Xylem 2015 equity report Nov 24

Xylem

The Fund @ Sprott Equity Research

Buy, Current: $37.50, Target: $50.36 November 24, 2015

Alejandro Barreto BCom Candidate 2016 Concentration: Finance

Sector Analyst [email protected] http://fund.ssb.carleton.ca

K. Gwynne Cunningham BCom Candidate 2015

Sector Manager [email protected] http://fund.ssb.carleton.ca

Investment Thesis

5-Year Performance

Source: Bloomberg

Unregulated Water Play:

All of Xylem’s revenues are directly related to the water and wastewater industry. Xylem’s

business is focused on the water equipment and application of it required through the water

cycle. This puts Xylem in an attractive position to exploit the long overdue global infrastructure

and water efficiency investments that are set to take place from now to 2030 through the

selection of high margin projects.

Favourable Macro-Economic Conditions:

Innovation and Technology driven Revenues:

There are three main macro-economic conditions that will help drive revenue growth. Due to

the water shortages that are being experienced around the world, regulating agencies are

continuously applying more rigorous regulations on utilities for water efficiency, and

environmental impacts. In addition, growth in population as well as the increasing water

infrastructure needs worldwide pose opportunities for XYL. These two factors will cause

increased spending in both infrastructure as well as specialized control and water efficiency

technologies.

Xylem’s products are highly engineered and customized. Value/innovative products always

have a more sustainable future, as they are not easily substitutable. Xylem currently has a

vitality index of 17%, which means that 17% of sales are from products innovated in the last 5

years, and plans to increase that index to 25% by 2020. This provides Xylem with a sustainable

strategic focus to continue to exploit and dominate the fragmented specialty water equipment

segment is competes in.

The Fund @ Sprott | Equity Research

Company Overview Xylem is an American company in the industrials sector that designs, manufactures, and applies highly engineered technologies for the water industry. They are a leading equipment and service provider for water and wastewater applications with a broad portfolio of products and services addressing the full cycle of water, from collection, distribution and use, to the return of water to the environment. Xylem has leading market positions among equipment and service providers in the core application areas of the water equipment industry: transport, treatment, test, building services, industrial processing and irrigation. Xylem operates its business under two separate segments; the Water Infrastructure segment and the Applied Water segment. Through their water infrastructure segment Xylem designs, engineers and manufactures water and waste water pumps, filtration, disinfection and biological treatment equipment, test equipment and controls employing primarily configure-to-order capabilities, and to a lesser extent engineer-to-order products for customers requiring customization. Xylem sells their products in over 150 countries using a combined distribution network of both a direct sales force and independent channel partners. Their geographic revenue segments are reported as United States, Europe, Asia Pacific and Other. In 2014 United States was responsible for 38% of Xylem’s total revenues while Europe, Asia Pacific, and other accounted for 35%, 12%, and 15% of the revenues respectively.

Figure 1: Revenue by Product Segment Figure 2: Revenue by Geographic Region

Source: Bloomberg, Student Estimates Source: Bloomberg, Student Estimates

Revenue Mix Water Infrastructure Water Infrastructure involves the physical systems needed in the process that collects water from a source and distributes it to users, and then returns the wastewater back to the environment. Within the Water Infrastructure segment, Xylem serves its customers, through three closely linked applications: Transport, Treatment and Test of water and wastewater. The estimated market size of the water infrastructure market Xylem serves is $20 Billion, of which Xylem retains a 12.5% market share with $2.4 Billion in sales.

Revenue Mix (Cont.) Applied Water

Applied Water involves the various uses of water. Since water is used to some degree in almost every aspect of human life, this segment has a significant number of potential applications and Xylem participates in all major areas of water demand. Irrigation applications constitute the majority of all water usage globally. Industrial Water applications account for the next largest amount of global water consumption. The remaining portion of global water use resides in human and building consumption, residential and commercial building services. The estimated market size of the water infrastructure market Xylem serves is $15 Billion, of which Xylem retains a 10% market share with $1.5 Billion in sales. Water Infrastructure: Transport: The Transport application includes all of the equipment and services involved in the safe and efficient movement of water from sources such as oceans, groundwater, aquifers, lakes, rivers and seas to treatment facilities, and then to users. It also includes the movement of wastewater from the point of use to a treatment facility and then back into the environment. Lastly, the Transport application also includes dewatering pumps, equipment and services which provide the safe removal or draining of groundwater and surface water from a riverbed, construction site or mine shaft. Xylem offers a wide range of highly engineered products such as water and wastewater submersible pumps, monitoring controls, and application solutions. In the Water Infrastructure Segment, Transport accounted for approximately 73% of the segment revenue in 2014.

