Xylem: Fund Managers Like This Top ESG-Rated Stock (NYSE:XYL)

Often, investors face a trade-off between stocks that are environmentally sound and those that promise good rewards. In Xylem Inc. (NYSE:XYL), they have a name with high ESG ratings and reasonable growth.

About Xylem

It is a global water technology company that designs, manufactures, and services “highly engineered products and solutions across a wide variety of critical applications, primarily in the water sector, but also in energy.”

In its 10-K for 2022, it also tells investors that it has a “broad portfolio of products, services and solutions to addresses customer needs of scarcity, resilience, and affordability across the water cycle, from the delivery, measurement and use of drinking water, to the collection, testing, analysis and treatment of wastewater, to the return of water to the environment.”

These are a few of the products featured on the home page of its website:

The company expanded dramatically in 2023 when it bought Evoqua Water Technologies Corp., in an all-stock transaction worth about $7.5 billion. In announcing the completion of the deal in a May 24 press release, the company noted, “the combined company becomes the world’s largest pure-play water technology company, with $7.3 billion in pro forma revenue and more than 22,000 employees globally.”

Institutional Investors

Institutional investors are generally fund managers with large pools of capital to invest on behalf of pension, mutual, and hedge funds, as well as banks, insurance companies and other entities that collect funds for investment.

As this excerpt from the Ownership section of the Xylem summary page at Seeking Alpha shows, institutional investors, which are mainly fund managers, hold almost all the company’s shares:

The three largest institutional holdings, according to Nasdaq.com, are three fund giants: the Vanguard Group Inc., BlackRock, Inc. (BLK), and State Street Corporation (STT). At the end of Q3-2023, 1,345 fund managers held Xylem stock.

ESG Credentials

Xylem is among the highest-rated firms as assessed by many sustainability-rating services. The company highlighted some of them in this slide from its January 2024 investor presentation:

In its annual Sustainability Report for 2022, the company reported progress on several of its goals, including:

• Treating over 13 billion cubic meters of water for reuse: At the end of 2022, it had reached 79% of its 2025 goal of 10.25 billion cubic meters.
• Preventing over 7 billion cubic meters of polluted water from flooding communities or entering local waterways: In 2022 it reached 93% of its 2025 goal of 6.54 billion cubic meters.
• Reduce water’s CO2e footprint by 2.8 million metric tons; in 2022 it had reached 100% of this goal.

Fundamentals

First, the company’s revenue, net income, and earnings per share have been recovering from the slump that started in the fourth quarter of 2021:

Second, those gains have been significant. On a TTM year-over-year basis, revenue is up 26.47%, EBITDA increased 37.47%, earnings from operations gained 54.23%, and diluted earnings per share rose 37.44%.

At the same time, margins continue to be okay, with the TTM gross margin at 37.59%, TTM EBITDA margin at 16.57%, and the TTM net income margin at 7.29%.

Third, return on common equity, at 7.49%, is well below the Industrials sector median of 12.17%. Similarly, the return on total capital and return on total assets lags the sector medians.

Looking forward, the company has reason to be optimistic. In the U.S., the Infrastructure Investment and Jobs Act of 2021 provides a total of $1.2 trillion in funding for all forms of infrastructure.

Of that amount, more than $50 billion will go into drinking water, wastewater, and stormwater infrastructure. Some would say that’s a good start, but still just a start. The American Society of Civil Engineers gives the country’s drinking water, stormwater, and wastewater infrastructure grades of C-, D, and D+, respectively.

It goes on to quote the Environmental Protection Agency as saying these three forms of water infrastructure need more than $743 billion in funding. And that’s just the federal government; states and other countries also need new or improved water infrastructure.

There’s another tailwind, of course, which is the ongoing decline in interest rates. Every time rates drop a point or sometimes even a fraction of a point, more shelved projects become feasible.

Based on the fundamentals, Xylem is well-positioned to grow over the next decade.

Demand for ESG Stocks

ESG stands for Environmental, Social, & Governance and refers to a set of standards that can help socially conscious investors screen their investments. As well as looking at a company’s environmental record, it takes in social issues such as a firm’s relationship with the communities within which it operates. Governance refers to how ethically the company is managed.

