Xylem: Great business but shouldn’t be valued like a growth company (NYSE:XYL)

Panoramic view Water purification of modern urban sewage treatment plants is the process of removing unwanted chemicals

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investment work

xylem (NYSE:XYL) is an excellent hundred-year-old business with only one problem. It’s a slow-growing value stock that’s priced like a fast-growing growth stock. This is a stock where you should be very patient to find the right entry point unfortunately it is not now.

dissolve water

Water is one of the greatest challenges of this century. Providing sufficient clean drinking water and wastewater treatment will be a major challenge. All of this at a time when the world’s population is growing and developing countries are now starting to consume more and more resources. At the same time, the climate could change dramatically, creating even more challenges. At the very least, weather and rain patterns seem to be changing, whether it’s from climate change, magnetic pole reversals, or whatever; it does not matter.

Our vision is simple. We dedicate our technology, time and talent to advancing the smarter use of water. We look to a future in which there are no global water problems.

Xylem Vision

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

Diversified worldwide

I like it when companies are global. Xylem has operations in the US, Europe, and some emerging markets, but the US accounts for about 60% of sales. For a water-focused company like Xylem, there is also a clear tailwind when countries become more prosperous, i.e. the middle and upper classes grow, because people’s demands then rise.

Current results and finances

The market has taken the latest quarterly figures very positively, and overall the share has been on an upward trend for several months. However, I do not see the results too positively and would like to explain why here.

Xylem Q3

Xylem Q3

There was a one-off non-cash settlement fee of US$140 million for a UK pension plan buyout; Because of this, there is a significant difference between reported and adjusted EBITDA. Overall, year-over-year revenue growth was 16% and EPS growth was 15% — both on an adjusted basis. However, I think the adjusted numbers are overdoing it. Almost all companies are currently adjusting their figures for currency fluctuations. But that’s part of the deal and it’s not clear if this is a one-off event or if the euro has permanently depreciated against the dollar and will remain so low. Do they then adjust their numbers downwards during periods of positive currency swings?

Anyway, I want to compare the nine months of 2022 to 2021. For a slow-growing company like Xylem, that makes more sense to get a clearer picture. Overall, this approach is less volatile than quarter-to-quarter.

Xylem 2022 vs 2021

Xylem Q3

As we can see here, total sales rose just 4% for the entire nine-month period. Even with the adjusted numbers, revenue rose just 8%. Orders were up just 2% (not shown in this image). Xylem was able to compensate for this difference through price increases. However, price increases cannot be a permanent solution. The percentage increase in orders is a key indicator. And 2% is very close to stagnation. Overall, I’m not entirely convinced that Xylem really is a recession-proof stock, given their many different areas of activity. Some companies are recession-resistant, such as B. Sewage systems. But what about building new ships, water parks and other commercial buildings? For those things, there might be less demand for Xylem’s solutions during recessions.

Overall, the margins also seem to be developing rather negatively – at least the current margin for all key figures in this screenshot is below the 5-year average.

xylem margins

Alpha wanted

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

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Data from YCharts

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 clearly in FAST Graphs. The blue line is the long-term average P/E. The stock has moved further and further away from this line. This started in 2020 as the hype around ESG, green stocks, electric cars and so on grew.

Xylem rating historical

fast graphics

Also, we can see here that there have always been years when EPS went down. Overall, then, it’s a relatively slow-growing industrial stock. This isn’t a surprise since the company trades in physical products and doesn’t scale as easily as a tech company. The stock is currently overvalued.

diagram
Data from YCharts

Depending on your portfolio and preferences, a good buying opportunity may have presented itself in July. However, the stock has run away again, so I think it’s significantly overvalued. If the stock falls back to its historical average P/E ratio, it could post a meager annualized return of about 2.8% by the end of 2024. And even that average P/E is still relatively high.

xylem fastgraphs

fast graphics

The dividend is only a tiny percent return. In contrast, the payout ratio has been rising for years. The dividend growth rate over the past five years has averaged 11%. Therefore, the increase is expected to be smaller in the future.

diagram
Data from YCharts

Stock dilution and insider selling

I always want to look at stock dilution and if there’s insider selling. There was a bit of both, but rather minimal.

diagram
Data from YCharts

risks

High valuations mean that the ideal world is already priced in and nothing should go wrong. This is probably the biggest risk for Xylem in general. If the stock were priced like other slow-growth value stocks, it would be at most half its price. The risk for shareholders is that the average price-to-earnings ratio moves ever closer to this value over the next few years. But of course that doesn’t have to be the case. The stock can consistently remain valued higher than other stocks simply because it fits so well with the zeitgeist of water, ESG, and the environment.

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

Conclusion

I was drawn to the company because I own a water ETF, where Xylem is one of the top positions. I checked it out, but was quickly put off by the rating. I think interested parties will have to be patient here and wait for situations like the ones that already existed in July this year. Even then, the forward P/E was still high at around 28, but the stock appears to consistently trade higher than other stocks. For my taste, the expected return is now too low, or in other words, the risk is too high. However, I wouldn’t short here, so I’m rating the stock with a hold rating.

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