Treatment: The Treatment application includes equipment and services that treat both water for consumption and wastewater to be returned to the environment. The primary markets served by Xylem in the treatment application are public utilities and industrial operations. Xylem focuses on three main treatment solutions, (i) filtration, (ii) disinfection systems and (iii) biological treatment systems. Filtration uses gravity based media filters and clarifiers to clean both water and wastewater. Disinfection systems (UV and ozone oxidation), treat both public utility drinking water and wastewater, as well as industrial process water. Biological treatment systems provide treatment and mixing of solids in wastewater plants. In the Water Infrastructure Segment, Treatment accounted for approximately 14% of the segment revenue in 2014.

Test: Analytical testing instruments are used across most industries to ensure regulatory requirements are met. Xylem’s testing instruments are predominately focused testing on water quality levels throughout the water infrastructure loop. Analytical systems are applied in three primary ways: in the field, in a facility laboratory, or real time, online monitoring in a treatment facility process. Xylem’s Test revenues accounted for 13% of the Water Infrastructure Segment revenues in 2014.

Applied Water: Residential & Commercial Building Services This business is focused on the four main uses of water in building services applications, such as in residential homes and commercial buildings, including offices, hotels, hospitals, schools, restaurants and malls. The first application is in HVAC, where Xylem specialize in pumps and valves that are used in water-driven heating and cooling systems, along with heat exchangers, valves, and monitoring and control products that make up the system. The second is the supply of potable water for consumption, such as for drinking and hygiene. Xylem provides pumps and boosting systems utilized within buildings, sourcing water from distribution networks or from wells. The third application is wastewater removal with sump and sewage pumps. The fourth water-related building service area is fire protection, where Xylem supplies full pump systems for emergency fire suppression. Building Services accounted for 53% of Xylem’s Applied Water revenue segment in 2014. Irrigation The irrigation business consists of irrigation-related equipment and services associated with bringing water from a source to the plant or livestock need, including hoses, sprinklers, center pivot and drip irrigation. Xylem focuses on the pumps and boosting systems that supply this equipment with water. The company offers mixed flow pumps, and specializes in equipment "packaged solutions" including monitoring and controls to optimize energy efficiency in irrigation delivery. Xylem also produces pumps for agriculture applications and irrigation of gardens and parks. Irrigation accounted for 7% of Xylem’s Applied Water revenue segment in 2014. Industrial Water is used in most industrial facilities to provide processing steps such as cooling, heating, cleaning and mixing. Xylem supplies vertical multistage pumps to bring in source water or to boost pressure for purposes such as circulating water through a manufacturing facility to cool machine tools, as well as heat exchangers for combined heat and power applications within power generation plants. Xylem also serves niche applications such as flexible impeller pumps for wine processing facilities, and water-based detergent dispensing and water circulation within car washes. Xylem’s boosting pumps are also being used in hydraulic fracturing applications. Industrial Applications accounted for 40% of Xylem’s Applied Water segment in 2014.

Revenue Mix (Cont.)

Figure 3: Applied Water Composition Figure 4: Water Infrastructure Composition

Sector Outlook Companies competing in the industrials sector generate revenues by producing goods used in construction and manufacturing. This sector‘s performance closely reflects the overall state of the economy, as increased construction is indicative of growth in the overall economy. The company’s in this sector tend to have large market capitalizations, and have globally diversified revenue streams. Due to the nature of business of the companies in this sector, global growth slowdowns can deeply impact the prices of their stocks.

Industrial stocks declined 5.7% so far in 2015, based on the Industrial Select Sector SPDR Fund ETF (XLI), almost tripling the 2% drop of the S&P 500. The industrials sector may continue to underperform the market due to the strong dollar, global growth concerns and exposure to the energy industry, where capital expenditures have been cut by almost all global oil giants. These companies generate a large portion of sales outside of North America and many expect a 4% to 7% drop from currency translation in 2015.

Due to the short-term factors which have punished most industrial companies’ stock prices, a buying opportunity in this sector is present. The companies that will likely outperform the sector performance are those which produce highly engineered products, whose revenue exposure is not heavily tied to China, as China’s growth revisions and currency devaluation pose long-term threats. This is due to the fact that highly engineered products are not as heavily impacted by growth concerns as a basic industrial product would be.

