Smart Water Strategy Should Widen Xylem's Moat

Xylem XYL is one of the leading water technology companies in the world. Its extensive portfolio spans a wide range of equipment and solutions for the water industry, including the transport, treatment, testing, and efficient use of water for public utilities as well as industrial, commercial, and residential customers. Xylem operates three business segments: water infrastructure, applied water, and measurement and control solutions.

The water infrastructure segment serves primarily utilities and industrial customers and accounted for approximately 40% of Xylem’s revenue and 50% of segment EBIT in the first nine months of 2018. Water infrastructure supports the entire water supply network, with solutions ranging from collection of water from a source (aquifer, lake, river, and so on), transport, treatment (including filtration, disinfection, and desalination), and distribution to users, through the treatment and transport of wastewater to either prepare it for reuse or release it to the environment. Water infrastructure also provides dewatering solutions that are used in construction, fracking, and mining applications.

The applied water segment, which primarily serves the industrial and commercial sectors, generated approximately 30% of Xylem’s revenue and 40% of segment EBIT through the nine months ended September 2018. Applied water offers building services and industrial water technologies for a variety of end markets, such as apartment buildings, retail stores, restaurants, hospitals, schools, and hotels. Applications include water pumps, valves, fire suppression systems, and boosting systems for farming irrigation.

The measurement and control solutions segment was formed in 2017 by combining Xylem’s analytics business with the Sensus and Visenti businesses acquired in 2016. The segment contributed approximately 30% of Xylem’s revenue and 10% of segment EBIT in the first nine months of 2018. Measurement and control solutions offers a wide array of smart meters, networking, and advanced analytics for utilities.

Extensive Patent Portfolio Among Intangible Assets We think Xylem has carved a narrow moat primarily due to customer switching costs and secondarily due to intangible assets. Since it was spun off from ITT in October 2011, Xylem has consistently outearned its cost of capital. Almost half of its revenue is recurring, with a large portion of sales driven by aftermarket service and replacement parts in the water infrastructure segment, replacement parts in the applied water segment, and long-term contracts (up to 15-20 years) in the measurement and control solutions segment. The company's moat is bolstered by intangible assets, including an extensive patent portfolio (over 2,000 patents as of fiscal 2017), reputable brands, and strong dealer relationships. We think Xylem is poised to benefit from long-term industry trends, including global population growth, water scarcity in developing countries, and the need to replace aging infrastructure in developed countries. We also believe the recent acquisition of Sensus, a leading water technology company offering smart meters and network technologies, will not only place Xylem in excellent position to help utilities address the problem of non-revenue water (revenue lost by water utilities due to physical leaks, unbilled consumption, meter inaccuracy, and so on), but also give it an opportunity to widen the moat around its data management platform and smart products.

We believe water infrastructure’s narrow moat rests on customer switching costs and intangible assets. Having a reputation for reliability is imperative in this segment, as the equipment often performs a mission-critical function (for instance, pumps for wastewater treatment facilities). Thus, while pricing is an important consideration, customers are relatively less likely to aggressively pursue cost savings by switching to a cheaper alternative as the cost of unscheduled downtime or product failures could far exceed potential cost savings. For public utilities, public safety considerations are also important, because equipment failures could even create an environmental hazard (for example, spills or sewer overflow). Furthermore, since water utilities tend to be risk-averse, they do not typically replace an individual pump that is part of a pumping network with an alternative one that uses different technology.

Xylem is the leader in the fragmented wastewater transport space, and its Flygt brand has a strong reputation for reliability and efficiency. The company benefits from a large installed base of public utility customers, which fuels robust aftermarket revenue on the operating expense side. Roughly 40% of the water infrastructure segment’s 2017 revenue came from aftermarket service and replacement parts tied to its installed base. Because of high switching costs, most customers are loyal, which makes sales relatively resilient. Additionally, Xylem’s continuous innovation and strong reputation for quality have allowed it to capture incremental market share gains in the transport space in recent years.

