Our Xylem thesis from 2018

Published on 08/20/21 | Saurav Sen | 3,772 Words

The BuyGist:

  • This thesis was originally published (in the old format) in September 2018.
  • In 2018, Xylem fit in perfectly into our portfolio - it sat right at the junction of 2 themes we were exploring: India and Urbanization
  • Since then, the stock has appreciated, especially over the last 12 months. 
  • We stepped back and took a macro view of the global water situation - the sport that Xylem plays. 
  • We've update our thesis and valuation here (available to subscribers only).

Thesis Summary

Xylem's products solve a major global problem - Water - especially in areas that are hit worst by the crisis: India and China. That, coupled with its cost improvements and focus on Analytics paint a compelling growth picture.

Competitive Advantage:

  • Core Competency? Technology to transport, treat and measure water.
  • Products: Better or Cheaper? Better. Offers comprehensive water solutions. 
  • Growth Story? India, China, and the Data Analytics business.

Durability of Competitive Advantage:

  • Competition? Fragmented. No one else offers a “one-stop-shop” solution yet.
  • Protection? Strong. Hard to uproot products which are built into Water infrastructure.
  • Cash Flow Resiliency? Resilient. Analytics business could be a wide Moat.

Management Quality:

  • Strategy & Action? Good. Focusing on China, India, Middle East. And Analytics.
  • Alignment of Incentives? Good. Line-managers’ compensation tied to Cash Flow.
  • Financial Productivity? Return-on-Equity > 30%. Improving Margins. Low Debt.
  • Sustainable Free Cash Flow? About $900 million. Translates to roughly $102/share

Competitive Advantage: The Castle

Core Competency? Technology to transport, treat and measure water.

The Buylyst likes to invest in “inevitabilities”. Well, those are practically non-existent, but some end-markets come close. We’ve discussed the inevitable growth in Urbanization, both around the world and in India. With that “near-inevitability” comes another inevitable problem: Water. In India and in other developing countries, the Water problem is more acute. 

Let me just frame this thesis with 3 numbers from the World Health Organization

  1. By 2025, half of the world population will be living in water-stressed areas. 
  2. At least 2 billion people drink water from a source that’s contaminated with feces.
  3. 844 million people lack even a basic drinking-water service.

At the risk of stating the obvious, this is a massive problem. And it’s not just a developing country problem. It’s a global one – need I remind you of the long drought in California (where residents were asked not to water their lawns) or the water contamination issue in Flint, Michigan. All countries – regardless of how rich or poor they are – are facing water issues. The fact is that nobody is immune to the effects of Climate Change. And water is one of the first casualties of this global phenomenon. In fact, 14 of the world’s 20 megacities are experiencing water scarcity and drought conditions. It’s not just cities; America’s second-longest river is running dry

Water is a complex issue, so I dumbed it down for myself.  As the WHO numbers above implied, there are 3 main problems: 

  1. Quantity: Too many people have difficulty getting enough water.
  2. Quality: Among the ones that do, too many don’t have access to clean water.
  3. Allocation: A major reason for #1 and #2 is inefficient allocation of water resources between cities and farmland.

I won’t expand on each of these problems, because this really isn’t a thesis on water. The more important questions are: 1) What are the solutions to those problems and 2) Where does Xylem fit it?

The solutions to the problems listed above are:

  1. Quantity: Transport water from areas with excess to areas with shortages. 
  2. Quality: Treat water – to decontaminate and re-use wastewater. 
  3. Allocation: Measure water flow and use. This would also be necessary if governments and utilities decide to price water as a commodity for “free market” allocation of the resource a la Australia

Xylem has been one of the leading firms for #1 and #2. And as of 2016 – upon the acquisition of a company called Sensus (no relation to me) – Xylem’s making a big push in #3. That’s how Xylem’s products map to the problems the company attempts to solve. In fact, its slogan is “Let’s Solve Water”. Amen to that. But the company breaks down its business into 3 slightly different segments: 

  1. Water Infrastructure: Essentially both Transport and Treatment solutions.
  2. Applied Water: Think pumps, pipes, valves, and other small components.
  3. Measurement Control and Systems: Think sensors connected to software – this is mostly via the Sensus acquisition. 

