2023-06-09 05:38:05 ET
Summary
- Xylem is well-positioned to benefit from the rising importance of water, which continues to drive the market expansion of water treatment.
- The company should be able to generate above-market growth rates thanks to its digital offerings that significantly enhance efficiency.
- The acquisition of Evoqua further expands its product portfolio and increases its presence in the industrial markets.
- The current valuation seems too lofty, which will likely limit its upside potential in the near term.
- I rate XYL stock as a hold.
Investment Thesis
Xylem ( XYL ) is a rare water pure play that does not get much attention from investors. The company has one of the most comprehensive portfolios of water solutions and is well-positioned to benefit from the rising importance of water, which continues to drive ongoing market expansion. The acquisition of Evoqua further strengthens the company's water treatment segment and increases its presence in the industrial markets.
The latest earnings continue to demonstrate upbeat momentum with double digits growth in both the top and the bottom line. While I really like the company's prospects, the current valuation seems too lofty, which could limit its upside potential. Therefore I believe investors should wait for a more favorable price point before initiating a position.
Rising Demand For Water
Xylem is a leading water company that provides comprehensive products and solutions to utilities, industrial, commercial, and residential customers. It operates in three segments including water infrastructure, applied water, and measurement & control solution. Water is a massive and growing market. According to Fortune Business Insights , the global market size of water treatment is forecasted to grow from $301.8 billion in 2022 to $489.1 billion in 2029, representing a strong CAGR (compounded annual growth rate) of 7.1%.
The increasing scarcity and importance of water continue to be a huge growth driver of the market. Due to the low availability of fresh and clean water, countries and companies are investing in water treatment solutions to convert seawater into clean water. On the flip side, wastewater also needs to be processed adequately to ensure safety and reduce wastage. I believe the declining supply of water and the worsening trend of climate change will further increase the investment in the industry moving forward.
Going Digital
Xylem is also aiming to digitize the water industry by accelerating customers' adoption of its leading digital solutions and services. Digital products are much more efficient as they offer remote monitoring and better communication capabilities. Thanks to improved connectivity, they also provide real-time insights and data that allow customers to refine their operations.
Besides helping customers, digital products also present huge growth opportunities for Xylem. According to the management team, digital revenue currently accounts for only 35% of total revenue and they expect the figure to reach around 50% by 2025, driven by the ongoing increase in adoption rate. By leveraging the massive existing installed base, the company should be able to onboard customers easily.
Evoqua's Acquisition
Back in January this year, Xylem acquired Evoqua in an all-stock transaction for a hefty price tag of $7.5 billion. Evoqua is a leading water treatment company in North America with advanced digital-enabled solutions and a large supporting service network. The combination should turn Xylem into a powerful force in the water industry.
Patrick Decker, CEO, on Evoqua's acquisition :
The combined company delivers an unparalleled portfolio of advanced technologies, integrated services and application expertise across the water cycle."
The acquisition will help the company expand its presence in the industrial sector, especially in high-growth markets such as microelectronics and life science, as industrial customers account for 82% of Evoqua's revenue. The combined company is expected to generate 47% of revenue from the industrial segment, up from just 35% previously.
It will also increase the contribution of recurring revenue, which vastly improves revenue stability and visibility. For instance, 60% of Evoqua's revenue is currently generated from recurring and aftermarket services. I believe the addition of Evoqua can extend Xylem's leadership in the water industry and help accelerate its expansion moving forward.
Great Financials
Xylem announced its first-quarter earnings last month and the results are very solid, with double digits growth across all segments. The company reported revenue of $1.45 billion, up 13.8% YoY (year over year) compared to $1.27 billion. On an organic basis, revenue growth was 17%.
The measurement & control solution segment was extremely strong, with revenue up 32% from $314 million to $406 million. The segment's backlog ended at $2.1 billion, which should continue to drive growth. The water infrastructure segment grew 15% from $533 to $589 million, driven by favorable pricing. The applied water segment grew 10% from $425 million to $453 million, led by a 15% growth from commercial customers.
The bottom line performed even better due to improved operating leverage and productivity. Gross profit increased 16.9% YoY from $467 million to $546 million, as the company benefited from a favorable price mix. The gross profit margin expanded 100 basis points from 36.7% to 37.7%. The net income grew 20.7% from $82 million to $99 million, as R&D spending slowed and interest expenses declined. The net income margin increased 40 basis points from 6.4% to 6.8%. The diluted EPS was $0.54 compared to $0.45.
Amid the upbeat traction, the company also raised its guidance for FY23. Revenue growth is now expected to be between 8% and 9%, up from the previous range of 4% to 6%. The adjusted EPS is expected to be $3.15 to $3.35, up from the previous range of $3.00 to $3.25.
Lofty Valuation
Xylem's valuation remains my major issue with the company. It is currently trading at an fwd PE ratio of 32.8x, which is quite lofty in my opinion. While the multiple is in line with other water companies such as Ecolab ( ECL ) and American Water Works ( AWK ), it is still expensive on a historical basis. For instance, the company has been trading at an average PE ratio of roughly 25x prior to the pandemic, representing a discount of 23.8% compared to the current price. While growth was pretty strong in the latest quarter, the figure is expected to slow in the second half, which makes it even harder to justify the valuation.
Investors Takeaway
I believe investors that are interested in the water industry should keep an eye on Xylem moving forward. The company's foundational products should benefit from the ongoing market expansion while its digital offerings should see above-market growth due to an increasing adoption rate amid rising needs for more advanced solutions. Its combination with Evoqua further expands its product portfolio and increases its presence in the industrial markets.
While the company demonstrated solid growth shown in its latest earnings, the lofty valuation is still hard to justify, and I simply do not see much upside potential at the current price level. I rate the company as a hold.
For further details see:
Xylem: A Pure Water Play