Investing in water and companies working with either services or setting up new infrastructure has been quite popular it seems the last few years. A noticeable trend I have seen appearing is that a lot of water companies have seen their valuations rise quite rapidly in a short period. with Watts Water Technologies, Inc. (NYSE:WTS) for example, the p/e has averaged over 25 in the last 5 years. In comparison to the industrial sector which is apart, that is a premium of 35%. As for shareholder value, there is a dividend but not a particularly large one at just 0.7%. Shares are being bought back but not at any partially rapid rate really, since 2019 only decreased by 2%.
Why are the market and investors seeing so much value in water companies? Well, I think it has to do a little with global warming and the fear that water may be like a currency in the future. Humans need to have access to clean and drinkable water and one of the companies ensuring that is WTS. That may be the cause of the premium currently applied. The last earnings report didn’t produce any results that I think justify a p/s of 3.2, the top line just rose by 3%. For a p/s that high I would at least expect double-digit revenue growth to make it reasonable. The market it works in is still something I consider worthwhile to have exposure in and for investors that have been in WTS for a long time then it’s worth holding on to shares here, but for investors looking to add WTS then I think it’s better to wait for a significant pullback.
WTS stands as a global leader in delivering comprehensive fluid and energy management solutions across diverse sectors. The company specializes in providing an array of products and services essential for efficient operations within various structures. Among its offerings are backflow preventers, pressure regulators, valves, mixing valves, and state-of-the-art leak detection equipment tailored for plumbing and hot water systems. These cutting-edge flow control and safety devices cater to both residential and commercial needs, ensuring optimal performance and reliability in fluid and energy management.
WTS introduced the IntelliFlow Automatic Water Shutoff Valve as a pivotal component of its cutting-edge smart home water management system. This innovative valve is designed with a primary objective: to swiftly halt any potential damage caused by leaks. Leveraging advanced technology, the valve is equipped to intelligently identify leaks and promptly initiate an automatic shutdown of the water supply. The positive about WTS over the last several years has been the organic growth of the assets without the additional debt to the balance sheet. The chart above showcases the total assets reaching over $2 billion whilst the LT debt is steadily decreasing following WTS’s ability to continue to generate consistent positive FCF.
With that said, WTS is continuing to be active on the acquisition front, and in the Q3 report, they mentioned the competition of acquiring Bradley Corporation for $303 million. This has increased the TAM for WTS as new products and services are added to their portfolio, some of these including handwash products and washroom specialties.
Taking a look at the latest earnings report from WTS a little closer which was released on November 1 2023 we see a slight uptick in the top line reaching above $500 million. YoY it seems WTS has been hiring more or raising wages as the selling, general, and administrative expenses rose by 8.1%. Should this continue and the revenues not exceed this I think it opens up a pretty significant risk of a correction occurring. It would highlight the lack of scalability of the business. For the bottom line though I think the results were more impressive as the EPS rose by 11.9% YoY. Thanks to higher revenues and a similar cost of goods sold as last year it all trickled down to the strong double-digit EPS growth. In a higher interest environment like now it’s crucial to monitor the expenses for the business and with WTS it has been on a decline YoY, which is a big positive of course.
The management of WTS also provided some outlooks for both Q4 and the full year. It anticipates an organic growth rate of negative 6% to negative 1% in Q4, a likely cause for this being the higher interest rate environment that is taking a toll on economic activity. As for the full year, when the revenues are anticipated to be quite flat, I don’t necessarily see as something significantly negative. If WTS can manage to consolidate here a little bit then going forward they could start to accelerate as more capital is built up to fund more acquisitions.
With the company trading at the multiples it does, I am still not that convinced of the company being a buy here. It trades without a 15% margin of safety, which I would prefer in this scenario. With a 15% discount to the historical p/e, we land at 21x earnings. This leaves a further 10% for the company to fall, which is reasonable in the short term should there be a broader market sell-off. For this reason, I would rather be holding shares than adding more to both buy at reasonable prices and limit my risk-taking.
Watts finds itself in direct competition with various enterprises operating in the same sector, contending with both longstanding industry leaders and new entrants to the market. The robust competition prevalent in this sector introduces challenges that extend beyond the immediate scope of market presence and profitability for WTS. The intensified competitive landscape may give rise to pricing pressures, potentially triggering a decline in the company’s market share and overall profitability.
This heightened competition raises concerns about a potential “race to the bottom,” wherein companies may engage in aggressive pricing strategies to gain a competitive edge. Such tactics could lead to a scenario where future earnings for WTS fall below initial investor expectations. This not only poses a threat to the company’s financial performance but also introduces a risk of market correction, potentially impacting the valuation of WTS stock. Investors who initially anticipated certain earnings may face a reality where the actual performance deviates from these expectations. It seems that the additional companies and products that WTS has been able to add in recent years have helped offset some of the potential margin losses. The chart clearly showcases a trend upwards and I think this in the future could continue if WTS continues its strategic acquisition program that most recently resulted in the purchase of Bradley Corporation. Having strict guidelines for companies to acquire will be crucial though, and too risky investments might cause short-term net margin losses.
The water industry has been seen as almost a haven in the last few years it seems and companies like WTS have had their valuation increase rapidly. I am not fully convinced these premiums are worth it right now though. There seems to be slow growth for WTS and it’s still trading at what I consider high multiples both for the p/s and the p/e. Given the relative stability of the company though I would say holding shares and maintaining exposure still seems advisable, making for a hold here.