Industry Dynamics Xylem (XYL) operates in the water industry. The water industry supply chain is composed of Equipment and services firms, Design and Build services companies and utilities companies. The utilities companies are responsible for the distribution of water to the end users. The rest of the water industry supply chain is in the business of providing singular or multiple functions to support the plant operations of Utilities. Besides providing services for utilities companies, Equipment and services firms also provide certain services directly to end users such as farms power plants and homes, in the applied water business segment.

Xylem is operates within the Equipment and Services market. These business address key processes of the water industry. The key processes of this cycle begin when raw water is extracted by

pumps, which provide the necessary pressure and flow, to move or transport, this water from natural sources, such as oceans, groundwater, lakes and rivers, through pipes to treatment facilities. Treatment facilities can provide many forms of treatment, such as filtration, disinfection and desalination, to remove solids, bacteria, and salt, respectively. Throughout each of these stages, analytical instruments test the water to ensure regulatory requirements are met so that it can be utilized by endues customers. A network of pipes and pumps again transports this clean water to where it is needed, such as to crops for irrigation, to power plants to provide cooling in industrial water, or to an

apartment building as drinking water in residential and commercial buildings. After usage, the wastewater is collected by a separate network of pipes and pumps and transported to a wastewater treatment facility, where processes such as digestion deactivate and reduce the volume of solids, and disinfection purifies effluent water. Once treated, analytical instruments test the water to ensure regulatory requirements are met so that it can be discharged back to the environment, thereby completing the cycle

Figure 5: Water Stress by Country: 2040

Source: World Resources Institute

Industry Dynamics Con’t Figure 6: Future Global Gap Without Efficiency Improvements: 2030

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Source: World Resources Institute

The world faces a serious water challenge. Less than 1% of the total water available on earth is fresh water, and this percentage is declining due to factors such as the draining of aquifers, increased pollution and climate change. In addition, demand for fresh water is not declining due to population growth, industrial expansion, and increased agricultural development. By 2025, more than 30% of the world’s population is expected to live in areas without adequate water supply. Even in developed countries with sufficient clean water supply, existing infrastructure for water supply is aging and inadequately funded. In the United States, degrading pipe systems leak one out of every six gallons of water, on average, on its way from a treatment plant to the customer. These challenges are driving opportunities for growth in the global water industry, which is estimated to have a total market size of approximately $550 billion. Within the Equipment and services segment of the industry there is 3 attractive growth drivers, Regulatory pressures, investments on water efficiency, water treatment and water infrastructure, and population growth.

Figure 7: Global Market Share: Subsectors Figure 8: Global Profiles: Water Demand

Source: World Resources Institute Source: United Nations

Growth Drivers Regulatory Pressures: As pressure on the world’s water resources continues to grow, national and local governments are trying to raise awareness as well as develop both short-term and long-term goals. Examples of current government initiatives can be found all around the world but two notable ones are China’s 5 year plan and Pennsylvania’s and California’s current water infrastructure investment incentives. From 2005 to 2010 China was able to reduce water consumption by 37%. As a result of successful measures, primarily regulations on farmers, requiring more water conserving practices in irrigation, and wastewater recycling, China has outlined that it will spend a further than $488 Billion Yuan to the Chinese water industry in 2015 of which half of will be used towards water conservation efforts. Vice-Minister Zhou Jian of the Ministry of Environmental Protection stated in 2014 that a total of $3 Trillion Yuan were going to be invested into treatment technologies to help fix China’s current water pollution issues. As well as the exemplary government initiatives in China, there is also a huge investment gap in the United States which has caused several states to provide the water industry with investment incentives to update the current infrastructure. In Pennsylvania the state’s government has begun to offer tax deferrals on profits earned from water infrastructure projects. To add to the tax cut the infrastructure costs can be charged directly to the utility users through an infrastructure repair surcharge, allowing the companies to earn a guaranteed return on infrastructure projects regardless of water consumption. In California due to the water shortage that the state is expected to face in the next 10 years, the state government has issues a quota of maximum usage per household, and has also decoupled revenues for utility companies. The trends of government regulation and government initiatives in the water industry demonstrate the growth potential of companies in the equipment and services segment as their innovative products will help drive the increased efficiency, and treatment in the water industry. Water Investments: The United States water infrastructure along with various other developed nations is aging and in need of maintenance. The useful life of the water systems used in developed nations is considered to be between 60-80 years. The current infrastructure used in the United States dates back to the late 19th century and early 20th. This aging infrastructure causes both leakages due to erosion as well as an inefficient water cycle process due to the use of outdated technologies. the water issues arising due to these outdated infrastructures can already be witnessed in various regions of the United states such as California. in this specific region the expected water shortages in the next 10 years have caused the state to both reduce vegetation areas and place a quota limiting the maximum amount of water that is to be used per household. The EPA suggests that approximately $1 trillion USD will be needed to update the current infrastructure to meet the required efficiency demands to create a sustainable water system in the United States. From this $1 trillion, $277 Billion is supposed to be used to address repairs and improvements needed in the current drinking water systems. These drinking water repairs and improvements are expected to be aided by the production of water conservation products manufactured by the higher-end technology focused equipment and services firms.

