | % | 15.6 | % | 90 | bp | |||||
| Restructuring and realignment costs | 20 | 16 | 25.0 | % | |||||||
| Special charges | 2 | — | NM | ||||||||
| Adjusted operating income | $ | 381 | $ | 328 | 16.2 | % | |||||
| Adjusted operating margin | 17.5 | % | 16.4 | % | 110 | bp | |||||
| Applied Water | |||||||||||
| Operating income | $ | 236 | $ | 194 | 21.6 | % | |||||
| Operating margin | 15.4 | % | 13.7 | % | 170 | bp | |||||
| Restructuring and realignment costs | 10 | 17 | (41.2 | ) | % | ||||||
| Special charges | — | 5 | (100.0 | ) | % | ||||||
| Adjusted operating income | $ | 246 | $ | 216 | 13.9 | % | |||||
| Adjusted operating margin | 16.0 | % | 15.2 | % | 80 | bp | |||||
| Measurement & Control Solutions | |||||||||||
| Operating income | $ | 118 | $ | 110 | 7.3 | % | |||||
| Operating margin | 7.9 | % | 8.6 | % | (70 | ) | bp | ||||
| Sensus acquisition related costs | — | 15 | (100.0 | ) | % | ||||||
| Restructuring and realignment costs | 18 | 8 | 125.0 | % | |||||||
| Special charges | 5 | — | NM | ||||||||
| Adjusted operating income | $ | 141 | $ | 133 | 6.0 | % | |||||
| Adjusted operating margin | 9.4 | % | 10.4 | % | (100 | ) | bp | ||||
| Corporate and other | |||||||||||
| Operating loss | $ | (59 | ) | $ | (64 | ) | (7.8 | ) | % | ||
| Sensus acquisition related costs | — | 7 | (100.0 | ) | % | ||||||
| Special charges | 5 | 6 | (16.7 | ) | % | ||||||
| Adjusted operating loss | $ | (54 | ) | $ | (51 | ) | 5.9 | % | |||
| Total Xylem | |||||||||||
| Operating income | $ | 654 | $ | 552 | 18.5 | % | |||||
| Operating margin | 12.6 | % | 11.7 | % | 90 | bp | |||||
| Restructuring and realignment costs | 48 | 41 | 17.1 | % | |||||||
| Sensus acquisition related costs | — | 22 | (100.0 | ) | % | ||||||
| Special charges | 12 | 11 | 9.1 | % | |||||||
| Adjusted operating income | $ | 714 | $ | 626 | 14.1 | % | |||||
| Adjusted operating margin | 13.7 | % | 13.3 | % | 40 | bp |
NM Not Meaningful
Water Infrastructure
Operating income for our Water Infrastructure segment increased $47 million, or 15.1%, with operating margin also increasing from 15.6% to 16.5%, a 90 basis point increase as compared to the prior year. Operating margin was negatively impacted year over year by increased restructuring and realignment costs of $4 million and special charges of $2 million incurred in 2018. Excluding these items, adjusted operating income increased $53 million, or 16.2%, with adjusted operating margin increasing from 16.4% to 17.5%, a 110 basis point increase as compared to the prior year. The increase in adjusted operating margin was primarily due to cost reductions from our global procurement and productivity initiatives, favorable volume and price realization, which were partially offset by cost inflation, unfavorable mix, increased spending on strategic investments and negative currency impacts.
Applied Water
Operating income for our Applied Water segment increased $42 million, or 21.6%, with operating margin also increasing from 13.7% to 15.4%, a 170 basis point increase as compared to the prior year. Operating margin was positively impacted by special charges of $5 million incurred in 2017 that did not recur and decreased restructuring and realignment costs of $7 million in 2018. Excluding these items, adjusted operating income increased $30 million, or 13.9%, with adjusted operating margin increasing from 15.2% to 16.0%, an 80 basis point increase as compared to the prior year. The increase in adjusted operating margin was primarily due to cost reductions from our global procurement and productivity initiatives, favorable volume and price realization, which were partially offset by cost inflation, negative transactional currency impacts and unfavorable mix.
Measurement & Control Solutions
Operating income for our Measurement & Control Solutions segment increased $8 million, or 7.3%, with operating margin decreasing from 8.6% to 7.9%, a 70 basis point decrease as compared to the prior year. Operating margin was negatively impacted by an increase of $10 million in restructuring and realignment costs and $5 million in special charges incurred in 2018. This impact was offset by $15 million of Sensus acquisition related costs incurred during the year in 2017 that did not recur. Excluding these items, adjusted operating income increased $8 million, or 6.0%, with adjusted operating margin decreasing from 10.4% to 9.4%, a 100 basis point decrease as compared to the prior year. The decrease in adjusted operating margin was primarily due to increases in cost inflation, spending on strategic investments and unfavorable mix impacts due to large energy project deployments. Purchase accounting impacts also negatively affected operating margin. These impacts were partially offset by favorable volume and price realization and cost reductions from our global procurement and productivity initiatives.
Corporate and other
Operating expense for corporate and other decreased $5 million, or 7.8%, compared to the prior year, primarily due to a reduction of Sensus acquisition related costs and special charges. Excluding these costs, adjusted operating expense increased $3 million, or 5.9%, compared to the prior year, mostly driven by an increase in employee related, non-cash share-based compensation costs.
Interest Expense
Interest expense remained constant at $82 million for both 2018 and 2017. See Note 14, "Credit Facilities and Debt" of our consolidated financial statements for a description of our credit facilities and long-term debt and related interest.
