Good day, everyone. Welcome to Xylem's investor conference call. At this time, all participants have been placed on a listen-only mode, and the floor will be open for your questions following the presentation. If you would like to ask a question at that time, please press star one on your touchtone phone. If at any point your question has been answered, you may remove yourself from the queue by pressing the pound key. We ask that you please pick up your handset to allow optimal sound quality. Lastly, if you should require operator assistance, please press star zero. I would now like to turn the call over to Phil DeSousa, Vice President of Investor Relations.
Thank you, Jackie. Good morning, everyone, and welcome to today's call to discuss Xylem's agreement to acquire Sensus. With me today are Chief Executive Officer, Patrick Decker, and Chief Financial Officer, Mark Rajkowski. Patrick will provide some remarks about Sensus, our rationale for the strategic acquisition, details about the transaction, and the shareholder value we believe will be created with the combined company. Following our prepared remarks, we will address questions related to the information covered on the call. In order to have enough time to address everyone on the call, I'll ask that you please keep to one question and a follow-up, then return to the queue. We anticipate that today's call will last approximately one hour. As a reminder, this call and our webcast are accompanied by a slide presentation available in the Investors section of our website at www.xyleminc.com.
A replay of today's call will be available until midnight on September sixth. Please note the replay number is 800-585-8367, and the confirmation code is 65483412. The call will be available for playback via the Investors section of our website under the heading Presentations. With that, please turn to slide two. We will make some forward-looking statements on today's call, including references to future events or developments that we anticipate will or may occur in the future. These statements are subject to future risks and uncertainties, such as those factors described in Xylem's most recent annual report on Form 10-K and subsequent reports filed by the SEC. Please note that the company undertakes no obligation to update any forward-looking statements publicly to reflect subsequent events or circumstances, and actual events or results could differ materially from those anticipated. With that, please turn to slide three.
For purposes of today's call, all references will be on an adjusted basis unless otherwise indicated, and non-GAAP financials have been reconciled for you and are included in the appendix section of the presentation. Please note that references to Xylem's 2016 metrics include the financial impact attributable to its previously closed acquisitions and have been adjusted to exclude non-recurring transaction costs. Finally, let me call your attention to a very important distinction. In our discussion today, we will discuss Sensus financial information that has been provided by Sensus' management and represents results from its fiscal year 2016, which ended on March 31st earlier this year. Please turn to slide four, and I will turn the call over to our CEO, Patrick Decker.
Thanks, Phil, and good morning, everyone. Thank you for joining us today. This morning, we announced very exciting news. We've signed a definitive agreement to acquire Sensus, which is a leader in smart meters, network technologies, and advanced data analytics services for the global water, gas, and electric utilities industries. The combination of Xylem with Sensus is a compelling and strategic fit. It will both open up attractive, fast-growing markets and provide new growth platforms for Xylem. It will accelerate our combined R&D and innovation initiatives. It will enable us to provide our customers with a broader portfolio of solutions that meet their critical needs. It will create new growth and development opportunities for our respective employees, and most importantly, it will create significant value for our shareholders.
The purchase price of $1.7 billion translates to a multiple of 10.7 times Sensus' 2016 adjusted EBITDA, a very attractive multiple for a higher growth, higher margin, and higher technology business. Upon completion, this transaction will not impact our 2016 adjusted earnings forecast, which we reaffirm today. We expect this to be accretive to Xylem's adjusted 2017 earnings by $0.10 to $0.12 per share. Finally, I want to highlight the terrific job my leadership team has done in targeting such an outstanding company, as well as constructing an elegant transaction that will unlock significant value through the use of a significant amount of non-U.S. cash. Please turn to slide five. Before we get into the details about this great company and how we expect to accelerate our growth together, I first want to remind everyone how we got here.
Let me go back to the strategic roadmap we outlined for you at our 2015 Investor Day. For the benefit of those who weren't there, we provided some insight into the comprehensive, data-driven value mapping exercise we conducted to assess the attractiveness of different parts of the water industry. The results provided the foundation for our long-term growth and margin expansion strategy, including our R&D investment activity and how M&A will help to enable our strategy. This work clearly identified several rapidly growing vectors in water, some where we already have a solid presence, and others representing attractive adjacencies that would be very complementary to our existing businesses and help to move Xylem's portfolio of solutions quickly up the technology curve. I'm not going to review all of them, but let me touch on the ones where Sensus plays.
First among them is the fast-growing area of advanced technologies, which includes measurement, analytics, and control technologies that are fueling the transition of the water sector to smart infrastructure. Another notable area was that of integrated solutions. As the name implies, this encompasses products and solutions that utilize a more holistic approach to target higher order customer challenges, including the perennial need to reduce the total cost of ownership. As we began to better understand Sensus' strong capabilities and solutions, as well as their deep technology expertise, we quickly determined that this company represented a very strong strategic adjacency that would significantly advance our strategy. This transaction is a great illustration of how M&A can serve as a very effective proxy for R&D. In fact, we believe the addition of Sensus will enable a step change in Xylem's innovation progress in the area of systems intelligence.
