Xylem: Great business, but shouldn’t be priced as a growth company (NYSE:XYL)

Manuel Paul Dipold profile picture

photovs

investment thesis

xylem (New York Stock Exchange:XYL) is an excellent century-old business with only one problem. It is a slow-growing value stock listed as a fast-growing growth stock. This is a value where you have to be very patient to find the right entry point, but unfortunately, it is not now.

fix water

Water is one of the greatest challenges of this century. Providing sufficient drinking water and sewage treatment will be a major challenge. All this at a time when the world population is growing, and now developing countries are starting to consume more and more resources. At the same time, the weather could change dramatically, creating even more challenges. At least the weather and rain patterns seem to change, either because of climate change, the magnetic pole investment, or whatever; no matter.

Our vision is simple. We dedicate our technology, time and talent to promote the smarter use of water. We look to a future where global water problems do not exist.

Xylem Vision

Xylem offers many different solutions through many marks. For agriculture, closed water circuits for aquaculture, water solutions for boats and water parks, water analysis systems and water analysis for the food industry. All kinds of products are used, such as pumps, turbines, fans, pipes and smart meters. But the company also offers software to monitor, for example, river levels. This is a complex company with many branches, but they are all related to water.

globally diversified

I like it when companies are positioned globally. Xylem operates in the US, Europe and some emerging markets, but the US accounts for around 60% of sales. For a company like Xylem, with its focus on water, it’s also a major tailwind when countries become more prosperous, meaning the middle and upper classes grow because people’s demands increase.

Also READ  TotalEnergies - SA Quantitative Top Pick (NYSE:TTE)

Recent results and finances

The market has received the latest quarterly figures very positively and, in general, the share has been on an upward trend for several months. However, I don’t view the results very positively and would like to explain why here.

Xylem Q3

Xylem Q3

There was a one-time non-cash settlement charge of $140 million for the full purchase of the UK Pension Plan; therefore there is a considerable difference between reported and adjusted EBITDA. Overall, year-over-year revenue growth was 16% and earnings per share growth was 15%, both on an adjusted basis. However, I think it’s getting overkill with the adjusted numbers. Right now, almost all companies are adjusting their figures for currency fluctuations. But that’s part of the business, and it’s not clear if this is a one-time event or if the euro has permanently depreciated against the dollar and will stay that low. Do they then adjust their numbers downward in times of positive currency fluctuations?

Anyway, I’d like to compare the nine months of 2022 to 2021. For a slow-growing company like Xylem, this makes more sense to get a clearer picture. In general, this approach is less fluctuating than quarter to quarter.

Xylem 2022 vs. 2021

Xylem Q3

As we can see here, total sales were up just 4% over the entire nine-month period. Even with the adjusted figures, sales were only up 8%. Orders were up just 2% (not shown in this image). Xylem has been able to compensate for this difference through price increases. However, price increases cannot be a permanent solution. The percentage increase in orders is a crucial indicator. And 2% is very close to stagnation. Overall, I’m not entirely convinced that Xylem is really a recession-proof stock because they’re active in so many different areas. Some businesses are recession resistant, like sewage systems. But what about the construction of new boats, water parks, and other commercial buildings? For these things, there may be less demand for Xylem solutions during recessions.

Also READ  Pentair shares are a good buy after a recent correction (NYSE:PNR)

In general, margins also appear to be moving in a fairly negative direction; at least the current margin is below the 5-year average for all the key figures in this screenshot.

Xylem margins

looking for alpha

EBITDA and net income are also slowly moving up and down.

Frame
Data by YGraphics

Valuation

Given this slow growth, the share price has performed very well in recent years, but this is not due to the business itself but to an increasingly higher valuation. This can be seen very well in FAST Graphs. The blue line is the long-term average P/E ratio. The stock has drifted further and further from this line. This started in 2020 when more and more hype emerged around ESG, environmental actions, electric cars, etc.

Historical assessment of the xylem

fast graphics

Also, here we can see that there have always been years in which the UPAs have fallen. So overall, this is a relatively slow-growing industry stock. This is not a surprise because the company deals in physical products and is not as easy to scale as a technology company. As such, however, the stock is overvalued at the moment.

Frame
Data by YGraphics

Depending on your portfolio and preferences, there may have been a good buying opportunity in July. However, the stock has slipped away again, so I see it as clearly overpriced. If the stock fell back to its historical average P/E, a meager annualized return of about 2.8% by the end of 2024 would be possible. And even this average P/E is still relatively high.

Quick Xylem Charts

fast graphics

The dividend is just a small one percent return. On the contrary, the payment rate has been increasing for years. The dividend increase rate for the last five years was, on average, 11%. Therefore, the increase will probably be smaller in the future.

Also READ  Apollo Endosurgery, Inc. 2022 Q3 - Results - Earnings Call Presentation (NASDAQ: APEN)
Frame
Data by YGraphics

Dilution of shares and sale of privileged information

I always want to see stock dilution and if there is any insider trading. There has been a bit of both, but rather minimal.

Frame
Data by YGraphics

risks

High valuations mean that the ideal world is already valued and nothing should go wrong. This is probably the biggest risk for Xylem in general. If the stock were valued like other slow-growing value stocks, it would be at most half as high. The risk for shareholders is that the average P/E gets closer to this value in the coming years. However, of course, this does not have to happen. The stock may remain permanently valued higher than other stocks simply because it fits so well in the zeitgeist with water, ESG and the environment.

Otherwise I don’t see too many risks here. The business model will continue to be in demand and the debt is not too high; the company is profitable and has been established for years.

conclusion

I was first introduced to the company because I own a water ETF where Xylem is one of the top positions. I looked at it briefly, but was quickly put off by the valuation. I think that interested buyers have to be patient here and wait for situations like the ones that already happened this year in July. Even then, the forward P/E was still high at around 28, but the stock seems to be trading consistently higher than other stocks. For my taste, the expected return is now too low, or what is the same, the risk is too high. I wouldn’t fall short here though, which is why I’m rating the stock a hold rating.

Leave a Reply

Your email address will not be published. Required fields are marked *