Xyelm manufactures industrial components that transport, treat, and test water. Their products range from pumps that maintain water pressure in buildings to water treatment devices at water utilities to pumps that remove water from mines. The business is focused on the crucial elements of larger systems. These crucial elements get designed into the broader system and are unlikely to be displaced by cheaper and unproven designs and competitors. This creates a high barrier to entry, pricing power, and recurring revenue from replacement parts. This has the markings of what can be a high quality business.
Business
Xylem divides its reporting in two segments: water infrastructure and applied water. Xylem estimates that there are over 20,000 companies that serve the equipment and services segment of the water industry. The figures below don’t include the full effects of the 2010 and 2011 acquisitions (YSI, Nova, Godwin Pumps).
2010 Rev
|
% Rev
|
Market Size
|
Market Share
| |
Water Infrastructure
|
1,930
|
16,000
|
12%
| |
Transport
|
1,436
|
74%
|
11,000
|
13%
|
Treatment
|
377
|
20%
|
3,000
|
13%
|
Test
|
177
|
6%
|
2,000
|
9%
|
Applied Water
|
1,327
|
14,000
|
9%
| |
Building Services
|
723
|
55%
|
8,000
|
9%
|
Industrial Water
|
509
|
38%
|
4,000
|
13%
|
Irrigation
|
95
|
7%
|
2,000
|
5%
|
Revenue is derived 40-35-25 from Europe, the US, and rest of world. End users are diversified between industrial, commercial, residential, and agriculture markets. Public utilities make up 40% of revenue, followed by industrial (35%), commercial (13%), residential (9%) and agriculture (3%). The company sells its products through its direct sales force and through distributors. Many distributors are provided with technical training on the company’s products in exchange for exclusive distribution.
Xylem is capable of consistently growing revenue with the exception of short-term hiccups in global growth. Xyelm can grow organically on the back of economic growth or innovation and through acquisitions. Xyelm spends 2% of revenue on R&D and didn’t decrease nominal R&D spending in 2008-2009. Even though acquisitions look pricey on a PE basis, Xylem’s sales force provides a larger selling footprint than a small company could afford. ITT has a decent track record with acquisitions. The industrials sector as a whole has been quite successful at it since the recipe is finding a bolt-on company, removing a layer of management, and leveraging existing sales relationships.
Xylem also has 120 service centers around the world, which serve 2 purposes. First, it better positions to company to respond quickly to customer needs for maintenance, repair, and replacement parts which are high margin recurring revenue that are currently 15% of revenue. Second, it gives Xylem’s products a competitive advantage against smaller companies that can’t afford this type of footprint. Since pumps or filters can be the difference between a customer being able to operate their facilities or not, having this capacity is a competitive advantage. While they are not precluded from having the capability in house or through distributors, competitors Gorman-Rupp and Idex make no mention of this in their filings.
Earnings
There are several factors that obscure projecting future earnings based on past earnings. As part of ITT’s break up, the industrial process segment that was previously included in the water business in corporate filings is going to be part of the industrial business post split. Exelis is receiving the control division from the industrial business in exchange. In addition, acquisitions in 2010 and 2011 should boost 2011 earnings.
2010
|
2009
|
2008
| |
Revenue
|
3,202
|
2,849
|
3,291
|
COGS
|
1,988
|
1,812
|
2,150
|
Gross
|
1,214
|
1,037
|
1,141
|
%
|
37.91%
|
36.40%
|
34.67%
|
SG&A
|
737
|
667
|
721
|
%
|
23.02%
|
23.41%
|
21.91%
|
R&D
|
74
|
63
|
64
|
%
|
2.31%
|
2.21%
|
1.94%
|
Restructuring
|
15
|
31
|
41
|
Operating Income
|
388
|
277
|
312
|
%
|
12.12%
|
9.72%
|
9.48%
|
Tax
|
59
|
14
|
88
|
%
|
15.21%
|
5.05%
|
28.21%
|
Net Income
|
329
|
263
|
224
|
%
|
10.27%
|
9.23%
|
6.81%
|
Going forward, the business will have $1,200 in debt. The company hasn’t released the rate on the debt related to the YSI acquisition, but $890m of the debt has an average interest rate of 3.75%. For the sake of figuring out what 2011 earning will look like on the conservative side, I calculate the average interest rate at 5% below.
Additionally, according to the Form 10 Xylem filed, they expect $25-35m in additional expenses in public company expenses not previously allocated to it by ITT. Exelis, the defense spinoff, did not report expectations of higher costs.
The company’s pro forma disclosure indicates that Xylem earned $153m in the first half of 2011 and $317m in 2010. This does not include the additional recurring expenses or the interest on the $1,200 of debt (only $890), which are included in the below rendering of Xylem’s earnings power. The tax rate is calculated as 35%.