As I've discussed many times since that Investor Day, another component of our strategic roadmap is to execute a balanced capital deployment strategy that includes disciplined M&A. We have clear financial criteria governing our M&A activity, and the acquisition of Sensus more than makes the grade on each element. Now please turn to slide six. Sensus will be a complementary partner that will significantly broaden our offerings, increase the value we bring to customers, and strengthen our industry leadership. They also come with an excellent management team that has made significant changes in the past number of years, which has resulted in stronger operational performance. When we complete this transaction, Sensus will immediately expand our presence in the water sector, specifically with water utilities. We are already a leading player in this area, where our strong brands and applications expertise are recognized globally.
Sensus has one of the strongest product portfolios in the metering industry and a leading position in the advanced metering infrastructure space. We view their business in the gas and electric utilities area or energy space as an attractive adjacency to our collective smart water infrastructure. All utility sectors are migrating at various rates to smart solutions, which are becoming more essential to operating more efficiently and effectively. They are also critical to making utility operations more resilient and reliable. Second, Sensus will bring network technologies, including FlexNet, that already are helping to connect millions of smart meters around the world. Sensus' proven ability to connect infrastructure over long distances in secure, reliable, and cost-effective smart networks is a real competitive differentiator that we expect to extend to Xylem's current portfolio of connected water solutions.
For example, in the U.S., their FlexNet communication network securely transmits and receives customer usage data at over two times the power of competitive systems. In addition, Sensus provides advanced data analytics capabilities that are truly a hidden gem. They offer utilities the ability to extract value from big data to optimize their operations. The company has built a robust and scalable portfolio for software-as-a-service solutions for utilities. This will be a strong platform for Xylem to provide an even broader range of advanced analytic solutions going forward. That's not all. These capabilities have the flexibility to extend into other adjacencies in the world of smart infrastructure. I'll get into more detail about this in a few moments, but let me be clear: We view the network technologies and advanced data analytics to be platforms for future organic and inorganic growth.
Finally, acquiring Sensus will advance our strategy to make Xylem a leading provider of systems intelligence solutions for our customers. While they already enjoy a strong position in the clean water sector, we look forward to extending their technology platforms into the wastewater and outdoor water sectors, where Xylem has a leading presence. Please turn to slide seven. Let me now provide some more detail about Sensus. Their portfolio of products and services enables better management and conservation of water and energy resources, resulting in a truly differentiated offering. They serve 14,000-plus customers and have more than 80 million metering devices installed globally. The total global metering market is valued at about $12 billion. Sensus offers a range of metering technologies that begins with basic mechanical meters and progresses to advanced smart meters. A smart meter is an automated intelligent flow measurement system with embedded communications technology.
This is the Advanced Metering Infrastructure space I just referred to, or AMI. It represents nearly half of the market overall and is the fastest-growing segment. We hear from our water customers every day about their urgent need for real-time data and better intelligence to help them avoid costly disruptions, reduce revenue loss due to inaccurate measurement, theft, and leaks, which in the industry is known as non-revenue water, and it also helps them to operate more efficiently. The advantages of automation are pushing adoption rates of these smart meters higher and faster. In fact, while the projected annual growth rate of the global meter market is about 5%, the AMI sub-sector is expected to grow nearly twice as fast. As a combined company, we will be able to offer proven smart networking and data analytics technologies that bring that intelligence to the smart water, wastewater, and outdoor water sectors.
As I mentioned, their network technology, known as FlexNet, can be used to support Xylem's current connected solutions, significantly increasing the value of our customer offering. The Sensus organization includes about 300 people globally, with a majority based in the U.S., where they generate approximately 70% of their revenues. Throughout our conversations with the Sensus management team and visits to many of their sites, we have been very impressed with their capabilities and expertise. They, like Xylem, have a laser focus on the customer, understanding their needs and building solutions that add real value to their businesses. This gives us great confidence about the fit of our two cultures. Now, please turn to slide eight. As you can see on the slide, the Sensus team has cultivated strong relationships with a diverse group of customers that includes major cities, local governments, and both public and private utilities.
One of the great synergies we will enjoy is a meaningful overlap of customers in the water sector. They have a large presence in the clean water space, and we are a leading player in the wastewater area. As a unified company, we expect to leverage these relationships to drive revenue synergies. An important note, our valuation of Sensus does not include the substantial revenue synergies we expect to realize as a combined company. Another commonality of Xylem and Sensus is the longevity of our customer relationships, which are rooted in the high quality and reliability of our respective products and services. Both companies also benefit from a significant percentage of recurring revenue. As you look at their revenue profile by sector, they generate roughly two-thirds of their revenue in water.
Their energy businesses in gas and electric, at about 24% of revenue, are growing profitable businesses that we expect to be solid contributors to our value creation opportunities going forward. Furthermore, their ability to serve all three utility sectors is a competitive advantage. This is particularly true in the case of multi-utilities, where two or three of the services are delivered by a single provider. As I already noted, their portfolio of software-as-a-service solution is growing at a double-digit rate. Their group of elite data scientists will continue to develop new solutions, and we believe this area will be a platform for significant future growth, both organic and inorganic. Let's turn now to slide nine. As I mentioned earlier, Sensus falls squarely in the higher growth areas that we examined as part of our value mapping work.
Both their existing portfolio and their innovation pipeline are focused on solving challenges that are driven by some of the same macro trends that are increasingly impacting our customers. These include rapid urbanization, aging infrastructure, and the need to build greater resilience across all communities to adapt to the effects of climate change. There have been numerous reports, most recently out of the World Bank, about the rising economic risk from climate change, especially with increased urbanization. The move into smart infrastructure is a crucial component to meeting these challenges. The fact is that adoption of smart meters and other elements of smart infrastructure is rapidly increasing. Regulations and broader policy mandates are driving some of that. As I've explained, the customers' need to improve their operations through higher productivity, increased energy efficiency, and water conservation is a primary factor, and healthy housing starts provide additional tailwind.