Amongst these, #1 and #2 are expected to grow in high-single-digits-percentages year-on-year, mostly because of growing water problems in China, India, and the Middle East. I think #3 is the real kicker. If Xylem can sell all 3 as a total package – which it’s attempting to do at the moment – it can really separate itself from the pack. 

The roadblocks are mostly associated with government inefficiency and bureaucracy. For most of the century, water has been a bit like oxygen – everyone takes it for granted when it’s there, but it’s catastrophic when it’s not. So, governments tend to act only if there is a calamity. The sad part is that calamities involve deaths. In many parts of the world, governments are realizing that they are approaching “Day Zero”, just like in Cape Town earlier this year. While it’s a thankless job, no government wants a Day Zero on their record. Xylem can help. 

Products: Better or Cheaper? Better. Offers comprehensive water solutions. 

It’s hard to say exactly how Xylem’s products stack up against competition. Usually, I make a judgement on this issue based on whether a company has some pricing power. In one of the Wall Street conferences, Xylem’s CEO had this to say:

“And historically, as we look back at this, we were trying to get a good feel for where do we have pricing power in the portfolio. And we’re actually in quite a good spot across the portfolio. I mean there are a couple of pieces that represent maybe 10% of our revenue that are a bit more challenged in terms of being big at price. But in those areas, we are unique and that we still have a lot of self-help margin opportunity to mitigate that.”

This would imply that they have some pricing power on about 90% of their portfolio. Even if they have pricing power across 60-70% of their portfolio, they’re decidedly not selling commoditized products and solutions. Common sense would suggest Xylem’s main customers – Utilities and Commercial/Residential buildings – wouldn’t try to skimp too much on water systems. As the water problem becomes more acute in many parts of the world, these customers would want to get it right, almost at any price. 

But I think Xylem’s pricing power should improve with its one-stop-shop portfolio, especially with the inclusion of Sensus. Together with its Transportation and Treatment products, they present a compelling argument.

Some other data points point towards Xylem’s competitive advantage. They win some “water awards”. And they were listed by Fortune magazine as among the top 10 companies that are changing the world. I think these accolades go back to their one-stop-shop portfolio. That’s what separates them. 

Growth Story? India, China, and the Data Analytics business.

Things have been good over the last couple of years: 

Xylem’s recent growth trajectory has been predominantly driven by these 3 factors – India, China and Data Analytics. India and China have been organic growth stories – driven by their governments’ realization that the water situation in those countries is untenable. 

It appears that just 20% of Xylem’s business today comes from Emerging Markets. And just 10% of total revenue comes from China and India. I think there is still massive room for growth in these countries – where a third of humanity lives. In the last quarter, Xylem’s China business grew by 30% year-to-date compared to last year. Here’s an underlying reason for why that’s happening:

In Beijing, 39.9% of water was so polluted that it was essentially functionless. In Tianjin, northern China’s principal port city and home to 15 million people, a mere 4.9% of water is usable as a drinking water source.”

As bad as the situation is in China, it’s on another level in India: 

Recently, the NITI Aayog released a report that highlighted the gravity of India's water situation. The country is facing its worst water crisis in history and if no action is taken to address this, the demand for water would far outstrip its supply by 2030. In fact, even by 2020, it is expected that 21 Indian cities will run out of groundwater.”

Only 62 per cent of urban households have access to treated tap water and only a little over 50 per cent are directly connected to a piped network. The average connected household receives water for approximately two hours per day. Only 33 per cent of the urban population is covered by a piped sewer system, while close to 40 per cent is dependent on septic tanks, and 13 per cent still defecate in the open. The capacity to treat sewage or wastewater is only 37 per cent of the total need in the country, and the actual treatment is even less, only 30 per cent.”

