Introducing Watts Water, a Strong Commercial Construction Play for 2014

The water sector has long been favored by long-term investors who like thematic trends. The critical necessity of water in industrial and commercial applications, and the need for potable water supply for a growing global population means that the sector has strong long-term prospects. However, while the trend maybe upward, the water industry is notably exposed to demand from new housing and commercial construction project, and that hasn't been a great place to be in recent years in the West. However, with these end-markets looking set to pick up in 2014, companies like water products manufacturers Pentair $PNR and Watts Water  $WTS look  well placed.

Watts Water and Pentair look set for growth
Foolish readers know why commercial construction is a good sector to be in next year. Simply put, the commercial construction sector tends to follow the residential sector, and with the housing market in good shape going into 2014, investors in the commercial construction sector should be feeling optimistic about the coming year.

Indeed, a quick look at what analysts have penciled in for Watts and Pentair reveals a positive consensus for the next few years.

Forecast EPS Growth Rates	2013	2014	2015	2016	2012-2016 CAGR
Watts Water Technologies	4.5%	25.4%	21.0%	13.3%	15.8%
Pentair	33.8%	23.8%	22.5%	9.5%	22.1%

Source: Nasdaq.com

Pentair is attractive in its own right, but its forecast revenue mix for 2013 demonstrates that residential and commercial activity only represents 25% of its end market.

Source: Company presentations

Pentair's diversified exposure is fine if you want an industrial play, but for those investors looking specifically for a residential and commercial play then Watts Water is better placed. Pentair's diversification would normally be seen as a major plus point, but not if you want to focus on commercial construction.

Watts transforms itselfWatts stands out for its cash flow generation. For example, Watts has converted around 150% of net income into free-cash flow, or FCF, over the last three years. 

Assuming that  Watts converts 130% of net income into FCF in future, and using these rates and analysts' earnings-per-share forecasts from the table above, can give an idea of FCF per share. For the sake of simplicity, assume that EV is equivalent to current values.

Source: Nasdaq.com, author's estimates

Watts Water looks like a good value. The impressive thing about Watts is that although its trailing-12-month revenue of $1,452 million is marginally above its 2008 level of $1,432 million, the company has increased gross margins from 33.7% to 36.1% over the period.  In other words, should revenues start to increase in the future, Watts has a good opportunity to generate higher profits thanks to better margins. Moreover Watts generates 50% of its revenue from commercial operations, so it's heavily exposed to a pick up in commercial construction.

On a more negative note, Watts generated only 52% of its sales from the U.S. in 2012 with 40% coming from Europe, the Middle East and Africa, or EMEA. In fact, its guidance for 2013 assumes that EMEA will decline by 4%-5% with North American core business sales estimated to grow 3%-5%. While Europe is likely to remain soft, Watts will come up against some easier comparisons in 2014. In addition, in its latest investor presentation, management outlined that "overall market confidence appears to be improving" in EMEA, while is North American commercial market is "starting to see signs of a pick-up".  Both statements are good signs.

The bottom line
If you are looking for an overall industrial play then Pentair is worth a closer look, but for a developed market play on a resumption in residential and commercial construction spending then Watts is better placed. The company has internally transformed itself over the last few years in order to improve cash flow generation and its return on invested capital. As long as the U.S. housing market remains in recovery mode, it's a good bet that commercial construction will follow, and Watts is well placed to outperform.

Time to Buy Roper Industries

Industrial conglomerate Roper Industries (NYSE: ROP  ) serves end markets as diverse as toll roads, water handling systems,oil & gas drilling, and medical imaging. But Roper underperformed the market this year, rising less than 10%, and also recently cut its full-year guidance. Despite those setbacks, however, its management has successfully continued its long tradition of integrating acquisitions, while squeezing every last penny of profit from its ongoing businesses. Let's review five key reasons why the stock's current slump could actually be a buying opportunity.

