Welcome to Xylem's first quarter 2014 earnings conference call. At this time, all participants have been placed in 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 touch-tone 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 De Sousa, Vice President of Investor Relations.
Thank you, Susan. Good morning, everyone, and welcome to Xylem's first quarter 2014 earnings conference call. With me today are Chief Executive Officer, Patrick Decker, and Chief Financial Officer, Michael Speetzen. They will provide their perspective on Xylem's quarterly results and discuss the full-year outlook for 2014. Following our prepared remarks, we will address questions related to the information covered on the call. At which time, I'll ask that you please keep to one question and a follow-up, and then return to the queue so that we will have enough time to address everyone on the call. 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.
All references today will be on an adjusted basis, unless otherwise indicated, and non-GAAP financials are reconciled for you in the appendix section of the presentation. A replay of today's call will be available until midnight on May 13th. Please note the replay number, 404-537-3406, and the confirmation code is 22345240. Additionally, the call will be available for playback via the investors section of our website under the heading presentations. With that said, 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 in subsequent reports filed with 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. Now, please turn to slide three, and I'll turn the call over to our CEO, Patrick Decker.
Thanks, Phil, and thank you all for joining us this morning. Today, we announced our first quarter 2014 results. In a moment, I'll give you some headline comments and perspective on the quarter. I will then share some perspective on what I've seen and heard thus far since joining the company six weeks ago. Then I'll turn it over to Mike to share more details on the quarter and our full-year outlook. Given the slow start to the year, which was driven in large part by severe winter weather conditions in North America, the team certainly closed the quarter strong and delivered a solid performance. Heading into the last month of the quarter, we understood it would be critical to drive hard to recover from the slow January and February to get back on track.
I'm very pleased with the way the team embraced the challenge, particularly during a CEO leadership transition and challenging market conditions. During the quarter, orders and revenue grew 3% overall and organically, with strong performance coming from emerging markets. We enter the second quarter with backlog of $793 million and 2014 shippable backlog of $679 million, which is up 6% year-over-year. We continue to invest for growth. During the first quarter, we spent $27 million in R&D, up 4% from the prior year. We expect those spend levels to continue through the year. We see prior years' investments in product development paying off. For example, sales of Flygt Experior embedded with new SmartRun technologies grew approximately 50%. This demonstrates the continued adoption of smart technology and Flygt's capability in market-leading product development. Additionally, our investment in MultiTrode is also driving growth.
For example, we just recently completed the release of our MultiSmart Controller in 12 additional languages, enabling us to expand sales of this line to approximately 20 new countries. Just as critical are our ongoing cost reduction initiatives, such as the $18 million of restructuring and realignment costs in the quarter targeted at reducing our overall cost base. We'll see the benefit from those actions in the latter half of the year. We continue to realize significant savings from the actions the team completed last year, which resulted in 150 basis point improvement in operating margins in the first quarter. To wrap up the first quarter results, volume growth and improved operating performance drove earnings per share of $0.34, up 26% over the prior year. Free cash flow was negative $3 million, primarily reflecting typical seasonality and working capital dynamics.
We are confident in achieving our full-year free cash flow target of 100% conversion of net income. Finally, on the capital deployment front, we increased our first quarter dividend by 10% and opportunistically repurchased $50 million in common stock. We will cover some of my initial observations since joining the company on the next slide. I'll highlight one message I've already stressed, the importance to get off to a good start, which in my view is key to delivering on the full-year commitments. We're off to a nice start, headed in the right direction, and have laid a strong foundation for the rest of the year. Thanks to the entire Xylem team worldwide for getting us off on the right foot in 2014. Turning to slide four. I'll turn it over to Mike to cover the first quarter results in more depth in a few minutes.
Before that, I'd like to share with you some of what I've seen and learned so far and what my early-stage priorities are for the business. One of the things that attracted me to Xylem in the first place, beyond the opportunity to be part of something that has the potential to make a big difference globally, is to be part of a young company with a tremendously bright future. That makes Xylem unique. We have a lot of experience to leverage within our business, and it's important to me to tap into that experience, to listen and learn, and to use that knowledge to help shape our future. Let me give you a sense of where I'm focusing my attention as I settle into my new role. After joining on March 17, I convened a set of briefings on key strategic topics with Steven Loranger and the team.
These meetings were crucial for me to gain an even deeper perspective on the business and to make sure I thoroughly understood our financial commitments and the actions necessary to deliver them. I want to thank Steven Loranger once again publicly for his tremendous leadership and sacrifice during his tenure as the CEO, and for the very smooth transition he has worked hard to provide me. I was excited to hit the road and develop an early sense for the strengths and opportunities in our business. Over the course of the first month, I visited more than 12 locations in five countries. The sites I visited represent some portion of all of our business lines and cover more than 20% of our global workforce. I'll be visiting more sites in the next few months with a particular focus on a number of our key emerging markets.