Growth Drivers (Cont.)

Water Investments Continued In emerging markets, the main issue is the development of water infrastructure as vast number of people inhabiting these countries are still not reached by clean potable water. This gap between supply and demand has been taken very seriously by the emerging economies and has caused a great amount of investment in the various water industry segments (infrastructure, treatment, efficiency technologies). In 2015 China alone will invest more than their 2014 investment of $79 Billion USD into the water supply chain. Almost half of this amount is targeted towards improving current conservation technologies. As well as the $79 Billion, China plans to spend a further $315 Billion on controlling the current water pollution damaging its water supplies. For emerging economies investments in all areas of the water cycle are excepted to grow from twice to three times as fast as investments in the developed world. In China a huge developing trend is intensive investments in water technology firms to develop efficient wastewater recycling facilities. The Chinese government are very concerned with assuring its entire population of clean water supplies.

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Figure 9: Forecasted Water Demand: 2030

Source: Water Resources Group

Growth Drivers (Cont.) Population Growth The United Nations Population Fund has estimated that the world’s population will increase by 20.7% from now to 2030. The total population at that point in time will reach 8.321 Billion. As the world’s population continues to grow it will continuously require more crops and therefore more agriculture. In the majority of the world’s underdeveloped nations, irrigation makes up between 70%-90% of total human water use. This would lead to an assumption that is still often made by investors, “If demand for agriculture grows, water withdrawals will also increase”. This assumption does not hold. Due to the fact the world is constantly becoming more efficient in both withdrawal methods, efficient irrigation systems, and technologically advanced water recycling methods. Through these developments in the water industry Asia, the one continent with significantly growing water withdrawals from 1975-2000 was able to reach its peak withdrawals in 2013 at 554.10 Billion Cubic meters. As peak water withdrawals have been reached in all continents, due to increasing water efficiency technologies, it is expected that total water withdrawals will not grow with the population but rather technology developments will continue to improve the efficiency in water usage to support the world’s water needs. This theory is supported easily comparing United States ‘ historical water withdrawals, with its historical population growth. In this comparison it is easy to identify the stagnant growth in water withdrawals over the last 40 years, significantly lagging the 48% population growth in the same time period.

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Figure 10: Investment in Infrastructure Imminent


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Figure 11: Market Share of Main Business Line Figure 12: Operating Margin Comparison

Source: Bloomberg Source: Bloomberg

Position and Strategy Pentair’s core competencies lie in its top-tier sales team, and its innovative , highly engineered

products focused on efficient water use and optimal fluid flow . Pentair has a diversified

portfolio of products, but is mainly exposed to fluids other than water (oil, beverages). 34% of

Pentair’s revenues come from valves and controls, 23% from flow and filtration, 24% from

technical solutions and 19% from water quality systems. Out of its $7 Billion in revenues 69%

is related to non-water services, while 31% is related to water. Although this is currently its

portfolio breakdown, Pentair has stated that it is will be focusing future growth efforts in the

water industry, as it is experiencing slacking revenues from its exposure to other industries.