I realize there's a lot on this slide illustration, we wanted to provide a glimpse of all the various touch points that Sensus products and services have in supporting smart infrastructure in the water, gas, and electric businesses, as well as Internet of Things sensors, lighting, and other industrial services. Please turn to slide 10. When we complete this transaction, we'll be taking a huge step forward in our strategy to being a leading provider of systems intelligence solutions to the entire water sector. Sensus provides us with an immediate leadership position in the smart clean water space. They have a large installed base that offers significant upgrading potential, in addition to replacement work, and we believe their advanced analytics will be a source of significant growth as we explore IoT adjacencies and new opportunities.
Integrating our companies will enable us to bring the Internet of Things to the wastewater and outdoor water sectors, as well as to the industrial water sector. Importantly, we will leverage Xylem's global commercial capabilities and scale to drive growth. During our due diligence, we conducted significant global voice of customer work, which helped to validate the value proposition of Sensus solutions and the strength of their capabilities and expertise. One particular operator who worked with their smart meters on the clean water side noted that there were more than 180 wastewater pump lift stations scattered around his town, and that any interruption at a single station had a material impact on their overall operations. He specifically said that he felt Sensus needed to bring their technology to the wastewater industry so their operators could leverage the communications infrastructure they already had in place.
Another customer, one that we share, discussed the benefits of utilizing the Sensus technology to monitor the community's lake levels. In addition to improving the accuracy and frequency of the data collected, the technology would eliminate the need to monitor the lakes manually. As these examples demonstrate, the combination of our two companies will create a powerful value proposition for all of our customers as we move the expanded Xylem portfolio significantly up the technology curve. Please turn to slide 11. There are also significant growth opportunities as we look to leverage our respective geographic presence. This is yet another area where we believe we can generate notable revenue synergies. Both companies have built significant leadership positions in the U.S. and strong, extensive customer relationships in Europe. This is going to result in promising cross-selling opportunities.
In the past couple of years, Sensus was awarded and is successfully executing on several major international contracts, including two long-term multi-year deals in the U.K. that together are expected to generate more than $300 million over the life of the contracts. As you know, Xylem has a solid and growing footprint in the emerging markets, which we continue to build out and invest in. Most recently, we've made significant investments in China, the Middle East, and India, all of which are yielding positive results. Sensus is earlier on its journey of emerging markets expansion. Make no mistake, they have a solid presence and rapidly growing business, particularly in areas such as the Middle East and certain parts of Asia Pacific, which are adopting smart infrastructure at faster rates.
Working together, we see nothing but upside potential and believe the addition of Sensus will further accelerate our progress across geographies. At this point, I'd like to turn it over to Mark, who will cover some of the financial details. Mark?
Thanks, Patrick. Please turn to slide 12. I'd like to begin by reviewing Sensus' current financial highlights and our projected growth profile for the business. Let's start with the market. As Patrick mentioned, the global metering market is about $12 billion today and is expected to grow at a CAGR of 5% through 2020. Over the last decade, Sensus has delivered on average, low to mid-single digit growth. With 2016 adjusted revenue of $837 million, we believe Sensus is very well-positioned to grow at faster than market rates for several reasons. First, Sensus' largest segment is in water, and water utilities are rapidly transitioning to AMI, which is expected to grow at approximately two times the rate of the global meter market.
Second, Sensus' FlexNet communications technology is particularly well-suited for small and medium utilities, which constitute two-thirds of the overall market, and due to the historically slower penetration of AMI, is the fastest growing sector. Lastly, as Patrick highlighted earlier, Sensus has developed a leading-edge set of new AMI products, which are well-positioned in the market. In fact, they are already seeing the benefits as reflected in the 10% revenue growth they delivered in the first quarter of their fiscal 2017. We have strong confidence in the business delivering 6%-7% revenue growth through 2020. This excludes the growth from the substantial revenue synergies we expect to realize. This transaction will be very accretive to Xylem's adjusted earnings. This will be driven in part by the $50 million in cost synergies that we expect to deliver largely by the end of year three.
These savings will primarily come from the areas of G&A consolidation, footprint rationalization, and procurement savings that we identified during our extensive due diligence process. To be clear, these cost savings are incremental to those discussed last fall at Investor Day, when Patrick and the team laid out our long-term financial targets. Shifting back to Sensus. We expect the adjusted EBITDA margin to expand by 400 basis points through 2020, driven by volume growth and cost synergies. We anticipate this transaction adding $0.10 to $0.12 to our adjusted EPS in 2017. We would expect this to equate to approximately $0.28 to $0.30 per share, excluding non-cash amortization of intangibles from purchase accounting. Finally, due to a closing date that will likely be late in the fourth quarter, we do not expect this deal to impact our 2016 adjusted earnings forecast. Please turn to slide 13.
