2023-08-18 14:58:12 ET
Summary
- Xylem is a well-positioned water technology company with solid financial performance.
- The company's profitability metrics have been stable, with positive free cash flow and consistent dividend growth.
- Xylem's recent acquisitions and partnerships position it for continued growth in the promising water technology industry.
Investment thesis
Recently, UNESCO warned regarding the imminent risk of a global water crisis. Honestly speaking, we are already amid the global water crisis in my opinion. According to UNESCO, 26% of the global population does not have safe drinking water and 46% lack access to safely managed sanitation. That said, humanity urgently needs to implement more responsible water management solutions to boost water usage efficiency. Xylem ( XYL ) is the largest pure-play water technology company demonstrating solid financial performance. The company is well-positioned to benefit from the industry tailwinds, and its stock is now fairly valued. All in all, I assign XYL a "Buy" rating.
Company information
Xylem Inc. is a global water technology company. XYL's products and services aim to improve how water is used, managed, conserved, and reused. The company's shares are a component of the S&P500 index.
The company's fiscal year ends on December 31 with three reportable segments: Water Infrastructure, Applied Water, and Measurement & Control Solutions. According to the latest 10-K report, the Water Infrastructure segment's revenue represented about 43% of the total. In FY 2022, the company generated 53% of total sales outside the U.S.
Financials
Xylem's financial performance has been decent over the past decade. The revenue demonstrated a steady 4% CAGR and profitability metrics were very stable. The free cash flow [FCF] margin ex-stock-based compensation [ex-SBC] has been consistently positive, though relatively volatile, in the past four fiscal years.
A relatively stable and positive FCF margin allows the company to return cash to shareholders via stock buybacks and dividends. While the forward dividend yield looks low at 1.3%, Xylem demonstrates stellar dividend growth history with eleven consecutive years of payout hikes. I like the balanced capital allocation approach because the company successfully balances managing growth, keeping shareholders happy, and sustaining a healthy balance sheet. Xylem has a substantial net debt position, but I do not see risks here. If we look at the leverage ratio, it is low, and the covered ratio looks high enough to keep calm about the credit risks. Liquidity metrics are also in excellent shape.
Seeking Alpha
The latest quarterly earnings were released on August 2, when Xylem topped consensus estimates. Revenue demonstrated solid YoY growth with a 26% increase. The adjusted EPS followed the top line and expanded from $0.66 to $0.98. The gross and operating margins narrowed slightly on a YoY basis. Organic revenue grew by 15%. The non-GAAP EBITDA margin widened by 250 basis points to 19.1%. During the latest earnings call , the management also slightly upgraded full-year guidance, which is a bullish sign.
The upcoming quarter's earnings are scheduled on October 30. Consensus estimates forecast revenue growth momentum to accelerate with a 45% YoY growth. The adjusted EPS is expected by consensus to expand from $0.79 to $0.89.
In January 2023 , the company announced its strategic partnership with Idrica "to accelerate the digital transformation of water utilities". Idrica is a strong data management and analytics company. The partnership is expected to offer an integrated software and analytics platform that enables managing all applications related to water utilities and data in one place. In May 2023 , Xylem acquired Evoqua Water Technologies Corp. in an all-stock transaction valued at $7.5 billion. This business combination creates the world's largest pure-play water technology company. The expected cost synergies comprise $140 million in three years.
Overall, I think that the company is well-positioned to continue its steady growth and profitability improvement. The crucial factor is that Xylem operates in an industry with bright prospects. The industry is expected to compound at 11.2% yearly in the upcoming five years, which is solid. Being now the world's largest pure-play water technology company with consistent profitability makes Xylem well-positioned to capture industry tailwinds. I also like that the company is innovating and have a promising partnership to accelerate the digital transformation of the industry. Over the long term, the most innovative company wins the race in my opinion.
Valuation
The stock underperformed the broad U.S. market with a 10% year-to-date price decline. Seeking Alpha Quant assigns the stock a low "D" valuation grade, likely because of substantially higher multiples than the sector median. On the other hand, if we look at historical averages, current valuation ratios look primarily fair.
Now, let me simulate the discounted cash flow [DCF] approach to better understand the valuation's fairness. I use a 9% WACC for discounting. I have revenue consensus estimates available up to FY 2027 and project a 5% revenue CAGR for the years beyond. I use the average FCF margin of the last five years and expect it to expand by 50 basis points yearly.
Based on the DCF, the stock looks fairly valued with slight downside potential. Since Xylem consistently pays dividends, we have more options for cross-checking. I also want to calculate the stock's fair value with the dividend discount model [DDM] formula. I use the same WACC for discounting. Consensus dividend estimates forecast a $1.42 payout in FY2024. For the dividend growth , I use the last three years' CAGR, which is 8%.
Author's calculations
The DDM outcome suggests massive above 40% upside potential if the company sustains an 8% long-term CAGR for dividends. The DDM formulate is susceptible to dividend growth. If I decrease the dividend growth projection by just 50 basis points, the stock's fair price equals 95% of the other estimate. That said, I think that the stock is fairly valued at the current level.
Risks to consider
Xylem generates more than half of its sales outside the U.S. It means that a substantial portion of sales is generated in foreign currencies. This exposes Xylem to the volatility of foreign exchange rates. Unfavorable fluctuations in foreign exchange rates might adversely affect the company's earnings. Operating globally across diverse geographic areas also exposes Xylem to significant political risks. Changes in government policies, trade tensions, or geopolitical issues can impact Xylem's international operations, ultimately affecting earnings.
Recently, Xylem completed the acquisition of Evoqua. This was a big deal relative to the company's scale and exposes Xylem to significant risks. The primary risk is that integrating both entities' operations, systems, cultures, and processes can be complex and challenging. Failure to deliver smooth integration could lead to disruptions and inefficiencies, which can ultimately cancel potential synergies expected by the management before the deal.
Bottom line
To conclude, XYL is a "Buy". I like the company's crucial mission to deliver improved technologies to increase the efficiency of global water consumption. Xylem balances well between delivering value to humanity and being a solid business with consistent profitability. The latest acquisition makes Xylem the global leader, and I think that the potential benefits outweigh the integration risks. The attractive valuation is also important, why I believe the stock is a Buy.
For further details see:
Xylem: Solid Buy For Long-Term Investors