A lot of recent global occurrences point to one thing - gradual but steady global crumbling of infrastructures. Some of these occurrences range from massive sinkholes to collapsed bridges and massive water main breaks. Bridges, roads and water mains to mention just a few, are in dire need of intensive repairs or total replacement. Among all these infrastructures, water is the most important one because when it comes to cooking, washing, drinking or bathing, it can never be replaced by any other liquid.
There is hardly any commercial establishment that can function properly without access to clean water. From hospitals to corporate offices and restaurants, there will always be need for access to clean water. In certain regions, farm produce flourish only with proper irrigation and this cannot be possible if the farmers lack access to water. Even in various industries, water will always play a huge part in their finished products at one or more stages of production. According to the World Health Organization (WHO), approximately 1 billion people lack access to safe drinking water.
There are three major water systems which are the clean water, wastewater and wet weather systems. The clean water systems are designed to collect source water from rivers and lakes and remove pollutants before distributing the clean water for various uses. The wastewater systems on the other hand are designed to collect used water and sewage and after getting rid of contaminants, the now clean water is discharged back into rivers and lakes for future use. With the wet weather systems, various types of pollutants including sewage and heavy metals are prevented from reaching the waterways.
Now the decaying water infrastructure is absolutely bad news, especially for the consumers but for the investors and companies that provide the equipment, products and skills needed to enhance, replace or repair these major water systems and other related systems, it is not all bad news. One company that stands to benefit among others from the demand for clean water and wastewater equipment and pumps is Xylem Inc. (XYL). Based in White Plains, New York, Xylem is a water-technology company that has made a name for itself in the industry from waste-pumping projects to disinfecting projects and others.
Spun off from ITT Corporation in 2011, Xylem has proven to be a profitable business. A global leader in water application solutions with leading positions in the markets it operates in, the company offers products and solutions for transportation, distribution and process treatment of water and wastewater the world over. Xylem also engages in activities geared towards improving sewage handling, flood control, tunnel construction and energy conservation. Presently, the company operates in approximately 150 countries where it offers a wide range of water and drainage pumps, including units for primary, secondary and tertiary water treatment.
The company's production plants are strategically located in Europe, Asia, and North and South America. It offers its products under various brands which include Flygt, Wedeco, Leopold, Steady and Sanitaire to mention just a few. Under Flygt brand, the company offers mechanical aeration equipment, submersible pumps and mixers. Under the Wedeco brand, it offers Ozone oxidation and UV disinfection systems which are mostly used in processing municipal drinking water and wastewater, with over 200,000 systems in use worldwide. These systems are also used for industrial process water. Under the Leopold brand, it offers rapid gravity media filtration and clarification solutions for water and wastewater plants. Steady offers a wide range of high quality wastewater pumps for the municipal market. Sanitaire offers sequencing batch reactor, diffused aeration, drum filters and state-of-the-art controls for complete biological wastewater treatment for industrial and municipal applications.
Xylem is also in partnership with a couple of businesses including Zenon,a registered trademark of General Electric (GE). In a nutshell, the company's products and services are offered to Commercial and Residential markets, Public Utility, Agriculture and Industrial markets. Indications point to the fact that present and future occurrences within the water service industry will continue to fuel demand for the company's products and services, both in the U.S. and overseas.
Segment overview
Xylem operates in two reportable segments which are Water Infrastructure and Applied Water. Known to be a $20 billion market, the Water Infrastructure segment accounts for approximately 64% of the company's revenues with the company's focus on transportation, treatment and testing of water. Some of the products offered in this segment include water and wastewater pumps, treatment and testing equipment under key brands like Flygt, Wedeco, WTW, Godwin Pumps, Leopold, and Sanitair.
Under the Applied Water segment, which is a $15 billion market and accounts for approximately 36% of the company's revenues, Xylem focuses on the commercial, residential, agricultural and industrial markets and offers products like valves, pumps, controls, dispensing equipment and heat exchangers. These products are offered under key brands that include Bell & Gosset, Goulds Water Technology, Flojet, AC Fire, Jabsco, Lowara, Standard and Flowtronex.
Where Xylem comes in
Research has shown that total available fresh water on earth is approximately 1% and this percentage is continually on the decline as a result of climate change, increased pollution and continued draining of aquifers. While this is happening, the demand for fresh water is rapidly increasing as the world's population grows. Add the industrial expansion and significant increase in agricultural development with projected double water consumption rate and you will be convinced it is an escalating situation. A recent study shows that by 2025, approximately 30% of the world's population will have limited access to adequate water supply.
It is not even better in the developed countries as the significantly underfunded and rapidly aging water infrastructure shows. In the United States alone, it is estimated that one out of every six gallons of water on average, leak from degrading pipe systems on its way from treatment plant to the end consumer. These happenings are steadily fueling growth in the global water industry which is valued at approximately $500 billion. This is where Xylem comes in.
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Xylem's business model is one that sees the company actively involved from the beginning of the above supply chain to the end of it. This it achieves through its provision of technology-intensive equipment and services. It operates in the Water Equipment and Services sector which is valued at approximately $280 billion and also has strong footing in the Design and Build, Utilities and End Use Applications sectors which are wholly valued at approximately $220 billion.
One interesting thing is that in the key Applications it operates in, Xylem maintains leading positions as depicted below:
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Still on the company's model, it is such that aligned its two operating systems with each of the sectors in the cycle of water as shown below. While the Water Infrastructure segment serves the Supply Infrastructure sector in the water cycle, the Applied Water segment serves the Usage Applications sector.
