Xylem: Don't Miss On This Water Technology Stock

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About: Xylem Inc. (XYL)
by: Abrar Hassan Saadi
Summary

Xylem has several stellar products covering a wide range in the water technology markets.

The firm has scaled up its top line and profitability in the last two years, thanks to its accretive growth strategy.

A substantial portion of revenue comes from international sales and the firm is expanding rapidly in the emerging regions.

Management is committed to increase dividends as earnings rise. I believe Xylem will gradually increase its payout ratio as it transitions to a matured phase.

Investment Thesis

Xylem (XYL) offers a comprehensive suite of products in water technologies market. The firm operates through three segments, Water Infrastructure, Applied Water, and Measurement & Control Solutions. In the last five years, Xylem has delivered a 5.87% yearly sales growth on average and a 10.54% average in profit margin. One of Xylem’s core strategies is to penetrate international water technology markets, and it has been very successful so far. Combining all the factors, Xylem is a buy.

More than half of Xylem’s revenue comes from non-U.S. regions, with Europe as the highest international contributor, making up about 28% of total sales in its latest fiscal year, followed by the Asia-Pacific with a 13% contribution and the rest accounted for by other nations. This year the firm expects to launch new technologies that combine its data, analytics and software capabilities in its installed base and enable the firm to tackle challenges related to water scarcity, affordability, and resilience. In its latest quarter, Xylem announced a 14% increase in the dividend which is in alignment with the management’s plan to grow its dividend in line with earnings growth. Although the dividend is small right now, the safety is high as shown by its coverage ratios. As Xylem matures, I expect a higher yield from the firm, but right now the firm exhibits growth characteristics. The midpoint revenue guidance is 5% organic growth for 2019, adjusted operating margin and adjusted EPS are guided to expand in between 100-150 bps and 11-18%, respectively.

Source: Earnings slide

Products that rock: Flygt Concertor and Godwin FP150

Flygt Concertor is a wastewater pumping system that features integrated intelligence and creates synergy between software functions and hardware. This system can sense real-time operating conditions while adapting to the required performance and provide instantaneous feedback to the operators in the stations. U.N estimates show that by 2025 the level of extraction of water from freshwater resources is expected to grow by 50% in developing countries and 18% by developed countries while by the same time approximately 1800 million people will live in the water-scarce regions and approximately two-thirds of the global population will live in water-stressed regions. This is a huge opportunity for firms like Xylem. Research report from Grandview Research estimated that the global water treatment systems market size was valued at USD 23.80 billion in 2016 which the firm expects to register a CAGR of 7.1% by 2025 due to factors like growing water pollution levels, increasing urban population, and rising health awareness and stricter government regulations to curb water contamination.

Flygt Concertor features

For more than 60 years, Xylem’s Flygt brand has continuously raised industry standards for compact, trouble-free pumping. Ever since introducing the world’s first submersible pumps, the focus has been on integrating technologies to reduce complexity and costs.”

The Godwin FP150 Dri-Prime Pump helps to protect commercial and industrial properties from damage or loss because of flooding from severe weather events. The foremost feature of the product is its simple maintenance that requires no special skills, as maintenance is limited to checking fluid levels and filters. It features dry-running, high pressure liquid bath mechanical seal with high abrasion resistant solid silicon carbide faces. There’s also an optional feature for remote monitoring & control through Godwin Field Smart Technology.

Financials

In the last two years, Xylem has substantially scaled up its revenue while free cash flow remains volatile. Xylem’s acquisitions have proven to be good so far. Xylem had a flat revenue curve till 2016, during the year Xylem’s $1.7-billion acquisition of Sensus added significant value to the firm. The price paid reflected a 10.7x premium over the target’s EBITDA in that year. Last year Xylem acquired all the issued and outstanding shares of Pure Technologies Ltd. which is a firm that focuses on leak detection and provides condition assessment solutions for a water distribution network.

Source: Intrinio

Profitability is only slightly volatile, usually, it ranges between 8% and 10%, but data suggests that an increase in scale is giving Xylem upside in gaining higher profit margins. Because acquisitions are a part of Xylem’s growth equation, there’s likely to be volatility in free cash flow until it reaches a more mature phase. During the next couple of years, I expect Xylem to increase its dividend payments, yields should rise and the transition from a growth stock to a matured stock will materialize. In the meantime, investors could enjoy significant price appreciation potential and enjoy its small, but comparatively safe dividends.

Source: Intrinio

Valuation

Xylem’s current Price to earnings ratio trades roughly at a 9.75% discount to its long-term average of 24.31x while its price to sales shows that the firm is trading at a substantial premium to its historical p/s average (approximately 26.3% higher). Its EV/EBITDA also suggests that it is trading at a premium to its long-term average. But the water technologies market has high growth potential and Xylem is a pioneer in the field with sales all over the globe. With its accretive growth strategy and innovative solutions, the firm is penetrating a diverse range of water technology markets rapidly. Considering all these factors, Xylem is a buy.

Source: Intrinio

Risk Factors

There are several risks involved with Xylem, I’ll discuss briefly with the “active” ones. Xylem has 53% of its business in various locations outside the United States which exposes it to foreign currency exchange risks, particularly regarding the euro, Swedish krona, Polish zloty, Canadian dollar, British pound, and Australian dollar. Adverse movements in these currencies could materially impact the firm’s ability to sell products competitively and control its cost structure, which could have a material adverse effect on its business, financial condition and results of operations. Xylem’s business is impacted by short cycle and book and bill business about which the firm has very little insights. The firm can also be impacted by timing changes in large projects due to customer requirements, which is not predictable. As of its latest fiscal year, Xylem had outstanding indebtedness of $2,308 million which exposes it to vulnerability should economic climate change. It also can limit to raise additional debt and create uncertainty and complexity in managing debt that uses LIBOR as a reference rate, including as a result of the planned transition away from LIBOR to the Secured Overnight Financing Rate.

Source: Intrinio

Conclusion

Xylem offers a wide range of products in water technologies market and holds a substantial market share. The firm has significantly scaled up its revenue in the last two years with accretive growth strategy and expanding its international sales rapidly. There are several risks involved and investors must be mindful of these, especially the active ones for the short run. However, investors with relatively higher risk tolerance and seeking growth exposure should consider Xylem for their portfolios.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in XYL over 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.