Roper Industries lowers guidance
The company started the year expecting 13% to 17% in EPS growth, and 8% to 10% in revenue growth. But analysts have now downgraded their full-year expectations to 13.1% and 8.5% respectively. Essentially, Roper was forced to guide the market lower due to a combination of weaker-than-expected performance at its nuclear business, Zetec, and some weakness in oil & gas drilling activity in the US. The market didn't like these developments, but in the long run, Foolish investors just might.

Five reasons to buy Roper Industries
First, Roper's order book and backlog is in excellent shape. Orders grew 18% in the quarter, and with a backlog of more than $1 billion, there should be plenty of growth to come next year.

Second, the weakness at Zetec is due to some unexpected nuclear plants being shut down, and a corresponding lack of orders for its testing equipment. Roper's management expects these issues to continue into the fourth quarter, this part of the company could easily bounce back in 2014.

As for the weakness in US oil & gas drilling, the best way to gauge industry conditions would be to look at the oil services company Baker Hughes' (NYSE: BHI  ) North American rig count data. This metric is the most widely followed indicator of North American drilling activity. In other words, if Baker Hughes is reporting strength, then Roper could expect to see some future improvement, too.

Source: Baker Hughes presentations

The count seems to be stabilizing, and Baker Hughes believes it will only decline 2.5% in the next quarter. However, companies can still generate growth if they innovate, and Baker Hughes actually saw record revenues for its North American drilling services thanks to "innovative products and services".  In a similar vein, Roper has a new drilling product called DuraTorque, which is "doing very well" according to Roper's CEO, Brian Jellison. DuraTorque has good chances to succeed, because it's aimed at an area of the market (larger-sized directional drilling) that thus far hasn't lived up to Roper executives' expectations.

Third, Roper's most profitable segments are outperforming the rest of the company. Here is a breakout of its operating profits for the third quarter.

Source:company presentations

In the third quarter, energy operating profit declined 4% and its industrial technology profit was flat. On the other hand, RF technology saw profit rising 15% while its medical and scientific unit recorded a 64% increase in operating profits. The latter was helped by contributions from Sunquest, which makes medical information software. Nevertheless, organic revenue growth remained at 3%. As for its RF technology segment, Roper forecasts double-digit organic growth in the fourth quarter.

Fourth, a lot of Roper's other end markets are seeing strong growth. Medical imaging solutions and RF technology (particularly for toll roads) are forecast to have "solid growth" in 2014, according to Roper's management.

Moreover, if housing starts continue to climb, then Roper's metering and water handling solutions (industrial technology segment) should see some upside in 2014.

One of its peers, Watts Water Technologies (NYSE: WTS  ) , recently gave an outlook which I would only describe as being cautiously optimistic. Watts generates 60% of its sales from residential & commercial flow control products, so just like Roper's water handling systems, it relies on construction activity for its growth.

The increase in new US housing starts in 2013 has been a strong support to Watts' residential business, but housing starts have stalled to around 900,000 (annualized rate) due to interest rate increases in the US. Watts is predicting that starts will return to 950,000 by year end , and that "the anecdotal evidence we're seeing suggest that the nonresidential construction market is likely to turn sometime next year." If Watts is right, then Roper could see some, upside too .

And finally, Roper's management has managed to improve its operational performance, despite having to reduce guidance. For example, its cash flow conversion has gotten even better, enabling the company to keep its full-year operating cash flow guidance at $800 million. In addition, the Sunquest acquisition that Roper made in 2012 has bedded in well. Given Roper's acquisition history and current cash flow generation, you can expect more deals to come in 2014.

Where next for Roper Industries?
Roper's valuation doesn't look cheap in relation to some of its peers.

ROP P/E Ratio (TTM) data by YCharts

However, analysts have 12% earnings growth forecast for 2014. In other words, if it ends 2014 on "fair value," then the stock price will be up 12%, and there may be upside to these estimates.

Looking forward, Roper will want to see a snap-back in nuclear activity in 2014, some stabilization in US oil & gas drilling, and a pickup in US construction activity. All three look like decent assumptions. Roper expects the nuclear plants to be reopened, the Baker Hughes data is suggesting conditions are bottoming, and housing construction continues to grow.

There's a strong argument that Roper's current dip makes the stock attractive. At least, I hope so -- because I bought some.