At the left of this slide, we highlight Xylem's current 2016 revenue and adjusted EBITDA margin expectations, which we are reaffirming today. Next to that are Sensus' reported adjusted revenue and EBITDA margin results from their audited fiscal 2016 financial statements. The key takeaway here is that the acquisition of Sensus accelerates Xylem's profitable growth and margin profile. Our expected growth rate for Sensus of 6%-7% through 2020 substantially exceeds Xylem's expected organic growth rate of 3%-5%. In addition to Sensus having higher organic growth profile, it also provides a new platform for future inorganic growth opportunities at Xylem. Furthermore, Sensus is a very profitable business today with a 19% adjusted EBITDA margin, which has accreted to Xylem's current margin by 150 basis points. This margin accretion will expand as the business grows, we deliver at least $50 million of cost synergies.
Another advantage of this transaction is that cash generation is largely in the U.S., which helps to balance Xylem's overall cash profile. Simply put, this acquisition will strengthen our ability to further accelerate capital deployment, providing cash flow to invest for growth in our business while also enhancing returns to shareholders. Lastly, but importantly, we have struck a deal with very attractive financial metrics. Currently, Xylem trades at a 14 times 2016 EBITDA multiple, we are acquiring Sensus at a multiple of 10.7 times its 2016 adjusted EBITDA. If we include our expected cost synergies, the acquisition multiple drops to 1.8 times. The bottom line, this acquisition will create significant value for Xylem shareholders. Please turn to slide 14. As Patrick mentioned earlier, we have clear M&A criteria, Sensus clearly checks each box. Just a few additional points.
To execute this purchase, we structured this transaction to enable us to optimize the utilization of our non-U.S. cash. Specifically, we will use more than $500 million in the aggregate. Including $400 million at closing and the remainder over the next three to six months as we pay down short-term euro borrowings with non-U.S. operating cash flows. This effective deployment of cash will by itself improve our return on invested capital by approximately 80 basis points. Further, we expect that the deal financing, which will include the issuance of long-term investment-grade debt, will reduce our weighted average cost of capital by approximately 50 basis points as we move our capital structure to a heavier weighting of lower cost debt. This structuring of this transaction will also unlock significant financial value for Xylem. Please turn to slide 15.
While this is a large transaction, the strength of our balance sheet enables us to maintain flexibility to continue to pursue our growth strategy while also enhancing return of capital to shareholders. First, we do expect to maintain our investment-grade credit rating following the close of this transaction. As we've outlined previously, our target leverage ratio is 2.5x-3x EBITDA. Today, we're at 2.6x. In post-close, we expect to be at approximately 3.6x. Importantly, due to the strong cash flow profile of the combined company as well as the deal financing structure, we can expect to quickly return to our target range within 12-18 months of completing this transaction. Because our number one value creation opportunity is to accelerate profitable growth, we intend to both continue to invest organically and cultivate a healthy M&A pipeline. That said, let me be very clear.
Our top priority is to remain laser-focused on bringing this transaction to a successful close and executing flawlessly on the integration to maximize the growth potential and capture the significant cost synergies we see ahead. Switching gears to returns of capital, it is important to note that we continue and expect to continue to grow our dividends in line with earnings, which we will be accelerating with this transaction. In addition, we will opportunistically repurchase shares after we have returned to our target leverage range. Please turn to slide 16. The transaction is subject to customary closing conditions. We will seek antitrust approvals in the U.S., Germany, and Austria, but given the minimal overlap in our businesses, we do not anticipate any significant issues. We will also pursue customary FCC approval for the transfer of certain wireless spectrum licenses, and this process takes a bit longer.
As a result, we anticipate closing the deal late in the fourth quarter of 2016. Now, please turn to slide 17 for some closing comments from Patrick.
Thanks, Mark. Let me summarize by reiterating how pleased we are to have reached this deal to acquire Sensus. This represents a new chapter in Xylem, and we can't wait to get started. The transaction economics are very attractive, and the joining of our two companies will enable us to offer even greater value to our customers. It will also create new and compelling opportunities for employees of both Xylem and Sensus. This is an outstanding company with industry-leading solutions, deep innovation and technology expertise, excellent management, and a strong, focused workforce that operate in fast-growing markets. The promise of their technologies and R&D pipeline will open up exciting new growth platforms for our combined company. This move is entirely consistent with the growth and margin expansion strategy we laid out nearly a year ago.
It is both complementary and additive to our solutions portfolio in water, it advances our intention to be a systems intelligence provider. Most importantly, the combination of Xylem and Sensus will unlock significant growth and cost synergies and create significant shareholder value. Operator, we'll open up to questions.
The floor is now open for questions. At this time, if you have a question or comment, please press star one on your touchtone phone. If at any point your question is answered, you may remove yourself from the queue by pressing the pound key. Again, we do ask that while you pose your question, that you pick up your handset to provide optimal sound quality. Thank you. Our first question comes from the line of Deane Dray with RBC Capital Markets.
Thank you. Good morning, everyone, congrats on the announcement. That's exactly in the sweet spot for you guys.
Thanks, Deane. Appreciate it.
Yeah. Good morning, Deane.
Yeah. I'd like to start on slide eight regarding the revenue profile for Sensus. I'm intrigued when you talk about the opportunity to grow the metering business in wastewater and also in outdoor water. Is Sensus there today in any meaningful way, and how close would you be to launching products in this space, and is that included in your 2017 assumptions?