That there is room for growth for Xylem in India is a ridiculous understatement. The follow-up question is: Will Xylem get a piece of the pie? Obviously, I can’t say for sure. But their India business has been growing in double-digit percentages. And they’ve expanded both research and production facilities in India. That’s a legit foot in the door, so to speak.

Management raised an interesting point in one of the conferences: Unlike the US, other countries like India and China have made water a priority. Their governments have no problems allocating funding to fund massive Water projects. The same goes for the Middle East and the rest of Asia. Xylem hasn’t really made strides in Africa yet, where government support for Water projects is probably not as strong. But that will change. 

At the risk of sounding like a broken record – I think the new Data Analytics business will not only help in closing deals in India and China but also in the US and Europe. In the last earnings call, Management mentioned that they’re expecting to win some contracts in the US and abroad. But they’re still figuring out pricing and contract details. Whether the Analytics business serves as a sweetener for their other businesses or as an attractive storefront item to draw in clients, the growth opportunities are legit.

Durability of Competitive Advantage: The Moat

Competition? Fragmented. No one else offers a “one-stop-shop” solution yet.

It appears that Xylem competes with a slew of companies. I found it interesting that when I line up their listed competitors by business segment, there are no common names. Check this out: 

  1. Water Infrastructure competitors: KSB Inc., Sulzer Ltd., Evoqua Water Technologies, United Rentals and Danaher Corporation.
  2. Applied Water: Grundfos, Wilo SE, Pentair Ltd. and Franklin Electric Co., Inc.
  3. Measure & Control Systems: Itron, Badger Meter, Landis+Gyr, Neptune (Roper) and Elster (Honeywell).

So, the market is fragmented. The pessimistic view of this that maybe Xylem is trying to be “everything to everybody”, which usually leaves a company being “nothing to nobody”. The optimistic view is that Xylem offers something that other companies don’t: A complete Water solution. If recent revenue and orders growth is any indication, I think the optimistic view is closer to reality. 

Protection? Strong. Hard to uproot products which are built into Water infrastructure.

The nature of Xylem’s products is such that they are slow cycle – once installed they’re immune from the vagaries of competitive pressure. And the nature of the industry is such that their clients are unlikely to keep changing vendors as and when Xylem’s products and solutions need replacement. However, it seems to me that the Applied Water business is more exposed to replacement risk than the other segments.

The other nice thing about the sport that Xylem’s playing is that its relatively immune from technological disruption. Transporting, collecting and treating water can’t really be automated by Silicon Valley. It’s a physical process, albeit one that can be made more efficient by technology. I can’t see too many start-ups focused on this space. 

Again, the more Xylem is able to infuse their new software or data analytics platform into their solutions, the wider their Moat will be. The strength of this analytics offering will be highly dependent on Xylem’s expertise in Water rather than the Sensus’s software expertise. Obviously, at some point AI will need to be infused.

Cash Flow Resiliency? Resilient. Analytics business could be a wide Moat.

Xylem’s cash flow has been relatively stable. It has grown with its revenue base. Partly, that’s because of the slow-cycle nature of the products. As sales in India and China accelerate for the reasons mentioned in the sections above, Xylem’s installed base expands. And then we’re looking at another 2-3 years before a serious replacement cycle. So, I would think Xylem’s got about 2-3 years to really infuse their analytics offerings into these massive projects. Software, by nature is always less immune to competition once it becomes intertwined with a customer’s workflow.

The challenge and the opportunity for Xylem is this: convince customers that it’s the big player that can get a massive-scale water project done from start to finish with minimal supervision.

Management Quality: The Generals

Strategy & Action? Good. Focusing on China, India, Middle East. And Analytics.

As I listened to Xylem’s earnings calls and read through its presentations, there are a few things about Management’s strategy that I liked:

  1. Focus on India, China, and other developing countries. 
  2. Focus on making something out of their Sensus (Analytics) acquisition.
  3. Focus on Free Cash Flow.

