Evoqua Stock: Continuing To Bubble With Growth Drivers (NYSE:AQUA)

Investors have bailed out of many water stocks recently, but Evoqua (AQUA) has held up considerably better. As a company that is actually a good play on water quality (including water treatment and remediation), and not actually more of a play on construction, that makes sense. Even so, I’m not going to pretend that I expected the shares to be as strong as they’ve been – up almost 70% since my last article.

At this point, valuation remains challenging, but then I wouldn’t expect a company with above-average revenue growth and margin leverage potential to trade cheaply. Not only is Evoqua a good play on eventual PFAS cleanup spending, but the company is also well-leveraged to a wide range of growth markets and further growth in its outsource “water as a service” offerings.

Strong Results On Broad End-Market Strength

Considering Evoqua’s strong leverage to industrial markets in general (around 70% of revenue) and specific markets like pharma, electronics, and chemical production, it’s not so surprising that Evoqua is seeing strong end-market demand and expecting that strength to continue through FY 2022.

Revenue rose 13% in organic terms in the fiscal first quarter (the calendar fourth quarter), good for a 5% beat versus the average sell-side estimate. Growth was balanced across the Integrated Solutions & Services (or ISS) and Applied Product Technologies (or APT) segments, with 13% growth in each.

Gross margin was up slightly from the prior year, while adjusted EBITDA rose 21%, beating expectations by 8%. Operating income rose 48% on an adjusted basis, with margin up 160bp to 7%, while segment profits rose 32%, with 35% growth in ISS (margin up 230bp to 14.6%) and 20% growth in APT (margin up 90bp to 15.2%).

Few Obvious Areas Of Weakness

Evoqua looks set to go from strength to strength as the year goes on. Book-to-bill has stayed above 1%, and the company reported that the backlog in the ISS business rose 15% yoy and 2% qoq.

With the exception of municipal wastewater, all of Evoqua’s major end-markets are growing (though wastewater has traditionally been a significant market at close to 20% of revenue). I don’t believe there’s anything fundamentally wrong with that municipal market beyond budgeting issues and timing related to the pandemic and the eventual receipt of funds under the infrastructure bill.

As for the industrial markets that Evoqua serves, it’s pretty much good news all around. As I said, markets like pharmaceuticals and chemicals are strong, as is electronics, and “general industrial” activity is quite strong. Food and beverage is also a strong vertical, as commented on by many industrial companies, but Evoqua has curiously small leverage to this end-market.

I was also a little surprised to see relative weakness in the “aquatics” vertical given still-healthy results from Pentair (PNR), but this vertical includes customers like water parks where business still has not normalized.

Management’s guidance for the remainder of FY’22 was more than 3% above consensus, which actually strikes me as a bit conservative. Even with slowing growth in some industrial markets, I think there’s still going to be growth, and I think Evoqua is establishing beatable expectations for the remainder of the year.

Leveraged To Clean Up And An Ongoing Shift To “Everything As A Service”

It remains to be seen exactly what various regulatory bodies will do about PFAS contamination cleanup and future emissions standards, but I think it’s a safe bet to say that Evoqua is looking at a significant opportunity here in the coming years.

The state of California has proposed exceptionally low acceptable levels of perfluorooctanoic acid and perfluorooctane sulfonic acid in drinking water, and New Jersey has already adopted more stringent standards. Assuming that other states follow suit, I expect that many industrial companies are going to have to revise and upgrade their effluent water treatment infrastructure.

On top of that is the clean-up effort for existing contamination. There is $10 billion in the infrastructure bill to help fund cleanup efforts, and I would expect many large polluters to have to fund significant cleanup efforts above and beyond that amount. Evoqua already has 30% to 35% share in large PFAS remediation installations, and this looks set to become a significant multiyear opportunity for the company.

Beyond this is ongoing growth opportunities in the company’s “water as a service” offering wherein the company basically designs, builds, and operates water treatment systems for customers under long-term contracts with guaranteed minimums. Not only are more companies looking to shift to a more variable cost structure (more “as a service” instead of owned equipment), but given the evolving standards for water quality, it may make more sense for companies to pay Evoqua to handle these needs going forward.

The Outlook

The timing and size of Evoqua’s PFAS cleanup opportunity creates a significant modeling challenge. To that end, while my long-term revenue growth estimate has jumped to over 7% on the back of cleanup/remediation and further growth in “water as a service”, there could still be meaningful upside, particularly as Evoqua is quite a bit larger than its rivals in most end-markets. On top of all that are ongoing emerging opportunities – purity requirements for semiconductor production are only going higher, and likewise in many other industries, while new markets like offshore wind (where water used to cool turbines has to be treated to prevent scaling and fouling) come online.

As revenue grows, I do expect meaningful scale advantages, and particularly as the company moves more of its business from product/equipment sales to contracted bundled services. I’m now looking for long-term FCF margins in the mid-teens, but again I’m acknowledging above-average modeling uncertainty here.

The Bottom Line

High single-digit revenue growth and high-teens FCF growth aren’t enough to drive a compelling fair value on a discounted cash flow basis, but again there is the potential of meaningful future upgrades to the outlook. There are similar challenges with a multiples-based approach – Evoqua shares already trade at more than 21x forward EBITDA, but the market generally doesn’t mind paying up for companies with differentiated revenue growth opportunities and significant margin leverage potential.

There are definitely times where the right call is to just hold your nose, ignore valuation concerns, and buy. That was certainly true with these shares a year ago, and it may well be true now. I definitely like the growth story here, but “ignore the valuation and just buy” is a tough call for a GARP guy like me to make.