Pat McKeough recently replied to an Inner Circle member looking for an opinion on Xylem Inc. While acquisitions and environmental trends will lift earnings for this water stock, its growth strategy carries risk, says Pat.

Q: Pat: What do you think of the water stock Xylem now that it has bought Sensus? Thanks.

A: XYLEM INC. (symbol XYL on New York; www.xyleminc.com) sells equipment and services related to managing water.

The company’s products help its clients collect, distribute, use and return water to the environment. Xylem is a Greek-derived word that refers to the vascular tissue responsible for carrying water and nutrients throughout plants.

The company operates two businesses:

The Water Infrastructure operation (61% of its sales) sells a wide range of products, including water and waste-water pumps, controls and systems, as well as water treatment and testing equipment.

The Applied Water business (39%) focuses on residential, commercial, industrial and agricultural water users. Its main products include pumps, valves, heat exchangers, controls and dispensing equipment.

Xylem was formed on October 31, 2011, after ITT Corp. split itself into three separate companies: Xylem; Exelis Inc., symbol XLS on New York (defense and information technology); and the new ITT Corp., symbol ITT on New York (industrial engineering).

ITT shareholders received one Xylem share for each share of ITT they held, plus one share of Exelis and one share of the new ITT. Xylem, as well as the other two companies, began trading on New York on November 1, 2011.

Growth Stocks: Earnings rise to $87 million for the quarter

In the three months ended June 30, 2016, Xylem’s earnings before unusual items rose 11.5%, to $87 million, or $0.48 a share, from $78 million, or $0.43 a share, a year earlier.

Sales in the quarter rose 1.3%, to $932 million from $920 million. The company has clients in more than 150 countries. Customers outside the U.S. account for about 60% of its revenue, so the high U.S. dollar hurts their contribution. If you disregard currency rates, sales rose 3.0% from a year earlier.

The company now holds cash of $586 million, or $3.28 a share. Its long-term debt of $1.1 billion is a low 12% of its market cap.

Xylem has expanded rapidly since ITT set it up as a separate company. Its purchase of smaller companies is responsible for most of that growth.

Xylem’s latest buy was the $1.7 billion acquisition of Sensus USA in August 2016. That privately held business provides smart meters and communications systems for utilities. About 76% of its customers are water utilities; electric and gas utilities make up the remaining 24%.

Sensus has 80 million metering devices installed globally. For the fiscal year ended March 31, 2016, it reported operating earnings of $159 million from $837 million in sales. It has 3,300 employees globally, in the U.S., U.K., Germany, Slovakia and China. However, it generated nearly 70% of its 2016 revenue in the U.S.

Sensus’s technology helps utilities turn their distribution systems into “smart grids.” These networks let a utility’s individual customers have more control over their consumption. That includes helping them make better use of off-peak hours, when rates tend to be lower.

Sensus should also gain as governments pressure utilities to better manage their own water and energy consumption.

Xylem expects Sensus to add between $0.10 and $0.12 to its annual per-share earnings.

More generally, the company aims to take advantage of a number of developments shaping the global water industry. They are:

1. About 80 countries now have water shortages, and less than 1% of the world’s total water is usable. As well, water demand tends to grow twice as fast as the world’s population, so continued population growth and economic development will spur rising demand for clean water.
2. Water infrastructure will need significant repairs and upgrades over the coming decades, especially in the developing world.
3. Changing weather patterns have resulted in more storms, floods and droughts. That can affect water supply. As well, people are becoming more aware of health issues; this is leading to increased efforts to deal with polluted water. More than one billion people still rely on unsafe water sources.
4. To cover the costs involved in repairing and upgrading water infrastructure, governments are increasingly outsourcing these functions to the private sector. This has created growth opportunities and attracted more investors to the water industry.

Xylem’s growth-by-acquisition strategy adds risk. In addition, low commodity prices could prompt customers in the oil and mining industries (contributing 8% of its 2015 revenue) to spend less on water treatment equipment. Still, the long-term outlook for both the water business and for Xylem itself is positive.

The stock trades at 25.4 times the $2.04 a share that Xylem will probably earn in 2017. The shares yield 1.2%.

Inner Circle recommendation: HOLD

For our recent report on a U.S. growth stock with a well-established niche, read Cloud computing spurs Paychex earnings, dividend.

For our advice on making successful decisions on growth stocks, read How to find growth investments—while at the same time avoiding costly mistakes.