Yeah, great question, Deane. Sensus does not play in the wastewater or outdoor water space today. Where there is some existing overlap are those utilities that provide both clean and handle wastewater. The technology validation that we did during diligence really confirms that we would very much immediately be able to connect their technology platforms with our install base of pumps and other sensors and instrumentation. Obviously, there's time involved in getting that coordinated and getting the commercial go-to-market solution figured out, and we'll do that straightaway here in the integration planning phase. Lastly, none of that is included in our 2017 revenue outlook or quite frankly, any time over the 2020 timeframe. That would all be upside.
That's great to hear. As a follow-up, I'd be interested in hearing any specifics you can provide today on the data analytics and smart grid capabilities. Very specific examples of where you think you can bring software solutions to market, and in what timeframe.
Sure. No, that's a great question, Deane. First, on the data analytics side, we really like their technology. We had our internal and external experts look deeply with them at their technology architecture. First of all, are very confident that the architecture sitting behind the data capture and the analytics is robust, it's scalable, it's an extensible platform. Second, we really like their team and the customer orientation. Data analytics are great as you know, but you have to know what customer problem you're trying to solve. This team has a great mixture of pure data scientists and software engineers, but they also have experienced utility domain experts who are already working together with customers to identify real customer needs and solutions, and then tailor the data analytics to their needs.
When we did our voice-to-customer work, a lot of our customers specifically called out their strong focus on their utility needs as a differentiator. In terms of where we see the applicability, again, we would see this as it relates to aspects of energy efficiency around the wastewater pump network. Certainly water quality real-time monitoring in the outdoor water space, and perhaps even on the treatment quality aspects of industrial uses of water.
Great. Thank you.
Thanks, Deane.
Our next question comes from the line of Scott Davis with Barclays.
Hi. Good morning, guys.
Good morning, Scott.
Thank you.
What are you going to do with the other third of Sensus that's not water? Is that something you'll try to build out and grow? How does it kind of play into what you do?
Sure. Yeah, it's a great question. We are, and will continue to be predominantly a water-focused company. As I've always said, we're not going to be dogmatic about water if there are attractive adjacencies that come with an acquisition. In this case, it's very clear to us that the energy-related businesses have strong commercial and operational synergies with the water applications. To be clear, Sensus is a high technology play that we do intend to grow. Obviously, we'll continue to make notable investments in their energy businesses.
Okay. Would that include M&A then, Patrick?
Perhaps. We'll explore that as we get further into their pipeline and understand what the gaps are and what the growth opportunities are.
Okay.
Yeah, one other point I'd add on that.
Oh.
Yeah.
Please
There are strong commercial and operational synergies across all three of those platforms.
Okay. I wanted to ask about FlexNet because I'm not an expert in this stuff, so I'm just trying to figure it all out. How does FlexNet work in with your existing software offerings? Is it open network and so allows your stuff to plug right in? Do you compete against FlexNet in any way, shape, or form currently, and you'd have two platforms then you'd have to consolidate? How does that really work?
Yeah, no, we don't compete with Sensus in any way, shape, or form, nor with their technology platform. This would be an immediate plug-and-play for us. What I would say, Scott, as you've heard us probably say on previous calls, how that we have been looking to build our own remote monitoring and control capabilities within our water infrastructure business. This really just significantly leapfrogs that. That's one of the areas of synergy and efficiency that we're going to drive immediately, is to really let the Sensus team take the primary lead on that. This is all new for us. The benefits of FlexNet, and we can certainly provide more detail on that, is it is a dedicated network. It has built-in redundancy for utility operators that are difficult to get in open mobile or mesh networks.
That's why it's such a big competitive differentiator for them, especially with the smaller utilities in more remote areas, which is the biggest part of the market.
Interesting. Okay. Very helpful. Thanks, and good luck, guys.
Thanks, Scott. To you.
Thanks, Scott.
Our next question comes from the line of Ryan Connors with Boenning & Scattergood.
Great. Thanks, and congratulations.
Thanks, Ryan.
You're welcome.
I wanted to ask about kind of the integration aspects of this. Always integration is a risk on a major deal like this, specifically, you're talking about innovation as a big potential part of the long-term upside here. Talk about the cultural assimilation and meshing those two R&D organizations physically. I know if I'm not mistaken, Sensus is based in Raleigh, North Carolina. You've got a major presence in Charlotte. Is there some kind of synergy going to happen there physically? Just talk to us a little bit about the integration and the roadmap to make sure that-
Sure
there are no stumbles there.
Yeah, sure. No problem. I'll give you a little bit of a lengthy answer here probably. First of all, on the integration side, I'd say that I'm very confident about our ability to integrate this excellent team and asset, because we've built a highly capable team here of experienced people around me over the last years that have done deals of this size or larger. There is a tremendous cultural fit between the organizations. We had an opportunity to build a relationship here over quite some timeframe. As our teams worked together extensively during the diligence process, that was one of the most important things for me to make sure this could be a successful partnership. It really just hit it out of the park in my view, in terms of the chemistry between the teams, and absolutely are going to leverage that here.
In terms of the integration team itself, we have put together a dedicated integration team that will be basically led by myself here. The dedicated integration leader is going to be our former interim CFO, Shashank Patel, who I believe you all have tremendous confidence in as well. He's going to be a terrific leader in that area. We'll have dedicated leadership from the Sensus team as well, working through that. In terms of some of the areas that you talked about, absolutely, we are going to be focused immediately on how we best leverage our combined R&D and systems intelligence capabilities. Preserving that team in Sensus is absolutely a top priority, and making sure that they are very much engaged in helping us identify the best path forward here.
