2023-03-17 17:47:31 ET
Summary
- Xylem Inc. has a strong competitive moat in the water industry as a result of a differentiated, innovative, end-to-end portfolio of products.
- The company has an impressive track record of innovation for many decades, as the company has many instances where it's the first to introduce an innovative concept to the industry.
- Xylem's strong digital offering has resulted in its share of revenue growing from 16% in 2016 to 50% by 2025.
- Emerging markets remain a huge opportunity for Xylem, as its products and solutions can help address their water challenges.
- I think that Xylem's current valuation is fair, with a potential to enter the stock at a more reasonable valuation as a result of its commercial and industrial exposures.
Introduction to Xylem
Xylem Inc. (XYL) is a leading equipment and service provider for water and wastewater applications.
It has a wide portfolio of products and services that helps customers address the full cycle of water. This includes the collection, distribution and use of water, as well as the return of water to the environment.
The company currently operates three segments: Water Infrastructure; Applied Water; and Measurement & Control Solutions.
Business mix
In terms of geographies, Xylem is more focused on opportunities in the United States and Western Europe, with 45% and 25% of the business in these regions respectively. As a result, these two geographies form 70% of Xylem's business. In addition, Xylem has 20% exposure to emerging markets and the remaining 10% exposure in the rest of the world.
Xylem has three main segments: Water Infrastructure, Applied Water and M&CS, which make up roughly 40%, 30% and 30% of the business, respectively. I will elaborate more on these segments in the next section.
In terms of end markets, 55% of Xylem's end markets are in utilities, while 30% are in industrial end markets. Commercial makes up the remainder 10% of its end markets, while the residential end market does not contribute significantly to Xylem's business.
Xylem's business mix (Xylem Investor Presentation)
Business segments, products and brands
Based on Xylem's latest annual report, we can delve deeper into its business segments.
The Water Infrastructure business segment serves two main market applications: Transport and treatment, with transport making up bulk of the revenue. The major products in this segment include water and wastewater pumps, filtration, disinfection and biological treatment equipment and mobile de-watering equipment.
For Applied Water, the three main market applications are Commercial Building Services, Industrial Water and Residential Building Services. As can be expected, Industrial Water and Commercial Building Services makes up 83% of revenue. The major products in the segment include pumps, valves, heat exchangers, controls, dispensing equipment systems, amongst others.
Lastly, in the Measurement & Control Solutions business, it serves the two main market applications of water and energy. The major products here include smart meters, data analytics, test equipment, sensor devices, amongst others.
Xylem business segment, products and brands (Xylem 2021 Annual Report)
As a result, we can see that Xylem's three business segments spans the full cycle of water. It starts with the Water Infrastructure segment where water is treated and transported, and then in the Applied Water segment where water is brought to the end users, and finally, to the Measurement & Control Solutions segment where Xylem helps customers to optimize the use of water using data.
Xylem expects to outpace the industry growth in its respective segments.
In the Utilities segment, where the industry growth is expected to be in the mid-single digit range, Xylem expects to grow at a high-single digit range. The drivers for its Utilities end market will come from the need to replace aging water infrastructure, regulations that requires certain standards for water infrastructure, and increasing adoption of digital technology that helps customer lower their capital requirements.
In the Industrial segment, the company expects to grow at a range of low-single digit to mid-single digit range for the next 5 years. The focus will be on driving the growth of more energy efficient solutions and focusing on underserved segments and geographies.
Lastly, the Commercial and Residential segment is expected to grow at a low single to mid-single digit range, as this growth will be driven by urbanization in emerging markets, and increased demand for more energy efficient solutions.
Xylem growth drivers by end market (Xylem IR)
This stronger growth profile we see with Xylem is a result of a long track record of innovation and offering differentiated solutions.
Strong track record of innovation and differentiated solutions
As can be seen below, Xylem has had a very long history of innovation in the water industry. It brought about multiple firsts to the industry as innovation is a top priority for the company.
Xylem's history of innovation (Xylem IR)
For example, in 1997, Xylem introduced the first ever self-cleaning submersible pump, in 2008 it introduced the long-range wireless network for smart metering, in 2019 it introduced the highest accuracy ultrasonic gas meter.
The focus of innovation has been heavily focused on digital new products as well as next generation products, as can be seen below. This is because customers have been increasingly adopting digital offerings and Xylem continues to build on its market leading digital ecosystem.
Xylem investments in innovation (Xylem IR)
The rise of digital
To elaborate further on why Xylem is focusing heavy investments into its digital ecosystem and products, we have to understand what the customer wants.
Today, the customer has twin requirements of water resilience and affordability.
Xylem has gradually grown its digital products, services and solutions over the years. In 2016, digital only made up of 11% of revenue and currently, it makes up 35% of revenue in 2021. By 2025, digital is expected to take up almost 50% of revenue.
I think that the value add that Xylem's digital products are offering customers is rather apparent. As can be seen below, by leveraging data and technology through its digital ecosystem, this has helped customers save $70 billion, reduce the use of workers, increase energy efficiency, amongst others.
Xylem digital business (Xylem IR)
The key benefit for Xylem is that as a result of such a strong value proposition, customers are adopting digital products and solutions at a rapid rate. The end result of that the spending on digital is 3 times faster than that of the average water utility spending.
