Profit From Water Woes

Contributing editor Glenn Rogers joins us this week from drought-stricken California where everyone suddenly realizes just how precious water is. Glenn is executive chairman of RAEN and a board member of Poler Inc. He has worked with private equity and venture groups on a variety of projects leading to successful exits for the investors. He recently was part of a group that sold a large beverage company to Amway. Glenn has worked in senior positions in both Canada and the U.S. and is a successful investor. He lives with his family in southern California. Here is his report.

Glenn Rogers writes:

Most of you will be aware that here in California we are experiencing a severe drought that has been going on for nearly five long years. California is the eighth largest economy in the world (yes, you read that correctly). The state has a growing population that is expected to add the equivalent of the population of New York State over the next 20 years.

Clearly, something dramatic has to happen with the water infrastructure in the state if we’re going to accommodate all that growth and continue to be a major source of agriculture for the U.S. and the rest of the world. It’s estimated that California will need to spend nearly $40 billion for drinking water and a similar amount to process wastewater during that time frame. Currently most of our reservoirs are nearly empty and the governor of the state has recently decreed that we must reduce water usage by 25% immediately. Many people think that isn’t enough.

Obviously, California is not the only place in the world struggling to meet the water needs of a growing population. Vast parts of the globe do not have nearly enough water to drink and support their agricultural needs. There are a number of initiatives underway by governments and charitable organizations around the world that focus on water, including one run by the owner of Cirque du Soleil.

So how can investors benefit from this obvious crisis? There are four U.S. ETFs and two mutual funds that focus on this area. Here’s a summary.

Source: Morningstar, ETFdb.com, through March 31, 2015

If you want a quick and easy way to invest in water-related companies, you could simply buy one of these ETFs (the mutual funds aren’t sold in Canada). Or you could take a position in the Canadian based iShares S&P Global Water Index Fund (TSX: CWW).

Alternatively, you can look through the holdings in these funds, identify some of the top companies in their portfolios, and buy individual stocks. One that is especially interesting is Xylem Inc. (NYSE: XYL).

Xylem is based in Rye Brook, New York but has a global footprint. It does business in 150 countries with over 12,500 employees worldwide. In case you’re wondering, the corporate name is derived from classical Greek and is the tissue that transports water in plants.

This is a very focused water play in an industry that is highly fragmented. Growth is generated by all the things that are troubling California: water scarcity, urbanization, population growth, environmental protection issues, and infrastructure needs. The company operates in all the major segments of the water industry, such as transportation, treatment, irrigation, industrial water treatment, building services, and testing. It also manufactures pumps, valves, filtration equipment, and biological disinfection technologies. As well, it provides an analytics platform to aid municipalities and utilities in making the correct infrastructure investments.

The projects it undertakes are varied and imaginative. Here are a few examples to give you an idea of the scope of the company’s business.

Saving Beijing from flooding. After a massive flood overwhelmed Beijing’s storm water system, the Chinese capital has begun installing Xylem’s submersible pumps, which are capable of handling even the heaviest rainstorms.?

Cleaning up Lake Como. By installing new Xylem pump and mixer models, the wastewater company that serves Italy’s national and natural treasure is keeping the lake clean and costs down.?

Protecting a California river. In California’s high desert country, flash floods damaged a pipeline and sent wastewater into key water source. Xylem pumps are part of the new bypass project that will protect the river.?

Monitoring Singapore’s drinking water. Xylem teamed with a local company to develop a monitoring system that will help Singapore address – and avoid – leaks, clogs, and water quality issues in its drinking water network.

The game goes on. Xylem pumps handle the flow of wastewater and storm water at New York’s Yankee Stadium.

The company reported annual revenue in 2014 of $3.9 billion (figures in U.S. dollars). Xylem receives 40% of its revenue from Europe, 30% from the United States, 14% from the Asia-Pacific area, 6% from Latin America, 4% from the Middle East and Africa, and 6% from the rest the world. Obviously, it is well diversified geographically, although that comes with currency risk.

On April 30, Xylem released first-quarter results and while they weren’t mind-blowing they were solid. Adjusted net income came in at $60 million ($0.33 per share), down one cent on a per share basis from the same period in 2014. Revenue was $837 million, up 1%. The results were depressed by the rise in the value of the U.S. dollar, which cut into overseas profits.

The foreign exchange situation prompted the company to reduce its guidance for the rest of 2015. Xylem now expects full-year 2015 revenue of approximately $3.7 billion, down 7%-8% from the full-year 2014 results. On an organic basis, Xylem continues to anticipate revenue growth in the range of 1%-3%.

Full-year 2015 adjusted operating income is now expected to be in the range of $469 to $494 million, resulting in adjusted earnings per share of $1.80 to $1.90. Excluding the projected unfavorable impact of foreign exchange translation, Xylem’s adjusted earnings per share growth expectations remain unchanged in the range of 5%-10% over the comparable full-year 2014 results.

Investors took the downgrade in stride and the shares actually moved higher after the results came out.

The company recently increased dividends by 10% and announced it will repurchase $130 million worth of its shares, which is up by 94% versus the prior year. During the first quarter of 2015, Xylem repurchased 1.4 million shares for an aggregate purchase price of $50 million. As of March 31, the company had approximately $50 million remaining under its current stock repurchase authorizations.

Xylem has a strong balance sheet and the company generates lots of cash. With a current annual dividend of $0.52 per share, the stock yields 1.4%.

Action now: Buy with a target of $45. The shares closed on Friday at $37.14.