Xylem: A Clean Water Play for the Future

The world's need for fresh water and related infrastructure grows every year. Xylem is a pure play set to take advantage.

Jul 21, 2014 at 4:02PM

Xylem (NYSE:XYL) is a water technology company with a global footing. It handles the transport, treatment, testing, and filtration of water. The company derives the bulk of its sales from the U.S. and Europe, with smaller percentages coming from emerging markets. Xylem is a pure play on water technology since most competitors are in multiple other industries. With a new CEO, a vision for the future, opportunities in emerging markets, and the growing need for water-related infrastructure, Xylem deserves a closer look. 

New CEO with a vision
In early March, Xylem hired a new CEO, Patrick Decker. Before being appointed CEO of Xylem, Mr. Decker was the CEO of Harsco Corporation, which is an industrial services company. One could argue that someone in the position of CEO would not leave his current post unless he saw a significant opportunity and believes there is significant value to be created. Mr. Decker currently owns 85,342 shares of Xylem stock with a current value of $3.2 million. He was awarded 165,584 stock options that do not fully vest until 2024, giving him a long-term incentive for performance. A CEO that is properly aligned and shares in the risk of shareholders is a good sign for long-term investing. 

Mr. Decker is a firm believer in a managerial tool called "Lean Six Sigma," which at its core is aimed at eliminating waste and increasing efficiency. He has had success using Six Sigma at prior companies with the goal of reducing expenses and increasing margins. While he was working at Tyco International, he grew revenues substantially in the emerging markets (which is a huge growth area for Xylem). Here we have a shareholder-aligned CEO with a vision. Investors should look for situations of this kind and go along for the ride. 

Opportunity arises
Developing countries will continue to need increased access to fresh water, whether it be for farmers who need irrigation systems, manufacturers, housing complexes, or business offices. In a recent investor presentation, Xylem cited the following areas for long-term growth: under-served markets, pent-up demand in the U.S. and Europe, emerging market infrastructure development, and increased demand for energy efficient products. 

Source: Xylem

This illustration shows locations for production and service centers run by Xylem. The concentration of locations in China and other emerging markets is minimal when compared to the U.S. and Europe. There is still a need for significant spending on infrastructure in the U.S., as the ASCE Report Card for American Infrastructure for 2013 gave the U.S. an abysmal rating. The report talks about our drinking water infrastructure being near the end of its useful life and the degradation of existing pipes leading to waste. Companies such as Xylem are set to upgrade these systems with more efficient and new equipment. 

The fracking boom in the U.S. oil and natural gas industry is a huge growth area for Xylem as well. Hydraulic fracturing requires significant amounts of water. This water has to be transported from somewhere, and Xylem provides the equipment to do so. We often see mentions in the news of pollution and the dumping of waste into water supplies in China. Xylem already does business in China to help combat these issues, so this is another potential growth area. 

Just because there is significant opportunity for new business doesn't mean that someone is going to pay for it. The poor infrastructure in the U.S. and China is easy to see, but for Xylem to benefit from this, spending needs to increase. Though the investment thesis behind this company is highly long-term in nature, the need for funding of these projects can cause volatility over short to medium time horizons.

This is evidenced by Xylem management stating in the most recent 10-Q: "In 2014, we continue to expect a slow recovery in the United States industrial markets combined with modest improvement in performance in our European industrial end markets. In general, we expect a slow recovery in most of the developed country end markets and modestly higher levels of growth in emerging markets."  

Xylem has operations in over 150 countries, causing the company to be exposed to many different kinds of currency fluctuations which could impact earnings. To take advantage of emerging markets growth, capital expenditures will need to be increased significantly. This will put a strain on free cash flow (FCF) growth in the near term while Xylem increases capacity. Increased capital spending will hopefully pay off in the long-term with increased revenue, market share, and FCF for shareholders.

Putting it all together
The investment thesis behind Xylem is a long-term play on the ever-growing need for fresh water and related infrastructure. There may be short- to medium-term headwinds as outlined above. Long-term investors should not be concerned with these kind of fluctuations, though. The need for the services that Xylem provides will only grow as emerging markets spend more on infrastructure upgrades. Investors would be wise to take a closer look at this pure play on water.

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Zach Friesner has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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