Stock of the Week - Xylem (09.01.2025)

Xylem (XYL.US), a global leader in water technology solutions, is strategically positioned at the intersection of two critical trends: increasing water scarcity and the rising water demands of technological advancement. With a market capitalization of $28.16 billion, Xylem provides essential technologies and services for water management, treatment, and transportation, serving both utilities and industrial customers worldwide.

Q3 FY24 Results 

For the third quarter, Xylem reported:

• Revenue: $2.104 billion (+1.35% year-over-year) vs. estimate $2.175 billion
• Adjusted EPS: $1.11 vs. $0.99 year-over-year (+12.12%)
• Net Income: $217 million
• Net Income Margin: 10.3% (+300bps year-over-year)
• Adjusted EBITDA Margin: 21.2% (+140bps year-over-year)
• Orders: +8% year-over-year

Earnings vs Estimates. Source: Bloomberg

Strategic Evolution 

Xylem's recent strategic moves demonstrate its commitment to technological leadership and market expansion through several key initiatives. The company has strengthened its digital capabilities through the acquisition of a majority stake in Idrica, which has enhanced the Xylem Vue platform to provide real-time insights for water utilities. This integration enables customers to better address challenges like water loss and aging infrastructure with more sophisticated solutions.

In the European market, Xylem has reinforced its presence through the acquisition of Heusser Water Solutions AG in Switzerland, adding significant local expertise in advanced pumping and treatment solutions. The company has also expanded its innovation pipeline with a $50 million investment in corporate venture capital, targeting emerging companies developing solutions for water scarcity, quality, and decarbonization. This builds upon successful partnerships with firms like Burnt Island Ventures and demonstrates Xylem's commitment to fostering technological advancement in the water sector.

Business Segment Overview 

Xylem operates through four main segments, each serving distinct market needs. The Water Infrastructure segment, representing 40% of revenue, focuses on the transportation and treatment of water through pumps, filtration, treatment equipment, and controls. This segment serves a geographic mix of 35% US, 35% Western Europe, and 30% emerging markets, with end markets split between wastewater utilities (60%) and industrial applications (40%).

The Applied Water segment contributes 25% of revenue and specializes in industrial and building solutions, including pumps, valves, heat exchangers, and controls. This segment maintains a stronger presence in the US at 50%, with Western Europe and emerging markets accounting for 20% and 30% respectively. The business serves both industrial (45%) and building solutions (55%) end markets.

Measurement & Control Solutions, accounting for 24% of revenue, delivers smart metering and testing solutions primarily to the US market (65%), with additional presence in Western Europe (15%) and emerging markets (20%). The segment predominantly serves clean water utilities (85%) with the remainder focused on industrial applications.

The Integrated Solutions & Services segment, while the smallest at 11% of revenue, provides specialized treatment and assessment services. This segment maintains a strong US focus (80%) and primarily serves industrial customers (70%) alongside utilities (30%).

Portfolio breakdown by revenue. Source: Company Data

Growth Drivers 

The expansion of artificial intelligence and data centers represents a significant growth opportunity for Xylem. The increasing water demands for cooling data center operations have created new markets for water-efficient solutions. Xylem has positioned itself well in this space through strategic partnerships, including collaboration with DataRobot for AI-powered pipeline assessment capabilities.

Google's Energy and Water Use. Source: Bloomberg

The growing desalination market presents another significant opportunity for Xylem's water treatment technologies. With global fresh water demand expected to outpace supply by 40% by 2030, according to the Global Commissions on the Economics of Water, desalination is becoming increasingly critical for water security. Industry forecasts from Morgan Stanley and Fortune Business Insights project the global desalination market to grow at a compound annual rate exceeding 8%, potentially expanding from $23 billion in 2023 to nearly $50 billion by 2032. Xylem's advanced treatment technologies and global presence position it well to capture share in this expanding market.

Drought Risk Map. Source: Bloomberg

Environmental regulations continue to drive demand for Xylem's solutions, particularly with new EPA PFAS regulations requiring over 5,000 U.S. water systems to upgrade their treatment capabilities. Xylem's proven PFAS remediation technologies, with more than 80 installations completed, position the company as a leader in addressing these regulatory challenges.

Infrastructure modernization provides another substantial growth vector, as aging water infrastructure in developed markets requires updating while emerging markets continue to build out new systems. The municipal bond issuance of $33.4 billion for water projects in 2024 indicates strong public sector commitment to water infrastructure improvement.

Management Guidance 

Looking ahead to full-year 2024, management expects revenue to reach $8.5 billion, representing a 15% year-over-year increase with 5% organic growth. The company anticipates an adjusted EBITDA margin of approximately 20.5% and has narrowed its adjusted EPS guidance to $4.22-$4.24. Free cash flow conversion is expected to exceed 120% of net income.

Valuation

Based on our analysis of Xylem using historical data and company guidance, we've developed projections that assume a moderate growth scenario. Our base case incorporates an 11% revenue growth and 17% operating margin over the 5-year forecast period. Given the significant impact of terminal value in DCF valuations, particularly for 5-year forecasts, we've used a more conservative 5.5% terminal revenue growth rate and a 10% terminal WACC, compared to 11% during the forecast period.

Under these assumptions, our DCF model indicates an intrinsic value of $137.84 per share, suggesting potential upside of 19% from the current share price of $115.91. However, it's crucial to acknowledge that DCF valuations are highly sensitive to input assumptions. The attached sensitivity matrices illustrate how the valuation varies under different scenarios for Operating Margin, Revenue Growth, Terminal WACC, and Terminal Revenue Growth rates.

Source: Bloomberg Finance LP, XTB Research

Source: Bloomberg Finance LP, XTB Research

To assess Xylem's relative valuation, we analyzed a peer group of four comparable companies in the industrial water technology sector: Parker Hannifin, Ingersoll-Rand, Veolia, and Idex. The peer comparison reveals interesting insights about Xylem's market positioning and valuation metrics.

The multiple-based valuations show mixed signals across different metrics. Using P/E and Forward P/E multiples suggests potential downside, with implied valuations of $92.88-$98.72 based on mean valuations. However, P/BV and Forward EV/Sales multiples indicate significant upside potential, with implied valuations of $170.95 and $171.19 respectively. The cap-weighted approach, which accounts for company size differences, suggests values ranging from $85.40 (P/FCF) to $212.74 (P/BV).

Notably, Xylem trades at higher multiples than the peer group median across several metrics, with a P/E of 35.39x compared to the peer median of 29.52x, and a Forward P/E of 24.65x versus 23.25x for peers. This premium valuation could be justified by the company's strong market position and growth prospects in the water technology sector, though it also suggests limited room for multiple expansion.

Source: Bloomberg Finance LP, XTB Research

Recommendations: Xylem has 22 recommendations, with 14 "buy" and highest price of $166 and 8 “hold”. The 12-month average stock price forecast is $146.86, implying a 26.7% upside potential from the current price.

Technical analysis (Daily interval): 

The stock is currently trading below the key level at the 38.2% Fibonacci retracement level. For bears, the target will be the 61.8% Fibonacci retracement level, which acted as strong support one year ago and previously led to a rally.

For bulls, the key target is to regain the 38.2% Fibonacci retracement level, which served as a strong support level during the previous bull run. The RSI is showing early signs of potential bullish divergence but is still consolidating near oversold values. Meanwhile, the MACD remains tight with no clear direction, though it slightly favors a bullish outlook. Source: xStation