Investment Opportunity: Water

Includes: VMI, XYL
by: Kent Croft

Although it doesn't produce the constant headlines like other commodities these days, water is irrefutably the most essential natural resource to human survival. Available fresh water is less than ½ of 1% of all of the water on Earth, and various trends are constantly driving the supply of fresh water lower and the demand for fresh water higher at increasing rates. Below are two companies that are benefiting in this context.

Companies with Exposure

Valmont Industries (NYSE:VMI) manufactures mechanized irrigation equipment (39% of 2011 operating income) that helps farmers to maximize crop yields while reducing costs. (The balance of Valmont's earnings comes from engineered support structures used to transmit electricity and benefits from upgrades and maintenance to domestic and international electricity grids.) Given the limited supply of available arable land globally, and the increasing demand for farm output driven by emerging markets' growing middle-class, farmers are willing to invest for the value-add that Valmont's irrigation equipment provides.

While agricultural irrigation accounts for ~70% of fresh water use, Valmont's systems conserve water and reduce water costs, resulting in a payback on investment of approximately three years. For example, in rice farming, Valmont's center-pivot and linear delivery systems are able to reduce growers' consumption of water by half when compared to conventional flood irrigation methods. Farmers are also able to grow rice on more acreage because the equipment does not require level fields. Furthermore, traditional drip irrigation systems require three to five times higher maintenance, resulting in higher labor costs to farmers.

Xylem's (NYSE:XYL) products serve the full cycle of water. The Water Infrastructure segment (~60% of revenues) collects, tests, distributes, and returns water to the environment. Product demand will be driven by the aforementioned need for energy efficiency, water scarcity and aging infrastructure solutions, and new installations in emerging markets. End markets are expected to grow in the mid-single digits for the next couple of years and subject to less cyclicality aided mostly by utility spending. The Applied Water segment (~40% of revenues) serves residential, commercial, industrial and agricultural markets and will be driven by population growth and urbanization trends over the next couple years.

The wide-ranging applications of strong-brand name products in items like valves and dispensers address the issues of increasing demand. XYL is the largest player in many of their highly-fragmented markets. They currently serve a total addressable market of about $40 billion and generated revenues of $3.8 billion in 2011. Their large installed base of pumps and systems provides the company with substantial high-margin after-market business which accounts for nearly 40% of revenues. FCF conversion of close to 100% for 2012 will continue to allow XYL to execute M&A and drive earnings accretion while supporting increased capital expenditures and a 1.5% dividend yield.

XYL's first report as a stand-alone showed 6.7% organic order growth and 7% organic revenue growth for the year ending 2011. Now that the spin-off is complete, XYL will be more focused on expanding existing R&D facilities in Sweden, China, and India as well as building their presence in emerging markets through manufacturing, sales efforts, and marketing.

Disclosure: I am long VMI, XYL. Croft Value Fund owns shares of companies mentioned above.

Disclaimer: Information in this commentary regarding market or economic trends or the factors influencing historical or future performance reflects the opinions of management as of the date hereof. These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that any market forecast or trend discussed herein will be realized. Although the information presented herein is based on sources believed to be reliable, such information is not guaranteed to be accurate and is subject to change.This material should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before making any investment decision.