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Xylem

has always been an attractive, albeit expensive, stock with a strong position in an important, growing industry. Then the company moved to purchase

Evoqua Water Technologies
.
Now Xylem is a more attractive company with a better growth outlook—and a lower stock price.

Rye-Brook, New York-based Xylem (ticker: XYL) is a leading water technology company making pumps, valves, filters, and meters for industrial and utility customers. Sales in 2022 are expected to be $5.4 billion, which is significant for a pure-play water company. By comparison,

Danaher

‘s (

DHR

) water business, which it plans to spin off later this year, generates about $5 billion inside a mammoth $200 billion market-cap industrial and health conglomerate.

Now, Xylem plans to get bigger. It is buying Pittsburgh-based

Evoqua

(

AQUA

) in a deal valuing the smaller maker of water treatment devices at about $7.5 billion. The strategic rationale is simple—and compelling. Evoqua is a significant provider of water and wastewater treatment systems whose sales hit about $1.8 billion in 2022, and will bring expertise that Xylem does not have. “These are complementary businesses,” Xylem CEO Patrick Decker tells Barron’s.

It sounds good, but investors don’t love the idea. Xylem stock dropped 8% the day the all-stock deal was announced and hasn’t budged since. Some of the decline is due to “arbitrage traders” who profit by selling Xylem and buying Evoqua, betting that the spread between the two stocks, currently about $1.30, will disappear once the deal closes. But fundamentally minded investors sold some stock, too, blanching at the all-stock nature of the deal, which will dilute their ownership in Xylem of the steep price Xylem paid, says RBC analyst Deane Dray.

Evoqua wasn’t cheap. Its shareholders get 0.48 shares of Xylem for every share of Evoqua they have. At the time the deal was announced, that valued Evoqua at about 22 times estimated 2023 earnings before interest, taxes, depreciation and amortization, or Ebitda. That’s pricey. The

S&P 500

trades for about 12.3 times 2023 Ebitda, while Xylem trades for about 19.5 times.

Dray, though, likes the deal and believes the $140 million in identified cost synergies identified by Xylem are conservative. Include them and the multiple paid for Evoqua drops to about 16 times Ebitda. That’s still more than the market, but is palatable for a company growing like Evoqua. Sales and earnings are expected to advance at average annual rates of about 6% and 8% for the coming three years. That’s one reason Dray has a Buy rating on Xylem stock, with a $122 price target on the shares, up about 19% from Wednesday’s price of $102.81.

The deal isn’t without risk. Integration is always a concern, something that could make those promised synergies evaporate. Mizuho analyst Brett Linzey notes that Xylem is targeting cost savings worth 8.2% of Evooqua’s sales, while industrial acquisitions usually attain synergies of 5.7% of sales. “It is not to say these aren’t achievable but the burden of proof will be on management to execute,” Linzey explains.

Xylem, however, has experience with acquisitions having purchased nine assets over the past six years. While Evoqua is the largest deal, CEO Decker points out that Xylem successfully integrated a large acquisition when it purchased smart-metering company Sensus in 2016. Sensus was smaller—it had $840 million in sales at the time of the acquisition—but Xylem was smaller too, generating about $3.8 billion in revenue. Proportionally, the deal is roughly the same size.

Stifel analyst Nathan Jones believes deal risks are manageable and upgraded Xylem shares to Buy from Hold following the announcement while bringing his price target up to $124 from $115 a share. That’s about 21% higher than recent levels, a reflection of the stronger growth that the companies will be able to drive together. “This [is] a 1+1=3 situation,” Jones writes.

The numbers bear him out. Sales of the combined companies should grow roughly 5% a year over the coming three years, while earnings per share should increase at a 16% clip including identified cost synergies. That earnings growth is a couple of percentage points better than Xylem’s current estimated growth of about 14%.

If all goes well, the combined company should be a stock that continues to perform at least as well as they have historically. Xylem stock has returned about 15% a year on average since the company was spun out of ITT in late 2011, beating the S&P 500, which returned about 13% a year over the same span, while Evoqua has returned about 20% a year since the company’s IPO in late 2017.

With the two companies combining forces, those returns should continue for years to come.

Write to Al Root at allen.root@dowjones.com