Obviously, we'll have more to share as we get deeper into the integration plan on other things like footprint, et cetera. Suffice it to say, we're going to do things the right way and the smart way, and not create disruption to either organization, going after the last dollar of synergy.
Got it. That's helpful, Patrick. I know there's not too much you can probably share with us, but you talked a little bit there about it being a lengthy process, and a good opportunity to get to know them well. Can you just elaborate to the extent that you're able to on the process? How that played out, how you came about the opportunity, and anything you can share with us there about how it went down?
Sure. Yeah. I would say that, as we said before in our value mapping work, we had looked at a number of different target opportunities in this space. We had already done a fair amount of diligence, as much as we could, on the company before they formally went through a process. I had developed and cultivated good relationships with the senior folks on that side, particularly with the chair. Then, of course, it was a competitive process, and a formal process that was public. That's taken place really over the last couple of months. Obviously, this has been a top priority for us and our team that was involved with it.
I can say that the Sensus team, they could not have been more accommodating and supportive of the work that we needed to do to make sure that we all got to the right answer.
Great. Well, congrats again.
Great. Thank you, Ryan.
Our next question comes from the line of Mike Halloran with Baird.
Hey, morning guys. Congratulations.
Hey, Mike. Thank you.
Let's talk about that growth rate. With limited data we've seen, the growth has been a little more stagnant over the last few years for the portfolio. Obviously, you guys have a high degree of confidence on what that growth rate looks like going forward. Maybe you could just talk a little bit about what was going on under the private ownership, and then what changes once you guys get in your fold in terms of growth. What were the priorities there? Probably more on the cost side than the growth side. Just some more historical context and then some thoughts on what's the go forward then.
Sure, yeah. I would say what we were most impressed by, Mike, amongst many things, was the management team there is a blend of folks that have been around for a number of years, but most notably, new leadership came in a few years ago, with a real focus on improving their customer quality processes, really ramping up their new product development pipeline, and strengthening their international contract negotiating capability. We were just roundly impressed by the rigor, the discipline, the processes they had in place, the things that they already have in backlog, as well as the health of the bidding pipeline that's there.
They've got a number of new products that they've got commitments on that are already hitting the market, that we feel comfortable with, as well as just the backdrop of it improving in market in terms of growth, as Mark shared with you earlier. The AMI market growing more like high single digits to 10% a year. We've seen that obviously, in their growth rates late this past year, as well as through the early part of their fiscal 2017, where they've been growing double digit rates.
Patrick, I'd add to that, certainly with the new management team they brought on, you clearly focus on quality, cost, Six Sigma, but they invested substantially in test of design, new product development, and we did a lot of work with the customer. Did a substantial amount of independent evaluation of these new technologies, not just on the networking side and data analytics, but also on metrology. We clearly believe that they do have leading-edge products, and as Patrick said, we are seeing the evidence through accelerated growth rates through the last number of months.
I would just maybe wrap it up there on that question at least, is I want to be clear again, we have not assumed any revenue synergy in these numbers, which we think can be quite substantial. I think we would be disappointed if we didn't see probably at least $100 million in revenue synergies over the course of the next three years, on a run rate basis. We've got more work to do, obviously, as we get together with the team there and really chart that out and get our teams actioned around that. That also gives me great confidence that there would only be upside to these top-line growth expectations.
That's actually a good segue. I was going to go on the revenue synergy side next. With that, obviously, I don't want to get in too much detail, but when you look at the channels and who you guys are currently selling to with your existing portfolio and who Sensus sells to, is it the same purchasing manager that you'd be dealing with on, say, the treatment side or some of the pump side in your current portfolio, how it looks like? Or is it a different group that you're selling to?
Yeah, it's a mixed bag. I would say, generally speaking there would be some overlap, but they're typically different parts of the operator themselves. When we look at the revenue synergies that are really top of mind for us right now, and I think the list only will expand, is they've got a really interesting international contract bidding pipeline right now that cuts across multiple utilities. A number of those are with customers that we already have relationships today that perhaps are maybe stronger than theirs, or they don't have a relationship there that we think we're going to be able to help them be successful on. 2. To your point around common utility operators where we've already got a foot in the door, and those utility operators are already asking for this type of network monitoring capability, but we've not had the capability to bring that.
Those are going to be easy conversations to have with the customer to see what we can possibly do together. I would say the other piece of this is in emerging markets, where we are, I'd say, a bit larger in a number of those markets. As I said in my prepared comments, whether it be in China, Middle East, India, Australia, we're certainly seeing that customers in those markets are moving to smart infrastructure at a faster rate. They're skipping beyond dumb infrastructure. We think this is an opportunity to help pull their technology through and create an opportunity there.
Okay, thanks. Appreciate it. Very helpful.
Great. Thank you.
Our next question comes from the line of Nathan Jones with Stifel.
Good morning, everyone.
Good morning, Nathan.
Good morning.
I'll add my congrats. This seems to be right in line with the stated strategy and to make good financial sense as well. Congratulations.
Thank you.
Thanks.
I guess if we could just dig in a little bit more on the revenue synergy side. There certainly does seem to be clear paths to top-line synergies here. Thanks for the $100 million number. Could you maybe rank them in terms of where the biggest opportunities are, how quickly you'll be able to realize those kinds of things? Just a little bit more color on the potential top-line synergies.