While pushing hard to get to know the business and our people, my primary responsibility, of course, is to direct our performance. As we move through the second quarter, it's critical that we stay laser-focused on driving our performance so we meet the targets we've set. Let's move on to recap what we have to do in 2014, because there's much work still ahead. We need to maintain and grow the confidence of our investors in Xylem by delivering on our commitments. Let's start with our financial commitments. In 2014, we must generate top-line growth and at the same time improve our operating efficiency and align our cost structure to be more competitive. For the year, we expect to achieve nearly $4 billion in revenues. As you already know, we're a company that addresses challenges around the entire cycle of water.
The world is changing rapidly, the world's problems related to water productivity, quality, and resilience are changing, too. It's exciting to think about our potential to take our innovative products and services and our strong relationships with our customers, and solve these new and evolving water challenges. To do that, we will need to continue to drive productivity that will enable further investment in innovation and our people in order to capture new growth opportunities. In terms of operating income, we expect margin to improve to the 13% range. This would result in earnings per share between $1.85-$2 as we've previously guided, and would represent somewhere between 11%-20% growth. To make or exceed our 2014 operating income goal, we need to execute on our initiatives in Lean Six Sigma and get the maximum leverage from our global strategic sourcing capability.
I am a big believer in the returns we can see from Lean Six Sigma. I've seen it work. The benefits go well beyond productivity, and we shouldn't think of Lean applications as only for the factory. Every business and every function within Xylem can and will benefit. We want to achieve a high level of incremental efficiencies. The great thing about the progress we make in this area is that it sets us up to be more efficient and competitive. Improvements in our cost structure that carry to the bottom line will certainly have a positive effect, not just on 2014, but on 2015 and beyond. In addition to our financial goals, we have a few other top-level priorities for the company this year. Among them, optimizing our integrated front end to accelerate our growth and improve our sales force effectiveness.
It is one of our most important initiatives. It's a big lever, and it will enable us to present a more informed, more focused, single face to our customers and allow us to cross-sell our portfolio of leading products and services. Integrating the front end and implementing the associated sales force effectiveness tools we're putting into place, like a customer relationship management system, is no small task for a company with our geographic breadth. It will enable us to significantly raise our game in the market. Next, under the umbrella of advancing and institutionalizing a high-performing organization and culture, we're reigniting the Xylem Management System, or XMS. We want to drive this disciplined approach even further into the organization, carving out and standardizing our key business processes, ensuring accountability and alignment. This helps ensure that we move seamlessly from strategy to execution.
Next is rebalancing our portfolio and our product investments to ensure that we've got the right allocation of resources in the areas that we think will create most meaningful value. We could be more disciplined in our allocation of financial and human resources. This is about investing our money and our time where it matters most, focusing on increasing return on invested capital and enhancing long-term shareholder return. I believe in benefits we can realize by developing stronger global strategic sourcing and Lean Six Sigma capabilities. There are companies in and out of the industrial water space of similar size and geographic footprint that do this really well. We're not one of them, at least not yet. We will be.
Moving beyond our financial and operational objectives for this year, there are three top focus areas, ways of doing business, if you will, that are very important to me. I shared these in my day one message to all employees and want to speak about them again briefly to you as well so you understand what's most important to me. These three concepts can be applied to any businesses, but I believe they are particularly applicable to our company. The first is putting customers at our center. To me, this means listening to customers, understanding them, and even anticipating their needs. A lot of companies say they do this, but not all of them do it very well.
I oftentimes use the expression, "Keeping our center of gravity squarely around the customer." I know many of Xylem's employees share that same view because I've seen that firsthand over the last few weeks. We must capture the voice of our customer and integrate it not only in how we sell to and service our customers, but how we tie the voice of the customer into how we innovate and further expand our portfolio of products and solutions. The second area is investing in our people. We have very talented people around the world with expertise and devotion to solving our customers' most critical water issues. We are a recognized market leader because of our people. More than having expert individuals, our power comes when we operate as a global team, leveraging everyone's important role in what we're aiming to accomplish.
I believe in empowering our people to do their jobs. This empowerment includes providing the right training and development, as well as honest and constructive feedback around performance to goals. Most important, I believe in providing an environment that ensures everyone's safety. In my experience, strong safety performance almost always coincides with good employee engagement, which ultimately translates into strong financial performance. The third area involves driving repeat performance. It bears repeating. Lean Six Sigma or continuous improvement works. It's important that we embed all these tools in what we do every day. Equipping our people around the world with continuous improvement skills will be a key part of our training and development efforts. It's not lost on me or any of my team that we have faced significant challenges, but I am convinced that we are well on our way to overcoming these.
I don't expect that road ahead will be entirely smooth, nor should you. I am excited about the direction we're heading, confident in the future, and very excited to be leading this team. With that, let me turn the call over to our CFO, Mike Speetzen, to walk you through the results and full-year guidance in more detail. Mike?