Income Tax Expense
Tax Act
On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act makes broad and complex changes to the U.S. tax code. As noted at 2017 year end, we reasonably estimated certain effects and, therefore, as permitted by SAB 118, recorded provisional estimates associated with the reduction of U.S. federal corporate tax rate and deemed repatriation transition tax. Our accounting for the reduction of U.S. federal corporate tax rate is complete. We recorded a provisional tax benefit for corporate tax rate reduction of $107 million as of December 31, 2017. Upon further analysis of our deferred tax assets and liabilities, we recognized a measurement-period adjustment of $1.5 million as an additional decrease of the net deferred tax liabilities and recorded a corresponding deferred tax benefit of $1.5 million during the period ended December 31, 2018. The effect of this measurement period adjustment on the 2018 effective tax rate was about 0.3%. A total decrease of the net deferred tax liabilities of $108 million has been recorded for the corporate rate reduction, with a corresponding deferred tax benefit of $108 million.
Our accounting for the Deemed Repatriation Transition Tax ("Transition Tax") is complete. We made an estimate of the Transition Tax and recorded a provisional Transition Tax liability of $153 million as of December 31, 2017. On the basis of revised E&P computations that were completed and additional guidance, we recognized a measurement-period adjustment of a $9 million decrease to the income tax expense in 2018. The effect of the measurement-period adjustment on the 2018 effective tax rate was approximately 1.6%. A total Transition Tax obligation to date of $144 million has been recorded, with a corresponding adjustment of $144 million to income tax expense.
The income tax provision for 2018 was $36 million at an effective tax rate of 6.1% compared to $136 million at an effective tax rate of 29.2% in 2017. The 2018 effective tax rate is lower than 2017 primarily due to the impact of an intercompany sale of assets, the reduction of the Transition Tax and the reduction of the U.S. federal corporate rate in 2018, partially offset by the 2017 benefit from the remeasurement of deferred tax assets and liabilities.
See Note 7, "Income Taxes" of our consolidated financial statements for further discussion of the Tax Act.
Other Comprehensive (Loss) Income
Other comprehensive loss was $111 million in 2018 as compared to income of $108 million in 2017. This decrease was primarily driven by unfavorable foreign currency translation impacts due to the weakening of the Euro, Great British Pound, Canadian Dollar, South African rand, Polish Zloty, Swedish Krona, amongst other various currencies, against the U.S. Dollar in the current year versus strengthening for the same period in the prior year. These decreases were partially offset by the favorable impact from movement in our Euro net investment hedges. The tax impact on the movement in the net investment hedges also contributed to the year over year decrease.
2017 versus 2016
Revenue
Revenue generated for 2017 was $4,707 million, an increase of $936 million, or 24.8%, compared to $3,771 million in 2016. On a constant currency basis, revenue grew 23.9%. This increase in revenue was primarily driven by additional revenue of $790 million from acquisitions. There was also strong organic growth of $122 million during the year, driven primarily by North America as well as strength in the emerging markets, particularly in China and India. Additionally, to a lesser extent, Europe contributed to this organic growth despite ongoing weakness in the United Kingdom during the year.
The following table illustrates the impact on 2017 revenue from organic growth, recent acquisitions and divestitures, and foreign currency translation in relation to revenue.
| Water Infrastructure | Applied Water | Measurement & Control Solutions | Total Xylem | ||||||||||||||||||||
| (in millions) | $ Change | % Change | $ Change | % Change | $ Change | % Change | $ Change | % Change | |||||||||||||||
| 2016 Revenue | $ | 1,932 | $ | 1,393 | $ | 446 | $ | 3,771 | |||||||||||||||
| Organic Growth | 56 | 2.9 | % | 34 | 2.4 | % | 32 | 7.2 | % | 122 | 3.2 | % | |||||||||||
| Acquisitions/(Divestitures) | — | — | % | (10 | ) | (0.7 | )% | 790 | 177.1 | % | 780 | 20.7 | % | ||||||||||
| Constant Currency | 56 | 2.9 | % | 24 | 1.7 | % | 822 | 184.3 | % | 902 | 23.9 | % | |||||||||||
| Foreign currency translation (a) | 16 | 0.8 | % | 4 | 0.3 | % | 14 | 3.1 | % | 34 | 0.9 | % | |||||||||||
| Total change in revenue | 72 | 3.7 | % | 28 | 2.0 | % | 836 | 187.4 | % | 936 | 24.8 | % | |||||||||||
| 2017 Revenue | $ | 2,004 | $ | 1,421 | $ | 1,282 | $ | 4,707 |
| (a) | Foreign currency translation impact primarily due to strength in the value of the Euro, Canadian dollar, Russian Ruble, Australian dollar, South African Rand and various other currencies, partially offset by weakness in the British Pound against the U.S. Dollar. |
Water Infrastructure
Water Infrastructure’s revenue increased $72 million, or 3.7%, in 2017 (2.9% increase on a constant currency basis) compared to 2016. Revenue benefited from $16 million of foreign currency translation for the year and included organic growth of $56 million, or 2.9%.
Organic growth for the year was driven by strength in the industrial end market, and to a lesser extent in the utility end market. The growth in both of these end markets was driven by strength from Asia Pacific and North America.
From an application perspective, organic revenue growth was driven primarily by our transport application. The transport application grew in the industrial end market due to strength in the dewatering business which benefited from the recovery of the industrial construction market, particularly within the distribution channel and recovery of oil and gas and mining markets in North America and Latin America. The transport application also grew in the utility end market driven by increased municipal spending in North America and increased projects in the Middle East and India. Organic revenue from our treatment application also contributed to the segment's growth primarily from growth in China from industrial treatment project deliveries as well as growth in Europe from municipal treatment projects.
Applied Water
Applied Water’s revenue increased $28 million, or 2.0%, in 2017 (1.7% increase on a constant currency basis) compared to 2016. Revenue benefited from $4 million of foreign currency translation for the year and the constant currency increase included organic growth of $34 million, or 2.4%.
Organic growth for the year was driven by strength in the residential and commercial end markets in the United States, Asia Pacific and western Europe, which were partially offset by declines in the industrial market.