Competitors: Xylem has positioned themselves as the World’s largest water pure-play company. Due to its focus on high-engineered water solutions at all steps of the water cycle, there are no competitors that are in the same number of water industry segments or that produce products and services of the same quality. Given this special competitive scenario that Xylem is in, the closest competitor that would be of concern to Xylem is Pentair. Pentair Pentair plc is a focused diversified industrial manufacturing company with four revenue segments: Valves & Controls, Process Technologies, Flow Technologies and Technical Solutions. Valves & Controls: Designs, manufactures, markets and services valves, fittings, automation and controls and actuators. Process Technologies : Designs, manufactures, markets and services innovative water system products and solutions to meet filtration, separation and fluid process management challenges in food and beverage, water, wastewater, swimming pools and aquaculture applications. Flow Technologies : designs, manufactures and markets products and services designed for the transfer and flow of clean water, wastewater and a variety of industrial applications. Technical Solutions : designs, manufactures, markets and services products that guard and protect some of the world’s most sensitive electronics and electronic equipment, as well as heat management solutions designed to provide thermal protection to temperature sensitive fluid applications


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Xylem’s peers were selected on the basis, that they are the four largest global companies, with

the largest amount of revenue exposure to water listed on American exchanges. The 3

companies that were selected as Xylem’s peers were Gorman Rupp ( GRC) , Flowserve Corp

( FLS), and Pentair (PNR), who directly competes with Xylem on various product segments

Xylem in comparison to its peers does not look undervalued. This is likely caused by the fact

that the entire water industry has been underperforming the rest of the industrials sector and

therefore the industry as a whole is potentially undervalued. Xylem’s 18.62 price to earnings

ratio closely resembles the S&P 500 price to earnings ratio of 18.67. I believe this is

comparison demonstrates a good buying opportunity for shares of Xylem. This is because

Xylem’s growth prospects and the water industry as a whole are a lot more enticing the

average of the 500 companies represented by the S&P 500. This essentially means that at its

current price, one can purchase Xylem’s shares at the same price to earning multiple at the

average price to earnings multiple of the 500 companies compromising the S&P 500 while

obtaining significantly better growth prospects. Due to positive growth outlook for Xylem it is

currently trading at a significantly higher PEG ratio than its closest peer Pentair.

To the benefit of Xylem shareholders, Xylem has a low debt to equity ratio at 15% when

compared to its peers, aside from Gorman Rupp(GRC) who currently has no debt on its books.

This is extremely positive when considering the expected growth of water efficiency products,

as well as the growth of worldwide water infrastructure investment, as it will assure that

Xylem will be able to easily, and at a low cost obtain cash through debt issuance if it needed

Given its growth focused strategy Xylem also offers a low dividend yield when compared to its

peers. This is positive as Xylem has consistently provided return on equity above 10%,

demonstrating the consistently effective reinvestment of capital.

Relative Valuation:

Source: Bloomberg

Risk Analysis

Competitive Positioning

Foreign Exchange Risk:

Xylem conducts approximately 62% of their business in various locations outside the United

States. This exposes them to fluctuations in foreign currency transaction exchange rates, Most

significantly with respect to the Euro, Swedish Krona, British Pound, Australian Dollar,

Canadian Dollar, Polish Zloty, and Hungarian Forint. Any significant change in the value of

currencies of the countries in which Xylem does business relative to the value of the

U.S. Dollar or Euro could affect Xylem’s ability to sell products competitively and control their

cost structure. Additionally, Xylem is subject to foreign exchange translation risk due to

changes in the value of foreign currencies in relation to the Us Dollar (Xylem’s reporting

currency). The translation risk is primarily concentrated in the exchange rate between the U.S.

dollar and the Euro, British Pound, Chinese Yuan, Swedish Krona and Canadian Dollar. As the

U.S. dollar continues to strengthen relative to other currencies, this could have a negative

effect on Xylem’s financial statements, as revenues from other countries will be significantly

less when translated to US Dollars.

Xylem has strategically positioned itself at all steps of the water cycle. With the water

industry projected to incur large investment growth as mentioned before, Xylem is a company

providing shareholders’ with large growth potential at a value stock price. Xylem is an

industry leader in all six of its diversified revenue segments. Xylem has differentiated itself

from its competitors by providing highly customized, highly engineered products with

unmatched functionalities at a reasonable cost, due to its increasingly lean operations. Xylem

has consistently been able to produce new and innovative products , while only allocating 4%

of its revenues to R&D. This is demonstrated through its high vitality index of 17%, meaning

that 17% of Xylem’s sales are derived from products innovated within the last 5 years. Xylem

has a revolutionary product development history, including the world’s first submersible

pump, which is vastly more efficient than jet pumps which were the standard, and suffered

cavitation problems from being elevated above water. Through these developments Xylem has

created a positive brand image and is able to attribute 40% of its revenues to recurring

revenues. As well as its industry leading products, Xylem has focused its growth in emerging

markets to take advantage of the new water infrastructure deployment and increasing water

regulations taking place.

