In a water-scarce world, the Xylem-Evoqua deal makes sense. Why some think it's too expensive

Published Mon, Jan 23 20233:12 PM ESTUpdated Mon, Jan 23 20233:48 PM EST

Christina Cheddar Berk @in/christina-cheddar-berk-b864404/

Xylem is a powerhouse in the water space, and expected to benefit as a drier climate makes supplies more limited . More recently, it's benefited as investors have looked to its business model's strength and steadiness amid economic uncertainty. Xylem has reliable demand from the municipal water utilities it works with. The result has been a stock that trades at an attractive multiple even as the broader market has struggled. On Monday, Xylem decided to put this muscle to use: The company agreed to buy water treatment company Evoqua Water Technologies for $7.5 billion in an all-stock deal. Evoqua shareholders will receive 0.480 Xylem shares, or about $52.89, for each one they own. That's a 29% premium to where Evoqua shares closed on Friday. 'Not what we had in mind!' Evoqua shares jumped 14% on the news, but Xylem shareholders are balking at what they see as a pricey deal. Its stock tumbled about 9%, and a Raymond James analyst said the acquisition is "emphatically not what we had in mind!" Read more The world is running out of fresh water. How to invest in the companies trying to prevent this crisis Xylem management has been eyeing Evoqua for a while, analysts said. When it went public in 2017, Xylem reportedly tried to buy it. " Honeywell was also reportedly interested and ever since, we have thought AQUA topped the wish list of XYL CEO Patrick Decker," wrote Gordon Haskett analyst Don Bilson, in a research note Monday. "It so happens that Decker, over the years, has not been shy when it comes to discussing M & A. And not only has Decker openly discussed his willingness to make a transformational deal but with XYL trading north of 20x EBITDA, he has stressed that he has the firepower to make such a deal happen." AQUA 1Y mountain Evoqua is a leader in PFAS remediation In announcing the transaction, the companies touted $140 million in cost savings they expect to reap within three years of its closing. Cost savings estimates 'could be low' "That could be low," Bilson said. The combination could have the power to accelerate revenue growth, several analysts said. They see Xylem using Evoqua's contacts to push further into the industrial, health care and utility markets, and Xylem's multinational scale could help Evoqua expand its business outside the U.S. At present, Evoqua's business is 90% in North America. According to Bilson, Evoqua has pitched itself as a leader in PFAS remediation, which he said should "enjoy a long tail wind as work in this area really begins to build." There has been growing demand for removal of this "forever" chemical, and the service has been expected to become a larger piece of Evoqua's earnings over the next five-plus years . In a research note, Citi analyst Andrew Kaplowitz said there was "compelling strategic logic" in merging the two companies since their product and service offerings were complementary. However, he was not surprised to see Xylem shares trading off on the news because the deal will dilute the company's 2024 earnings. XYL 1Y mountain Xylem shares sell off in the wake of Evoqua deal That's one of problems Raymond James analyst Pavel Molchanov raised. He has wanted Xylem, which has long been a consolidator in the industry, to make an acquisition — he even cited the lack of deal-making in his downgrade of the stock earlier this month. However, Molchanov said he doesn't expect this combination — the largest water technology deal ever — is the right one. Not only won't it add to Xylem's earnings in 2024, it also has a high degree of integration risk, since there is so little overlap in the two companies' businesses, he said. The deal is expected to close mid-year and is subject to shareholder approval. Xylem shareholders will own 75% of the combined company, while Evoqua investors will own the remaining stake. Molchanov said he isn't so sure Xylem investors will want to approve the deal, though he admitted that "very few management-endorsed buyouts get vetoed by shareholders." Trading in Evoqua shares doesn't appear to indicate expectations of a competing bid surfacing, and some analysts have said they didn't expect one. However, having Honeywell offer a counterproposal "also wouldn't leave us slack jawed," Bilson wrote. Companies operating in the broader water treatment space may be attractive in the coming years. Water has been scarce in many areas due to changes in the climate. The water treatment services these companies can provide are seen as a key component toward working to solve this problem. — CNBC's Michael Bloom contributed to this report.