Xylem Is Too Expensive
- Although Xylem is expected to slow over the next year, long term I think it's a great, well run business.
- That said, a great company can be a terrible investment at the wrong price. For that reason, I must avoid until a better entry price comes along.
- For those like me who are impatient, I recommend a specific short option trade here that presents investors with what I consider to be a "win-win" trade.
In spite of the recent drop, shares of Xylem Inc. (NYSE:XYL) are up about 8.2% over the past year. The fact that the shares are down nicely over the past few weeks has put the company on my radar. I thought I’d check in to see if this is a buy at these levels.
I’ll try to answer this question by looking at the state of the business, highlights of the financial history, and the stock. For those who are impatient enough to stop and read the title of this article, and who can stand neither the suspense, nor my writing, I’ll come to the point. This is a fine company, the problem is that the shares remain too expensive. Thankfully, the options market provides an alternative to simply buying at these levels.
2019 was actually a fairly good year for the company, with revenue up across all four segments. The following graphic describes this well.
Source: 2020 Xylem Presentation
What’s particularly interesting to me is the strong free cash flow investors saw in 2019, up 75% to $613 million.
That said, the company was offering muted guidance before the market seemed to start focusing on Covid-19. Per the following, investors should expect flat revenue growth over the next year.
Source: 2020 Xylem Presentation
Thus, I think the immediate future for the business is going to be a bit soft, and I’m expecting sclerotic returns for the company over the short term. As I’m about to point out, this has generally been a growth company over the past five years, but it seems that management is telegraphing that that growth is going to be muted in the near future.
In my view, Xylem has been a growth company over the past five years. In particular, revenue, operating profits, and net income have grown at a CAGR of about 7.5%, 7.7%, and 3.5% respectively. Given the above, though, I think it might be naive to assume that this level of growth will continue.
Management treats investors relatively well in my estimation. In particular, over the past five years, the company returned just under $900 million to shareholders. Fully $226 million of this comes from stock buybacks, and the balance of $670 million in the form of ever growing dividends. This combination of buybacks and dividend growth has caused dividends per share to grow at a CAGR of about 11.5% since 2015. Finally, in my view the dividend is reasonably safe, given that the payout ratio is only about 43%.
Turning to the capital structure, the level of debt has risen at the most dramatic rise of any of the other financial function. Over the past five years, total debt has grown at a CAGR of about 12%, and interest expenses have grown at a CAGR of ~4% over the same time period. Although this is an alarming rate of growth, I’m less worried about debt than I might otherwise be for a few reasons. First, fully $276 million of the debt is commercial paper which carries a weighted interest rate of .22%, which I consider to be quite low. Second, fully 39% of the debt is due in 2026 later. Finally, the company has cash and equivalents that are worth about 32% of total debt. All of this suggests to me that there’s little risk of a solvency or credit crisis anytime soon.
Source: Company filings
Welcome to the section of the article that I find most challenging. It’s necessary to deliver the same message in a fresh new package each time, as doing so might improve the probability that someone will read this very important message. The message is this: the price an investor pays for the stock is at least as important as the financial history, and growth prospects of the enterprise. The market is capricious, and that share prices move up and down much more rapidly than should be warranted by the changing fortunes of the business. Given that, we must avoid picking up shares that are priced excessively. To drive this point home using Xylem as an example, consider that an investor who bought shares in mid-February is sitting on a 6.7% loss, while someone who bought two months prior is sitting on an 8.25% gain. What a difference a couple of months and a few dollars makes.
With that as backdrop, I’d remind investors that the more they pay for a stream of future cash flows, the lower will be their subsequent returns. For that reason, we must stay on guard against overpaying. I judge whether investors are overpaying for a given business in a host of ways. On the one hand, I like to compare the simple PE to the overall market, and to the company’s own history. On that basis, I think it fair to suggest that Xylem is richly priced at the moment. The following picture is worth at least 1,000 of my words.
Thus, in my view, Xylem is like so many other companies I’ve written about recently in that it’s a great business that is trading at too rich a valuation for my blood. This is especially so in light of the fact that even prior to the market’s sudden worries about the impact of COVID-19, management signalled that the business will slow over the next twelve months. Thankfully, there is an alternative to either overpaying today or waiting for the shares to drop in price. The options market provides investors a “win-win” trade in my estimation, and I’ll outline the specifics of that trade below.
Options to the Rescue
Just because I think Xylem is a terrible investment in the low $80 range, that doesn’t mean I dislike the business, or wouldn’t be willing to buy if the price was right. In particular, I’d be very happy to buy these shares at $65, for instance. For that reason, I’d be willing to sell someone the right to sell me the shares at that price. At the moment, my preferred short puts on this name are the July expiry with a strike of $65. These are currently bid-asked at $2.15-$2.90, and I think selling these puts presents investors a “win-win” trade. If the shares remain above that price for the duration, the investor simply pockets the premia, which is not a terrible outcome. If the shares drop, the investor will be obliged to buy, but will do so at what I consider to be a great net price of $62.85 ($65 less premium received). Holding all else constant, this net price represents a dividend yield of 1.65%, and a PE multiple of about 20. I would consider that buy price to be very reasonable. Note that the company hasn’t traded at or below $65 since December 2018. Investors may remember that that was also a terrible time for longs.
Institutional Buy Activity
Although I don’t think it makes sense to buy at these levels, in the interest of fairness, I should point out that some very smart investors may disagree. As I’ve written repeatedly on this site, the fact is that some investors are better at this than the rest of us, and it makes sense for the rest of us to at least be aware of their moves. With that in mind, filings reveal that Joel Greenblatt, and Ken Fisher bought 15,047 and 19,775 shares respectively in the final months of last year. That said, I should point out that the shares are much more expensive than they were this past December, so we have limited knowledge of whether these two would buy at today’s valuations.
I think Xylem is a very well run business that remains consistently profitable. The fact that management is signalling that the business will slow over the next twelve months is of little consequence to me, as I try to think past four quarters. My problem is not with the business here. My problem relates to the valuation, and for that reason I must recommend avoiding the shares. That said, the current jittery market has presented investors with an opportunity in the options market. I think selling the puts I mention above makes the most sense at this point. If the shares rally from these levels, the investor pockets “free” premia. If the shares drop over 20% from these levels, the investor will be obliged to buy. Buying at that price, though, represents opportunity for great long term returns in my view. I think the shares are overpriced, and I must therefore recommend avoiding them. The put options are too compelling to pass up, though, and I recommend selling aggressively.
This article was written by
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.
I'll be selling the puts mentioned in this article this week.
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