Thanks, Patrick. Please turn to slide five. We generated revenues of $906 million, up 3% from the prior quarter. It's worth noting that we're comparing to first quarter last year, where we experienced 7% organic revenue contraction. The public utility, industrial, and residential end market showed strength relative to poor performance last year. The public utility end market was up 5%, driven by continued infrastructure investment in emerging markets. While we did have some sizable projects deliver in Europe and the U.S., customers remained focused on operational expenditures and small project activities. Growth of 1% in industrial stemmed primarily from emerging market demand, including the delivery of several projects for the power market in Korea and heavy industry in China.
While the commercial market came in flat for the quarter, residential continued to demonstrate growth, up 6% over the prior year, driven by growth in both the U.S. and emerging markets. I'll cover off more specifics by segment, but generally speaking, we saw strong growth from emerging markets, up 18%. Modest growth of 1% in the U.S. was down 1%, most significantly impacted by weather. We delivered strong operational performance. Operating income of $94 million was up $16 million or 21% over last year, and operating margins increased 150 basis points or 10.4%. The first quarter performance was driven by the increase in organic volume and savings from cost reduction initiatives across our businesses. Cost reductions totaled $31 million and included approximately $10 million of restructuring savings, with the balance coming from sourcing and Lean initiatives.
Partially offsetting these tailwinds was inflation of nearly 2% and unfavorable mix due to lower dewatering rental revenue, which stemmed from the severe weather conditions experienced early in the quarter. Incremental margins were 59%, including the benefit from restructuring savings and unfavorable foreign exchange. Excluding these items, incremental margins were still strong at 42%. EPS expanded 26% to $0.34, better than we anticipated, driven by favorable revenue performance and accelerated cost actions given the slow start to the year. Core operations drove the year-over-year EPS improvement, contributing $0.10, driven by organic volume growth combined with execution on productivity and cost management, including restructuring savings of $0.04. Let me provide more detail on each of our reporting segments. Please turn to slide six. Water Infrastructure reported revenue of $568 million, up 4% organically.
Additionally, we had one percentage point of growth from acquisitions, and foreign exchange was a two-point headwind. We experienced organic growth in all of our applications, with transport up 3%, treatment up 9%, and test up 5% year-over-year. Regionally, we saw the most significant growth come from emerging markets, which were up 24%. Europe was positive, up 2%, and slightly better than our expectations, but was more than offset by the U.S., which was down 6%. I'd summarize our revenue performance as follows. Growth was driven by water and wastewater infrastructure investment in emerging markets, for example, China, which was up more than 50% year-over-year. Increased demand for mixers and project deliveries drove mid-teens treatment growth in Europe, which was partially offset by the slow recovery of the U.S. CapEx market.
Test was up 5% for the quarter, driven by project shipments into the emerging markets, such as a $3 million order to Brazil's National Water Agency, ANA, our largest analytics delivery into this region to date. In addition, Test had two large shipments to China's Ministry of Environmental Protection. Lastly, our dewatering business was down low single digits as we lapped a tough compare with Superstorm Sandy and saw the negative impact to our rental business due to the severe weather in the U.S. Operating margin increased 80 basis points from 9.4% to 10.2% due to increased volume and cost reductions. Restructuring savings of $7 million, coupled with sourcing and Lean initiatives, more than offset the negative effect of inflation, unfavorable mix due to weather impacts on our rental business and foreign exchange. Let me now turn to slide number seven and talk through our Applied Water segment.
Revenue was up 3% overall, with organic growth at 2%. As you can see, building service applications grew 2%, driven by strength in the U.S. market. Irrigation, while relatively small, was up 7%, and industrial water was flat year-over-year. Regionally, we saw growth across the U.S. and emerging markets, which were up 3% and 6% respectively, while soft market conditions continued in Europe, which was down 4% for the quarter. I'd summarize our revenue performance as follows. Growth was driven by continued strength in U.S. residential and agriculture markets, while industrial projects and residential investment fueled growth in emerging markets such as Asia Pacific and the Middle East. While we saw low single-digit growth in our U.S. commercial building services business, we were flat overall, with weakness coming from Europe. Operating margin expanded 100 basis points from 12.2% to 13.2% year-over-year.
Margin improvement was driven by volume leverage, coupled with the favorable impact of cost reductions. Although price was positive, we continue to see downward pressure given current market conditions. Now let's turn to slide eight, and I'll cover the company's financial position. Xylem maintains a strong cash position with a balance of $466 million at the end of Q1 and approximately 71% held outside of the U.S., consistent with our geographic business mix. Our net debt to net capital ratio is a healthy 26%, and our commercial paper and revolving credit facilities remain in place and continue to be unutilized. We remain committed to our balanced capital deployment strategy, which is to maintain and grow the business while enhancing shareholder returns through dividends and share repurchases.
