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"Waterworld," the post-apocalyptic film released in 1995, featured Kevin Costner as "the Mariner." In this futuristic film the polar ice caps have melted submerging planet earth underwater. As a result, the Mariner travels the seas in search of food and resources while battling outlaws. With the planet covered in water (salt water), fresh water is an extremely scarce resource. Perhaps life for the Mariner and others could have been more tolerable if only they had access to advanced water treatment and testing solutions that are available today.

Just as the survivors in Waterworld struggled with limited fresh water resources, millions today face extreme conditions regarding access to clean water. Despite that over 70% of planet earth's surface is covered by water less than 1% is fresh water. Over one billion people today live without access to clean drinking water and 2.6 billion lack basic sanitation, according to the World Water Council. Further, millions of people die each year from treatable water-borne diseases. We strongly believe companies supplying technologies and solutions to address scarce fresh water resources and the treatment of wastewater will be in demand for the foreseeable future.

Xylem (NYSE:XYL) is a Leader in the Water Industry

One of the key beneficiaries of scarce water resources is Xylem, which supplies equipment and solutions for clean water and wastewater applications. XYL, which became a publicly-traded company last month as the result of a spin-off from ITT Corporation (NYSE:ITT), generated over $3B in revenue last year. XYL is truly a global company generating 65% of revenue overseas from customers in over 150 countries. Developing countries, a key driver of growth, comprise approximately 18% of total revenues.

While XYL is generally #1 or #2 in many of the segments it completes, the industry is highly fragmented. XYL estimates the total available market for water equipment and services at $280B, with the company's existing product portfolio serving only $30B of this market. We see significant opportunities for XYL and others to consolidate market share.

The industry is estimated to grow in the low single-digits over the next few years versus XYL's internal target of 4-6% annual organic growth, implying market share gains. Acquisitions also play an important role in XYL's growth strategy, adding an additional 1-2% to growth. Finally, XYL is growing revenue through partnerships. Last month, it inked an agreement with General Electric to become a distribution partner for the conglomerate’s advanced membrane filtration products. We also see a more remote potential for larger companies such as GE, Siemens or Danaher that serve segments of the water industry to potentially acquire XYL.

Four Key Long-Term Growth Drivers

Organic growth in the water industry is driven by four secular trends, including population growth, aging water infrastructure, urbanization and industrial demand.

First, global population growth of approximately 0.7% per year (through 2050) will continue to drain existing aquifers increasing demand for clean water and wastewater solutions. This scarcity of fresh water resources will also lead to increased government regulations, driving even greater investment in water infrastructure. While population growth in developed markets is more muted, developing regions will continue to experience higher growth. Developed countries currently comprise only 15% of the approximately 7 billion people living on our planet today. According to projections from the United Nations, the global population is expected to increase by over 2 billion by 2050 with virtually all of the growth occurring in developing countries. These developing countries will require significant new investment in water infrastructure.

Second, aging water infrastructure in developed markets will drive increased demand from public utilities (40% of XYL's revenues). While weak economic conditions in the U.S. and Europe will constrain infrastructure spending in the near-term, utilities will need to invest billions of dollars over the next decade to maintain and upgrade infrastructure installed more than a half-century ago. As recently as 2009, the American Society of Civil Engineers (ASCE) "Report Card for American Infrastructure" gave our nation's water and wastewater treatment infrastructure a grade of "D-" due to decades of underinvestment. Over the next two decades nearly $1 trillion (Yes, with a "T"!) in drinking water and wastewater investments are needed, according to the ASCE.

Third, urbanization will result in significant investments in water-related infrastructure. The scale and speed of urbanization underway in emerging economies is far greater than that experienced in the U.S. and Europe during the 18th and 19th centuries. Today, over one-half of the world's population lives in urban cities. In many developing regions populations are migrating from rural to urban areas to seek higher standards of living. This trend will require governments to invest in large-scale projects to build new clean water and wastewater transport and treatment facilities that enable urban communities to access clean water, reduce pollution of fresh water resources, and improve public health. According to the International Monetary Fund, global urban populations are expected to grow 1.8% per year over the next two decades, or over two times the growth rate of total population growth.

Fourth, global industrial demand will eventually recover resulting in increased demand for clean water and wastewater treatment solutions. As industrial production and capacity utilization increase, usage of and investments in water solutions will increase. Industrial customers, which comprise 35% of XYL's total revenue, include power generation companies, chemical manufacturers, machine shops, clothing manufacturers and beverage production and dispensing companies. The energy industry, in particular hydraulic fracturing, is a huge growth opportunity for water solutions.

Hydraulic fracturing, or fracking, is used to extract unconventional gas resources from underground rock shale formations by mixing water, sand and chemicals and injecting these into gas wells at high pressure. Fracking requires millions of gallons of water per each well, creating water shortages in regions ripe with unconventional gas resources. Further, environmentalists are concerned that fracking may contaminate underground aquifers and are pressuring regulators to increase clean water regulations. This will require energy companies to install expensive equipment to recycle, treat and test water used in fracking, representing a significant growth opportunity for the water industry. XYL is particularly well positioned to benefit given its analytics solutions (instruments and software) used to test water quality for fracking contaminants.

Relatively Stable Revenue Sources

While growth in XYL's revenues may be muted in the near-term due to weak global economic conditions, the company represents a good defensive play in a low-growth GDP world. We are particularly attracted to the relatively stable components of XYL's revenue sources. These include aftermarket revenues (i.e., recurring revenue sources) which comprise almost 40% of total revenue. The aftermarket consists of repair parts and services (16% of total revenue) and replacement equipment (22%). Further, no single customer represents over 2% of revenue, so the company has a well diversified customer base. Finally, city and municipal governments play a critical role in ensuring sources of clean water, sanitation and wastewater removal. These public utilities comprise almost 40% of XYL's business and represent a relatively stable revenue source given that much of their funding for water investments comes from tariffs levied upon end users.

Investment Risks

The company's high exposure to Europe (39% of revenue) could pose a near-term problem if spending slows significantly due to austerity measures. XYL also has a limited track record as a public company leading to increased uncertainty in terms of how the financials and stock will perform. Therefore, investors will not likely give management the benefit of the doubt for any missteps. Third, investors face the risk of XYL misusing cash by overpaying for future acquisitions. Acquisitions also involve execution and integration risks. Finally, it may be challenging for XYL to achieve its 5-year operating margin target of 14.5%-15.5%. This compares to 2010's 12.6% margin, excluding restructuring charges. Margin headwinds include the potential for higher than expected costs to operate as a stand-alone company and poor execution in gaining market share.

Near-Term Upside Limited, Long-Term Potential is Promising

We don't see any near-term drivers to materially move the shares higher given concerns regarding global economic growth. Based on forward P/E's, XYL trades at 12.7x versus 13.5x for other industrials. If market conditions weaken we will look to build upon our existing position. Based on our scenario analysis of discounted cash flows (our primary valuation methodology), we believe the shares currently discount a low-growth environment where the company falls short of its market share growth and margin goals. Given this environment, investors will at least benefit from the 1.6% dividend yield and limited downside risk due to the lower expectations already built into the shares. If XYL achieves its growth and margin targets over the next five years, then we believe the shares could be at least 35% undervalued.

Source: Xylem Inc.: Waterworld