ZWS - Zurn Elkay Water Solutions: Valuation Remains Too High For A Buy

2023-04-14 10:02:30 ET

Summary

• Zurn Elkay Water Solutions Corporation has seen impressive growth as shown in the last earnings report, but the valuation remains too high.
• The market has a very strong outlook with a high CAGR expected until 2028.
• The company has a strong balance sheet and good outlooks which makes it a hold for now until the valuation reaches levels more in line with the industry.

Investment Summary

Zurn Elkay Water Solutions Corporation ( ZWS ) is a company that's all about managing water in smart and sustainable ways for places like hospitals, office buildings, and other public areas. It's actually a partnership between two major players in the plumbing world: Zurn Industries and Elkay Manufacturing Company.

When it comes to water management, Elkay Water Solutions Corporation is an established company in the industry. They focus on making sure that water is used efficiently and responsibly, and they've got plenty of products and services to make that happen. This focus has also netted them a very impressive last earnings report where net sales saw a 46% YoY increase. But despite that the valuation on a forward basis remains quite high and offers in my opinion too much downside risk than reward right now. Because of this, I will be rating the company a hold for now. With a strong outlook, I don't see enough of a buyback right now with the high valuation.

Catalyst

In a report by MordorIntelligence , the smart water management market is expected to have a 13.89% CAGR between 2023 and 2028 which I think represents a major opportunity for investors looking to get some exposure to the industry.

In the report, the major trend that is mentioned to push this growth forward is water scarcity in the world. Statements like these really paint the scenario for how dire the situation is and that there is plenty of growth possible for companies whilst also helping out. “According to the World Water Council, nearly four billion people are expected to face water stress by 2025”.

Besides an urgent need for people to have water, there also seems to be a push from governments around the world to secure their own supplies and mitigate the risks of scarcity happening within their borders. The estimated growth is something I think ZWS is able to capture as well as perhaps be able to justify the current valuation.

Risks

The water management market is facing a major risk from the rising occurrence and severity of natural disasters like floods and droughts. These events can wreak havoc on water infrastructure, disrupt supply chains, and lead to water scarcity, which can increase prices and decrease demand. It's a daunting challenge that the industry must confront head-on.

Another challenge faced by the water management market is intense competition . With so many players vying for market share, new entrants and smaller companies may struggle to make an impact. In order to stay ahead of the competition, companies in the industry must invest heavily in research and development to keep up with the latest technological advancements. This is essential to staying relevant and providing customers with the best possible products and services.

Those are some more sector-broad risks that of course ZWS could also be affected by. From an investor's point of view, I think one of the first things that pop out as a risk is the share dilution the company has been keeping up for the last few years. This hurts any position in the company and the negative levered free cash flows don't help the case either. I think share dilution will keep going until the company manages to get a hold of its bottom line and get more stable margins.

Financials

Zurn Elkay Water Solutions' balance sheet shows a significant increase in assets as of December 31, 2022, compared to the previous year. The company's total assets increased from $1,077.7 million to $2,864.0 million. One of the main highlights I saw from the balance sheet has to be the increase in the cash position. Going from $96 million to around $124 million is a very good increase and I feel the company prioritizes aligning even more with my own when I see this. In times when debt is expensive and competition is always fierce I like to see companies building up a good war chest to help themselves both keep and take market share.

The company's liabilities also increased slightly, from $951.3 million to $1,249.0 million, with long-term debt accounting for the majority of this increase. This has me worried since I mentioned previously the cash flows have been negative which presents a major risk to investors as share dilution most likely will continue to happen until the company gets its bottom line in order. Until then I’d like them not to take on more debt. If they still do however I will view that as a major red flag and would heavily consider a sell rating then instead.

Valuation & Wrap Up

Right now I think the company is trading at a slightly too high of a valuation to justify the current price. Forward p/e is also increasing indicating a shift in earnings from the company and the margins it has. Despite this, I will maintain the hold rating as I think the market trends in the industry are enough to carry growth and buyer incentive for the company.

Looking at some notable peers in the industry, a company like American Water Works Company Inc (AWK) has also seen a drastic increase in share price and trades at 31x forward earnings. I think the sector has seen an immense demand and what worries me is that perhaps some companies won't be able to live up to those expectations. The reason I think ZWS might be the better option is simply the lower valuation despite the perhaps poorer profit margins than an established company like (AWK).

I would like to buy ZWS preferably at a lower p/e, around 17 on a forward basis. But that would mean it needs to drop to around $15 a share. Which might not be very likely unless the company has disappointing earnings released in the near future. Besides the p/e presenting a risk to investors, I feel the negative cash flows are also enough to make the company a hold instead of a buy. All in all it's a promising company and offers great exposure to a very fast-growing industry that I would like to be a part of.

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