Xylem Inc.

Moat: 3/5

Understandability: 3/5

Balance Sheet Health: 4/5

Xylem is a leading global water technology company that designs, manufactures, and services highly engineered products and solutions for a variety of water and wastewater applications.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

Xylem operates in three main segments: Water Infrastructure, Applied Water, and Measurement & Control Solutions.

Water Infrastructure is the largest segment, encompassing equipment and systems that transport water from sources, treat water and wastewater, and manage stormwater. This segment is primarily geared towards public utilities, industrial users and municipalities. It offers a wide variety of products, including pumps, valves, treatment systems, and pipe inspection and control tools.
Applied Water focuses on the efficient use and management of water in commercial, residential and industrial applications. It sells products like pumps, valves, and heat exchangers. Its customers include agriculture, building services, and various industrial end users.
Measurement & Control Solutions is centered around enabling smart water management through advanced technologies. The products and services include sensors, communication networks, analytics and digital water solutions. This segment focuses primarily on technology-based solutions and is sold to utilities, industrial customers, municipalities, and other public organizations.

Competitive Landscape

The water industry is characterized by several key players, including multinational conglomerates, diversified industrial companies, and smaller niche players. Competitors range from manufacturers of water equipment and devices to engineering services providers.

In an industry like the water industry, the scale is very critical. Scale can create efficiencies in operations, supply chain and distribution. The company also needs a reputation for innovation, technical capabilities and strong brand awareness to compete effectively.

What Makes Xylem Different?

Xylem’s advantage lies in its differentiated portfolio of products and services designed to serve a wide range of water-related challenges with a focus on innovation and sustainability. The company’s products have an application across the entire water cycle and cater to both developed and emerging markets.

Technological Edge: Xylem spends heavily on R&D and has a history of innovation, particularly in water infrastructure and advanced water analytics solutions, placing them at the forefront of technological advancements in the industry.
Global Presence: With operations in over 150 countries, Xylem has a broad geographical reach which is advantageous to service global customers in both developed and emerging markets.
Integrated Solutions: Xylem goes beyond merely selling water equipment. The company aims at providing integrated solutions, from the initial stages of water management to delivery, which allows them to garner more market share.
Sustainability Focus: Xylem places a high importance on sustainability, often emphasizing its focus on environmental responsibility and stewardship. This allows them to capitalize on the sustainability trend.
Strong Brand Recognition: Xylem’s brands include Flygt, Godwin, and Sensus. These brands have strong reputation among utility and industrial customers.

Financial Analysis

Looking at Xylem’s financials, we get a clearer picture of how the business is performing, and the robustness of its moat.

Revenues Xylem’s revenue is highly diversified and relatively stable. It increased from around $5.2 Billion in 2019 to approximately $7.4 Billion in 2023. Revenue growth is driven by a combination of organic expansion and strategic acquisitions and has been resilient even in the face of macroeconomic headwinds.
Profitability Gross margins are robust at approximately 37% in 2023. Operating margins are at around 14% for the year ended December 31st 2023 showing a decent profitability which is attributable to the company’s strong competitive advantages and operational efficiencies.
Profitability by segment Water Infrastructure had revenues of $2,247 million with an operating profit margin of 13.1%. The Applied Water segment had a revenue of $1,729 million and a operating profit margin of 14.6%. While the Measurement and Control Solutions segment has a revenue of $1,991 million and an operating profit margin of 18.9%.
Cash Flow: Free cash flow stood at $817 million for FY2023, showing a strong capability to generate cash. This allows them to reinvest into the business.
Capital Structure: Long-term debt is significant and stands at $2.7 Billion as of 2023 end. Xylem’s credit rating has remained at a relatively strong BB. Xylem has an interest coverage ratio of almost 16 times which suggests that the company is easily able to cover its debt payments.

Xylem’s financials are generally robust, with consistent revenue growth, healthy profit margins, and strong cash flows. However, the high debt and low dividend yields do require caution.

