Watts Water Tech: Strong Construction And Retrofit Markets, Boosted By Excellent Execution

Writing about Watts Water Technologies (NYSE:WTS) ("Watts") in late February, I said I preferred to wait in the hopes of seeing an even better entry price. The shares continued to slide through late June to mid-July, bottoming out below $117 before rebounding nicely since those doldrums.

I've been impressed with the execution at Watts, as management has leveraged a healthy retrofit/renovation market and improving new construction markets to gain share. I'm even more impressed with the strong margin execution against a backdrop of input and distribution cost pressures. As far as criticisms and concerns go, I do have some concerns about the impact of higher rates on new-builds, as well as a declining tailwind from renovation projects spurred by the pandemic. Valuation isn't superb, but this is a quality name leveraged to construction growth (balanced between non-residential and residential) and trends like energy efficiency and loss prevention.

 

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Watts Water Tech: Strong Construction And Retrofit Markets, Boosted By Excellent Execution

As Water Stocks Come Off The Boil, Watts Water Technologies Looking More Reasonably Valued

 

Investor sentiment can be a funny thing, but if you don’t consider it, then a lot of stock moves will make no sense to you. The action in water stocks is a good case in point. While many of these companies are really more construction plays than any particular play on water quality or water conservation, Wall Street nevertheless took them on a run that has recently cooled off in a big way.

Watts Water Technologies (WTS) is down about 15% since my last update on the company, underperforming the larger industrial sector, but still doing less-bad than other water theme names like Pentair (PNR) and Xylem (XYL) over that period. Although I still wouldn’t call Watts cheap today, this sector is worth watching as investors bail out on their one-time darlings and valuations get more reasonable.

 

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As Water Stocks Come Off The Boil, Watts Water Technologies Looking More Reasonably Valued

Watts Water Tech Riding The Tsunami Of Water-Stock Love

 

Water is cheap – I pay less than $0.003/gallon to my water utility, but water stocks are another story. If you want to own a good water infrastructure company, be prepared to pay at least $17 for every dollar of EBITDA, and in some cases quite a bit more. I’d like to say that these premium valuations are justified by the underlying fundamentals, but I still don’t see it – I like the leverage to increased efficiency and digitalization, and I understand the growing power of ESG investment mandates, but it still seems excessive.

Given what’s happening in the space, I’m not that surprised that Watts Water Technologies (WTS) is up another 40% in just the four months since my last update on the company. Water infrastructure companies are reporting torrid demand and strong operating leverage, and again, this is a popular place to play. While I do think Watts is more reasonably priced than many stocks, and I think the probability of additional beat-and-raise quarters is higher here than for many sectors, I can’t make sense of the valuation beyond investors wanting to pile into a hot space.

 

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Watts Water Tech Riding The Tsunami Of Water-Stock Love

Watts Water Technologies Looks Like An Expensive Way To Play Water Themes

 

Water technology remains an area of the market where you really don’t go looking for bargains, and this has been true for quite some time. What I find interesting, though, is that these stocks haven’t necessarily lived up to the hype – the growth has been fine, and there’s been margin improvement, but the sector hasn’t been that breakaway success you might have expected, and the returns haven’t been that exceptional over the last three or five years.

Turning to Watts Water Technologies (WTS), there are a lot of things I like about this company, including its credible and growing leverage to smart/connected devices. What I don’t like, not surprisingly, is the valuation. I do expect non-residential demand to improve in 2022, and I do see a window of opportunity for connected devices to drive margin improvement, but that seems well-reflected in the share price.

 

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Watts Water Technologies Looks Like An Expensive Way To Play Water Themes

Rexnord Still A Work In Process

It has been a while since I've written on Rexnord (NYSE:RXN), largely because I thought the valuation wasn't all that interesting back in mid-2013. The shares are up about 10% since then, which is well below the return of the S&P 500, but in line with rival Regal Beloit (NYSE:RBC) and better than ABB (NYSE:ABB). Since the time of that last article, Rexnord has borne the brunt of a rough stretch in its industrial and resource-centric end-markets, and the company's margins have gotten worse, bringing the company down to mid-pack (or a little worse) in the industrial conglomerate space.

These shares have had a run since the election, but there may still be enough value here to merit a closer look. I really like the company's leverage to healthier end-markets like aerospace and food/beverage, as well as the prospects for improvement in industrial markets, eventual improvement in resource industries, and possibly a renewed focus on water infrastructure spending in North America. I believe management still has to earn the benefit of the doubt with respect to margin improvements, but mid single-digit FCF growth can support a fair value above $21 and a double-digit total expected return.

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Rexnord Still A Work In Process

Watts Water Pursuing Multiple Avenues Of Self-Improvement

Watts Water Technologies (NYSE:WTS) has had more than its share of management turnover in the past 15 or so years and the company's returns on capital have long been less than you'd expect from a company with market-leading products, but current management can't be faulted for sitting on their hands. Not only has the company undergone a fairly meaningful product portfolio restructuring, management has also set out to streamline its distribution and manufacturing footprint, while also seeking out cross-selling opportunities and international growth, and pursuing reinvestment in product development.

Margins have been picking up (on a non-GAAP basis), but organic growth hasn't been so impressive. What's more, the company's core markets aren't looking tremendously dynamic. I accept that companies in the water technology space often get a premium valuation, but paying a double-digit multiple on 12-month EBITDA for a company that is likely to generate high single-digit EBITDA growth isn't so appealing to me right now.

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Watts Water Pursuing Multiple Avenues Of Self-Improvement

Seeking Alpha: Wall Street Betting That Mueller's Profits Will Start To Flow

The markets have long loved water/fluid-management stories like Xylem (XYL), ITT (ITT), and Franklin Electric (FELE), and if you can add a residential construction rebound, you have an even better story in the making. That has certainly worked for Mueller Water (MWA), as shares have risen more than 75% over the past year, 235% over the past two years, and about 300% over the all-time low set in November of 2011.

Not surprisingly, it looks like the market has put a definite premium on the recovery potential here. I do believe that residential construction is on its way back, and I also believe that Mueller's investment in advanced products like advanced metering (AMI), leak detection, and pressure monitoring will provide a nice kicker to its growth in valves and hydrants. Mueller shares do look pricey on a cash flow basis, and could be vulnerable if the residential recovery proves shallower than expected, but I won't ignore the possibility that strong leverage could lead to significant profit growth and even higher multiples.

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Wall Street Betting That Mueller's Profits Will Start To Flow

Seeking Alpha: Despite Attractive Market Shares, Rexnord Doesn't Look Too Interesting

More often than you might think, you find situations where there's a meaningful gap between the merits of the company and the merits of that company's stock. Rexnord (RXN) is a significant player in the process/motion control and water infrastructure spaces - two markets that not only have above-average long-term growth prospects, but where Rexnord holds the #1 or #2 market share position in the segments that produce about 85% of its revenue.

Put together market-leading positions, a credible management system/philosophy, and potential rebounds in key end-markets like construction, and I can see solid prospects for the business. The stock, though, doesn't make nearly so much sense to me. Even though the shares are down almost 10% over the past year, robust expectations for margins, cash flow, and/or EBITDA aren't enough to generate a fair value that makes these shares look appealing today.

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Despite Attractive Market Shares, Rexnord Doesn't Look Too Interesting