5 Reasons to Buy This Sustainable Water Stock

Sustainable water supplies is one of those investing themes that you really feel you should be investing in but don't know how. If that's the case, you might be interested in a stock like Xylem (XYL 1.45%). Let's take a look at the key reasons why the stock is attractive for investors.

Sustainable water stocks

Investing in sustainable water stocks makes sense, thanks to both the likelihood of long-term demand from urban population growth in emerging markets and the need to replace aging infrastructure in the developed world. Meanwhile, the increasing rigor of environmental regulations around water treatment should encourage demand for Xylem's products.

CEO Patrick Decker believes Xylem can grow revenue in double-digits in markets such as China, India and the Middle East "and high single-digit growth in emerging markets overall" over he long-term. 

Image source: Getty Images.

Advanced Infrastructure Analytics

In addition to existing end-market demand, Xylem is improving its revenue growth prospects by investing in smart technology solutions that will serve the advanced infrastructure analytics (AIA) market.

Most of the excitement centers on the measurement & control solutions segment (29% of 2018 revenue) and the potential for its AIA solutions (think smart metering and monitoring) to tackle the significant issues of leakage, theft, and inaccurate metering/billing in the industry. Decker has previously estimated that up to 60% of water produced by utilities gets lost. 

Even though AIA only represents around $100 million of revenue, compared to $5.2 billion for the total company in 2018, Decker said on the company's fourth-quarter earnings call that it's "growing[at] a very healthy double-digit [rate] and is accelerating in 2019 versus 2018, both [for] orders and revenue." It's definitely a growth driver for the future.

A defensive stock to buy

The chart below shows the company's revenue by end market, and as you can see its key customers are utilities -- a relatively stable source of revenue. As such, management is expecting another year of good growth, with overall organic revenue growth forecast to increase by 4%-6% on 2018.

In fact, management is expecting mid-single-digit growth from utilities in 2019, with low to mid-single-digits from industrial and commercial and only low-single-digit from residential. This is a good outlook considering that expectations for U.S. industrial production growth are for growth to slow to 2.6% and 2% in 2019 and 2020, compared to 4% in 2018. In other words, Xylem is relatively well positioned in the industrial sector.

Data source: Xylem presentations. Chart by author.

Good orders and earnings momentum

Management's guidance for 2019 is for 4%-6% organic revenue growth that should, in turn, lead lead to 11%-18% EPS growth. The primary driver for faster EPS growth is expected to be an expansion of its adjusted operating margin to 14.7%-15.2% from 13.7% in 2018. Free cash flow (FCF) conversion from net income is expected to be 105%, but more on that in a moment.

Margin expansion is expected to come from a combination of higher pricing, cost reductions, and moderating capital investment levels. Xylem's revenue projection is backed up by good order momentum so far. For example, orders totaled $5.4 4 billion at the end of 2018, compared to revenue of $5.2 billion.

Moreover, total company orders improved 12% compared to 2018, and orders in the fourth quarter were up 9% compared to the same period last year. Clearly, 2019 looks like it's going to be another good year -- Decker said the orders the company were receiving gave him "great confidence around our margin expansion and growth in 2020."

Valuation matters

A $3.30 midpoint for adjusted EPS guidance puts the stock at a forward PE ratio of nearly 24 times earnings. That's not particularly cheap, but it should be noted that Xylem does tend to be a pretty good generator of FCF. As such, management expects to convert 105% of net income into FCF in 2019. By my calculations, that's a figure of nearly $600 million, putting the stock on a forward price to FCF multiple of 23.

Again, that's not cheap, but you need to consider that Xylem is in growth mode, and has been making relatively heavy capital expenditures in recent years. As you can see below, capital spending has been significantly in excess of depreciation. As a rough rule of thumb, an industrial company will spend capital at a ratio of roughly 1-1.1 times depreciation.

Data source: Xylem presentations. Author's analysis

Assuming the ratio I've discussed above would add around another $100 million to 2019 FCF, bringing underlying FCF to $700 million, the company has a forward price to FCF multiple of 20.

That's not bad for a company with such excellent long-term growth prospects. Putting it all together, Xylem looks like a good value for investors looking to play the sustainable water theme.