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What’s “The #1 Blue Chip Stock of Tomorrow?”

Sleuthing out the water stock hinted at in the ads for Growth Stock Advisor

By Travis Johnson, Stock Gumshoe, January 18, 2018

“This safe growth stock should be a lock in your portfolio for the next 25 years.

“You Must Invest Before April 1”

That’s the headline that’s getting the attention of Gumshoe readers, as several folks have asked me today about the “Blue Chip Stocks of Tomorrow” pitch from Tony Daltorio.

I’ve never looked at one of his ads before, and know nothing about the track record of his Growth Stock Advisor ($77, published by Investors Alley), but he says he’s been a financial researcher and broker for decades and would have gotten you into “blue chips of tomorrow” like Coke and Exxon back when they were just huge, not gargantuan. So that’s the strategy he likes: Buy stocks that are already large and high-quality companies, but have a “clutch opportunity” to begin to really dominate their industry and set off on a long period of more dramatic growth.

Here’s how he describes it in the ad:

“You don’t have to invest in risky, unknown stocks to get wealthy and retire well.

“Forever stocks with massive returns could come from billion-dollar, innovative companies.”

It’s good to check out some more “regular” stocks now and again and not get totally sucked into the the speculative fervor of mining, biotech and technology small caps that tend to dominate the world of teaser promotions… so let’s dig in and see what these “Blue Chip Stocks of Tomorrow” might be. Heck, maybe we’ll even find some dividend payers in this bunch.

So what’s the attention-getter of the tease?

“… you’re about to see the very best BCST staring right at their clutch moment.

“In fact, they’ll be tackling the ‘#1 biggest threat facing the planet,’ according to the World Economic Forum.

“Like the past BCSTs I shared before, they have exponential growth in their future. Their revenues are estimated to be up an incredible 25% from 2016.

“That’s better than Apple or Google.

“Their industry is about to explode to $1 trillion dollars by 2020 (it currently sits above $500 billion).”

OK… that may be splitting hairs, Apple is certainly not in a rapid growth phase on the revenue side, their year over year revenue growth most recently was 12%, but Alphabet, whose revenue is less than half of Apple’s, is still awfully close to 25% (23.7% year over year in the most recent quarter). Still, we get the point: Those are not the fastest growing revenue lines in the market… so what’s this one being teased by Daltorio? Well, he’s not being shy about how much he likes it, more from the ad:

“I’m telling everyone who listens to buy and hold this company forever. A play so great you might even pass it on to your grandkids if you want.”

And then we get on to some specific clues that I can feed into the gaping maw of the Mighty, Mighty Thinkolator…

“I’ve watched this company for a year. It’s doing around $4 billion in revenue. Yet, no one’s heard of them….

“ calls this sector a ‘multi-trillion dollar opportunity’ ….

“The stock’s already up 100.84% and still climbing.

“My calculations predict the best window to invest is before April 1, 2018. This company could easily be a $50 billion dollar company….

“Its dividend yield has grown annually the past 5 years….”

So what’s this “huge opportunity” sector? Later we’re told that the opportunity will be brought by crisis: Water shortages.

That’s not an iconoclastic or contrarian position, of course, lots of investors are always intrigued by “water” stocks because of the nature of that commodity: Water is one of the only irreplaceable ingredients for life, and conflict over water has been a defining aspect of humanity for much of recorded history… and the shortage and unequal distribution of clean, fresh water on earth seems destined to create opportunities for investment gains, somehow.

So we’ve seen plenty of water-related teaser pitches over the years, and lots of stories about the innovations in the space, from new pollution controls or water treatment facilities to water transport systems (including past efforts, mostly failed to tow icebergs or giant bags of water to drought-stricken areas). What angle is Daltorio pursuing here?

More clues from the ad:

“The future blue chip stock I mentioned before resides in the water space. Their stock is taking off, but there’s still time.

“They’re generating close to $4 billion in revenues annually giving them a solid foundation.

“They generate revenue in 150 different countries. The US only accounts for about 46% of their overall revenue.”

We’re gold that this business sources, collects, treats and transports water… so that’s pretty much the whole magilla. What else?

“In 2016, they made major acquisitions in the ‘smart water’ space. This means they’ve invested in cloud-based technology, smart meters, water analytics. New technology in an old industry is always the sign of a pioneer.”

And they’re working on desalination…

“They’ve spent 24 years researching how to remove minerals and salt from undrinkable water. The water is then used for irrigation and animal consumption.”

And the growth, we’re told, is spiking now… though the shares “just hit the perfect price point”:

“From 2011 – 2016, they kept revenue steady around $3.8 billion.