Moat Assessment

Xylem has competitive advantages that give it a moderate moat, but I rate this at a 3 out of 5:

Intangible Assets: The company owns recognized brands, and patents which give it a competitive advantage and provides some pricing power. However, patents have a limited life, thereby reducing moat durability.
Switching Costs: High costs of replacing water infrastructure components can cause lock-in effects. A customer using a certain brand may be hesitant to switch due to the costs associated with the swap, like labor, costs associated with different machinery, and the time taken to train personnel on the new equipment. This creates decent switching costs, but not impenetrable.
Economies of Scale: The high level of fixed costs associated with research, manufacturing, and distribution has made this a business where the company needs scale in order to maintain profitability. Xylem’s large distribution network and strong market position give them a scale-based advantage. However, given the industry’s consolidation, this moat is only medium and not wide.

Risks to the Moat and Business Resilience

Some key risks could affect Xylem’s moat and its long-term business prospects.

Technological Disruption: Xylem operates in a sector where technology is evolving very rapidly. Failure to keep pace or adopt innovations may lead to loss in competitive advantage. Also, a new company may introduce a superior technology and grab market share from Xylem.
Economic Downturn: As many companies in the utility sector, Xylem is susceptible to economic downturns, which can affect both capital spending and construction activities, ultimately affecting the demand for Xylem’s offerings. The company did experience a reduction in demand and has had to reorganize its activities.
Increased Competition: The water industry is known to be competitive, therefore, Xylem must continue investing to maintain an edge. Failure to do so may mean a loss in market share and price power.
Environmental Regulations: Changes in environmental regulations can increase compliance costs and may reduce profitability.
Acquisition Integration Risk: A lot of its growth comes from acquiring smaller companies. There are integration risks including conflicts in workplace culture, loss of key personnel, and difficulty in achieving synergies.

Xylem has demonstrated resilience and ability to adjust to changing conditions. They have successfully absorbed smaller acquisitions, innovated and introduced new products, and maintained long-term sustainability goals. These characteristics may help the company in handling challenges posed by market forces.

Understandability Rating

The overall understandability of Xylem as a business is a 3 out of 5.

While the basic business of providing water solutions is easy to understand, the nuances of its technological offerings and the complexities of the water industry, including regulations, and competition make it more difficult for most investors.
The company’s strategy around mergers and acquisitions and integrating different business models requires some understanding.

Balance Sheet Health Rating

Xylem has a robust balance sheet, with good management of its assets and liabilities. This gives them a 4 out of 5 rating.

Xylem’s cash and cash equivalents stands at almost 1 Billion Dollars as of December 31st, 2023. Receivables are at $1.8 Billion, and inventory is at $1.1 Billion. These figures are healthy and reflect sound working capital management.
The liabilities are under control and include a current portion of long-term debt of $230 million and trade payables of $1.1 Billion. Long-term debt stands at $2.7 Billion, and their total debt to enterprise value is about 0.4. This is acceptable and shows that the debt position has not gone out of control.
A reasonable liquidity is also reflected, as current assets stand at 4.6 Billion against current liabilities of 2 Billion, implying a current ratio of around 2.3.
Though the debt situation isn’t concerning, it is worth noting the company’s low dividend yield and substantial capital requirements.

Recent Concerns, Controversies, and Management Discussion

Xylem faced higher input costs, supply chain volatility and higher interest rates over the last year. However, the company is expecting a better financial picture in the coming quarters with increasing market demand and a stronger ability to price their offerings.

The company is currently focused on maximizing operating margin and cutting costs to deliver better results. In the last earnings call, the company’s management noted that the restructuring initiatives and pricing actions were expected to yield positive results in the second half of 2023 and beyond. The management noted the company’s strong market share in most areas and a healthy backlog as strong points.

In summary, Xylem is a well-managed company with a decent moat, sustainable profits, and a history of stable revenue growth. However, the business needs careful and continuous monitoring to maintain an edge against disruption, competition, and industry volatility. The complexity of this industry may be why an average investor would struggle to understand Xylem.