During the first quarter, we invested $25 million into capital expenditures, and we returned $74 million to shareholders through dividends and share repurchases, which is up substantially from $37 million in 2013. The increased return of capital to shareholders was driven by the 10% increase in dividends per share we announced earlier this year and an increase in share repurchases of $36 million. Free cash flow was a negative $3 million and reflects typical seasonality and working capital dynamics. Relative to the prior year, our free cash flow performance improved by $7 million. With that said, please turn to slide nine, and I'll cover our 2014 guidance. This slide summarizes our expected 2014 organic revenue performance by end market. Overall, we continue to see low double-digit growth across the majority of our end markets. Beginning with industrial, our largest end market, representing 45% of our total revenues.
In the U.S., the industrial market continues to slowly recover, and market reports suggest that demand conditions are generally improving. In Europe, macro indicators suggest that the market may have bottomed out. Lastly, partially offsetting growth in these regions is a continued weak global mining market. Public utility, at 34% of our total revenues, is our second largest market. We continue to expect growth in emerging markets. While we are currently expecting a slow recovery in the U.S. and European CapEx markets, we have seen market indicators suggesting conditions could be improving. We have already seen some of this activity in our bookings, and we still have a robust pipeline of projects we are actively pursuing. We expect to continue to see strength in maintenance and repair activity.
While we expect building service applications in the commercial and residential markets to be up low single digits in 2014, commercial growth is expected to come from emerging markets and a successful launch of new products. However, we expect to continue to see soft conditions in the U.S. institutional building market and a slow recovery in Europe. We've seen slightly better performance from residential in the U.S. but anticipate this will subside as the housing recovery moderates. In Europe, we expect conditions to continue to stabilize, and it's also important to note that last year we posted very strong residential growth, creating a tough year-over-year compare. Lastly, our bookings and backlog position coming out of Q1 supports a low single-digit revenue growth trajectory. Our backlog position as a percentage of the balance of full year revenue is 22%.
While encouraging, we still have to see consistently improving book and bill rates throughout the balance of 2014. I'd also like to note that we're encouraged by the strength in backlog deliverable in 2015, which is up 34%. Please turn to slide 10. Let me spend a few minutes covering our full year guidance in detail. We anticipate 2014 revenues in the range of $3.9 billion to nearly $4 billion, which reflects organic growth of 1%-3%. For Water Infrastructure, we expect revenues of approximately $2.5 billion, reflecting organic growth of 2%-3%. For Applied Water, we expect revenues of approximately $1.5 billion, reflecting organic growth of 1%-2%. Segment margins are anticipated to be in the range of 14.1%-14.6%, and operating margins are projected to be in the range of 12.6%-13.2%.
We anticipate earnings per share of $1.85-$2, excluding 2014 restructuring and realignment costs of approximately $40 million-$50 million. We expect approximately $15 million of the savings from restructuring to be realized in 2014 from these actions. This is in addition to the carryover savings of $25 million from the actions executed in 2013. Our operating tax rate is expected to be approximately 21%, and fully diluted share count is expected to be approximately 185 million, which takes into account anticipated share repurchases of approximately 130 million in 2014, of which 50 million has been completed. Please turn to slide 11. I'd like to spend a minute calibrating everyone on the call around what we expect our first half and second half revenue and operating income profile to be in 2014.
While we do not provide quarterly guidance, we recognize that it's helpful to highlight trends and expectations to assist in modeling. For revenue, we see the first half representing approximately 48% of our full year, which is consistent with our typical seasonal profile. This reflects sequential growth in Q2 of 8%-10%, with growth balanced between both segments. While our backlog is up 10% year-over-year, Q2 shippable backlog is up only 3% versus last year, supporting a Q2 organic growth rate range of 1%-3%. Operating income performance in the second half will be driven by volume leverage and incremental cost improvements in areas such as global sourcing and lean. We see second quarter margins improving sequentially from the first quarter by 130-170 basis points. We are on track to deliver the $40 million restructuring savings, which is equally split between first and second half.
Although corporate expense was below the full-year run rate, we do anticipate spending between $55 million and $60 million for the year. In summary, backlog trends are supportive of the 1%-3% organic growth target, and we're pleased with the progress being made thus far on cost reductions to ensure we meet our profit expectations. With that said, please turn to slide 12, and let me hand the call back over to Patrick for some final comments. Patrick?
Thanks, Mike. We delivered a solid first quarter, which gets us off to a good start to the year, and we're very excited by the direction Xylem is headed. As Mike indicated, we see stable market conditions and are gaining momentum in orders activity. Operational performance is improving. While we are not where we need to be yet, I am pleased with the progress the team has made and the trajectory we are on. As I mentioned in my opening comments, we are clear about our focus areas and remain committed to delivering on our financial commitments and recognizing the full potential this company is capable of delivering. Operator, we can now begin the Q&A session.
The floor is now open for questions. At this time, if you have a question or a comment, please press *1 on your touch-tone phone. If at any point your question is answered, you may remove yourself from the queue by pressing the # 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 Citi Research.