Yeah. Obviously, there'll be more that we'll share after we close this transaction and we've had a chance to get together with their team and develop specific action plans and put real targets around those. Based upon the areas that we've seen thus far in discussions with them, I wouldn't say there's a clear distinction between one, two, and three, but I would say certainly directionally, helping them even develop more success around winning some of these large multi-year international contracts would be a clear first start. Secondly would be, as I mentioned, the opportunity around, as rapidly as possible, connecting our install base to their FlexNet platform. Obviously building out the value proposition around a number of key accounts would be a second area of big synergy.
Third, as I mentioned, would be, I think on the emerging markets side, where again, I think there's going to be an opportunity very early on for us to be able to pull them into those more advanced conversations with our customers as it relates to a monitoring and control capability.
Okay. Then could you talk a little bit about how you leverage their R&D capabilities and potentially how they leverage your R&D capabilities to drive innovation at a faster pace?
Sure. Yeah. That's a big aspect of this transaction. At the end of the day, strategically, that is a core element, That's why we're going to be very clear here on preserving, protecting, and leveraging our combined capabilities. I would say that we have already been doing a number of things early stage as it relates to building out this broader systems intelligence capability and moving into the IoT space. We're now going to be able to really, quite frankly, simply leverage their capability and really have that team take the lead with our commercial support. Because at the end of the day, it has to be made relevant to our customer base. That'll be a clear marriage that we'll be focusing on early on.
I think that the other thing that they clearly are going to bring to us is we've spent a lot of time here over the last year with Jay Iyengar coming on board as our innovation technology leader in building out an infrastructure that we can really build a broader ecosystem, where we do more open source innovation with external partners. I think bringing Sensus into play now only expands that opportunity in terms of the types and quality of companies that are going to want to partner with us. Third, what we bring, we've got deep domain expertise, both in the R&D area, but also in the commercial area around energy efficiency within our pumps. Obviously, we already do data analytics to some degree in our analytics platform.
I would say we bring more of the domain expertise with respect to our customers on the things that matter most to them around the equipment and products that we have installed.
Okay. Then I've just got one little thing to pick on slide 12. You're looking at them currently 19% on $837 million of sales. If you just add in the $50 million of synergies on no growth, that would actually get you to a 25% EBITDA margin. How come the target in 2020 is only 23%?
Well, certainly there's some costs that we'll incur as we bring them on for public company costs. There's some IT costs. We're also going to be continuing to invest in growing the business, so sales, marketing. We think that is an appropriate margin level that is clearly achievable.
Okay. That's helpful. Thank you very much.
Yeah. To be clear also on this, because we didn't say this in our comments. The synergy numbers that we're talking about here on the cost side are going to be on both sides of the house. So, this is going to be a combined effort to get to that number and deliver on this commitment.
Okay. Thank you.
Hey. Yeah, one other point I want to make. I'm getting kicked by Phil under the table.
Not too hard.
I think there was a transpo in one part of my prepared remarks where I talked about the multiple post synergies, and maybe it was wishful thinking. I think I said 1.8 times. It's actually 8.1 times. Let the record show, just in case anybody was listening closely.
It would be a really fantastic deal if it was 1.8, though.
Right. We're working on it.
Thank you.
Sure. Thank you.
Our next question comes from the line of Robert Barry with Susquehanna.
Hey, guys. Good morning. Congratulations.
Hey, good morning, Robert.
Good morning. Thank you.
Just picking up on some of these questions about deal context. You mentioned the very attractive valuation, and I would agree. Just given the public nature of the sale, the competitive process, I'm curious how you'd reconcile the much lower multiple you're paying versus Xylem's multiple, especially given this firm seems to have actually even better growth and margin characteristics.
Sure. Robert, I'd say, first of all, that every company and transaction has its differences, and it wouldn't be appropriate for us to comment on that or other public companies' trading multiples, et cetera. Having said that, we've done extensive work here. Our due diligence suggests that we obtained a very good price here for an excellent asset that has significant growth potential and very solid fundamentals. That's probably about all I could share on that.
Got you. Anything noteworthy on the balance sheet in terms of pension or asbestos or anything like that?
They do have some pension obligations that we'll obviously assume. They're not very significant. It's a relatively asset-light business. There's not anything significant in terms of contingent obligations. That's not an issue or a concern for us.
I think you're also going to find, Robert, when we close this and you see the financials for Sensus, I think you're also going to be impressed by their working capital performance, given the nature of their business model and how well they run the operations there. It'll be much lower than ours.
You did also mention regulation as a driver. To what extent are we in some sort of regulatory-driven cycle here? If that's significant, what stage would you say we're in there?
Yeah, I would say we are still in the earlier stages. Now, I'm talking specifically about the water sector, certainly in the energy space they play in. That's been a highly regulated sector for quite some time, which drives specifications and need for data. I'd say we're in the early innings on the water side. That obviously depends upon which geography we're talking about. I would say it is a big opportunity in some of the emerging markets where actually the regulations are quickly getting ahead of those in the U.S. We think that's a big selling and opportunity on the data analytics, et cetera. I would say here in the U.S., again, probably early to mid-innings in that area. We're clearly seeing that drive.
That's also one of the areas that we think can be an opportunity as it relates to the industrial sector in terms of using water as there's increased regulations on water discharge and pre-treatment of water. We think there's going to be an opportunity in that space as well.
Great. Congrats again. Thanks.
