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Xylem Inc(XYL-N)
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Tech Manufacturing Is on the Rise in the U.S. -- a Water Stock Could Be a Key Beneficiary

Motley Fool - Thu Apr 6, 2023

Perhaps you've heard: The U.S. is aiming to "reshore" manufacturing operations -- and especially in the tech sector -- after spending the last few decades offshoring to countries where production is far cheaper (all in the name of boosting profit margins, of course).

Now, with inflation in basic commodities on the rise, bringing some of that manufacturing home is going to be tough. The Federal government is ready to help with legislation like the U.S. CHIPS Act (semiconductor manufacturing) and related Inflation Reduction Act (funding for renewable energy and related projects) to help grease the skids.

With hard asset investment like tech manufacturing on the rise, a number of industries could be key beneficiaries through 2030 -- and one of them could actually be a water stock. Here's why Xylem (NYSE: XYL) is worth a look.

Water fuels a lot more than life

Perhaps when you think of water stocks, a utility company that supplies your home comes to mind. Indeed, if dividend income and slow-but-steady growth is what you're after, this could be a good place to start.

Water is more than just for drinking, though. Indeed, according to the U.S. Environmental Protection Agency (EPA), industrial and manufacturing businesses account for about 12% of public water use. Ironically, while water can bring a premature death to our finished electronics, water is a key ingredient in their manufacture.

Semiconductor fabs (the plants that produce chips) in particular gulp down an incredible amount of water (millions of gallons a day, according to some public estimates) to clean silicon wafers as they go through multiple stages of manufacture. The water is also used to process other chemicals and keep equipment from overheating.

With water-intensive industry coming back to the U.S., more efficient use of water could become an absolute must. That's where Xylem comes in.

The water industrialist

Xylem is an industrial company through and through. It provides treatment and measurement equipment and related software that a wide variety of companies need to manage their water supply -- from water utilities and wastewater plants themselves (about half of revenue) to industrial businesses and manufacturing facilities (35% of revenue). Xylem was founded in 2011, spun off from engineering company ITT.

Xylem announced in January 2023 its intent to acquire fellow water equipment infrastructure company Evoqua (NYSE: AQUA) in an all-stock deal worth $7.5 billion. Combined, the two companies think they'll be better able to address global water scarcity and affordability issues. Additionally, Evoqua's water equipment addresses key growth markets like electronics manufacturing and energy infrastructure.

The price tag for Evoqua amounts to a steep premium, considering the company generated GAAP net income of just $75.5 million and free cash flow of $50.8 million in 2022. However, Xylem points out that Evoqua's adjusted EBITDA (earnings before interest, tax, depreciation, and amortization) was $298 million last year, and Xylem management has targeted $140 million in "synergies" (cutting of duplicate costs once the businesses are merged) it thinks justifies the purchase.

For what it's worth, I started researching Xylem before the merger was announced in January. I have questions about how well this merger will work, but nevertheless remain interested in the company's long-term prospects. The merger is expected to be complete sometime during the middle of 2023.

Why Xylem now?

Of course, water scarcity isn't a new revelation in 2023. So why get interested in Xylem stock now?

Besides rising demand from water-intensive industries like tech manufacturing in the U.S., Xylem is already plenty busy. It's working through a big backlog of orders from customers as a result of the chip shortage. The company didn't have enough semiconductors to make enough equipment early in the pandemic the last few years and is playing catch up.

As a result, revenue was up 6% in 2022 (up 11% on an organic basis when excluding divestitures and foreign currency exchange rate headwinds). Q4 revenue increased 20% year over year on an organic basis, and adjusted earnings per share jumped 46%.

2023 organic revenue (excluding the possible tie-up with Evoqua) is expected to be up 4% to 6%, and adjusted earnings per share up as much as 14%. It's a conservative guide, but one factoring for some macroeconomic headwinds this coming year after the Federal Reserve hiked interest rates by a record amount in 2022 to try to slow the economy down.

Xylem trades for a premium of nearly 50 times trailing-12-month free cash flow as of this writing. I'm not getting too hasty with any purchase just yet. I believe exercising some patience here could pay off if the stock retreats in the coming quarters. Nevertheless, this is a key supplier to the tech and heavy industry parts of the economy, and I think Xylem's business could enjoy steady growth for years to come.

It also pays a modest 1.2% yielding dividend, but it's been steadily raising that payout every year since it became an independent company in 2011.

XYL Dividends Paid (TTM) Chart

Data by YCharts.

Along with other key tech manufacturing suppliers like Air Products and Chemicals, I'm putting Xylem on my watch list and am considering firing up a dollar-cost averaging plan to build a position in the company over time.

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Nicholas Rossolillo and his clients have no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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