Hey, that was a nice clean quarter. I had a couple questions. The first will be on the emerging markets. Seeing an 18% organic revenue is very impressive, as well as the 50% up in China. If you could just give us some additional color, how much of that, is it a lumpy business? Are these big projects? Is there any MRO associated with them, how does that play out the balance of the year?
Thanks, Deane. The 18% growth was terrific, and as you indicated, there's definitely project activity that comes with that, and it was pretty balanced across the various regions. I think the key point I'd make is that we are anticipating that it will decelerate. We anticipate the full year emerging markets will be in the high single digits. Although it'll continue to be very positive for the business, we do see it moderating a bit. As you indicated, we are dealing with some of the project deliveries and saw a couple of those accelerate into the first quarter, which created a little bit of a distortion in the growth rate.
Deane, I would just add that the emerging markets, that whole area, in my mind, from a strategic standpoint, is I think a big area of opportunity for us. I'm actually going to be traveling over to Asia for the first couple of weeks of June to hit a number of our markets over there and just get a better feel for the pulse of the business. I'm very pleased with the quarter, but I'm also very much focused on what the long-term potential is for us in those markets.
I should have also added, it's rather be in a position of explaining why the emerging markets are up so much rather than the other way around.
Yeah.
All right, the second question for Mike, I know you alluded to the fact that corporate expense came in light this quarter. Maybe if you could calibrate for us what some of the puts and takes were. I know from our estimates, it came in light by about $0.025 favorable. Was there some discretionary spending that you pulled back, and what other puts and takes might there be?
Look, there's always puts and takes relative to things like compensation accruals and things like that. I think, given that we saw the year starting off slow and saw the weather having a pretty heavy impact on our very profitable dewatering business, we made some discretionary decisions around deferring certain costs out of corporate. That was really consistent with what you've seen us do in the past, where we're keeping a very quick pulse on the business and reacting quickly as well. We do anticipate some of that coming back into the business. As I mentioned in my prepared remarks, we see corporate being in the range of $55 million-$60 million for the year. You ought to anticipate us being around $15 million-$16 million per quarter.
Perfect. Just last one from me is maybe you can address how the cadence of the quarter played out. You said January and February were light, March came in strong. Can you give it to us on an organic revenue growth basis by chance?
Yeah. I guess maybe I'll put it in these terms. When we looked at February, as I mentioned in Patrick's introduction call, we were actually flat year-over-year. When we looked at how much we had delivered through that point, we were at about roughly $500 million worth of revenue. We were anywhere from two to three percentage points behind where we have historically been. By default March came through a couple of points better than we had originally anticipated. I really give a lot of credit to the teams, given the weather conditions improved. Teams went back out at it. Dewatering, for example, we had seen utilization rates in the low 40s, 40% range in January and February, and we saw those utilization rates improve back up into the high 40s.
We did not recover the January and February missed revenue, particularly in that business, the teams really took advantage of the weather being back. We didn't run special promotions or anything like that. The teams just went out and made sure that we were executing on the business.
I would just add, Deane, that I, having come in the middle of the month and knowing and seeing firsthand the level of focus and intensity the team was placing on this, I was very impressed by how they came together. Rather than making excuses, we're really going out and just, as Mike said, doubling down, and the teamwork across the organization was very impressive those last three to four weeks and months.
Your next question comes from the line of Ryan Connors with Janney Montgomery Scott.
Thank you. Yeah, this question is for Patrick. Patrick, you mentioned the top three focus areas on slide four, and the number one focus area there is putting customers at the center. There's been some level of chatter in the marketplace, maybe some of it opportunistic by your competitors, that given the last few years, there's been a lot of distraction, the spin out, multiple changes at the top. Is the fact that that goes at the top of your list any reflection that you think there is merit to that distraction and now we need to refocus? Or is it something else that you saw in your travels that led you to put that at the top?
Yeah. Well, I appreciate the question. I'd say, first of all, throughout my entire career, it's always been very clear to me that keeping customers at the center is got to be at the forefront for any organization and company. I will then add that I think, any organization that is going through a number of changes in transition, a company like Xylem has done, naturally there are going to be magnetic forces that pull people away sometimes from focusing on the customer. I have been very impressed by what I've seen out at the local level in terms of people's passion for the customer, the whole passion for being very entrepreneurial at a local level. All I'm trying to do here is to really elevate that. You've heard Steve talk in previous calls about the importance of us investing in innovation.
That also is very much a centerpiece for me, because I do think we have opportunities here to, again, leverage our productivity to invest even more in innovation over time.
Then kind of a related follow-up is just in terms of compensation structures and incentives, both for, I guess, in both the manufacturing side of the house and maybe more importantly, in the customer-facing side of the house. As you look at the way things are structured, are there any changes or tweaks you think that need to be made in terms of how the teams are incentivized to drive the business?
Well, I would say, again, good question. It's early days for me. It's my seventh week in the organization. Obviously, making sure that we've got the right organization model in place, which I feel good about in terms of the changes that have been made here. Making sure that the incentive structure is aligned with that are clearly very much on my radar screen. I think it's premature for me to comment right now on that.
