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Morningstar | Xylem Posts Standout 2Q, but We Think Shares Are Running Ahead of Fundamentals

Narrow-moat Xylem turned in a very strong quarter, and the market responded accordingly, with a nearly 9% rise in the stock price. The stock has seen a lot of near-term volatility, rising to about $79 at various points throughout March and April (aside from July 31), to a low of about $65-plus in June. We see the stock intrinsically worth towards the lower end of that range and are not surprised by the latest results, which are mostly in line with both our near-term forecasts and management's updated guidance. We are, however, raising our fair value estimate to $64, from $62. About $1 of that raise is attributable to the time value of money, and another $1 is related to a lower cost of debt than we previously modeled based on our model-driven credit rating.

Xylem posted revenue of about $1.32 billion, up 13% year over year on a reported basis (8% organically). On a GAAP basis, operating margins were 13% or 13.8% on an adjusted basis, with adjusting up 70 basis points (or 90 basis points when further adjusting for purchase accounting). Revenue was broad-based and driven by several positive drivers, including tailwinds from emerging market projects in the water infrastructure segment (emerging markets grew 18% year over year during the quarter), industrial strength in the U.S. and China in the applied water segment (up 9% year over year), and strength from both smart gas and software-as-a-service in the measurement and control solutions segment (20%-plus growth from both applications).

While Xylem's reported results are certainly impressive, we are hesitant to model an additional increase given that a portion of the results were driven by non-organic tailwinds this quarter. Our new fair value estimate implies a 19.1 times multiple to our 2018 adjusted EPS estimate. By our calculations, the market is applying about 22.6 times multiple (on our 2018 adjusted EPS estimates), which we currently see as a bit rich.

That said, the only slight negative in the quarter that we see is residential softness in the U.S. and Canadian markets from tough prior-year comparisons, which really doesn't overly concern us given the 15% year-over year-growth in last year's second quarter. Even so, management indicated it's a competitive business environment, and it only expects low-single-digit growth from this business for the rest of the year. Impressively, management is stating it's expecting free cash flow conversion of over 115% for the year, on the high end of our diversified industrial coverage.

On the earnings call, management provided an update to the second half of 2018's tariff outlook. A lot of industrials have been addressing these concerns, particularly how they'll optimize their supply chain. Xylem stated it benefits from a product localization strategy in China (that is, what's produced in China is sold in China). That said, the firm isn't completely immune from tariff impacts, but we expect that they can offset some of this through price increases given the strength of its intangible assets.