From an application perspective, growth in residential building services was primarily driven by strength in the United States, where we benefited from the timing of promotions and market share gains, and continued strength in Asia Pacific. Commercial building services also grew, primarily in North America, western Europe and Asia Pacific, driven by new product traction and sales channel investments. This growth was partially offset by a decline in industrial applications, primarily driven by unfavorable weather conditions impacting the agriculture business in the United States, partially offset by strength in western Europe.
Measurement & Control Solutions
Measurement & Control Solutions revenue increased $836 million, or 187.4%, in 2017 (184.3% on a constant currency basis) compared to 2016. The revenue increase for the year was almost entirely from $790 million of revenue related to acquisitions that we did not have in the prior year. Most of the additional revenue contributed by the Sensus business was generated in the United States with additional revenue coming primarily from western Europe and China. The majority of the Sensus business revenue came from water applications with gas and electric applications making up most of the remaining sales for the year. Organic revenue growth in the Measurement & Control Solutions segment was $32 million, or 7.2%, for the year. Organic growth was driven primarily by growth across all applications, except electric which had slight declines. Much of the organic revenue increase was in the water application, which had increased AMI deployments in North America as well as higher demand for iPerl product in eastern Europe and the Middle East. Organic revenue also increased in the gas application, primarily due to AMI deployments in North America, as well as in the software and services application, primarily driven by a couple of major contract upgrades. The test application also contributed to the increase in organic revenue as a result of strength from the environmental monitoring business in the United States.
Orders/Backlog
| Water Infrastructure | Applied Water | Measurement & Control Solutions | Total Xylem | ||||||||||||||||||||
| (in millions) | $ Change | % Change | $ Change | % Change | $ Change | % Change | $ Change | % Change | |||||||||||||||
| 2016 Orders | $ | 1,957 | $ | 1,405 | $ | 462 | $ | 3,824 | |||||||||||||||
| Organic Growth | 139 | 7.1 | % | 79 | 5.6 | % | 42 | 9.1 | % | 260 | 6.8 | % | |||||||||||
| Acquisitions/(Divestitures) | — | — | % | (11 | ) | (0.8 | )% | 762 | 164.9 | % | 751 | 19.6 | % | ||||||||||
| Constant Currency | 139 | 7.1 | % | 68 | 4.8 | % | 804 | 174.0 | % | 1,011 | 26.4 | % | |||||||||||
| Foreign currency translation (a) | 16 | 0.8 | % | 3 | 0.2 | % | 14 | 3.0 | % | 33 | 0.9 | % | |||||||||||
| Total change in revenue | 155 | 7.9 | % | 71 | 5.1 | % | 818 | 177.1 | % | 1,044 | 27.3 | % | |||||||||||
| 2017 Orders | $ | 2,112 | $ | 1,476 | $ | 1,280 | $ | 4,868 |
| (a) | Foreign currency translation impact primarily due to strength in the value of the Euro, Canadian dollar, Russian Ruble, Australian dollar, South African Rand and various other currencies, partially offset by weakness in the British Pound against the U.S. Dollar. |
Orders received during 2017 increased by $1,044 million, or 27.3%, to $4,868 million (26.4% increase on a constant currency basis). The order growth on a constant currency basis was primarily driven by additional orders from recent acquisitions, primarily Sensus, of $762 million. Organic order growth was $260 million, or 6.8%, over the prior year.
Water Infrastructure segment orders increased $155 million, or 7.9%, to $2,112 million (7.1% growth on a constant currency basis). Orders benefited from $16 million of foreign currency translation for the year and included organic growth of $139 million, or 7.1%. The majority of the organic order growth for the segment came from the transport application, driven by the utility sector in the United States, as well as strong project orders in China and India. Additionally, dewatering distributor orders increased driven by storm related activity and the strengthening of the oil and gas markets. Treatment applications also had strong order intake, primarily from projects in the emerging markets, Latin America and North America.
Orders increased in our Applied Water segment by $71 million, or 5.1%, to $1,476 million (4.8% increase on a constant currency basis). The order increase was primarily due to organic order growth of $79 million, or 5.6%, driven by strength in the emerging markets and strong commercial building and industrial performance in North America, which was partially offset by the loss of orders related to divested businesses of $11 million.
Orders increased in our Measurement & Control Solutions segment by $818 million, or 177.1%, to $1,280 million (174.0% growth on a constant currency basis). This increase included orders from recent acquisitions, primarily Sensus, of $762 million and organic order growth of $42 million, or 9.1%, primarily from Sensus order increases in North America for most applications, as well as increased orders from test application strength in the United States and China.
Backlog includes contractual customer commitments as well as orders on hand as of the end of the period. Delivery schedules vary from customer to customer based upon their requirements. Annual or multi-year contracts are subject to rescheduling and cancellation by customers due to the long-term nature of the contracts. As such, beginning total backlog, plus orders, minus revenues will not equal ending total backlog due to contract adjustments, foreign currency fluctuations and other factors. Typically, large projects require longer lead production cycles and deployment schedules, and delays can occur from time to time. Total backlog was $1,513 million at December 31, 2017 and $1,292 million at December 31, 2016, an increase of 17%. The December 31, 2016 backlog balance has been revised to include contractual agreements that Sensus has with customers that do not have minimum commitments but which we believe will be executed upon over the terms of the contracts. This year over year increase in backlog of $221 million is due to strong order growth in the fourth quarter across all of our segments as well as benefits from currency translation impacts. We anticipate that over 60% of our total backlog at December 31, 2017 will be recognized as revenue during 2018.
Gross Margin
Gross margins as a percentage of consolidated revenue increased to 39.2% in 2017 from 38.8% in 2016. The gross margin increase was primarily due to the benefits realized from cost reductions from global procurement and continuous improvement initiatives, as well as a decrease in the inventory step-up charge for Sensus in 2017. These positive impacts on gross margin were partially offset by cost inflation and unfavorable product mix.
