Xylem Stock: Good Performer, Likely to Be Fully Rated in (NYSE:XYL)

Xylem Inc. (NYSE:XYL) has performed well over the past 12 months, with the share price up 45% since November 2023.

In this article, I set out to review Xylem’s recent financial performance with a focus on headwinds and pressures the company is currently facing, including a significant decline in orders in the water infrastructure segment due to delays in major infrastructure projects in China.

In my view, the shareholders have fully appreciated the good performance of the company and the smooth integration of Evoqua Water Technologies.

I believe that the overbought activity in May, followed by a 10% drop in the share price, could be an early sign of cooling shareholder enthusiasm, which could continue into the second half of the year.

I will provide the reasoning behind my Hold in rating perspectives section. For now, I’ll start with a brief overview of the company for those readers new to this stock.

Business overview

Xylem is an American company that designs, manufactures and services products for water-related applications. They are focused on the entire water cycle, from the delivery, treatment and measurement of drinking water, to the collection and treatment of wastewater before returning it to the environment.

I thought I’d include a breakdown of their revenue by business segment for the past 3 years below.

Click to enlarge

An author’s compilation of the most recent 10-K available.

As a side note, their new Integrated Solutions and Services segment was introduced in 2023 after acquiring Evoqua Water Technologies.

Despite the fact that the water infrastructure segment accounted for 40% of their total revenue in 2023, I like that the other segments are not far behind; applied water accounts for 25%, which is about the same as measurement and control solutions, and their integrated solutions segment accounts for 11%.

On a side note, my investment style favors businesses with diversified revenue streams that don’t rely heavily on a single segment.

In terms of company ownership, their latest published 14A shows that the total shareholding among all 19 directors and executive officers is less than 1%. Honestly, I’d like to see management have more skin in the game.

Recent performance

As always, I like to start with dessert, so I’ll cover the headwinds first.

The measurement and control solutions segment saw an 18% drop in new orders, with a 12% reduction in backlogs compared to last year. In my opinion, this is a strong indication of their high sensitivity to delays in large infrastructure projects.

Another example of these delays is the decline in China’s water infrastructure orders in the first half of 2024 due to broader economic challenges in China, where government funding for large infrastructure projects is becoming tighter.

Another pressure comes from weaker demand in developed markets, particularly in commercial real estate and manufacturing (mainly the US and Europe), which led to a 4% decline in revenue in the applied water systems segment. In my view, this segment is highly cyclical and sensitive to macroeconomic conditions, which can cause large fluctuations in total revenues.

Aside from these headwinds, their Q2 results were quite favorable, beating both EPS and revenue estimates and raising guidance for the full year.

EPS rose 78% and revenue rose 26% to $2.2 billion. This was mainly driven by a 26% increase in revenue in their measurement and control solutions segment.

In addition, the water infrastructure segment performed well with a 22% increase in revenue.

From a profitability perspective, I favor 1.7% year-over-year growth in Adjusted EBITDA, despite the challenges that come with integrating a newly acquired company.

In terms of newly revised guidance, management raised full-year revenue guidance to $8.55 billion, up 16%, with a forecast for organic revenue growth of 5% to 6%. Adjusted EPS guidance was raised from $4.18 to $4.28.

Despite these strong results and an increase in guidance, the stock price fell more than 5% during the day of the Q2 earnings release. I see this as a strong indication that shareholders are already appreciating good results. I will discuss more details in the next section.

Outlook

Let’s start with a quick look at the weekly chart below.

I like the clear uptrend that started in 2020, which I think is supported by solid growth. A quick look at the chart below shows an increase in both operating income, net income and EBITDA starting in 2020.

However, the weekly chart above shows the RSI above 80 in mid-May 2024, indicating overbought activity. Therefore, I am not surprised to see a 10% decline in the share price from the peak in May this year.

From a technical analysis perspective, I don’t like to see the uptrend support line much below the current share price. I’m not saying that the price will drop to that support line – in fact, I think there’s a very small chance that it will reach the $100 level. However, if the pressures and headwinds we discussed earlier persist and miss guidance for the full year, this lower support line could be an interesting entry point for a long position if there is a major selloff .

The main reason I think now is not a good time to go long is because of their excessively high valuations.

EV/EBITDA is 53% above the sector median, price to sales is 152%, price to cash flow is 83% and price to book is 9% above the industry sector median.

Another key factor in my investment style is recent insider buying activity on the open market. Frankly, I am disheartened by the lack of insider buying activity over the past 2 years, which in addition to reduced management participation in the company (

Conclusion

To conclude, I believe that despite a good second quarter with strong revenue, adjusted EBITDA growth and high guidance, the company’s strong performance is most likely fully priced.

The overbought activity in May followed by a 10% drop in share price could be an indication of waning shareholder enthusiasm, which I consider a healthy sign given that the RSI was above 80 in mid-May.

However, I think there is still a risk for a continued decline towards support of the uptrend line on the weekly chart, especially if delays in China’s large infrastructure projects persist into the second part of the year.

Another factor driving my Hold rating is the high valuation ratios compared to the industrial sector, particularly for price-to-sales and EV/EBITDA.

However, I think it’s worth keeping this stock on your watch list in case a sell-off lowers the stock price to the uptrend line support level. This would be close to the $100 price threshold, which I think is a good price to initiate a long position. However, until then, my rating on this stock is a Hold.