Your next question comes from the line of Mike Halloran with Robert W. Baird.
Morning, everyone.
Mike, good morning.
Could we just go through the puts and takes when looking at the front half of the year versus the guidance for the back half of the year? Obviously, a large portion, a little over half of that's going to be just the sequential volume uptick that you guys are projecting. What are some of the other puts and takes there sequentially from a mix perspective as you see restructuring layering in and any other items like that?
Yeah. I think a couple of things, Mike. Restructuring is going to be pretty even throughout the year. It's going to be about $20 million in the first half and the second half. What you really see is a couple of things, and you hit it. It's the volume leverage as we get into the back half of the year. We're going to end up delivering, call it another $150 million worth of revenue. It's going to have a pretty hard mix in our Water Infrastructure segment, which as we've indicated, drops at a pretty high rate. In addition to that, as we laid out in our guidance, we talked about the $100 million worth of cost reductions. It's a little more biased towards the back end of the year. If you look at our first quarter, we get about 22% of the total savings, including restructuring.
We're going to end up picking up another, call it $15 million-$20 million in the back half, which is really the work we're doing to accelerate a lot of the sourcing savings that we think the business has the potential to recognize, as well as just getting the lean projects up and going. You've got the volume leverage coupled with a higher level of the profitability coming through on the productivity savings.
Makes sense. Then on the dewatering platform, obviously mining is a little bit of a headwind. Weather was a headwind in the first quarter. Maybe you could just talk a little bit by end market, what you're seeing there as weather and trends start normalizing, and which of these are areas of strength or improvement, and which areas are still soft?
I think you're right. The mining is going to continue to be a headwind, especially in the first half, because then we'll start to lap some of the things we saw playing out last year. For us, the first quarter, whether it was public utilities or construction, given the freezing conditions, the fact that we had, I think, over 20 Godwin branches that were shut down due to weather and construction sites being down. We saw that part of the dewatering business down kind of, call it mid-single digits. As we go through the balance of the year, we're not anticipating a recovery in mining. We definitely see the construction markets improving, we'll definitely see public utilities getting back to a more stable environment.
I think that'll really help from a mix perspective, back to your first question, with the rental business picking up momentum through the course of the year.
Appreciate the time.
Thanks, Mike.
Thanks.
Your next question comes from the line of Nathan Jones with Stifel.
Good morning, Patrick, Mike, Phil.
Morning.
Morning.
Patrick, during your prepared comments, you spent a fair bit of time talking about your philosophy and your approach to management in terms of Lean Six Sigma voice of the customer. It's probably unfair to ask you about where the opportunities are within Xylem at this point, but could you just expand on that a little bit more and how you intend to drive those changes down through the organization?
Sure. Again, thanks for the question. I would summarize it as this. As I've traveled around, I've clearly seen some pockets of real strength and excellence, as it relates to the application of Lean Six Sigma, and also even in the area of sourcing activity. I do believe that there's an opportunity for us to make that more consistent in its application, to also make it deeper in its application. For example, what I've not seen as much of is the application of Lean Six Sigma kind of beyond the four walls of a factory. When you start getting into the sales and marketing area, the R&D area, I've seen pockets of it, but I think there's more opportunity for us in that area that will also help us enable to drive growth.
In terms of how I go about doing it, again, I think messaging across the organization and making sure that people understand it is a number one priority for me, is where it starts. Also making sure that we are investing adequate resources, in terms of training, certification, but also how we deploy the resources across the organization. There's a multitude of things that I'll be driving in that area as we go forward. As you know very well, this is a journey, and it's a journey that's never ended. I think that we are well on the path to realizing it, but there's still opportunity in front of us.
Okay, my follow-up is on the tests, strong growth there. You did call out some large project shipments in that business. Is that something that you're expecting to recur, or are we expecting to see a moderation of the growth rates there?
I think there'll be a little bit of a moderation, as I've commented overall for around the emerging markets. With us, 18% in the first quarter, we're going to see that moderating down into what I'll say is the high single digits as we move forward. Again, it could move around within the quarters, but at this point, I don't anticipate seeing anything significant for that particular business unit anyway.
Great. Thanks, guys.
Thank you.
Thanks, Nathan.
Your next question comes from the line of Scott Davis with Barclays, please.
Good morning, guys.
Hey, Scott.
Morning.
Patrick, I know it's early days, so it's kind of hard to answer some of these questions, I'm guessing, but I wanted to touch on a couple topics. First is just the cost base. It was always our understanding, at least, that the high fixed cost base in Europe needed to be chipped down at. Have you dug into that or at least have any early read on whether that cost out, take out the past restructuring that's already done, but whether that cost base can in fact be brought down to better levels, or do you just need volumes to come back to make that business look better? I guess I'll just open it up to that.