I won’t repeat the case for expanding the India and China business. But there is one other component to the India and China strategy – “localization”. That means that a significant majority – about 80% - of the products sold in India and China are manufactured in those countries. This helps with a few things: 

  1. Cost Management: it virtually eliminates pricing issues related to FX.
  2. Inventory Management: Being closer to customers reduces the need to tie up Working Capital in inventory. 
  3. Trade War issues: this is specific to China, but Xylem doesn’t need to depend on imports from the US.

Their claims of Localization are backed up by hard numbers. I looked into the distribution of their Property, Plant and Equipment, and it roughly matches their revenue distribution across geography. 

Point #2 directly impacts Free Cash Flow. In fact, over the last few years, Xylem has made a concerted effort to reduce its Working Capital needs. Management expects to continue this trend as revenue keeps growing and inventory is better managed. 

I give Management an “A-“ for how far they’ve pulled Xylem along. That would change quickly to an “A” if they’re able to turn their newly acquired Analytics business into a real recurring revenue stream.  

Alignment of Incentives? Good. Line-managers’ compensation tied to Cash Flow.

I won’t reproduce their proxy report here. But one of the details that jumped out of the last earnings calls was that (and I’m paraphrasing) “their top 200 managers have a part of their compensation tied to changes in Working Capital”. This is one of the most specific attributions of compensation to free cash flow that I’ve seen. 

Otherwise, it was heartening for me to hear Management talk about Free Cash Flow extensively (although they also talked about EPS). They’re focused on margins and on Working Capital – two significant levers to pull to increase free cash flow as sales keep growing in India, China and the Middle East.

Financial Productivity? Return-on-Equity > 30%. Improving Margins. Low Debt.

Improving margins and Low Debt/Equity ratio – that’s exactly what I like in a company from a numerical standpoint. Management doesn’t intend to issue more debt, and it expects margins to keep improving over the next couple of years. I expect Xylem to be able to sustain a return-of-equity profile of more than 20%.

For a company like Xylem, high ROE is even more important for me because there isn’t massive upside in the stock. When a company generates a lot of cash from a fairly modest capital base, it significantly increases the probability that the value of the company (and consequently, it’s stock) will grow at a pace that reflects their ROE numbers. That reduces the need for a massive Margin of Safety. 

Sustainable Free Cash Flow? About $900 million. Translates to roughly $102/share.

It turns out that Xylem is about fairly priced, based on how much cash it generates now. That’s my opinion. Of course, it would be just awesome if there was enough margin of safety in the stock price based on its current cash flows. That’s what Charlie Munger would call “lollapalooza”. But it’s also true that those types of opportunities are hard to find. 

If I factor in some growth assumptions into Xylem’s numbers, one can argue that I may be reaching. I would buy that argument if there wasn’t a legitimate case to assume any growth. Here are the facts:

  1. It deals with a problem that’s life-threatening: Water. 
  2. Xylem’s end-markets are growing. About a third of humanity is facing severe Water issues. 
  3. Xylem has been capturing its fair share of those end-market growth stories. 
  4. Management has demonstrated that it can cut costs and release cash flow from better inventory management.

Now here’s where we jump into Opinion territory:

  1. I expect revenue from India and China to continue growing – thanks to the potent combination of urbanization and industrialization.
  2. I expect Management can continue to deliver on cost improvements. 
  3. I expect Management can continue to decrease the company’s working capital needs. 

The opinions above translate to these assumptions: 

  1. Revenue grows another 20% over the next 2-3 years – mostly due to the growth in India and China – before it plateaus. 
    • Management expects revenue growth of 6-7% (organic) over the next 12 months. And it expects that trend to continue over the next 2-3 years.
  2. EBITDA margins improve to 19%, lower than Management guidance of 19.5-20%. 
  3. Management finds another $150 million of working capital improvements, based on their “localization” strategy and better inventory management. 
    • This is roughly in line with the trend over the last 2 years.

All that culminated to a price target of about $102. The Margin of Safety is not phenomenal but considering the stability and expected sustainability of Xylem’s cash flows, it’s plenty.

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