Xylem Benefiting From End-Market Diversity And Good Cost Management

Six months ago, I thought that both Xylem (NYSE:XYL) and Franklin Electric (FELE) looked attractive on overdone sell-offs tied to supply chain challenges and a sharp correction in at least some theme stocks (like water stocks). Since then, the shares are up a little more than 11%, beating the S&P 500 handily as well as the broader industrial space (and beating Franklin by a bit).

I like Xylem’s leverage to water utility infrastructure spending, as well as industries like mining and food/beverage, and I think Xylem could benefit from relatively less exposure to construction markets that could see a sharper slowdown in the face of higher interest rates. Valuation is not as attractive anymore, but I would still regard this as a solid hold and a name to watch for another pullback.

Strong Industrial Demand, Tempered By Softer Utility And Commercial Growth

Xylem reported 6% organic growth in the second quarter, beating expectations by 4%. While that growth arguably pales next to the mid-teens growth of Watts (WTS) and Zurn Elkay (ZWS), they do serve different markets and Watts and Zurn have benefited from strong construction markets, particularly in the renovation/retrofit markets.

Xylem’s Water Infrastructure business (pumps, valves, and water treatment) reported 9% growth, beating expectations by 4%. Applied Water (pumps used in light industrial applications like HVAC and food/bev, fire systems, and irrigation) grew 7%, just barely beating sell-side expectations. Last and not least, Measurement & Control Solutions (or MCS), which focuses on smart metering, analytics, and smart devices like leak detection systems, saw 2% contraction on ongoing component shortages, but that was good for an 8% beat versus sell-side expectations.

Gross margin declined 40bp (to 38.1%), but improved 140bp sequentially. Management has been active on pricing, but price/cost was still a 30bp headwind in the quarter. Operating income declined 3% on a 2% improvement in segment income. Segment income beat expectations by 20%, or $0.11/share, with Water Infrastructure driving the beat ($0.10/share versus expectations). Water Infrastructure profits rose 19% (margin up 250bp to 18.8%), while Applied Water declined 2% (margin down 80bp to 14.7%) and MCS declined to a small loss (margin of -0.3% versus +3.5% a year ago).

Looking at end-markets, industrial led the way with 12% year-over-year growth on strong demand from mining companies for dewatering, as well as healthy demand tied to HVAC and food/beverage. Residential was technically even stronger (up 13% on strong home construction), but makes up only around 5% of the business.

Utility revenues rose 2%, as healthy trends in transport, wastewater, and water quality were offset by metering (which has been weak on component shortages, particularly semiconductors). Commercial revenue was down 1%, but this isn’t a very large business (about 10% of the total) and it hasn’t leveraged the hygiene-driven retrofit trend like companies including Zurn Elkay have.

Orders rose 6% in organic terms on top of a 29% improved in the year-ago quarter. Water Infrastructure was strongest (up 21%), but while MCS orders did decline 9%, the book-to-bill was still a solid 1.4x. Overall backlog rose 40% yoy, and an MCS recovery is gated in part by eventual improvements in chip availability.

Underlying Demand Trends Remain Positive

I continue to like Xylem’s diverse end-market exposures, and I don’t see particularly worrisome risks to the outlook over the next 12 to 18 months aside from supply chain issues.

Dewatering activity should remain healthy given greenfield and brownfield capital projects in mining. I also expect improving demand from utilities for pumps and treatment products as the infrastructure bill kicks in (with its focus on improved drinking water quality/supply). Metering should recover with increased chip production volume in 2023, and I still see meaningful growth opportunities for analytics, management software, and smart devices (sensors and communication devices) aimed at detecting leaks in water distribution.

Light manufacturing will likely be a little mixed as I expect companies to pull back a bit on the investments they’ve been making to upgrade their production capacity and meet growing backlogs. Longer term, I could see Xylem as an ongoing beneficiary of increased manufacturing automation (pumps for a range of processing or hybrid end-markets like food/beverage) and reshoring.

Supply chain/input cost trends aren’t showing the same improvement yet, and they may well not until 2023. Xylem is getting solid pricing in the meantime, but the company would clearly benefit from normalization of its input costs.

The Outlook

I’m looking for full-year revenue growth of around 4% in FY’22 and long-term growth of around 5% relative to the prior highwater mark in 2019. I expect margins and FCF generation to recover and re-scale over the next three years, and I think FCF margins will get to 15% and beyond over the longer term, driving mid-to-high single-digit FCF growth.

The Bottom Line

Discounted cash flow doesn’t suggest that Xylem is especially cheap now, and likewise the forward multiples on EBITDA are not low, even acknowledging Xylem’s strong margins and ROIC, attractive and diverse end-markets, and leverage to environment themes.

It’s tougher to recommend the shares after this rebound, but Xylem is one of those stocks that has shown it can head higher despite high multiples, and I see some attractive multiyear investment trends in many of major served markets. At worst I’d call this a solid hold and a name to consider on another pullback, but you have to be more liberal on valuation today to make a “buy” case.