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Morningstar | Xylem’s Organic Revenue Growth Remains Healthy, but Operating Margins Fall Short of Expectations

We modestly raise our fair value estimate for Xylem to $73 from $72 despite first-quarter adjusted EPS of $0.52 missing consensus estimates by roughly 10%. We made some puts and takes in our model, but the time value of money since our last update more than offset slightly lower operating margin assumptions (now 14.7% for 2019, at the midpoint of management’s updated guidance, versus 15.1% in our previous model).

Demand remains healthy, as the firm delivered 6% year-over-year organic revenue growth, fueled by 11% growth in the U.S. and 12% growth in emerging markets (notably 58% in India and 14% in China). Earnings were adversely affected by currency headwinds, unfavorable sales mix, and lower production levels at some factories due to inventory buildup in the prior quarter. Xylem revised its full-year 2019 adjusted EPS guidance to $3.12-$3.22 from $3.20-$3.40 due to foreign exchange translation and first-quarter results falling short of expectations. Management remains confident it can reach its target 17%-18% operating margins but shifted its target from 2020 to 2021. We don’t mind this change, as we already conservatively assumed that margins would not rise above 17% until 2021.

The announcement does not fundamentally alter our thesis, and we remain optimistic about Xylem’s prospects. We reiterate our narrow moat and positive moat trend ratings. Xylem’s recently announced deal with Philadelphia Water, which incorporates both smart metering infrastructure and communications technology, is emblematic of the revenue synergies the company can achieve from the Sensus acquisitions. Revenue synergies have reached nearly $200 million, exceeding management’s original $150 million-$175 million target, and we believe that cross-selling opportunities will allow Xylem to solve multiple problems for customers, thus increasing switching costs and customer loyalty. We think these integrated offerings will help widen Xylem’s moat and lead to higher margins in the long run.