Emerging market opportunity
With water, the greatest opportunities lie outside of the developed countries.
As a result, Xylem knows that the emerging market opportunity is an important one.
As can be seen below, China makes up a significant 30% of its emerging markets revenue, while other larger markets include Latin America, Eastern Europe, Rest of Asia, which all take up 15% of the emerging market revenue each.
Xylem emerging market business (Xylem IR)
I do think that Xylem has a strong value proposition to penetrate and grow in emerging countries given their differentiated end-to-end water solutions provided.
Each specific market has a specific challenge that Xylem can help to address. For example, in China, the driver for the business will be wastewater treatment, delivering high drinking water quality and providing resilience for extreme weather events. In Africa, Xylem sees the strong population growth and improving urbanization trend as key drivers for its business in the region.
Xylem has set a 5-year target to grow the emerging market revenue by 2 times the growth of the developed markets.
Well positioned for long-term secular trends
There are three trends that are driving a long-term demand for Xylem's products and solutions. This includes the rising need for resilience in the water infrastructure, urgent need to lower the affordability of water and the increasing demand for water that is resulting in populations facing scarce clean water.
Secular tailwinds for Xylem (Xylem Investor Presentation)
Financials
In the recent fourth quarter results , Xylem showed strong demand and execution for most of its end markets. For example, we saw the utilities, commercial, residential and industrial end markets grow 34%, 24%, 17% and 15% respectively.
That said, while I think that Xylem's end market demand strength in the fourth quarter could continue in 2023, management did guide for slowing of orders by 3% in 2023.
At least there is the current backlog of $3.6 billion , which is up 14% year on year. This current backlog does provide visibility for earnings growth at least in the first half of 2023.
The adjusted operating margin for the fourth quarter of 2022 of 14.2% was impressive, in my view, as it highlights that there are favorable pricing dynamics relative to costs and that productivity improvements have taken place in the quarter. I expect that we will continue to see margin improvement continue in 2023 as a result of continued favorable pricing dynamics and productivity improvements. Management guided for a 50 to 100 basis points improvement in adjusted EBITDA margin for 2023 as a result of the factors mentioned above, as well as improving supply chain and availability of chips.
In addition, Xylem met expectations for an 80% free cash conversion in 2022 and management remains confident in its ability to achieve 100% free cash flow conversion in 2023 as a result of optimization in working capital.
Longer term, Xylem looks to grow at mid-single digit revenue growth rate, while expanding adjusted EBITDA by 50 to 75 basis points on average each year and achieving 100% free cash flow conversion, by 2025.
Valuation
Xylem is currently trading at 27x 2024 P/E and 16x 2024 EV/EBITDA. The company is expected to grow EPS at a CAGR of 10%. Based on 2024 FCF projections, Xylem is trading at 4% FCF yield.
As a leader in the industry with innovative and differentiated products, I think that Xylem's wide range of portfolio products does give Xylem a strong competitive moat.
As a result, I do think that Xylem should be trading at a premium to its peers. Based on the current 2024 EPS estimates, Xylem's peers are trading between 15x to 30x 2024 P/E.
As a result, I applied a 35x 2024 P/E to my estimate of Xylem's 2024 EPS. This implies a 1-year price target of $115. This implies an upside potential of 20%.
Cyclicality
As a result of about 40% exposure to industrial and commercial end market customers, Xylem is also potentially not as resilient in an economic climate where we could be heading into a recession. As a result of this exposure, there are some cyclicality factors to account for in owning Xylem as a weakening of macroeconomic environment could result in weakening of growth in the industrial and commercial end markets.
Ramping up of digital
While I think that the business case for rising adoption of digital products and solutions is clear, there are risks that the ramp up of Xylem's digital ecosystem could slow. One potential risk is that customers may be holding back on spending and investment in this area in a time of economic uncertainty.
Competition
Competitive pressures are more apparent in Xylem's Applied Water segment where the competitive landscape is fragmented and there is strong competition from European players. If competitive pressures increase, this could result in lower pricing power for Xylem and also potentially a lower growth profile for about 30% of Xylem's business segment.
Conclusion
After looking deeper into the company, I am initiating Xylem Inc. with Neutral rating.
I think Xylem Inc. has strong fundamentals. The company is a leading player in the water and wastewater industry and should continue to bring stronger and more resilient growth than peers. This is because of their strong innovation track record and continued focus on investing in the next generation water products of tomorrow. In addition, the industry has secular tailwinds as water scarcity, affordability and infrastructure security remain top priority for many countries. This brings opportunities for Xylem not just in the developed regions like United States and Western Europe, but also in emerging markets, where the growth is expected to be stronger as a result of lower penetration. At the end of the day, I also think that water efficiency will be one of the priorities for governments around the world working on their green transition plans given how important and potentially scarce this resource may be in the future.
That said, I think that the current Xylem Inc. valuation of 27x P/E is fairly balanced, in my view. As I always tell members of Outperforming the Market, my priority here is to help you buy companies at a discount, which will help generate better future returns. As a result, I am of the view that staying on the side lines is better at the moment as I think we need to see some weakness in the commercial and industrial segments, the more cyclical part of the business, before I think we will see a more reasonable valuation to enter Xylem Inc. and a better risk reward perspective.
For further details see:
Xylem: Strong Competitive Moat With Tailwinds From Green Transition