Operating Expense
| (in millions) | 2017 | 2016 | Change | |||||||
| Selling, general and administrative expenses | $ | 1,089 | $ | 914 | 19.1 | % | ||||
| SG&A as a % of revenue | 23.1 | % | 24.2 | % | (110 | )bp | ||||
| Research and development expenses | 181 | 110 | 64.5 | % | ||||||
| R&D as a % of revenue | 3.8 | % | 2.9 | % | 90 | bp | ||||
| Restructuring and asset impairment charges | 25 | 30 | (16.7 | )% | ||||||
| Operating expenses | $ | 1,295 | $ | 1,054 | 22.9 | % | ||||
| Expense to revenue ratio | 27.5 | % | 28.0 | % | (50 | )bp |
Selling, General and Administrative Expenses
SG&A increased by $175 million (increase of 19.1%) to 23.1% of revenue in 2017, as compared to 24.2% of revenue in 2016. The increase in SG&A expenses includes approximately $160 million of incremental SG&A spending for the Sensus business that we did not have prior to the acquisition in the fourth quarter of 2016. The remaining increases in SG&A expenses were primarily due to inflation, investments in regional sales channels and operational capabilities and foreign currency impacts, which were partially offset by savings from restructuring and other cost actions.
Research and Development Expenses
R&D spending increased $71 million or 64.5% to 3.8% of revenue in 2017 as compared to 2.9% of revenue in 2016 primarily due to additional R&D spend from our recent acquisitions and investments in new products and technologies.
Restructuring Charges
Restructuring Charges
During 2017, we incurred restructuring costs of $7 million, $8 million and $5 million in our Water Infrastructure, Applied Water and Measurement & Control Solutions segments, respectively. We incurred these charges related to actions taken in 2017 primarily as a continuation of our efforts to reposition our European and North American businesses to optimize our cost structure and improve our operational efficiency and effectiveness. The charges included the reduction of headcount and consolidation of facilities within our Applied Water and Water Infrastructure segments, as well as headcount reductions within our Measurement & Control Solutions segment.
During 2016, we recognized restructuring costs of $12 million, $10 million, $6 million and $2 million in our Water Infrastructure, Applied Water, Measurement & Control Solutions and Corporate, 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.
The following table presents expected restructuring spend:
| (in millions) | Water Infrastructure | Applied Water | Measurement & Control Solutions | Corporate | Total | |||||||||||||||
| Actions Commenced in 2017: | ||||||||||||||||||||
| Total expected costs | $ | 18 | $ | 12 | $ | 3 | $ | — | $ | 33 | ||||||||||
| Costs incurred during 2017 | 5 | 4 | 2 | — | 11 | |||||||||||||||
| Total expected costs remaining | $ | 13 | $ | 8 | $ | 1 | $ | — | $ | 22 | ||||||||||
| Actions Commenced in 2016: | ||||||||||||||||||||
| Total expected costs | $ | 13 | $ | 14 | $ | 10 | $ | 2 | $ | 39 | ||||||||||
| Costs incurred during 2016 | 11 | 10 | 6 | 2 | 29 | |||||||||||||||
| Costs incurred during 2017 | 2 | 4 | 3 | — | 9 | |||||||||||||||
| Total expected costs remaining | $ | — | $ | — | $ | 1 | $ | — | $ | 1 |
The Water Infrastructure, Applied Water, Measurement & Control Solutions, and Corporate actions commenced in 2017 consist primarily of severance charges and are expected to continue through the end of 2018. The Water Infrastructure, Applied Water, Measurement & Control Solutions and Corporate actions commenced in 2016 consist primarily of severance charges and are largely complete. The Water Infrastructure, Applied Water and Measurement & Control Solutions actions commenced in 2015 consist primarily of severance charges and are complete. As a result of these actions initiated in 2017, we achieved savings of approximately $4 million in 2017 and estimate annual future net savings beginning in 2018 of approximately $15 million, resulting in $11 million of incremental savings from the 2017 actions.
Asset Impairment Charges
During the first quarter of 2017 we determined that certain assets within our Applied Water segment, including a tradename, were impaired. Accordingly we recognized an impairment charge of $5 million. Refer to Note 11, "Goodwill and Other Intangible Assets," for additional information.
Operating Income
We generated operating income of $552 million (operating margin of 11.7%) during 2017, reflecting an increase of $144 million, or 35.3%, when compared to operating income of $408 million (operating margin of 10.8%) during the prior year. This increase in operating income was largely driven by the inclusion of Sensus operating income for the full year in 2017. Sensus acquisition related costs and restructuring and realignment costs decreased $31 million and $6 million, respectively, while special charges increased $6 million when compared to the prior year period. Excluding these costs, adjusted operating income was $626 million (adjusted operating margin of 13.3%) for 2017 as compared to $513 million (adjusted operating margin of 13.6%) for 2016. The decrease in adjusted operating margin was mostly due to cost inflation increases, increased spending on strategic investments and Sensus purchase accounting impacts, which were largely offset by cost savings from our global procurement and productivity initiatives and restructuring savings. The non-cash Sensus purchase accounting impact on adjusted operating margin for the year was 50 basis points.