Sure. Yeah. Volume always helps certainly, and we've shown certainly this quarter that leveraging that volume growth is a great way to expand margins. My assessment right now is that I think the commentary that's been made in the past around there being a couple of 100 basis points or so of SG&A opportunity that's still in front of us, I think is very fair. I've seen opportunities as I've traveled around that I do believe we can drive that number down. In terms of margin expansion, again, I still believe that through, again, some of the Lean work that we can do, there will be opportunities in that area as well, as we go forward.
In terms of any other kind of cost takeout actions, I think, again, there's opportunities there in terms of helping us get this business to that mid-teen margin that's been put out there in the past as a long-term goal.
Okay. Fair enough. As a follow-up, one thing that was missing in your slides in the early days, it was really the portfolio in M&A. How do you think of driving the M&A organization? Do you have to take a back seat for a while until you make the cultural changes you're looking for, or can you proceed on continuing to look at assets and maybe even potentially getting more aggressive?
Sure. Yeah. I think that acquisitions are and definitely will be a key element of our growth strategy, in terms of getting our growth rate up to where we have stated we want it to be. We've continued, and I've seen the teams continue to cultivate opportunities, even while we've been in this slight pause for a while. I think now that we've made a lot of progress on the operating improvement actions, obviously we still have work to do there, that gives me increased confidence in execution. Obviously, we no longer have the lingering questions around CEO change. I'm very pleased the team has maintained a pipeline of candidates, and continue to have a strong balance sheet that we can obviously leverage when the time is right. Again, a little bit more time for me to spend with the team.
Of course, the market factors always come into play here and when the right opportunity is available, but I can reinforce that acquisitions will be a key element of our growth strategy.
Okay, great. Welcome, and good luck, Patrick.
Thank you.
Thanks, Scott.
Your next question comes from the line of Matt Summerville with KeyBank.
Good morning, guys. This is Joe Radigan for Matt. My first question is just a follow-up on an earlier answer. Have you seen the pickup in March? Has that carried through into April so far? What are you seeing more up-to-date trends?
Yeah. We're actually right on the forefront of getting results for the month of April. Based on what we've seen and heard, there's a little bit of softness. Some of that's the project deliveries that accelerated into March. Otherwise, we really haven't seen any significant deviation from the trends that we saw in the month of March.
Okay. Mike, I think you said, in your prepared comments, that you've seen some early signs of the CapEx-related business improving. Was that a U.S. comment or a global comment? What are you seeing there that gives you more confidence that maybe we could be seeing a recovery at some point on the horizon here?
Yeah. I think it's between both regions. As you know, Europe is a number of different regions. We tend to see more of the strength in the, call it, western and northern part of Europe. The reason that we have increased confidence is when you look at the backlog that's shippable for 2015, it's up 34%. When you look at it between the two segments, it's actually up over 40% in Water Infrastructure. That obviously has some projects that are in emerging markets, but it does also contain the work that we see going on, and we've seen it. I'll comment more specifically around the treatment market in the U.S., where last year, as you know, we continue to see declines in the order rates. That's impacting our revenue as we get into 2014.
We are seeing order rates starting to pick up. That'll obviously bode well for 2015. We're not ready to call that we're out of the woods yet, but it certainly feels like things are moving in the right direction. The bid pipeline is still very active, and we feel like we're competitively positioned to take advantage of that.
Great. Appreciate it.
You bet.
Your next question comes from the line of Brian Konigsberg with Vertical Research.
Yes, hi. Good morning, everyone.
Good morning, Brian.
Good morning. Hey, Mike, maybe can you just touch a little bit more on price cost? It was a little bit mixed in the quarter. I think you had some decent opportunities in the second half of 2013. Maybe it decelerated a little bit in Q1. I just want to know what your thoughts were for the remainder of the year, particularly through the channel.
I think, we saw a little price, about 20 basis points, in Q1, and it was actually more biased towards Applied Water. Water Infrastructure was essentially flat. It was better than we were anticipating slightly. I do expect that the competitive pressures that we see in the market are going to still weigh on us through the balance of the year. The discussion that we had around pricing being anywhere from a 25 to 50 basis point headwind for the year still holds. From a cost standpoint, we're actively pushing from a productivity standpoint.
Even though pricing isn't pulling its share of the weight that it was in the past, we've made up for that with not only the restructuring, but also pushing forward more on the sourcing and the lean savings in the business and creating a nice spread that's going to give us the margin uplift that we need for the year.
Got you. Just going over to the Customer Relationship Management System. Where are you in that installation process? Are those costs embedded in Q1 numbers? If not, I guess maybe just touch on the cadence of the spending and potentially even the benefits.
Yeah. The implementation is really right at the beginning, at the early stages right now. The team had been studying alternatives for a while, certainly before I joined, and I'm very supportive of the decision that we've made to move forward. It's a big enabler to our whole integrated front end, getting our sales organizations able to talk to each other, get visibility to what our opportunities are with customers across the portfolio, and sharing those leads. The money itself, again, is not going to be incremental to what we've guided to before. It's all been embedded in our outlook for the year. Again, at the end of the day, we expect that this is going to have a pretty meaningful impact for us over time in terms of driving top-line growth, and as well, obviously, margin expansion.