The applied water segment benefits from similar industry dynamics as water infrastructure, as it also manufactures equipment that performs vital functions. This leads to relatively high switching costs, as any plant downtime can be extremely costly for industrial and commercial customers. Thus, a reputation for quality and reliability is important, and Xylem benefits from a strong portfolio of brands and a large installed base, which leads to a relatively sticky business. A large portion of the segment’s revenue is recurring, as customers tend to replace equipment with similar products from the same company, which drives robust aftermarket revenue.

Nevertheless, while applied water delivers solid midteens operating margins (comparable to water infrastructure), and we think the segment merits a narrow moat based on switching costs and intangible assets, we acknowledge that the moat around applied water might be narrower than the moat around water infrastructure. The latter sells most products directly to customers, whereas the former sells most products through distributors. We think this creates an additional layer of distance between Xylem and the ultimate consumer, which might result in a lower degree of loyalty and make the applied water segment relatively more vulnerable to competition in the long run.

That being said, the segment currently enjoys a strong market position, solid operating margins, healthy aftermarket revenue, and long-standing relationships with major distributors. As such, we think the segment warrants a narrow moat and is more likely than not to outearn its cost of capital throughout the next decade.

Finally, we believe measurement and control solutions also has a narrow moat attributable primarily to switching costs. Customers in this segment often sign long-term contracts (up to 15-20 years), which consist of equipment purchases in the first few years, followed by a subscription fee during the latter part of the contract. A large installed base and long-term contracts contribute to an even higher percentage of recurring revenue than the other two segments.

Xylem’s moat around measurement and control solutions is supported by intangible assets. Since CEO Patrick Decker took the helm in 2014, management has significantly increased investment in research and development and pursued “M&A as a proxy for R&D” by making strategic acquisitions to gain immediate access to new technologies and markets. For example, recently acquired Sensus is a leader in smart meters, which help avoid costly disruptions, minimize revenue loss due to inaccurate measurements, and significantly reduce labor costs by allowing customers to monitor water quality remotely. Another pair of recent acquisitions, Visenti and Pure, both offer real-time leak detection for water utilities. We think these investments will contribute to Xylem’s moat and enhance the company’s portfolio of offerings aimed at solving the problem of non-revenue water.

Upgrading Our Moat Trend Rating We believe that Xylem merits a positive moat trend rating as management is implementing several strategies that we expect to result in the company's moat widening over the next few years. In our view, the company's intangible assets are strengthening as a ramp-up in R&D spending has already started to bear fruit, while switching costs are likely to increase in the water infrastructure and measurement and control segments as a result of the Sensus acquisition. We project that these trends (along with synergies from the Sensus acquisition and selling, general, and administrative cost reductions) will help drive a 400- to 500-basis-point operating margin expansion over the next few years.

Xylem has made a commitment to innovation, with management targeting an increase in R&D spending as a percentage of sales from roughly 3% in 2015 to 5% by 2020. Additionally, management has been pursuing what it refers to as M&A as a proxy for R&D, which involves making strategic acquisitions in companies that own strong intellectual property in order to gain immediate access to new technologies and markets. As a result, Xylem has already introduced roughly 40 new products since 2015 and has an additional 50 next-generation products in development, many of which have digital capabilities. The company has already started to reap benefits from its increased R&D spending, as its vitality index (the percentage of total revenue derived from new products launched within the last five years) has continued to increase in line with R&D expenditures, and management projects it to grow from roughly 18% in 2015 to 30% by 2020.

Many of the new products are focused on embedded intelligence, energy efficiency, and localization for emerging markets. For example, Flygt Concertor, the first intelligent wastewater pump in the world, can sense temperature and clog conditions, adjust its own performance, and deliver up to 70% energy savings. Xylem has made several acquisitions (including Sensus, Visenti, and Pure) to bolster its portfolio of technology solutions, including smart meters, leak detection, and data management and analytics. As these investments have enhanced Xylem’s ability to address industry challenges such as aging infrastructure and non-revenue water, we think they will improve the company’s long-term prospects. In fact, Xylem’s commitment to innovation has already started to pay off, as management claims that new products are increasing revenue at faster rates than legacy products, gradually helping capture market share, and generating accretive margins.

