A Potential 50% Premium Takeover Candidate

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In the 2013 Barron’s Roundtable, Mario Gabelli discussed many of his investment ideas, including Hillshire Brands and Post Holdings. He was also bullish on a leading water and wastewater treatment equipment business called Xylem (NYSE: XYL). He considered Xylem a potential takeover candidate with a 50% premium to the current stock price within two years. Let’s dig deeper to see whether or not we should follow Gabelli into Xylem.

Business Snapshot

Xylem was spun off from ITT Corporation in 2011. It is a global leading provider of highly engineered technologies for the water industry, with several brands such as Flygt, Wedeco, AC Fire, Standard and Bell & Gossett. It has two main business segments: Water Infrastructure and Applied Water. The majority of revenue, $2.4 billion, or 63% of the total revenue, was generated from the Water Infrastructure segment. Applied Water contributed nearly $1.45 billion in revenue in 2011. Xylem has a diverse customer base, as no individual customer represented more than 10% of the total revenue in 2011. In terms of geography, the United States and Europe accounted for 36% and 37% of the total sales, respectivley.

High Potential Growth

As of September 2012, Xylem had more than $2 billion in total stockholders’ equity, $424 million in cash, and nearly $1.2 billion in long-term debt. The goodwill and intangible assets, around $1.1 billion, seemed to be high.  In the last 5 years Xylem has managed to generate consistent positive net income. The net income has been fluctuating in the range of $219 million--$329 million. In 2011, Xylem generated more than $3.8 billion in revenue, and Mario Gabelli expects the revenue to increase to $4.6 billion by 2016. EBITDA could reach $800 million by that time, and EPS might rise from $1.80 to $2.50. At the current price of $28 per share, the total market capitalization is $5.2 billion. The market is valuing Xylem at 9.72x EV/EBITDA.

50% Potential Premium on Takeover

Xylem has a quite diversified end market. Industrial and public utility customers accounted for 40% and 36% of the total revenue, respectively. The industrial market is considered to be less cyclical than the commercial market, and public utility is non-cyclical. Thus, customers from those two markets could be considered sticky. In addition, because only Xylem can produce the replacement parts for its equipment, the customer switching cost is high. Gabelli commented: This is a yummy for a large corporation that wants to have distribution and products in water industry.He thought that the company might be acquired at a 50% premium to the current price within the next two years. 

Cheapest Among Peers

Xylem looks cheap in comparison to its peers, including Danaher (NYSE: DHR) and Franklin Electric (NASDAQ: FELE). With a total market capitalization of $41.6 billion, Danaher is valued at 11.4x EV/EBITDA.  Franklin Electric is the smallest company among the three, with only a $1.56 billion market cap. Franklin Electric has the highest valuation, at 12x EV/EBITDA. Both Xylem and Franklin Electric had a 13% operating margin over the last 12 months. Danaher’s operating margin, 17%, is the highest among the three. Currently, Xylem is paying a 1.4% dividend yield to investors, while Danaher and Franklin Electric are paying only 0.2% and 0.9% yields, respectively. 

My Foolish Take

Indeed, Xylem has the strong advantages of technical expertise and a market-leading position in the water treatment industry. A high switching cost creates loyal customers and fuels Xylem’s future growth. Investors might consider Xylem as a long-term stock in their portfolios.

hoangquocanh has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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