1H 2011
|
2010
| |
Revenue
|
1861
|
3347
|
COGS
|
1145
|
2062
|
Gross
|
716
|
1285
|
%
|
38.47%
|
38.39%
|
SG&A
|
464
|
824
|
%
|
24.93%
|
24.62%
|
R&D
|
50
|
74
|
%
|
2.69%
|
2.21%
|
Restructuring
|
15
| |
Operating Income
|
202
|
407
|
%
|
10.85%
|
12.16%
|
Interest
|
30
|
60
|
Tax
|
60.2
|
121.45
|
Net Income
|
111.8
|
285.55
|
%
|
6.01%
|
8.53%
|
The first half of 2011 has seen year over year growth in revenue and profits, but the above calculation knocks this back a little bit by increasing SG&A and interest expenses. In my opinion, the above most accurately reflects the business going forward. It’s really anyone’s guess what the next 6 months will look like from an earnings perspective – impact from YSI acquisition, transaction expenses for the split and acquisitions, corporate overhead not ramping up as high as expected.
Guidance for 2011 given pre-split announcement said acquisitions related to the fluid segment and which will remain in Xylem would contribute $35m to net income. Post spin, with the effect of increased interest payments and stand-alone costs, the net effect of earnings growth and impact from acquisitions should be more or less neutral.
The above calculation of net income, which tries to include the negative impacts neglects quantifying positive aspects from acquisitions since the information to base it on is non-existent. What will full year 2011 earnings look like? Probably around double what they earned in the first half when all the smoke clears. Management states their internal forecast is low to mid single digit growth in the water market through 2015. There will be some issues in the short term as public utilities are a major source of revenue and Europe and the US are stalling infrastructure investment. Water is a necessity, which should protect against major drops in revenue, but spending on water projects can be pushed off into the future.
Valuation/Competitors
This type of business is fundamentally attractive, although the $1,200 in debt is a knock against the valuation. The below chart includes several competitors of Xylem.
PE (TTM)
|
EBIT (TTM)
|
EBIT Margin (TTM)
|
Debt (MRQ)
|
Mkt Cap
|
EV
|
R&D (2010)
|
% of 2010 Rev
| |
Gorman-Rupp (GRC)
|
18.8
|
48
|
14.28%
|
25
|
583
|
608
|
n/d
|
n/d
|
IDEX (IEX)
|
16.1
|
285
|
17.19%
|
878
|
2,860
|
3,738
|
32
|
2.12%
|
Flowserve (FLS)
|
11.9
|
544
|
12.85%
|
489
|
4,980
|
5,469
|
29
|
0.72%
|
Pall Corporation (PLL)
|
18.8
|
388
|
14.71%
|
486
|
5,120
|
5,606
|
80
|
3.03%
|
Nalco (NLC)
|
17.2
|
620
|
13.95%
|
2,782
|
5,060
|
7,842
|
n/d
|
n/d
|
Xylem
|
407
|
10.85%
|
1,200
|
74
|
2.21%
|
With the exception of Flowserve, which is more concentrated in the oil & gas sector, peers trade at high multiples of earnings relative to the market. While Xylem has a similar EBIT/debt multiple to IDEX, Xyelm has lower operating margins. The operating margin is potentially depressed since it is calculated with recurring stand-alone expenses at the highest of the expected range given ($35m).
Compared to GRC, Xylem has a large sales force and R&D spending, which GRC offers no disclosure on. GRC sells its products through distributors and likely spends money on R&D, but the 10-K offers no breakdown. This is at least a partial explanation for the difference in operating margins.
Nalco and Pall are larger businesses with more diverse products and end markets, although they do compete with Xylem in water treatment. They offer just a vague approximation of a similar line of business. Pall gets 75% of its revenue from consumables, which is a different business model and likely worth its premium multiple.
Nalco is being purchased by Ecolab, which provides a transaction multiple for the space, but they are focused on water treatment with manufactured products as well as chemicals. According to Ecolab it is being done at 11x EV/EBITDA pro forma, but 9x EBITDA with the assumed synergies. This tends to be the thinking behind many acquisitions in the industrial space, which allows for some pretty steep acquisition multiples. Some pretty absurd numbers could be concocted if this type of multiple was applied to Xyelm - $4.3bn equity value at an 11x EV/EBITDA multiple. This is not a valuation to hang your hat on, but does provide some backstop to the valuation remaining low.
What is the right multiple for Xylem’s earnings? Vaguely, the 13-15x range. That pegs Xylem’s value around $2.9-3.3bn. This is the same as 10x EV/EBIT valuation, which is about the going rate for specialized industrial firms.
This value is likely on the low end since taxes were assumed to be 35%, despite 60% of the revenue being international, the high end of the expected additional expenses was used, and some one time transaction costs are included. Margins at the historical fluid segment in ITT filings were much higher, although they excluded corporate expenses and included the industrial processes business and excluded the flow control business. The industrial business has higher margins than flow control, so Xyelm should have lower margins than the historical fluid segment. There is still the possibility for margin expansion with sales growth if the company can leverage its sales force.
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