Restructuring And Tariffs Will Test Margins While Evoqua Offers Promise

Key Takeaways

• Workforce reductions and restructuring may disrupt operations, potentially affecting EBITDA margins despite anticipated cost savings.
  
• Tariffs and unfavorable foreign exchange rates could pressure margins, countering potential gains from operational improvements.
  
• Successful integration of Evoqua and strategic transformations are enhancing profitability, operational efficiency, and growth prospects amid healthy demand and a strong financial position.

Catalysts

Engages in the design, manufacture, and servicing of engineered products and solutions for utility, industrial, and residential and commercial building services settings worldwide.

• Xylem's restructuring program, which is expected to result in workforce reductions of nearly 10% and may disrupt operations, suggests possible future headwinds that could affect EBITDA margins adversely, despite the anticipated cost savings.
  
• The company's short-term margin expansion for the Measurement and Control Solutions segment is vulnerable to a negative mix shift between energy and water meters, potentially pressuring overall EBITDA margins.
  
• Xylem faces potential tariff impacts from proposed tariffs by the U.S. administration in key regions, including China and Mexico, which may add pressure to net margins if escalated pricing actions are insufficient.
  
• Extending further into 2025, Xylem's revenue growth outlook is relatively weak at 0% to 2%, hampered by 80/20 actions which may have larger impacts in the initial implementation phases, contributing to a less optimistic revenue trajectory.
  
• The company acknowledges the impacts of unfavorable foreign exchange rates as a headwind, which could impact earnings and counterbalance potential EBITDA margin gains from productivity improvements and price realizations.

Xylem Future Earnings and Revenue Growth

Assumptions

• This narrative explores a more pessimistic perspective on Xylem compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming Xylem's revenue will grow by 3.4% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 10.4% today to 12.7% in 3 years time.
• The bearish analysts expect earnings to reach $1.2 billion (and earnings per share of $5.05) by about April 2028, up from $890.0 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 30.4x on those 2028 earnings, down from 31.7x today. This future PE is greater than the current PE for the US Machinery industry at 20.9x.
• Analysts expect the number of shares outstanding to grow by 0.25% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 7.24%, as per the Simply Wall St company report.

Xylem Future Earnings Per Share Growth

Risks

• Xylem reported record revenue growth of 6%, expanded EBITDA margins by 170 basis points, and increased EPS by double digits in 2024, indicating strong financial performance and potentially positive future earnings growth.
  
• The successful integration of Evoqua is delivering cost synergies faster than expected, which could improve net margins and boost profitability.
  
• Xylem anticipates demand will continue to be healthy through 2025, despite some regional uncertainties, suggesting stable revenue prospects.
  
• The company’s strategic transformation initiatives, including refining its operating model and optimizing its portfolio for growth and profitability, could enhance operational efficiency and contribute to earnings growth.
  
• Xylem has a strong financial position with solid EBITDA margins, healthy order growth, and a robust balance sheet, providing it with resilience and flexibility to navigate potential challenges and maintain profitability.

Valuation

• The assumed bearish price target for Xylem is $121.0, which represents one standard deviation below the consensus price target of $137.89. This valuation is based on what can be assumed as the expectations of Xylem's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $174.0, and the most bearish reporting a price target of just $115.0.
  
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be $9.5 billion, earnings will come to $1.2 billion, and it would be trading on a PE ratio of 30.4x, assuming you use a discount rate of 7.2%.
  
• Given the current share price of $116.1, the bearish analyst price target of $121.0 is 4.0% higher. The relatively low difference between the current share price and the analyst bearish price target indicates that they believe on average, the company is fairly priced.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.