The table below provides a reconciliation of the total and each segment's operating income to adjusted operating income, and a calculation of the corresponding adjusted operating margin:
| (In millions) | 2017 | 2016 | Change | ||||||||
| Water Infrastructure | |||||||||||
| Operating income | $ | 312 | $ | 295 | 5.8 | % | |||||
| Operating margin | 15.6 | % | 15.3 | % | 30 | bp | |||||
| Restructuring and realignment costs | 16 | 16 | — | % | |||||||
| Special charges | — | 2 | (100.0 | ) | % | ||||||
| Adjusted operating income | $ | 328 | $ | 313 | 4.8 | % | |||||
| Adjusted operating margin | 16.4 | % | 16.2 | % | 20 | bp | |||||
| Applied Water | |||||||||||
| Operating income | $ | 194 | $ | 188 | 3.2 | % | |||||
| Operating margin | 13.7 | % | 13.5 | % | 20 | bp | |||||
| Restructuring and realignment costs | 17 | 16 | 6.3 | % | |||||||
| Special charges | 5 | — | NM | ||||||||
| Adjusted operating income | $ | 216 | $ | 204 | 5.9 | % | |||||
| Adjusted operating margin | 15.2 | % | 14.6 | % | 60 | bp | |||||
| Measurement & Control Solutions | |||||||||||
| Operating income | $ | 110 | $ | — | NM | ||||||
| Operating margin | 8.6 | % | — | % | NM | ||||||
| Sensus acquisition related costs | 15 | 25 | (40.0 | ) | % | ||||||
| Restructuring and realignment costs | 8 | 13 | (38.5 | ) | % | ||||||
| Special charges | — | $ | 3 | (100.0 | ) | % | |||||
| Adjusted operating income | $ | 133 | $ | 41 | 224.4 | % | |||||
| Adjusted operating margin | 10.4 | % | 9.2 | % | 120 | bp | |||||
| Corporate and other | |||||||||||
| Operating loss | $ | (64 | ) | $ | (75 | ) | (14.7 | ) | % | ||
| Restructuring and realignment costs | — | 2 | (100.0 | ) | % | ||||||
| Sensus acquisition related costs | 7 | 28 | (75.0 | ) | % | ||||||
| Special charges | 6 | — | NM | ||||||||
| Adjusted operating loss | $ | (51 | ) | $ | (45 | ) | 13.3 | % | |||
| Total Xylem | |||||||||||
| Operating income | $ | 552 | $ | 408 | 35.3 | % | |||||
| Operating margin | 11.7 | % | 10.8 | % | 90 | bp | |||||
| Restructuring and realignment costs | 41 | 47 | (12.8 | ) | % | ||||||
| Sensus acquisition related costs | 22 | 53 | (58.5 | ) | % | ||||||
| Special charges | 11 | 5 | 120.0 | % | |||||||
| Adjusted operating income | $ | 626 | $ | 513 | 22.0 | % | |||||
| Adjusted operating margin | 13.3 | % | 13.6 | % | (30 | ) | bp |
NM Not Meaningful
Water Infrastructure
Operating income for our Water Infrastructure segment increased $17 million, or 5.8%, with operating margin also increasing from 15.3% to 15.6%, a 30 basis point increase as compared to the prior year. Operating margin was positively impacted year over year by special charges of $2 million in 2016 that did not recur, while restructuring and realignment costs remained flat. Excluding these items, adjusted operating income increased $15 million, or 4.8%, with adjusted operating margin increasing from 16.2% to 16.4%, a 20 basis point increase as compared to the prior year. The increase in adjusted operating margin was primarily due to cost reductions from global procurement and continuous improvement initiatives as well as restructuring savings and favorable volume. These drivers were partially offset by increases in cost inflation and spending on strategic investments, as well as unfavorable transactional foreign currency impacts.
Applied Water
Operating income for our Applied Water segment increased $6 million, or 3.2%, with operating margin also increasing from 13.5% to 13.7%, a 20 basis point increase as compared to the prior year. Operating margin was negatively impacted by higher special charges for a non-cash impairment of $5 million and a $1 million increase in restructuring and realignment costs. Excluding these items, adjusted operating income increased $12 million, or 5.9%, with adjusted operating margin increasing from 14.6% to 15.2%, an 60 basis point increase as compared to the prior year. The increase in adjusted operating margin was primarily due to cost reductions from global procurement and continuous improvement initiatives and restructuring savings, which were partially offset by increases in cost inflation, unfavorable mix and the impact from the change in accounting for pension costs.
Measurement & Control Solutions
Operating income for our Measurement & Control Solutions segment increased $110 million (operating margin of 8.6%) for the year as compared to operating income and margin of zero in 2016. Operating margin was positively impacted by decreases in Sensus acquisition related costs, restructuring and realignment costs and special charges of $10 million, $5 million and $3 million, respectively. Excluding these items, adjusted operating income increased $92 million, or 224.4%, with most of the increase coming from the inclusion of the incremental adjusted operating income for Sensus in 2017. Adjusted operating margin increased from 9.2% to 10.4%, a 120 basis point increase as compared to the prior year. The increase in adjusted operating margin was primarily due to cost reductions from global procurement and continuous improvement initiatives, restructuring savings and favorable volume impacts. These drivers were partially offset by the inclusion of Sensus margins, which were negatively impacted by purchase accounting. Non-cash Sensus purchase accounting negatively impacted the segment's full year adjusted operating margin by 200 basis points.
Corporate and other
Operating expense for corporate and other decreased $11 million, or 14.7%, compared to the prior year, primarily due to a $21 million decrease in Sensus acquisition related costs and a $2 million decrease in restructuring and realignment costs. This was partially offset by $6 million of special charges incurred during the year which we did not have in the prior year. Excluding these costs, adjusted operating expense increased $6 million compared to the prior year, driven mostly by employee related costs as well as the impact from the change in accounting for pension costs.
Interest Expense
Interest expense was $82 million and $70 million for 2017 and 2016, respectively. The increased interest expense for the year includes additional interest expense in 2017 related to debt entered into in the fourth quarter of 2016 to fund our acquisition of Sensus. The increase in interest expense was partially offset by the reduction in special interest charges incurred in 2016 of $8 million in connection with the early extinguishment of our Senior Notes due in 2016 and $5 million of financing charges on the bridge loan related to the Sensus acquisition, neither of which recurred in 2017, as well as a lower interest rate on the Senior Notes due 2023 which effectively replaced the Senior Notes due in 2016. See Note 14, "Credit Facilities and Debt" of our consolidated financial statements for a description of our credit facilities and long-term debt and related interest.
