2023-10-24 11:45:41 ET
Summary
- Xylem is nearing the completion of a merger with Evoqua, which provides possibilities for organic growth and margin expansion.
- Xylem's financials show low long-term historical growth, but recent quarters have seen improved performance as the company has increased pricing.
- The stock is currently priced quite high at a forward P/E of 25, which I see as an overvaluation.
Xylem Inc. ( XYL ) provides water technology products. The company is nearing the completion of the merger with Evoqua. I believe that the merger provides the combined entity with possibilities for some organic growth as well as margin expansion. Although the merger is promising, I believe that the stock is currently priced too high at a forward P/E of 25; the required performance from the company is above my expectations. For the time being, I see a sell-rating as constituted.
The Company & Stock
Xylem provides different water utility solutions that are meant for the transportation and treatment of water. The company splits its operations into four segments : Measurement & Control Solutions, Water Infrastructure, Applied Water, and Integrated Solutions & Services:
The Water Infrastructure segment has clearly become Xylem’s largest segment as the company is going through a merger with Evoqua. The company is focusing to close the merger with Evoqua, a water treatment solutions provider, that the company merged with for an implied valuation of $7.5 billion. The acquisition price seems steep – the valuation correlates to an EV/adj. EBITDA ratio of 25. When considering the targeted synergies of $140 between the merging companies, the ratio comes down to around 17.0, still implying quite a heavy multiple.
Merger With Evoqua (Xylem Evoqua Merger Presentation)
Xylem’s stock price has had a pretty good past. In the past ten years, the stock has returned around 214% implying a CAGR of 12.1%. On top, the company pays out a small dividend with a current yield of 1.44% with eleven years of dividend growth.
Financials
Xylem achieved a low amount of growth historically. From 2008 to 2022, Xylem’s compounded annual growth has been 3.8%:
In recent quarters, Xylem’s performance has been clearly better than the achieved long-term history. For example, in Q2, the company achieved organic growth of 15%. The achieved growth doesn’t seem to be due to a significantly improved demand, as pricing seems to explain the growth – Xylem’s organic orders shrunk by 2% in Q2 on a year-over-year basis.
The company’s EBIT margin has mostly stayed stable throughout Xylem’s history. The company has achieved an average EBIT margin of 12.1% from 2008 to 2022, with the trailing margin currently standing at 12.0%. The company plans to execute some margin expansion through the merger with Evoqua, as the company's target for synergies of $140 million on an annual basis. In addition, Evoqua’s adjusted EBITDA margin is slightly higher than Xylem’s.
Xylem has some long-term debt on the company’s balance sheet . Currently, the company holds around $2.4 billion of long-term debt, of which $165 million is in the current portion. In addition, Xylem has a small amount of short-term borrowings at $75 million. On the other side of the balance sheet, Xylem does hold a good amount of cash and equivalents at $0.7 billion.
Valuation
In my opinion, Xylem seems expensive. The stock is currently trading at a forward P/E of 25.0, around the company’s ten-year average of 26.7:
To further contextualize the valuation and to estimate a fair value for the stock, I constructed a discounted cash flow model for Xylem. In the model, I estimate Xylem’s revenues to grow by 30.4% in 2023 as a result of the Evoqua merger as well as organic growth. The estimated growth is in line with Xylem’s own guidance as of Q2. After the year, I estimate a growth of 15% in 2024 as the merger still adds to the growth in the first half of 2024. Beyond 2024, I estimate an organic growth of 7% in 2025 that slows down in steps into an organic growth rate of 2% into perpetuity.
For the company’s margin, I estimate Xylem to break out of its long-term range as the merger provides room for margin expansion. For 2023, I estimate an EBIT margin of 13.5%, 1.8 percentage points above the achieved 2022 level. After the year, I estimate further leverage as Xylem starts to realize the merger synergies and grows the operations organically. I estimate the company’s EBIT margin to reach an eventual level of 16.2%, 2.7 percentage points above the estimated 2023 level.
The mentioned estimates along with a cost of capital of 10.40% crafts the following DCF model with a fair value estimate of $54.58, around 40% below the price at the time of writing – the stock seems quite significantly overpriced:
The used weighed average cost of capital is derived from a capital asset pricing model:
CAPM (Author's Calculation)
In Q2, Xylem had $12 million in interest expenses. With the company’s complete amount of interest-bearing debt, Xylem’s interest rate comes up to an annualized figure of 1.91%. I believe that the company either capitalizes some of the interest expenses, or has locked down a significantly lower interest rate than most companies in the current interest rate environment. In the CAPM, I estimate Xylem’s long-term debt-to-equity ratio to stay near the current ratio with a figure of 10%.
On the cost of equity side, I use the United States’ 10-year bond yield of 4.87% as the risk-free rate. The equity risk premium of 5.91% is Professor Aswath Damodaran’s latest estimate for the US, made in July. Yahoo Finance estimates Xylem’s beta at a figure of 1.07. Finally, I add a very small liquidity premium of 0.2% into the cost of equity, crafting the figure at 11.39% and the WACC at 10.40%.
Takeaway
Xylem has interesting times ahead as a company as the merger with Evoqua is nearing. Unfortunately, I believe that the company is priced too high even with the merger prospects. My DCF model estimates a significant downside of 40 percent for the stock, corresponding to an estimated fair forward P/E estimate of 15 for the stock compared to the current ratio of 25. The company has achieved higher organic growth in recent quarters than I estimate in the DCF model, but as the growth seems to be due to price inflation, the growth doesn’t seem sustainable – for the time being, I have a sell-rating for the stock.
For further details see:
Xylem: Overvalued Stock Despite An Interesting Merger