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Water Water Everywhere

(Guest Commentary by Rick Konrad – May 28, 2009)

Dear Subscribers and Readers,

For those who had wanted to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary.  Rick is a regular guest commentator and usually writes for us every third Wednesday of the month.  Rick had a medical emergency last week and thus was unable to write for us.  Thankfully, he has recovered – we wish you all the best, Rick.  We also highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick will again focus on an investment trend that he believes is ripe for investment – that of our deteriorating water infrastructure.  Specifically, Rick's discussion will revolve around the opportunities surrounding water utilities – including, among other things, a friendlier regulator environment and the potential for further consolidation of inefficient operators in the industry.  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Keeping Your Feet on the Ground but What a Rally!” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

First of all, I would like to apologize for the delay in getting this post out to you, Unfortunately, as Henry has commented, I had a medical emergency that put me out of commission for a few days. I appreciate your well wishes and am glad to be back in the saddle again!

We have enjoyed a decent run in this market, which fortunately for us as readers and adherents of, Henry has encouraged a leveraged participation. But clearly, there is considerable hand-wringing out there as far as whether we have gone too far too fast.

Though anecdotally, positive management comments generally lean toward stabilization or a slowing of the downward spiral, there is a perma-bear cult that morosely speaks of a never ending recession, permanent dollar weakness, or hyper-inflation. Strong evidence of a pickup in the economy is starting to materialize however.

The Consumer Confidence Index, based on the Conference Board's US Consumer Confidence Survey, consists of the Present Situation Index, which increased from 25.5 in April to 28.9 in May, and the Expectations Index, which increased by close to 50%, from an adjusted score of 51 in April to 72.3 in May.

Similarly, today the NY Fed Empire State Manufacturing Survey has showed a 40 point rise in the last two months for the future general business conditions index, suggestive of the end of a recession's approach.

But many investors remain unconvinced. Are there market themes to exploit that are less dependent on an economic growth forecast. As I look back over major investment themes that have emerged over time, it has been possible to ride those waves almost oblivious to economic forecasts. For example, in the Reagan era, defense contractors had the assurance of political force as a major driver. Title insurance companies were a no brainer for years when securitization of mortgages essentially demanded that national scale title insurers would emerge to ensure a quality standard for title. Over the long run, these stocks ran essentially GDP unaware.

One theme that I suspect may mirror those successes is that of the water industry. It is trite to reflect on water's important role in maintaining life. However, I believe that the water industry will be a beneficiary of the infrastructure spending that is part of our economic recovery plans.

The US has gone through many decades of benign neglect of its water infrastructure. Consequently, the needs for repair are deeply seeded and the urgency of addressing these needs as a corollary of increased government spending should drive a boom. According to some, the needs for water infrastructure could be $1 Trillion over the next 20 years. Unlike most utilities, there is little remedial work…we deal with deteriorating water mains after they collapse.

Water utilities are probably as defensive an industry as one can find. Most revenues come from residential customers whose demands are very stable and predictable and hardly subject to much change in consumption. Industrial demand for water is economically sensitive but represents at best about 5% of the industry demand. In a downturn, industrial consumption may fall 10 or 20%, but hardly moves the overall needle.

Most water utilities in this country are tiny, serving two to three thousand customers. There are probably 50 to 60,000 water companies out there with very little scale to improve their service but with loyal and stable customer bases. So, there should be a continued consolidation effort. For a municipality, the competition for funds is great whether it be for roads, schools, a police force or healthcare facilities. The municipal utility is something that can actually be sold off to provide capital for other needs. Some 80% of the country is served by municipalities. Large consolidating utilities have the ability to put in place funding to meet the maintenance needs and improve the water quality.

The regulatory environment for water utilities also seems quite benevolent. Even in tough states like Pennsylvania and New Jersey, water utilities have received substantially (80-90%) of what they have asked for in revenue increases despite the difficult economic environment.

Water is after all, pretty cheap in most places. If your water bill is $40 a month, a 10% increase of $4.00 is less than the cost of a hamburger and fries. The price point makes rate increases fairly easy to swallow, particularly compared to electric or gas bills.

European utilities and the UL utilities are more globally focused and could see the US as a great opportunity, especially given the dollar weakness. The ten largest cities in the US, New York, LA, Chicago, Houston, Phoenix, Philly, San Antonio, San Diego, Dallas, and San Jose all operate their own water utilities. European utilities, not unlike companies such as Macquarie which operates toll highways, run municipal water utilities globally under very long term contracts. After a flurry of takeovers, most of these European consolidators have backed off their ownership and neglected the local regulatory environment and the politics. I suspect that the future consolidation for this industry will be American based.

There are several companies that I think are worth considering. In the water utility space, American Water Works (AWK) looks quite reasonable.

American Water Works Company, Inc. provides water and wastewater services to residential, commercial, and industrial customers in the United States and Canada. As of December 31, 2008, it served approximately 15 million people with drinking

water, wastewater, and other water-related services in 32 states and Ontario, Canada. The company owned approximately 80 surface water treatment plants, 600 groundwater treatment plants, 1,100 groundwater wells, 50 wastewater treatment facilities, 1,100 treated water storage facilities, 1,200 pumping stations and 100 dams, and 48,000 miles of mains and collection pipes. American Water Works Company also enters into public/private partnerships, including operation and maintenance contracts; and design, build, and operate contracts for the provision of services to water and wastewater facilities for municipalities and the United States military.

With a dividend yield of 4.6% and trading at 0.75 of book value [Henry's note: it is also trading at 1.1x tangible book value], the stock is down some 15% year-to-date. The negative is that its parent RWE will likely reduce its ownership further, but I suspect that increased float will actually be positive for institutional investors who can barely cram into the industry. Though on a PE basis, most utility analysts will prefer their electric utility, it seems to me that given the greater ability to put through price increases, a friendlier regulatory environment, and the large opportunity to consolidate inefficient competitors, growth will accelerate for AWK.

Other water utilities to consider include California Water Service (CWT) yielding about 3.4% , but sells at a much higher P/Book of 1.8 times.  Consolidated Water (CWCO) yields about 1.5% and sells just under twice book value.

Because of the significant acquisitions and capex spend for most of these companies; they are not generating significant free cash flow at this point. For example, at AWK capex represents some 40% of revenues, at CWT capex is 32% of revenues, and at CWCO it is merely 7% of revenues. However, given the inherent nature of these utilities, the actual maintenance capex needs for these businesses are modest.

There are many other companies to consider with respect to the manufacturers of equipment and processing systems for water treatment. We will be reviewing some of these and their valuations in Value Discipline in the coming weeks.

As the Rime of the Ancient Mariner proclaimed, water, water everywhere. Water is easy to take for granted, especially because it is low cost and seemingly ubiquitous. The ubiquity argument is not necessarily true. Even today in the U.S. there are some 670,000 households representing about 1.7 million people who live without running water. In 1950, 27% of households lacked such facilities. Here is an interesting article which describes how this has occurred:

Bottom line, this is an industry that does not really “feel” a recession. The users of water such as beverage companies, bottled water companies, manufacturers, electronics companies all have a need for pure and reliable water supplies. As a commodity, it is dirt cheap and consequently has considerable flexibility in getting higher prices. Most major municipalities which are budget constrained own a water utility which could easily be monetized. Finally, government spending is encouraging the upgrade of infrastructure which will no doubt include water infrastructure. I believe that this is a genuine growth opportunity that the current market has neglected.

Disclaimer: I, my clients, and friends may own current positions in some of the stocks mentioned here.

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