Due to the increasing water regulations in developed nations, Xylem’s test and

control, as well as its residential and commercial building services are poised to see revenue

growth. This is due to the increased regulation for energy and water efficiency in buildings as

well as increased control of contaminants in water distributed for use as well as water

returned to the eco system. Xylem provides industry leading products in both of the affected

revenue segments, positively positioning Xylem for the future.

As for its emerging economy growth, Xylem has established a local presence in China ,

and is recognized locally as the water technology leader. Using its brand presence as well as

technological expertise, Xylem will highly benefit from the recent Chinese government

mandates focused on water protection, pollution and control. By 2020 Xylem plans to earn

25% of its revenues from emerging economies, as opposed to the current 21% it earns. Xylem

plans to drive both its emerging market growth and developed market growth through

increased innovation , and aims to raise its vitality index to 25% by 2020.

Therefore the two main business aspects allowing Xylem to position itself better

than its competitors its is drive to grow through innovation, and its strategic brand position in

emerging markets, allowing Xylem to be better equip to prosper from the growth of these

markets.

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Income Statement

Xylem’ revenues have been forecasted to increase by 31% over the next five years. The main

driver for revenue growth will be Xylem’s emerging market revenues. I have forecasted a 9%

growth rate in its Asia Pacific revenues for 2015, slowing down to a 5.5% revenue growth in

2019. This estimates are based on industry experts estimates for Chinese investment in water,

as well as Xylem management’s projected growth for revenues within Asian Pacific markets.

Xylem’s operating margins are forecasted to increase significantly from 14.2% to 17.3% due to

Xylem’s increasing lean initiatives, and its intention of opening production facilities and

research facilities in emerging economies, with India being its primary target By successfully

decreasing operational square footage and opening production and research facilities in

emerging economies, Xylem will be able to take advantage of lower costs.

EPS is forecasted to grow continually from $1.85 in 2014 to $2.90 in 2019. This growth will

be sustained through Xylem’s increasing revenues and margins, and continued anti-dilutive

share repurchases

Figure 11: Income Statement Forecast

Balance Sheet

Xylem’s low debt to equity ratio will allow to issue debt necessary for growth at a low cost and

without significantly increasing the company’s bankruptcy risks. Due to this positive ratio, I

have forecasted Xylem to issue $600 Million in debt in 2016 , to support its emerging market

growth efforts.

Financial Statement Analysis

Source: Bloomberg, Student Estimates

Figure 12: Balance Sheet Forecast


Inflation, and other manufacturing and operating cost increases:

Increased inflationary forces could be detrimental to Xylem’s business, as manufacturing uses

raw materials and commodities as inputs, which tend to see the highest increases in prices,

not completely offset by increases in Xylem’s products’ pricing. Xylem’s operating costs could

experience negative fluctuations, particularly due to changes in commodity prices, raw

materials, energy and related utilities, freight, and cost of labor. In order to remain

competitive, Xylem may not be able to completely offset the increased costs with increasing

pricing.

Risk Analysis (Cont.)


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Cash Flow Statement

Xylem has continuously been able to produce cash flows from operations greater than 100%

of its revenues. This signals Xylems ability to earn its cash through its core business activities,

and its ability to efficiently use its working capital. Given its historical numbers, Xylem is

projected to continue to produce operating cash flows of over 100% of its net income.

Xylem’s has historically grown its business through organic growth supported through capital

expenditures. Management has given guidance stating that Xylem’s future growth will be

aided by bolt-on acquisitions in emerging markets. For this reason $100 million has been

forecasted annually in acquisition investments, as well as Xylem’s guidance for $125-$135

million in annual capital expenditures

Xylem has authorized $70 million in share buybacks for 2015, and an additional $250 million in share buybacks with no specific timeline, which has been forecasted into the cash flow statement. As well as the share buybacks an issuance of $600 million in debt has been forecasted to support Xylem’s growth activities

Figure 13: Cash Flow Forecast


Valuation Discounted Cash Flow

We decided to use a discounted Cash Flow model to value Xylem’s shares. We believe that this

was the best model to use, as there were no significantly similar peers for a relative valuation

model, as well as the fact that Xylem’s reliable operating cash flows allowed for a fair DCF

valuation

A CV rate of 4% was utilized as we view Xylem to be operating in a n industry with high

growth potential, and therefore elected to go with a CV higher than both inflation and world

GDP growth. Although 4% was used as the CV growth rate, Xylem would still be undervalued

had a 2% rate or higher been used.