We expect that Xylem’s emphasis on smart meters and data management will lead to higher customer switching costs, especially in the measurement and control solutions segment. Sensus, acquired in 2016, has a large installed base of smart meters and benefits from long-term customer agreements (up to 15-20 years), which lead to a relatively stable portfolio and an even higher percentage of recurring revenue than Xylem’s legacy businesses. We forecast Sensus to grow at a faster rate and generate higher operating margins than the legacy businesses by the end of our explicit five-year forecast period.

Moreover, we think Xylem can continue to capitalize on revenue synergies with Sensus. The company has already secured roughly $100 million in revenue synergy wins through the first nine months of 2018, and we think that it can benefit from further cross-selling opportunities by extending Sensus’ offerings from mostly the clean water sector to the wastewater and outdoor water sectors, where Xylem has a strong position. We think the ability to cross-sell these products and link them together will allow Xylem to solve multiple problems for customers, thus increasing switching costs and customer loyalty. After acquiring Sensus, Xylem now owns a proprietary communication network called FlexNet, which uses a licensed radio spectrum to allow utilities to collect, manage, and analyze data from smart meters and sensors. We think Xylem’s focus on building out its smart meter and analytics portfolio will allow it to offer utilities a comprehensive solutions package, with pumps, sensors, smart meters, and leak detection, as well as a data management platform to monitor and analyze data from all these products.

With the intangible asset and customer switching cost moat sources strengthening, we believe Xylem merits a positive moat trend rating. Increased R&D spending has already resulted in a growing portion of revenue attributable to new products, which are generating accretive margins. Other key drivers contributing to the margin expansion in our forecast are cost savings due to business simplification, global procurement, implementing Lean Six Sigma, and revenue and cost synergies from the Sensus acquisition. We expect management’s initiatives to be completed by the end of our explicit five-year forecast period, and we think they will result in Xylem being a more profitable company with a more durable economic moat, as we project returns on invested capital to increase from roughly 11% in 2017 to almost 19% by 2022.

Recurring Revenue Lessens Risk We assign Xylem a medium fair value uncertainty rating as the company exhibits an average degree of cyclicality and has consistently delivered strong margins since its spin-off from ITT in 2011.

Xylem’s risk is somewhat mitigated by its large installed base, as almost half of the company’s revenue is recurring, driven by aftermarket service and part replacement in the water infrastructure and applied water segments as well as long-term customer contracts in the measurement and control solutions segment.

Significant cost inflation and persistent strength in the U.S. dollar could impair Xylem’s profitability. Xylem is more localized than many of its competitors, with manufacturing facilities in the United States, Europe, China, and the Middle East. Although the company has been able to pass through some of the cost increases to customers, rising commodity prices coupled with a strong U.S. dollar could threaten to erode Xylem’s margins.

Xylem owed roughly $2.5 billion of long-term debt as of Sept. 30, 2018, compared with approximately $400 million in cash and equivalents. The company had an underfunded pension plan position of $377 million at the end of 2017, equivalent to an aftertax obligation of approximately $1.65 per share.

Debt maturities are reasonably well laddered over the next few years, with a $600 million note due in 2021 and a $586 million note due in 2023. The company also relies on commercial paper to meet short-term borrowing needs and has a $600 million revolving credit facility that augments its liquidity. We estimate the company will have a debt/EBITDA ratio of roughly 1.7 in 2019.

We forecast that Xylem will generate average annual operating cash flow of approximately $850 million over the next five years. Management has indicated it will prioritize organic growth (including capital expenditures of 2.5%-3.5% of sales), continued dividend growth (increasing roughly in line with earnings growth), and strategic acquisitions, with excess capital allocated to share repurchases.