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Parnassus Digest - May 2014

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The Water Industry - The Case for Pentair and Xylem

The world is facing a staggering fresh water shortage. In a 2009 report, the 2030 Water Resources Group (WRG), a consortium of public and private entities that promotes sustainable water resource management, estimated that by 2030 projected population and economic growth will lead to global water demand that exceeds current supply by 40%. In this issue of the Parnassus Digest, Senior Research Analyst Minh T. Bui discusses two companies that provide equipment and services necessary to address the growth of the water industry.

Water demand is primarily tied to economic growth and development, with agriculture representing close to 70% of the demand, followed by industrial needs (18%) and the remainder coming from domestic uses. The 2030 WRG report projects that global water demand will increase at a compounded annual growth rate of 2% through 2030, while the supply will remain relatively unchanged. As this imbalance worsens, there will be an increasing need to improve water productivity through equipment and services used for the transport, treatment and testing of water.

The global water industry is estimated to be a $500 billion market, split between a $280 billion market for equipment and services and a $220 billion market consisting of public utilities and engineering and construction companies. From a broad point of view, demand in developed markets is driven mostly by repair and replacement due to an aging infrastructure and increased regulatory requirements. Meanwhile, developing markets are more geared towards water infrastructure build-out to support industrial expansion, agricultural development, population growth and urbanization.

From a global perspective, various industry surveys indicate that water infrastructure spending requirements could reach a cumulative total of $12 trillion to $22 trillion over the next 20 years. This wide range is due to different assumptions with respect to population growth, costs of technology and levels of service. Moreover, some of the estimates include the costs of new capital infrastructure but exclude the costs of maintaining existing infrastructure.

Given these capital needs, companies that provide equipment and services necessary to address this market should see continued growth over the long-term. We think that the water industry should be able to sustain an annual growth rate of 2%-4% over the next several years. Developing markets should see faster growth between 6%-8%, while developed market growth rates should range between 1%-3%.

Portfolio Companies
We believe that the water industry offers compelling investment opportunities given the industry’s secular tailwinds. Pentair1 and Xylem2 are two portfolio holdings that participate in the $280 billion market for equipment and services. In addition to the growing relevancy of their businesses, they both have the investment characteristics that we require for our holdings, including sustainable competitive advantages, strong management teams, reasonable valuations and strong environmental, social and governance (ESG) profiles.

Pentair is a $15.4 billion market capitalization, diversified industrial company with leading positions in pumps, filters, valves and thermal solutions. The company had total revenues of $7.5 billion in 2013, with about 45% of that total derived from water applications through its Flow Technologies and Process Technologies segments. Xylem, a $6.6 billion market capitalization company, is considered the world’s largest water pure-play with more than 90% of its $3.8 billion in revenue coming from water applications. The company has leading positions across the transportation, treatment and testing of water, as well as in the building services, industrial water and irrigation markets.

Both companies have positioned their businesses around the nexus of food, water and energy demands. Over the coming decades, changing demographics and population growth, increasing energy demand, shifts in food consumption and water scarcity will be powerful trends driving growth in the three areas of the nexus. Pentair and Xylem are poised to benefit from these positive trends which, as a well-known fact to investors, is already reflected in the companies’ stock valuation. Our differentiated view is that the current market consensus underestimates the long-term earnings power of these two companies.

Pentair
Pentair merged with Tyco’s Flow Control business in 2012, creating a stronger, more balanced industrial and water flow control company. This transformative merger nearly doubled Pentair’s size and broadened the company’s product offering by combining Tyco’s expertise in valves, controls and water and fluid management tools with Pentair’s expertise in filtration, pumps and its legacy portfolio of electric enclosure products.

We think that the biggest source of earnings upside will come from additional cost savings and synergy opportunities stemming from the merger. Pentair implemented lean techniques nearly a decade ago with the objective of reducing costs through operational efficiencies, supply chain management and cash flow management. The company will continue to apply the same lean culture across the Tyco Flow Control unit.

At the time of the merger, Pentair’s management outlined $160 million in cost savings by 2015. However, once the merger was completed, management was able to identify an additional $70 million in cost synergy opportunities. Consequently, the company updated its 2015 synergy guidance to $230 million.

More recently, the company realized $130 million in annual cost savings during 2013, well above its initial 2013 target of $90 million. As a result, operating margin expanded from 10.9% in 2012 to 12.6% in 2013. In addition, management again raised its total synergy expectations to $310 million, which would translate to an operating margin over 16% by 2015.

We consider that these upward synergy revisions demonstrate Pentair’s ability to execute on its goals and that there are still ample sources for additional cost savings through lean processes. More importantly, the majority of the cost synergies are derived from initiatives under management’s influence, such as productivity improvements, back-office standardization and direct sourcing programs. This means that the company has control over its margin improvement trajectory and that it will depend less on volume growth to drive earnings growth. Overall, we think that there is more upside to the cost synergies target and that operating margin can continue to improve beyond 2015.

Xylem
We view Xylem’s portfolio as one of the strongest in the industry. The company has a sticky installed customer base, strong brand loyalty, technology leadership and a global reach. The large installed customer base allows Xylem to sell higher-margin aftermarket products and services. This aftermarket business represents close to 40% of the company’s revenue, and it provides a predictable and stable source of revenue and income.

Similarly to Pentair, Xylem still has significant long-term opportunity to drive operational improvement through the implementation of lean processes and other rationalization initiatives. Management expects operating margin expansion of 10 to 55 basis points annually over the next years, leading to an operating margin of 14%-15% by 2017, compared to 11.8% in 2013. We see no structural reason why the margin cannot reach, and maybe even exceed, that level.

Having spoken earlier this year with the new CEO, Patrick Decker, we think that he has the right skills and experience to lead the company. He joined Xylem from Harsco, a global, diversified industrial company, where he successfully implemented lean manufacturing and Six Sigma continuous improvement processes. Before that, he was the President of Tyco’s Flow Control business before the merger with Pentair. We’re confident that he will continue to focus on executing the lean enterprise implementation and leverage Xylem’s leading portfolio.

We think that investors have become too pessimistic about Xylem’s growth potential due to its high exposure to Europe (36% of 2013 total revenue) and the municipal water markets (34%). Spending in those markets could still be constrained in the near-term, but with low expectations from investors and signs of stabilization in Xylem’s end-markets, we see a compelling opportunity to own a leader in the water industry for the long-term.

1.As of March 31, 2014, Pentar Ltd. represented 3.0% of the Parnassus Core Equity Fund and 3.5% of the Parnassus Mid Cap Fund.
2.As of March 31, 2014, Xylem Inc. represented 3.2% of the Parnassus Core Equity Fund and 3.6% of the Parnassus Mid Cap Fund.

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