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Future occurrences that will further boost the company's top and bottom line growth
According to a Water Report from American Society of Civil Engineers (ASCE), the overall annual capital need for Water Infrastructure in the U.S. for 2010, 2020, and 2040 are $91.2 billion, $125.9 billion and $195.4 billion respectively. However, there have been capital gaps in previous spending and as such, there are estimated capital gaps. The study also points out that additional factors might possibly result in additional costs in the future thereby increasing the future capital spending on water infrastructure. Some of these factors include the consequences of climate change and the need to construct and operate more technologically advanced and energy-intensive treatment facilities. These advancements are in wastewater recycling, removal of newly regulated contaminants and lots more.
With Xylem's position as a market leader, it stands to benefit immensely from these water infrastructure allocations in the U.S. The company's 2012 Annual Report shows that it is and will continue to invest in new technology and innovation as it works towards developing breakthrough products and solutions both in its core and emerging markets. As at the end of Fiscal year 2012, United States accounted for 37% of the company's revenue with Europe accounting for 35%, and Asia Pacific 12%.
From the ASCE research, the following table shows the expected wastewater treatment and drinking water infrastructure needs and investments in the U.S. in 2011, 2020 and 2040:
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Source: ASCE Water Report
With Xylem maintaining a leading position in the Treatment application market, it stands to benefit immensely from these future investments in the above mentioned water infrastructures in the U.S. In summation, there is considerable and sustainable growth in the emerging markets, especially in the company's key markets.
Growth through acquisitions
From 2010 till date, Xylem has spent approximately $1.4 billion on strategic acquisitions. The acquisitions are broken down as follows:
Shareholder-friendly Xylem
Xylem has proven to be a company that returns money to shareholders through dividend payments and increases and share repurchases. In 2013, the company announced a 15% Dividend increase, $250 million share repurchase program and 3 acquisitions have been completed to date. Below is a breakdown of the company's capital deployment in third quarter of 2012 and third quarter of 2013. 
Xylem's financial position
The graphic below shows the company's financial position. It currently maintains a strong cash position with approximately $394 million in cash. In terms of the company's debt, there are no significant debt maturities until 2016 and at the same time, Xylem has an unutilized $600 million in revolving credit facility and unutilized access to commercial paper. This shows that the company is financially sound to return money to shareholders and also engage in small-sized M&A activities.
Xylem's financial performance
As at 1H of 2013, the company's revenue and Adjusted EPS declined 3% and 27% respectively in comparison to the same period in 2012. This is mostly attributed to weak Industrial and Public Utility markets, restructuring and realignment charges and weak European market. However, the image below shows a 4% increase in Q3 2013 revenues versus Q3 2012 revenues. Same goes for adjusted EPS for the same period as it increased 11%. It is an indication of slight improvement in the Industrial and Public Utility markets and stabilizing European market. Also, the strong growth recorded in emerging markets and benefits of the restructuring and realignment activities are contributing factors to the increase.
Also, the company's operating margin increased from 10.8% in 2008 to 12.9% in 2012 (+210 Bps with Stand-Alone Costs).
Peer comparison and valuation
Although Xylem has significant growth prospects and maintains a strong balance sheet, its shares presently trade below fair value, especially in relation to its peers in the industry. An overview of Xylem and a couple of its peers is presented in the table below. The companies included are Middleby Corp. (MIDD) and Flowserve Corp. (FLS). The figures are expressed in United States dollars.
The only area from the above valuation that Xylem is trading at a slight premium is its trailing P/E of 26.44, slightly above its peers average of 25.73. From the above table, Xylem trading at 2.87 book value shows it is trading at approximately 60.62% discount to its peers. In terms of P/S ratio, Xylem's shares are trading at approximately 39% discount to its peers average of 2.28. On EV/EBITDA, it is trading at approximately 11.93% discount.
Catalysts to fuel the company's growth in the years ahead
Some of the factors that will help in fueling further growth in Xylem include:
- Near-term global expiration of a higher percentage of existing water infrastructures and impending repairs and replacement.
- Continued improvement in the Industrial and Public Utility markets.
- Strong revenue growth in emerging markets, especially in China.
- Accruing benefits of the previous restructuring and realignment activities carried out by the company in the first half of 2013.
- Stabilizing European market conditions.
- Extended period of debt maturities.
- Strong cash position.
- Currently simplified and delayered operating model.
- Annual cost savings of ~$35 million as a result of the 2013 Restructuring and Realignment activities.
- Increased activities in the Real Estate industry.
- Strong bidding activity.
- Large installed base with loyal customers.
Downsides to the investment thesis
As with every investment, there are certain risks associated with investing in Xylem and they include:
- Unfavorable foreign exchange
- A downturn in the already stabilizing European market
- A relapse in the Industrial and Public Utility markets
- Decline in the demand for its products and services in any of its key end markets
- Unfavorable international economic circumstances that could lead to a decline in revenue from international markets, which accounted for ~63% of the company's revenue in fiscal 2012.
Conclusion
All said, there is no denying the fact that well-maintained drinking water and wastewater infrastructure is a necessity in the society. Should capital spending on global water infrastructure keep pace with needs, Xylem and its peers in the industry are in for continued growth in revenue and net income.
Although the municipal budgets in the U.S. is very tight, Xylem will continue its growth streak as a higher percentage of its revenues come from outside the U.S. With its expansion into emerging markets, the company has huge long-term prospects which will see earnings increase in the long term.
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