Income Tax Expense
The income tax provision for 2017 was $136 million at an effective tax rate of 29.2% compared to $80 million at an effective tax rate of 23.5% in 2016. The 2017 effective tax rate is higher than 2016 due to the provisional one time deemed repatriation transition tax under the newly enacted Tax Cuts and Jobs Act, partially offset by the benefit from the remeasurement of deferred tax assets and liabilities and the release of valuation allowances.
See Note 7, "Income Taxes" of our consolidated financial statements for further discussion of the Tax Act.
Other Comprehensive Income
Other comprehensive income was $108 million in 2017 as compared to an $80 million loss in 2016. This increase was driven primarily by favorable foreign currency translation impacts, primarily due to the strengthening of the Euro, Great British Pound, Chinese Yuan, Polish Zloty, amongst other various currencies, against the U.S. Dollar as compared to the weakening of these same currencies in the prior year. Partially offsetting these favorable movements, was the Euro movement on the Company's net investment hedge as compared to the prior year. The tax impact on the foreign currency translation related to the net investment hedge also contributed to the year over year increase. Finally, year over year movement in foreign currency translation on postretirement benefit plans partially offset the increase in other comprehensive income.
Liquidity and Capital Resources
The following table summarizes our sources and uses of cash:
| Year Ended December 31, | |||||||||||
| (in millions) | 2018 | 2017 | 2016 | ||||||||
| Operating activities | $ | 586 | $ | 686 | $ | 497 | |||||
| Investing activities | (643 | ) | (181 | ) | (1,886 | ) | |||||
| Financing activities | (40 | ) | (421 | ) | 1,034 | ||||||
| Foreign exchange (a) | (21 | ) | 22 | (17 | ) | ||||||
| Total | $ | (118 | ) | $ | 106 | $ | (372 | ) |
| (a) | 2018 impact is primarily due to the weakness of the Chinese Yuan, Argentine Peso, Indian Rupee and various other currencies against the U.S. Dollar. 2017 impact is primarily due to the strengthening of the Euro and the Chinese Yuan against the U.S. Dollar. 2016 impact is primarily due to the weakness of the Euro and the Chinese Yuan against the U.S. dollar. |
Sources and Uses of Liquidity
Operating Activities
During 2018, net cash provided by operating activities was $586 million, compared to $686 million in 2017. The $100 million year-over-year decrease was primarily driven by an increased use of working capital for inventory, which was built up at year end to maintain service levels impacted by component shortages as well as to make strategic purchases to manage tariff impacts. Operating cash also decreased during the period as a result of increased receivables from higher growth levels. These negative impacts to operating cash flow were partially offset by increased cash from earnings during the year.
During 2017, net cash provided by operating activities was $686 million, compared to $497 million in 2016. The $189 million year-over-year increase was primarily driven by increased cash from operating activities of the Sensus business acquired in the fourth quarter of 2016 and strong operating cash performance across the rest of the business.
Investing Activities
Cash used in investing activities was $643 million in 2018, compared to $181 million in 2017. This increase of $462 million was primarily driven by the $433 million spent on 2018 acquisitions, primarily the acquisition of Pure Technologies Ltd., versus the $33 million spent for various acquisition activities in the prior year. Spending on capital expenditures also increased by $67 million over the prior year, primarily due to increased spending on software development, building up of the dewatering rental fleet, as well as increased spending on other strategic capital investments to meet increasing demand.
Cash used in investing activities was $181 million in 2017 compared to $1,886 million in 2016. The decrease of $1,705 million was primarily driven by the $1,782 million spent on the acquisition of Sensus and two other businesses in 2016 as compared to the $33 million spent for acquisitions in 2017. This impact is partially offset by increased spending of $46 million over the prior year on capital projects, including spending on capitalized software in the Sensus business.
Financing Activities
Cash used by financing activities was $40 million in 2018, compared to cash used by financing activities of $421 in 2017. The decrease in cash used during the year was primarily due to the net issuance of $335 million in short term debt in the current year, which was largely used for acquisition financing. Additionally, short term debt repaid during the year was $52 million versus $282 million during the prior year period (see Note 14, "Credit Facilities and Long-Term Debt" of our consolidated financial statements for a full discussion of debt activities). These drivers are partially offset by the higher net repayment of $120 million of long-term debt in the current year, an increase in share repurchase activity of $34 million and an increase in dividends paid of $22 million as compared to the prior year.
Cash generated by financing activities was $421 million in 2017, compared to cash generated by financing activities of $1,034 in 2016. In 2017, the net decrease in cash provided was primarily due to the issuance of long-term and short-term debt related to acquisition financing in 2016 versus the net repayment of short-term debt in 2017 (see Note 14, "Credit Facilities and Long-Term Debt" of our consolidated financial statements for a full discussion of debt activities). Also contributing to the decrease in cash generated by financing activities were increased share repurchases and higher dividend payments in 2017.
Funding and Liquidity Strategy
Our ability to fund our capital needs depends on our ongoing ability to generate cash from operations and access to bank financing and the capital markets. Historically, we have generated operating cash flow sufficient to fund our primary cash needs centered on operating activities, working capital, capital expenditures, strategic investments and dividends. 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 such financing will be available to us on acceptable terms or that such financing will be available at all.
We monitor our global funding requirements and seek to meet our liquidity needs on a cost effective basis. 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.
We anticipate that our present sources of funds, including funds from operations and additional borrowings, will provide us with sufficient liquidity and capital resources to meet our liquidity and capital needs in both the United States and outside of the United States over the next twelve months.
Credit Facilities & Long-Term Contractual Commitments
See Note 14, "Credit Facilities and Long-Term Debt" of our consolidated financial statements for a description of our credit facilities and long-term debt.
Non-U.S. Operations
For 2018 and 2017, we generated 53% and 54% of our revenue from non-U.S. operations, respectively. 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 expect that a substantial portion of 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 we believe it is cost effective to do so. We continually review our domestic and foreign cash profile, expected future cash generation and investment opportunities and reassess whether there is a need to repatriate funds held internationally to support our U.S. operations. As of December 31, 2018, we have provided a deferred tax liability of $13 million for net foreign withholding taxes and state income taxes on $1.9 billion expected to be repatriated to the U.S. parent.