“After the final 2017 numbers are tallied, they are projected to increase that number 25%…up into $4.7 billion.”

So who is this? Thinkolator sez he’s teasing us about Xylem (XYL), the which was spun out of ITT (ITT) back in 2011.

A lot of water-related stocks have struggled to keep up with the market over the past few years — you can see this in the performance of the Calvert Global Water Fund (CFWAX), a mutual fund that specializes in all things water… that has returned about 27%, lagging behind the S&P 500’s 47%… but Xylem, though it has hit a few bumps, has dramatically outperformed both of those with a three year return of about 115%.

The risk, I suppose, is similar to the risk that most of the market faces right now: Most of the recent gains have not been because of dramatic earnings growth, they’ve been because of a dramatic growth in the PE ratio.

Or to put it another way, the earnings per share for Xylem right now are about the same as they were three years ago, roughly $1.90 in profit per share on a trailing basis… it’s just that in 2015 investors were willing to pay 20X those earnings to own a piece of the company, and today they’re willing to pay 40X those earnings.

That doesn’t mean the company is necessarily overvalued — perceptions change, both of markets and of individual companies, and companies can certainly become more valuable even before the actual underlying earned profits change. Sentiment about valuations is driven by future expectations, for the most part, so what seems to have happened is that the company went from having very low growth expectations to having high growth expectations.

Perhaps that’s partly because of the investments they’ve made — Xylem has been an active acquirer over the past couple years, most notably with the purchase of Sensus in 2016 and has been talking for a couple years now, most notably in their investor meeting last April, about using those acquisitions to accelerate growth. They also added another decent-sized company to their portfolio in December, with the $400 acquisition of Pure Technologies (water system analytics and leak detection).

What appeals to me probably more than anything else here is the acquisition strategy — particularly the fact that they are making these acquisitions to expand more into growing and higher-margin markets using cash and relatively low-cost debt and, therefore, not diluting shareholders by issuing new shares to pursue this growth. That doesn’t necessarily work forever, of course — at some point you add enough debt that the balance sheet begins to appear a bit worrisome — but Xylem doesn’t appear to be in any danger of overextending itself just yet, and their history as a division of ITT, one of the more successful conglomerates of the 1960s and 70s before it was broken up in subsequent decades, gives some indication that M&A is likely to be a strong part of their DNA.

Before the Pure Technologies acquisition (which isn’t in the books yet), they had about $2.2 billion in long-term debt… and that debt is costing them something in the neighborhood of 4% or so, perhaps a little more, so I’d guess their debt service is likely to stay well under $100 million a year (most of the debt has at least 4 years to run before the bonds will need to be refinanced), easily handled with EBITDA of well over $700 million.

Even if you allow for depreciation, which is large for Xylem and is a real expense, there’s still almost $500 million in EBIT — earnings before interest and taxes — enough to easily handle their ~20% effective tax rate and $100 million in interest payments and leave quite a bit left over to compound earnings, pay down debt, and make more smaller acquisitions.

And pay dividends, which Xylem has been doing for five or six years. They have raised the dividend for five years in a row… and will likely announce their next dividend increase when they release their fourth quarter earnings on February 1. The dividend increases have been pretty solid, never much less than a 10% increase in the payout and the year-ago increase was 16%, which could be a good sign for management optimism about growth prospects.

It’s not a high dividend, to be clear — the current yield is 1%. But for the long term investor, if you’re looking at a 10 year+ investment time horizon and thinking of this as a “future blue chip,” as Daltorio believes it to be, dividend growth is often substantially more important than current yield. At the current growth rate, it would still take roughly five years for the size of the dividend payment to double (and therefore provide a 2% effective yield in the future for folks who buy today), so it’s not all that juicy — but it could become meaningful over time, and there is, with what analysts forecast to be 14% earnings growth over the next five years, an easy pathway to growing the dividend by at least that much. The payout ratio is right around 40% right now (meaning that about 40% of earnings are paid out as dividends), which is generally considered to be a nice, sustainable rate for slow-growth companies (though Xylem appears to be moving beyond its “slow growth” past).

If there is a catalyst coming in April, as Daltorio hints, it would likely be the company issuing any new guidance or saying something optimistic (or pessimistic, of course — catalysts can go both ways) at their next Investor and Analyst Day, which would presumably be in early April (last year it was on April 4, I haven’t seen one announced for this year).

So what do they do? The company is mostly focused on water infrastructure, with water and wastewater equipment and services, and on what they call “applied water,” which relates to more specific uses — building services, water equipment for factories, etc., but most of the focus lately has been on the growing “analytics” division, headlined by the Sensus acquisition, that is basically “smart water” technology… technologies that make water use more efficient.