Until recently, ESG was often seen as a fringe investing strategy, but in recent years demand has grown. Fund managers now pursue ESG stocks to keep their individual and institutional clients satisfied.

According to PwC’s Asset and Wealth Management Revolution 2022 report, “ESG-oriented AuM is set to grow at a much faster pace than the AWM [Asset & Wealth Management] market as a whole.”

How much faster? PwC says, “With a projected compound annual growth rate (CAGR) of 12.9%, ESG assets are on pace to constitute 21.5% of total global AuM in less than 5 years. It represents a dramatic and continuing shift in the asset and wealth management [AWM] industry”.

As for sacrificing returns for socially conscious investments, PwC says that’s no longer the case. It reported that nine out of ten asset managers surveyed believe ESG integration will improve overall returns. And, 60% of institutional investors surveyed said that ESG investing had already delivered higher performance yields when compared to non-ESG equivalents.

So, fund managers and others need to find ESG companies, and Xylem is one of the best. As the Sustainability slide above shows:

• Sustainalytics ranks it 25th out of the 578 companies it rates, putting it in the top 5%.
• MSCI gives it its highest grade, AAA; only 5% of all stocks they rate rank this highly.
• EcoVadis assigns it a Gold rating for ranking in the 94th percentile.

The other ratings on that page have similarly high levels.

All of which means demand for ESG stocks is rising, and again, Xylem is well-positioned to be one of them.

Valuation

At first glance, the company’s stock appears overvalued. Forward P/E Non-GAAP is 29.85, which is nearly 60% higher than the sector median of 18.17.

However, when we factor in the growth of earnings, the current valuation seems more reasonable. The forward PEG Non-GAAP is 1.23, which is in the Fair-Valuation range but still costlier than the sector median of 0.84.

My focus on valuation, though, mainly goes to the earnings estimates, which are as follows:

• Full-year 2023: $3.73, a year-over-year increase of 30.95%, based on the forecasts of 16 analysts.
• 2024: $4.07, an annual increase of 9.00%, based on 17 analyses.
• 2025: $4.58, representing Y-0-Y growth of 12.60%, based on 14 analyses.
• 2026: $5.42, an increase of 18.32%, based on 3 analyses.
• 2027: $5.80, or 6.93% Y-o-Y, based on 2 analyses.

During 2023, earnings are expected to increase 30.95%. If we add that amount to the December 30, 2022 share price ($110.57 + 30.95%), we arrive at a share price of $144.79.

Since the December 29, 2023, price was $114.36, then I’m going to argue that Xylem was undervalued as we entered 2024. More specifically, it was undervalued by $30.43, or that it has a 26.61% margin of safety.

Using the same process from the end of 2023 to the end of this year, I expect a share price of ($114.36 + 9.00%) $124.65 at the end of 2024. Further price projections are possible, but with a lesser degree of confidence.

And how has the share price growth tracked earnings growth over the past five years? Not perfectly, but perhaps reasonably:

Risks

My concern about risk is tempered somewhat by the fact so many fund managers own the stock, given they have many more resources than the rest of us to analyze risks and rewards. Still, there are several risk factors that deserve our attention:

• How well will Xylem be able to integrate Evoqua, a company for which it just paid $7.5 billion.
• 53% of its 2022 total revenue originated outside the U.S., leaving it exposed to geopolitical and currency risks.
• It faces the risk of disruptive new products and services from competitors.
• As recent military actions in the Red Sea remind us, supply chains can be slowed, stopped, or made more expensive by any number of factors.
• As the company puts it in its 10-K, defects, inadequacies, or quality issues in the manufacture, design, software, security, or service of its products could have an adverse effect.

Conclusion

There are two good reasons for the strong institutional investor interest in Xylem Inc. It is one of the highest-rated ESG stocks available, and it appears poised to improve its fundamentals over the next three to five years.

I consider its shares to be undervalued since the share price is close to where it was at the end of 2023. And, I expect the share price to gain 9.00% over 2023’s closing price. With those criteria, I am giving Xylem a Buy rating.