Why invest in sustainable water stocks? If you thought the answer was about emerging market demand for water for personal, commercial, and industrial use, you'd only be partly right. Water is also extensively used in agriculture, and the overwhelming majority of global power generation is water-intensive.
Given the need for food and energy in order to support booming population growth in emerging markets, there'll be a need for significant investment in sustainable water solutions. It's a compelling long-term investment case, and I think Danaher Corporation (NYSE:DHR), Xylem Inc. (NYSE:XYL), and Pentair plc (NYSE:PNR) are stocks well-placed to play the investment theme. One of the interesting things about water is that there's no lack of it or difficulty in finding it; the problem is ensuring its quality (for both potable water and wastewater) and transporting it to the right places. This means there's likely to be good long-term demand for companies serving the market.
Here's how you can make money from it.
Danaher is set for growth
Danaher Corporation's exposure to sustainable water comes through its environmental and applied solutions businesses ChemTreat (industrial water treatment), Hach (water quality testing), McCrometer (flow meters), and Trojan Technologies (ultraviolet disinfection of water and wastewater); these businesses were responsible for slightly more than 30% of total company operating profit in 2017. In total, water quality is responsible for around 15% of Danaher's operating profit, and is also its highest-margin business (above 25% adjusted EBITDA margin in 2017.
Danaher's management believes that increasing regulatory requirements will drive growth at Hach and Trojan, while increasing industrialization in emerging markets will also increase demand for Trojan and ChemTreat solutions. In a nutshell, Danaher's environmental and applied solutions division is set for long-term growth. When you consider that its other segments -- dental, diagnostics, and life sciences -- also have defensive growth characteristics, then the stock starts to look like a very attractive blend of safety and growth.
Xylem is a pure-play sustainable water stock
Xylem operates in three segments. Water infrastructure ($2 billion in revenue in 2017) provides water and wastewater equipment technologies. Applied water ($1.4 billion) provides commercial and industrial water technologies. But the company's smallest segment, measurement and control solutions ($1.3 billion), is arguably its most exciting.
Given the scarcity of water in certain areas of the world, it's critically important for public utilities and industrial companies to ensure they're efficiently using water, and monitoring the efficiency of their existing infrastructure. That's where Xylem's measurement and controls solutions come in, and the $1.7 billion acquisition of Sensus (smart meters, network technology, and data analytics) in 2016 is helping boost Xylem's growth rate. Indeed, management expects the segment to grow organically by 7% to 8% in 2018, compared to an overall company rate of 4% to 6%.
In fact, Xylem's growth is surpassing its own expectations. Back in 2015 when management gave its targets for 2015-2020 growth, it expected 3% to 5% organic revenue growth, with operating margin expanding to 16% to 17%, and EPS growth of 8% to 12%. Fast-forward to 2017: Management now expects 4% to 6% revenue growth, 17% to 18% operating margin, and EPS growth in the mid-teens.
As long as public utilities (47% of Xylem's revenue) in developed and emerging economies are spending on water and wastewater projects, then Xylem has a bright long-term future. Throw in the near-term catalyst of improving global industrial production in 2018 (36% of revenue), and Xylem has the potential to surprise on the upside in the near and long term.
Welcome to the new Pentair
In common with many other industrial companies, like Danaher, Pentair has been taking action to become a more focused investment proposition for investors. The sale of its valves and controls business to Emerson Electric (NYSE:EMR) in the spring of 2017 turned out to be well-timed for Emerson, as it occurred precisely at the time when oil and gas capital spending started picking up.
Moreover, it allowed Pentair to continue to exit the industry, and one year later Pentair split into two companies. The newly listed nVent Electric (NYSE:NVT) will be focused on electrical solutions, while the remaining Pentair will contain water pumps, filtration, and desalination solutions.
The new Pentair differs from, say utility- and industrially focused Xylem, in that 80% of its revenue comes from residential and commercial end markets. As such it's more focused on conditions in housing and construction than the other two companies. Indeed, management's focuses for the new company are to increase sales of its pool-related solutions, and increase penetration of filtration in commercial and residential markets, while also expanding in emerging markets like China and Southeast Asia.
Which stock to buy?
Danaher offers water exposure, but it's more of a life science and diagnostics play. Pentair is a pure play on water, but its heavy exposure to construction end markets means you need to be confident about global construction markets. If you're looking for a pure play on water, with a focus on public utilities investing in infrastructure, then Xylem is the best-placed of the three.
Moreover, as you can see in the chart above, Xylem is the cheapest stock on a forward EV/EBITDA basis and given its stronger earnings growth profile (mid-single-digit revenue growth combined with strong margin expansion and mid-teens EPS growth) over the next few years it's the best way to play the theme, in my view.