Water Quality Stocks

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by Debra Fiakas CFA

Pipes, pumps and values are only part of the drinking water story we began telling last week.  The Ecological Society of America estimates that the U.S. spends more than $2 billion annually on clean water projects in an attempt to prevent pollution and clean contaminated water.  Water quality is a diverse market, beginning with projects to promote natural ecosystems which are the ultimate ‘water filter.’  The market extends to water treatment facilities, filtration systems and purification technologies among other solutions to ensure that our drinking water is safe.

The market for water quality solutions is highly fragmented with numerous small operators, often with some engineering or technological expertise, addressing the peculiar water issues in their immediate locale.  Few companies have gains national or international scale, save for those large engineering firms that have broad interests in a variety of civil engineering projects.  Most of the players are private, leaving few options for investors to take a ‘pure play’ position in water quality.  Nonetheless, we found one private player that offers some interesting water quality solutions.  Two more public companies provide good plays on water.

Headquartered in Pennsylvania, Evoqua Water Technologies has built a network of 170 sales offices and production facilities in eight countries. Evoqua sells a mix of water and waste water treatment products such as activated carbon and sludge thickener or disintegration products.   The company also sells a broad selection of systems for biological treatment of water, waste water handling, aeration and anaerobic digestion, among other equipment and components.  Engineering and project integration services to commission, maintain and optimize water and waste water facilities.  Besides catering to the municipal drinking water and waste water market, the company also serves various industry verticals such as aquatics, food and beverage, pharmaceuticals and chemicals processing, among others. 

Recently, Evoqua won contracts to build four wastewater treatment plants that will expand the capacity of three different communities and one private agricultural company.  The company’s Davco-branded field-erected treatment solution will be installed in each site for expansion of existing facilities.

Unfortunately, there is no public data available on the company’s financial performance or market share.  That said we believe it is highly likely that the company is profitable and has been successful enough to generate strong cash flows that have funded the company’s expansion beyond its home market in the U.S.  With its brand presence on several continents, we expect Evoqua to eventually end up on someone’s radar, either for a move to the public capital market or as an acquisition target.

Xylem, Inc. (XYL:  NYSE) does provide a publicly traded stock for investors interested in the water market.  In the most recently reported twelve months ending December 2015, Xylem reported $3.65 billion in revenue from the sales of water infrastructure and equipment, providing $340 million in net income.  That represents a net profit margin of 9.3%.  The conversion of 12.7% of sales to operating cash flow is even more impressive.

The company got its start with an innovative submersible wastewater pump, parlaying that leading edge technology into a broad range of water and waste water systems and components.  Among the menu of products Xylem sells, is a selection of treatment systems and analytical instruments that address water contamination issues.  Xylem provides filtration, biological treatment and desalination solutions.  The company has systems or products in use in over 150 different countries.

Xylem is no small-cap.  It has earned a market capitalization of $7.4 billion or 2.0 times sales.  That may seem pricey, but we note that the stock is trading at 18.8 times projected earnings of $2.00 in earnings per share in 2016.  A forward dividend yield of 1.7% helps sweeten the pot.  Forward price multiples in the water and waste water industry also suggest Xylem is priced a bit dear.  The sector is commanding valuations only 11.8 times 2016 earnings estimates.

A significant competitor for Xylem is Danaher Corporaton (DHR:  NYSE), which is an even bigger company with products and services well beyond the water market.  Danaher describes its business as a science and technology operation.  In a few words its product line falls under test instruments, environmental products and services and life sciences products.  Danaher can measure the quality of the water at your tap so you can brush your teeth with confidence.  They can also provide products to fix your teeth.  That wide array of products earned Danaher $20.6 billion in revenue in the year 2015.

Danaher is on the calendar to report financial results for the March 2016 quarter on April 21st.  Analysts are expecting Danaher to report a buck in net earnings per share.  Given that the company has met or exceeded the consensus estimate in each of the last four quarters, that $1.00 EPS figure seems like a safe bet.  

Likewise Danaher is trading at a healthy 17.9 times the full year 2016 EPS estimate of $4.88 per share.  A forward dividend yield of 0.7% helps make the case for DHR.

Debra Fiakas is the Managing Director of Crystal Equity Research, an alternative research resource on small capitalization companies in selected industries.

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.

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