The peer group includes quite a few companies that have similar valuations, with forward PEs generally in the mid-20s, though most of them have somewhat lower growth expectations — places to browse for comparison might be Flowserve (FLS), Watts Water (WTS), Badger Meter (BMI), Layne Christensen (LAYN), all of whom are different but also provide some similar products and services… or some of the more broad-based industrial suppliers who also have some competing segments, like AMETEK (AME), Circor (CIR) or Graco (GGG).

The potential for acceleration from here is perhaps boosted a bit by the fact that 2015 and 2016 were, in some ways, rough years for them — that’s because their industrial clients in oil and gas and mining were all having down years then, which is partly what kept Xylem’s revenues pretty flat (they did well with utilities and acquisitions, but industrial weakness slowed them down pretty sharply in 2015 from what could have been). If you’d like to get a taste for the company’s prospects, the 2017 Investor Day presentation from last April is still worth a look — the numbers are not current, of course, but it gives a pretty good overview of the strategy (the most recent earnings presentation is here, from October… next one is expected Feb. 1).

So where do we come down? Well, for me the negatives are that it’s relatively expensive at 40X trailing earnings per share, with a low dividend and trading at all-time highs… and the positives are that it in the process of growing earnings at about a 20% clip, with a tailwind from global spending on water infrastructure and some meaningful potential to expand on that if the oil and gas business really heats up again, and that they’ve shown some capital allocation skill in the recent past with growth-minded acquisitions that are accretive to earnings in pretty short order.

Analysts have been increasing their estimates slightly in recent months, though this isn’t a company that will get a huge jolt from tax cuts (they already pay a pretty low rate, and less than half of their business is in the US), and in a few weeks, once the Feb 1 earnings are out, the forward PE will begin to be based on 2019 estimates, which right now stand at about $3.23… so the forward PE is likely to bump down from 26 to 21, assuming the forecasted earnings don’t change. Paying a forward PE of 21 still seems high, particularly if, like me, you’re a little nervous about the broad market’s valuation… but for a company with expected earnings growth of about 15% for the next several years, that’s pretty reasonable.

Which leaves me pretty interested in this one, actually — I don’t know if it will be the next blue chip, but I like the growth trajectory and the financials, particularly compared to the other water equipment stocks I’ve looked over lately, so I’ve thrown a few of my chips on the table and bouight a small position… with a mind to possibly expanding it after earnings as we see what the next dividend hike looks like and whether they have any updates to their guidance. So the Irregulars will see that in the next update to the Real Money Portfolio, which should come out late tomorrow… and we’ll see where it goes from here.

I don’t know what the short-term future will bring, and I would not count on an abrupt move in the stock, but I think the odds are pretty good that they can, if management is successful in following the strategy, become a solid long-term growth stock. If they’re to reach that goal of a $50 billion market cap that Daltorio cites, they probably have a long row to hoe to get there, and that would be a pretty substantial 300%+ increase in the current $12 billion market cap — but the addressable market is certainly large enough. The largest risk that I see, beyond the unpredictables of a “bad quarter” or a surprisingly pessimistic forecast from the company when they next update investors, is that I could be overpaying at ~20X 2019 earnings. The stock could easily drop by 30-40% if investors decide to start paying 12 or 14X forward earnings for large-cap industrial growth stocks instead of paying 20X forward earnings — that’s possible if sentiment shifts or interest rates rise dramatically, but is unlikely to happen abruptly.

That’s just my opinion and assessment, though, and when it comes to your money it’s your thinking that matters — so what say you? Interested in Xylem, or do you see other water treatment and equipment companies as more appealing? Think the whole sector’s too expensive? Let us know with a comment below.

P.S. We’re always looking for feedback about the investment newsletters you’ve subscribed to — and we’ve never heard from any Growth Stock Advisor subscribers, so if you’ve ever tried out that newsletter please click here to let your fellow investors know what you think about Tony Daltorio’s service. Thanks!

Disclosure: As noted above, I have bought shares of Xylem. I do not own any of the other stocks mentioned above, and will not trade in any covered stocks for at least three days per Stock Gumshoe’s trading rules.

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4 years ago

I hear more positive than negative from you on this one which is unusual. Are you flashing a “buy” signal?

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4 years ago

40x on water, I think not.

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4 years ago

One of the best water stocks for the next few years: CDZI.
Disclosure: I am long this stock.

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Curt Squires
Curt Squires
4 years ago