Contractual Obligations
The following table summarizes our contractual commitments as of December 31, 2018:
| (in millions) | 2019 | 2020 - 2021 | 2022 - 2023 | Thereafter | Total | ||||||||||||||
| Debt and capital lease obligations (1) | $ | 257 | $ | 600 | $ | 570 | $ | 900 | $ | 2,327 | |||||||||
| Interest payments (1) (2) | 76 | 152 | 93 | 451 | 772 | ||||||||||||||
| Operating lease obligations | 76 | 104 | 55 | 64 | 299 | ||||||||||||||
| Purchase obligations (3) | 154 | 2 | — | — | 156 | ||||||||||||||
| Other long-term obligations reflected on the balance sheet | 1 | 16 | 17 | 27 | 61 | ||||||||||||||
| Total commitments | $ | 564 | $ | 874 | $ | 735 | $ | 1,442 | $ | 3,615 |
In addition to the amounts presented in the table above, we have recorded liabilities for net investment hedges of $46 million and employee severance indemnity of $16 million. These amounts have been excluded from the contractual obligations table due to an inability to reasonably estimate the timing or amounts 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” of the consolidated financial statements and deferred income tax liabilities and uncertain tax positions are presented in Note 7, "Income Taxes" of the consolidated financial statements, and as such, these obligations are not included in the above table. Finally, estimated environmental payments and workers' compensation and general liability reserves are excluded from the table above. We estimate, based on historical experience, that we will spend approximately $2 million to $3 million per year on environmental investigation and remediation and approximately $4 million to $5 million per year on workers' compensation and general liability. At December 31, 2018, we had estimated and accrued $4 million and $21 million related to environmental matters, and workers' compensation and general liability, respectively.
| (1) | Refer to Note 14, “Credit Facilities and Long-Term Debt,” of the consolidated financial statements for discussion of the use and availability of debt and revolving credit agreements. Amounts represent principal payments of short-term and long-term debt including current maturities and exclude unamortized discounts. |
| (2) | Amounts represent estimates of future interest payments on short-term and long-term debt outstanding as of December 31, 2018. |
| (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 able to cancel without penalty have been excluded. |
Off-Balance Sheet Arrangements
As of December 31, 2018, 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, financial condition, changes in financial condition, revenues or expenses, liquidity, capital expenditures or capital resources.
We obtain certain stand-by letters of credit, bank guarantees and surety bonds from third-party financial institutions in the ordinary course of business when required under contracts or to satisfy insurance related requirements. As of December 31, 2018, the amount of stand-by letters of credit, bank guarantees and surety bonds was $275 million.
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,” of 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. As discussed in Note 2, "Recently Issued Accounting Pronouncements", Xylem adopted the new guidance on recognizing revenue from contracts with customers as of January 1, 2018. In accordance with this new guidance Xylem recognizes revenue in a manner that depicts the transfer of promised goods and services to customers in an amount that reflects the consideration to which it expects to be entitled to for providing those goods and services. For each arrangement with a customer, we identify the contract, the associated performance obligations within the contract, determine the transaction price of that contract, allocate the transaction price to each performance obligation and recognize revenue as each performance obligation is satisfied.
The satisfaction of performance obligations in a contract is based upon when the customer obtains control over the asset. Depending on the nature of the performance obligation, control transfers either at a particular point in time, or over time which determines the recognition pattern of revenue.
For product sales, other than long-term construction-type contracts, we recognize revenue once control has passed at a point in time, which is generally when products are shipped. 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. We recognize revenue on product sales to channel partners, including resellers, distributors or value-added solution providers at the point in time when the risks and rewards, possession, and title have transferred to the customer, which usually occurs at the point of delivery.
Revenue from performance obligations related to services is recognized over time, as the performance obligations are satisfied. In these instances, the customer consumes the benefit of the service as Xylem performs.
Certain businesses also enter into long-term construction-type sales contracts where revenue is recognized over time. In these instances, revenue is recognized using a measure of progress that applies an input method based on costs incurred in relation to total estimated costs. We also recognize revenue for certain of these arrangements using the output method and measure progress based on shipments of product where control has transferred to the customer.
For all contracts with customers, we determine the transaction price in the arrangement and allocate the transaction price to each performance obligation identified in the contract. Judgment is required to determine the appropriate unit of account, and we separate out the performance obligations if they are capable of being distinct and if they are distinct within the context of the contract. The transaction price is adjusted for our estimate of variable consideration which may include a right of return, discounts, rebates, penalties and retainage. To estimate variable consideration, we apply the expected value or the most likely amount method, based on whichever method most appropriately predicts the amount of consideration we expect to be entitled to. The method applied is typically based on historical experience and known trends. We constrain the amounts of variable consideration that are included in the transaction price, to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur or when uncertainties around the variable consideration are resolved.
The adoption of the new revenue guidance did not provide materially different results from historical revenue guidance.
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.
Due to the Tax Act, we have recorded net foreign withholding taxes and state income taxes on earnings that are expected to be repatriated to the U.S. parent. We have not recorded any deferred taxes on the amounts that the Company currently does not intend to repatriate as the determination of any deferred taxes on this amount is not practicable.
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 or litigation, 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 resolution.
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.
Business Combinations. We record acquisitions using the purchase method of accounting. All of the assets acquired, liabilities assumed, contractual contingencies and contingent consideration is recorded at fair value as of the acquisition date. The excess of the purchase price over the estimated fair values of the net tangible and intangible assets acquired is recorded as goodwill. The application of the purchase method of accounting for business combinations requires management to make significant estimates and assumptions in the determination of the fair value of assets acquired and liabilities assumed, in order to properly allocate purchase price consideration between assets that are depreciated and amortized from goodwill. These assumptions and estimates include a market participant’s use of the asset and the appropriate discount rates for a market participant. Our estimates are based on historical experience, information obtained from the management of the acquired companies and, when appropriate, includes assistance from independent third-party appraisal firms. Significant assumptions and estimates include, but are not limited to, the cash flows that an asset is expected to generate in the future, the cost to build/recreate certain technology, the appropriate weighted-average cost of capital, and the cost savings expected to be derived from acquiring an asset. These estimates are inherently uncertain and unpredictable. In addition, unanticipated events and circumstances may occur which may affect the accuracy or validity of such estimates.
