Evoqua: Steady Growth And M&A Interest Push Valuations

Summary

• Evoqua's IPO has been a great success, as investors like predictable and steady growers.
• This demand has pushed up valuation multiples quite a bit, a bit too much to my taste.
• Looking to learn more about the outlook for 2018, I remain cautious for now.

Evoqua Water Technologies (AQUA) has gone public in an IPO which has been well received by the market. Shares jumped 16% on their opening day to nearly $21 per share after shares have been sold at the midpoint of the preliminary offering range of $17-19 per share.

Success was nearly guaranteed as investors like predictable business models after Honeywell (HON) was reportedly interested to acquire the company outright. This demand has pushed up valuations a bit too much, despite predictable growth, and I am not jumping aboard with an earnings yield being equivalent to the yield on Treasury bonds.

Water Treatment Solutions

Evoqua claims to be the largest North American provider of clinical water treatment solutions with over 200,000 installations and 38,000 service contracts. The company claims that its 1,250 pending and granted patents ensure that it can achieve purification levels which are 1,000 times greater than "typical" drinking water. The company has grown to become quite a giant with over a billion in revenues, over 4,000 employees, and operations which are mostly focused on North America. Half of these sales come from industrial end markets, a quarter from the municipal market, and the remainder from the so-called products business.

While the company has been in business for over 100 years, the current form of the business is highly impacted by the 2015 acquisition of the water business of German-based Siemens (OTCPK:SIEGY) which came at a price of $730 million. Ever since the company has made numerous other acquisitions including the 2016 purchase of Neptune-Benson at $284 million and multiple smaller deals.

The Offering

Some 27.8 million shares were sold to the public, of which just 8.3 million were sold by the company which saw gross proceeds of $150 million following the offering. The other shares were sold by AEA, a global private equity firm which is reducing its stake in the business following this IPO but still holds a majority stake.

The 113.3 million shares which are outstanding are now trading at $21 apiece, giving the company a market value of $2.38 billion. On top of this comes a pro-forma net debt load of $691 million following the IPO, valuing the entire business at $3.07 billion.

The company reported a 7% increase in sales in its fiscal year which ended on September 30, 2016, with revenues amounting to $1.14 billion. The company reported an operating loss of $5 million, which is a bit misleading after it already accounted for $42 million in interest expenses.

Revenues were up 9% in the first nine months of this year to $891 million. Acquisitions drove much of this growth as organic growth comes in around 2-3%. Reported losses narrowed by a million to $6 million, even as interest expense increased by $10 million to $39 million. Adjusted EBITDA improved from $101 million to $136 million for the nine month period.

Sales growth is set to continue and accelerate in the fourth quarter of the year, with revenues seen up around 11% to $355 million. That would result in annual revenues of $1.25 billion. Adjusted EBITDA is seen around $206 million which values the company at a steep multiple of 15 times. Furthermore, leverage ratios are fairly elevated at 3.3 times EBITDA, although the business is extremely predictable and EBITDA can reasonably be expected to rise further this year.

Regular D&A charge is seen at $78 million this year, which results in an EBIT number of $128 million. Assuming a 5% cost of debt on net debt, earnings could hit $93 million before taxes which with a 35% tax rate could work out to after-tax earnings of $60 million. That translates into just $0.50-0.55 per share which reveals that earnings multiples are very high with shares trading at $21 per share. This high multiple is the result of investors who have been bidding up any company which has anything to do with water to fat multiples.

Growth prospects and stability have been key drivers behind these very steep valuations. While shares are expensive based on the earnings calculation as detailed above, GAAP earnings are currently still far lower as a result of transaction/restructuring related costs, and still elevated interest expenses, which will in part come down following the IPO.

Too Steep For Me

Let me be clear, water businesses are typically a great (thematic) investment. Growth is foreseen for many years to come, and the business is highly stable and diversified. The problem is the high valuation in my eyes, as Evoqua trades at roughly 40 times pro-forma earnings. While EBITDA multiples of 15 times look reasonable, the business is quite capital intensive, resulting in a high "D&A" component. While past dealmaking, realisation of synergies, further growth and deleveraging could boost earnings potential in the coming years, shares are certainly not cheap.

I am not jumping on board, as it is dangerous to short high valued shares as well. An example of this is the reported attempt which Honeywell has made for the business, but that deal broke apart.

I am looking forward to comments made by management about the prospects for the upcoming fiscal year, but probably end up concluding that the valuation is too steep to my taste, as I congratulate investors who participated in the offering with their successful investment.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.