Thank you.
Thank you.
Our next question comes from the line of John Walsh with Vertical Research.
Hi. Good morning, and congrats on the announcement.
Thanks, John.
Thanks.
I wanted to go back to an earlier question, just kind of thinking about that gap on the adjusted EBITDA margin out in 2020 and relative to what the synergies imply. It sounds like the business has kind of already done a little bit of investment here for AMI, already elevated the growth rates. Thinking about going forward, what's embedded in the plan to kind of sustain and realize that 6%-7% top-line growth. I don't know if you can talk about R&D as a % of sales or-
Yep
or some other metric like that.
Sure. Yeah. We clearly would be expecting here to, and it's built into our financial models, that we would be doing further investment in this business, whether it be, again, supporting the needs for data analytics capabilities, building out that business model. The team's done a great job. They did a great job already of building that out, and we think there's opportunities to potentially accelerate that. We're going to be needing to invest in some further sales and marketing capability for the combined organization, especially as we're looking to commercialize this on the wastewater and outdoor water side. I would say third is in the area of R&D. They have been spending upwards of, if you look at all of their R&D, including some of the software development that they capitalize, it's been about 10% of revenue over the last couple, three years.
Not putting a number out there just yet as to what that number will be, we do think there needs to be a healthy continued investment there. We think we're going to be able to fund a portion of that by some of the things that we're not going to need to do here on the Xylem side that we would've otherwise had embedded in our three-to-five year outlook.
All right. Gotcha. Maybe a little early to talk about what the business is seeing, but in that 400 basis points of improvement through 2020, is there any price embedded in that assumption?
No, there's not.
Okay, great. Thank you.
Okay.
Yep.
Thank you.
Our next question comes from the line of Ryan Castle with Seaport Global.
Good morning, congrats.
Good morning.
Good morning. Thanks.
You mentioned a couple of times the use of $400 million of non-U.S. cash. I just want to be clear because it's a U.S.-headquartered company, it appears. Are you bringing some of this cash back to the U.S. or there's some advantages and nuances here that I'm missing that you could help me with?
Sure. No, we're not. While they are largely a U.S.-based company, they do have operations outside the U.S. What we've been able to do is structure the transaction such that we're able to use cash that we have outside the U.S. to acquire those entities.
Okay, great. You talked about utilities rapidly transitioning AMI and that growth rate, perhaps 10%+, if I heard that correctly. Can you just talk about how sustainable is that and if the spending cycle there jives in terms of the timeline and duration with the legacy Xylem product spending cycle that we've been hearing about?
Sure, yeah. Obviously, one never knows how long the cycle is on these things in terms of definitively, and certainly things can happen. We've corroborated those outlooks with a number of different sources, and it's consistent with what we've seen historically here over the last number of years. I mean, this is a market that's been growing in the healthy mid to high single digits for a while. We've seen, again, this continued adoption of AMI. The nice thing about this is AMI is actually cannibalizing the other parts of the metering market. That's what's really driving the higher growth rate. It's less to do with utilities' budgets and spending. It's more to do with they've got a certain amount they have to spend on reinvestment in their metering network.
It's a matter of putting smarter network in rather than the historical dumber networks.
Yeah, to that point, it is, particularly in the water space, AMI is just less penetrated than it is in gas and in electric. Particularly, I mentioned this in some of my comments, particularly in the smaller to mid-size utilities, they've been a little bit behind the larger utilities in terms of their investments in networked solutions.
Great. Congrats. Thanks.
Thank you.
Thanks.
Our final question comes from the line of Jim Giannakouros with Oppenheimer.
Good morning. Thanks for taking my questions, and congratulations.
Thank you.
Thanks.
Just to make sure I understand, are you differentiating between AMI and AMR? Is Sensus going after AMI displacing AMR, or are you using the terms to cover both?
No, we're using AMI to cover AMI, and it is working to replace AMR.
Got it. Okay. When just looking back at Sensus' historical growth over the last 13 years or so, they've grown on a CAGR of 4%, a little lower than what you're projecting on a go-forward basis, appreciating that we had a monster dip years ago. Is there anything else that would explain why revenues hadn't grown greater than that in their decade plus in their predecessor's hands? Thanks.
Yeah, sure. Part of that is FX. You need to adjust for that in terms of what the impact would be, and that's what really drives it more to a mid-single digit kind of growth. Obviously, as we said before, the new management team coming on board really had been focused in on addressing some of the legacy customer quality issues, as well as ramping up their new product development pipeline, a number of which are related to addressing some of those issues. We're encouraged by what we've seen here over the last number of quarters in terms of what they're delivering at this point, as well as what we're seeing just in the sheer uptick of the overall metering market, but specifically the increased adoption of AMI.
Great, thanks.
Thank you.
That was our final question. I'd like to turn the floor back over to Patrick Decker for any additional or closing remarks.
Well, again, thanks everyone for joining the call on short notice today. I think you can hear that we're obviously very excited about this transaction, and the opportunity to join forces with our colleagues there at Sensus. Obviously, we're laser-focused here on executing on our base Xylem business, as well as being all over the integration plan development here with the Sensus team. We'll have more to report out to you on our next earnings call. Between now and then, have a joyous end to the rest of your summer. Safe travels, and we'll talk to you shortly. Thank you.
Thank you. This does conclude today's conference call. Please disconnect your lines at this time and have a wonderful day.