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. For goodwill, the estimated fair value of each reporting unit is compared to the carrying value of the net assets assigned to that reporting unit. If the estimated fair value of the reporting unit exceeds its carrying value, goodwill is not impaired. If the carrying value of the reporting unit exceeds its estimated fair value, then an impairment charge is recognized for that excess up to the amount of recorded goodwill. We estimate the fair value of our reporting units using an income approach. We estimate the fair value of our intangible assets with indefinite lives using either the income approach or the market approach. Under the income approach, we calculate fair value based on the present value of estimated future cash flows. Under the market approach, we calculate fair value based on recent sales and selling prices of similar assets.
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 2018, we performed our annual impairment assessment and determined that the estimated fair values of our goodwill reporting units were in excess of their carrying values. Future goodwill impairment tests could result in a charge to earnings. Our AIA business within our Measurement & Control Solutions segment was the only goodwill reporting unit whose fair value was not substantially in excess of its carrying value. The majority of this business was purchased during 2018 and was recorded at fair value in Xylem’s financial statements. As a result, our 2018 assessment indicated that the fair value of the AIA business exceeded its carrying
value by less than 10%. The goodwill associated with the AIA business was $290 million at December 31, 2018. 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 require us to do so.
We determined that no impairment of the indefinite-lived intangibles existed as of the measurement date in 2018. However, future indefinite-lived intangible impairment tests could result in a charge to earnings. We will continue to evaluate indefinite-lived intangibles 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.
Contingent Liabilities. As discussed in Note 19, "Commitments and Contingencies" of the consolidated financial statements, the Company is, from time to time, involved in legal and regulatory proceedings that are incidental to the operation of our businesses (or the business operations of previously owned entities). The Company recognizes a liability for any contingency that is known or probable of occurrence and reasonably estimable. These assessments require judgments concerning matters such as litigation developments and outcomes, the anticipated outcome of negotiations, the number of future claims and the cost of both pending and future claims. In addition, because most contingencies are resolved over long periods of time, liabilities may change in the future due to various factors, including those discussed in Note 19 of the consolidated financial statements. If the liabilities established by the Company with respect to these contingencies are inadequate, the Company would be required to incur an expense equal to the amount of the loss incurred in excess of the recorded liability, which would adversely affect the Company’s financial statements.
Receivables and Allowance for Doubtful Accounts and Discounts. Receivables primarily comprise uncollected amounts owed to us from transactions with customers and are presented net of allowances for doubtful accounts and early payment discounts.
We determine our allowance for doubtful accounts using a combination of factors to reduce our trade receivable balances to their estimated net realizable amount. We maintain an allowance for doubtful accounts based on a variety of factors, including the length of time receivables are past due, macroeconomic trends and conditions, significant one-time events, historical experience and the financial condition of customers. In addition, we record a specific reserve for individual accounts when we become aware of specific customer circumstances, such as in the case of bankruptcy filings or deterioration in the customer’s operating results or financial position. The past due or delinquency status of a receivable is based on the contractual payment terms of the receivable. If circumstances related to the specific customer change, we adjust estimates of the recoverability of receivables as appropriate. We determine our allowance for early payment discounts primarily based on historical experience with customers.
Credit risk with respect to accounts receivable is generally diversified due to the large number of entities comprising our customer base and their dispersion across many different geographical regions. We perform ongoing credit evaluations of the financial condition of our third-party distributors, resellers and other customers and require collateral, such as letters of credit and bank guarantees, in certain circumstances. As of December 31, 2018 and 2017 we do not believe we have any significant concentrations of credit risk.
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,” of 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 2018 and 2017.
| 2018 | 2017 | ||||||||||
| U.S. | Int’l | U.S. | Int’l | ||||||||
| Benefit Obligation Assumptions | |||||||||||
| Discount rate | 4.50 | % | 2.60 | % | 3.75 | % | 2.43 | % | |||
| Rate of future compensation increase | NM | 2.92 | % | NM | 2.93 | % | |||||
| Net Periodic Benefit Cost Assumptions | |||||||||||
| Discount rate | 3.75 | % | 2.43 | % | 4.25 | % | 2.63 | % | |||
| Expected long-term return on plan assets | 8.00 | % | 7.23 | % | 8.00 | % | 7.20 | % | |||
| Rate of future compensation increase | NM | 2.93 | % | NM | 2.76 | % |
| NM | Not meaningful. The pension benefits for future service for all the U.S. pension plans are based on years of service and not 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,” of 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.
| 2018 | 2017 | 2016 | ||||||
| Expected long-term rate of return on plan assets | 7.34 | % | 7.30 | % | 7.32 | % | ||
| Actual rate of return on plan assets | (3.85 | )% | 5.70 | % | 12.20 | % |
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. The weighted average expected long-term rate of return for all of our plan assets to be used in determining net periodic benefit costs for 2019 is estimated at 7.09%. 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, 2019, is 2.82%. 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, 2019, our expected rate of future compensation is 3.02% 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 8.24% for 2019, decreasing ratably to 4.48% in 2027. 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 $3 million.
We currently anticipate making contributions to our pension and postretirement benefit plans in the range of $15
million to $25 million during 2019, of which $5 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 $29 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, 2018 and 2017 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 $26 million.
New Accounting Pronouncements
See Note 2, “Recently Issued Accounting Pronouncements,” of the consolidated financial statements for a complete discussion of recent accounting pronouncements.
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