Figure 14: DCF Calculation


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Disclaimer This report was written by a student currently enrolled in a program at the Sprott School of Business. The purpose of this report is to demonstrate the investment analysis skills of Sprott students. The analyst is not a registered investment advisor, broker or an officially licensed financial profes-

sional. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any securities. This report is written

solely for the consideration of this student managed investment fund and should not be used by individuals to make personal investment decisions. Unless otherwise noted, facts and figures included in this report are from publicly available sources. We cannot guarantee that the information in

this report is 100 percent accurate, although we believe it to be from reliable sources. Information contained in this report is only believed to be

accurate as of the day it was published, and it is subject to change without notice. It cannot be guaranteed that the faculty or students do not have an investment position in the securities mentioned in this report.

Buy, Price: $37.50 Target : $50.36

Investment Positives

Growth Through Emerging markets:

Xylem’s focus on emerging market growth will prove to be successful due to several factors.

Xylem has clear prioritization and focused investments in China, Middle East and India which

will drive greater market penetration as it is targeting optimal markets. As well as focusing its

growth on optimal emerging economies, Xylem will benefit from the its local brand

recognition in the markets it intends to generate its growth from.

Expanding Margins:

Xylem has continuous cost optimization as one of its three strategic priorities. Xylem will be

able to realize decreasing expenses, through the continuous reduction of facility square

footage as well as its drive for global talent procurement, allowing it to access labor at lower

costs.

Growth Stock at Value Price:

Since its spin–off form its parent company, Xylem has provided a share price appreciation of

47.929% as opposed to the 72.09% price appreciation that XLI ( Industrials etf) has produced.

This means that Xylem has underperformed its industry in the past and therefore trades at a

low p/e multiple due to its stock performance. Since we anticipate that Xylem’s core business

will provide higher than sector return for the foreseeable future, it is reasonable to assume

that at its current price levels, one would be purchasing Xylem’s income growth at a discount.

Investment Negatives

Xylem’s Exposure to the Euro:

Since 35.2% of Xylem’s current revenues are from Europe, the devaluation in the Euro as well

as the instability of the European Union have negatively impacted Xylem’s revenues. If this

economic situation were to prolong itself Xylem’s profits could be significantly impacted. To

mitigate this risk Xylem has focused its future growth in other regions.

Overall, I feel that the positives of investing right now outweigh the negatives of investing and that is why my final recommendation is a Buy.

Investment Recommendation


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Appendix A Pro-forma Financial Statements

Figure A1: Income Statement


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Figure A2: Common Size Income Statement


Page 17

Figure A3: Balance Sheet


Page 18

Figure A4: Common Size Balance Sheet


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Figure A5: Cash Flow Statement


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Appendix B Valuation Charts and Sensitivity

Figure B1: Profitability Forecast

Figure B3: Dividend Payout Ratio and Net Income to Operating Cashflows




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Figure B5: DCF Sensitivities

References

1. http://investors.xyleminc.com/phoenix.zhtml?c=247373&p=irol-reportsannual— Various 10-K reports 2. 3. http://www.bloomberg.com/news/articles/2015-03-31/china-plans-increased-investment-for-water-

conservation-efforts 4. https://s3.amazonaws.com/cd.live/uploads/content/file_en/8035/chinas-long-march-to-drinking-

water-2015-en.pdf 5. http://www-wds.worldbank.org/external/default/WDSContentServer/WDSP/

IB/2009/01/14/000333037_20090114011126/Rendered/PDF/471110PUB0CHA0101OFFICIAL0USE0ONLY1.pdf?pagePK=64193027&piPK=64187937&theSitePK=523679&menuPK=64187510&searchMenuPK=64187283&theSitePK=523679&entityID=000333037_20090114011126&searchMenuPK=64187283&theSitePK=523679

6. http://www.paxworld.com/system/storage/17/af/6/2322/investing-in-water.pdf 7. http://blogs.ei.columbia.edu/2011/05/05/how-china-is-dealing-with-its-water-crisis/ 8. http://chinawaterrisk.org/resources/analysis-reviews/8-facts-on-china-wastewater/ 9. http://www.goldmansachs.com/our-thinking/pages/interconnected-markets-folder/chinas-

environment/report.pdf

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