Got you. If I could just ask one more. Maybe I'm reading this incorrectly, but it looks like the FX headwind, it was a $0.03 headwind in the quarter, but it was only a $4 million revenue headwind. How do I reconcile those two things?
Yeah. Brian, there's two components. There's the translation, which is the smaller impact this quarter. As we anticipated, we saw a heavier transaction impact. While we do hedge, that only ends up smoothing out the eventual impact that you have from a foreign exchange perspective, and we're only hedging about 75%-80% of the total. For us, it's really around the mix of where you derive revenue and where your costs are based. Not to get into a lot of the details, but we've got a lot of euro-based revenue, but a cost base based in Sweden. You end up with some differential there. Then we obviously have a bunch of cross-currency issues with Australia and the Canadian dollar, which have both been heavily impacted this past quarter.
I think the key message is, this is consistent with what we built into the guidance. We don't see any issues as we go through the balance of the year either.
Just curious. I imagine these are hedges that were put in place, but do you have an offset that hits gross margin a couple of quarters down the line as these things are delivered, or is that not really play?
No, this is more what actually lives through and what I'll call a differential in the cost base. The hedging handles all the transactional pieces, but over time, all that does is smooth you out. If you end up with an imbalance between two regions, you're ultimately going to have that impact your P&L, and that's essentially what this is.
I see. All right. Thank you very much.
You bet.
Thanks, Brian.
Your last question comes from the line of David Rose with Wedbush.
Good morning, everybody.
Good morning.
Good morning.
Hey, just a follow-up question on the margin side. SG&A was, I think, lower than many of us anticipated. Given the gross margins were essentially flat, how should we think about the gross margin pressure going forward? I think the implication is it's pretty hard to get the leverage there if sales are flat on the gross margin side, given what you've talked about in terms of pricing. Am I missing something there? That's, I guess, the first part. The second part is, if we think about the, I wouldn't call it aggressiveness, but I think Steve had put it before in a prior call that the team was more aggressive in seeking out orders, I guess you were going to be a little bit more competitive on pricing.
What is it, in terms of comfort level on the backlog, how do you get comfort with that backlog? Maybe that question is for both of you and Patrick and Mike, that you don't see further margin pressure in what's in the backlog?
Yeah. On the gross margin, I guess a couple of comments. One, Q1 was heavily impacted by the fact that we came up a bit short on the dewatering rental, and we were a bit overweight to the emerging markets, where we tend to see a little bit lower gross margin in terms of what that revenue comes through at. As you know, it's project-based, so it tends to be on the lower end of the margin scale. As we progress through the year, though, a couple of things. One, there is improving mix as we see the Water Infrastructure business ramp up. That starts as we get into the second quarter. We're also working a number of initiatives that I've talked to in prior calls around the lean, also sourcing, where we think that there's more capability to drive sourcing savings throughout the business.
That would tell you that our gross margin will improve on a year-over-year basis at the full-year level, probably around 50-plus basis points, despite what we anticipate is some pricing headwind. On your second question around the orders, it's a good question, it's something that we're pretty active in reviewing all the bid activity. When you think about that improvement in the backlog that's shippable going out beyond next year, the review process we have is to make sure that we're bidding at the right level of margins. Given that there is project activity, there is going to be some pricing pressure there relative to what we would see coming through some more of the developed regions. It's not a surprise, and it's something that we build in as we think about our cost plans and our margin improvement plans as we go forward.
We're adjusting our cost base accordingly, and I think there's plenty of opportunity for us to continue to see the margin expansion.
I would just reinforce what Mike said here around, again, the opportunities in global sourcing are very real, and that really has been under-leveraged, in my view. Again, the commentary Steven made in past quarters I think is spot on, and we're working hard in that area. Again, the opportunities around Lean deployment. While those tend to be longer term, I think there are some near-term opportunities there. The team is working this hard, as Mike pointed out. We all know the pricing environment that we're operating in, and we, again, want to do what we can to really use our productivity to drive growth, both investment as well as being competitive from a margin standpoint.
Okay, great. Thank you.
Thanks.
Thanks.
There are no further questions at this time. I would now like to turn the floor back over to Patrick Decker for any additional or closing remarks.
Thank you. As I mentioned in my opening comments, we're very clear about our focus areas and remain committed to delivering our financial commitments and recognizing the full potential the company is capable of delivering. We're pleased with our performance in Q1. We have a lot of work yet to do to deliver 2014, but we're confident. The plans and actions are in place to do exactly that. Again, I want to thank you all for joining today and for your support interest, and look forward to connecting you again in the near future.
Thank you. This does conclude today's Xylem First Quarter 2014 Earnings Conference Call.