Water Utility Stocks Are All Bubbly

Don’t think there are no crocodiles because the water is calm.
Malayan Proverb

Investors have been deluged by articles about the need for clean water in the Western United States and Far East.  In the US, the influx of residents to Nevada and California has strained those state’s water infrastructure.  Likewise, the Wall Street Journal has published numerous articles about the coming water crisis in India and China since those countries lack the water resources to support their growing population.  China has already experienced several major water shortages because of chemical spills. 

Unfortunately for investors, the increased focus on the coming water crisis has already been reflected in many of the stocks.  Most of the good water plays are already sporting bubbly valuations that make the stocks unattractive.  Nevertheless, this sector will continue to experience strong growth so understanding the stocks and the industry is a worthwhile endeavor because eventually the stocks will experience a sharp correction. 

There are numerous ways to play the growth in water and water infrastructure so I’ve broken the water industry down into several sub sectors:  Water Utilities, Pipes, Filters, Pumps, Testing, Large Cap Water Plays and Other.  I wouldn’t know a can of Pringles from an 18 inch RIB PVC sewer pipe, but having reviewed the stocks in the industry, these classifications make sense to me. 

The following chart highlights some key statistics for each sub sector.  All statistics and charts are courtesy Baseline. 

Water Utilities

The most obvious play the water theme is by investing in water utilities. But, as is often the case with investments, the most obvious plays aren’t the best ones.  That’s because water utilities aren’t exactly undiscovered stocks.  While these stocks have come down in price recently, they have on average already risen 200% – 300% in the past two years.   

The water utilities are monopolies with steady earnings and decent growth rates which make them very attractive investments.  Like gasoline, demand for water is very inelastic.  No matter what the price, you need to buy water.  But unlike gasoline, there aren’t any substitutes for the product.  Therefore, aside from weather variations, demand for water is constant and predictable.  These companies are a stock analysts dream because it’s not hard to forecast what the companies will earn in the upcoming years.   

In addition, the industry is highly regulated, which is both an advantage and disadvantage.  It’s obviously an advantage because most of the water companies are monopolies and therefore aren’t subject to competition.  Also, dealing successfully with regulators when doing acquisitions in a consolidating industry is a competitive advantage. 

The regulators are also spurring the current growth and consolidation in the industry.  Regulators hold great power because they are in control price increases.  But regulators usually tie rate increases to improvements in the utilities infrastructure.  In other words, if a utility wants to increase the price of its water, it has to spend more to improve its plant.  Otherwise, the regulators will likely decline a request for a rate hike. 

The increased cost of doing business has allowed larger publicly traded utilities to consolidate the small operators with limited resources and rate bases.  This consolidation trend is what has spurred so much growth and interest in the water utility sector over the past several years. The 50,000 smaller water utilities across the country can’t afford to upgrade their infrastructure and therefore, usually don’t get their requests for rate increases approved.  And even when a utility spends on infrastructure, a requests for rate increase often involves a lengthy and difficult to predict process.  Therefore, larger utilities with more resources and geographic dispersion have a significant advantage to small utilities which are bound within a geographic region.  Many of the smaller utilities are now selling to the larger companies who have these resources.

Regulators can also greatly increase the cost of doing business by adding new regulations. State and national regulators can both necessitate upgrades of infrastructure which can make it prohibitively expensive to operate smaller utilities. The EPA has increased the testing and filtration requirements numerous times and the new concerns over the environment will likely add to the pressure for higher water standards.   In fact, the EPA recently indicated that it expected water utilities to increase their expenditures on new pipes by 10 fold. 

Offsetting the positives from the consolidation trend are several major negatives.  As I mentioned, the water utilities have to spend a ton on infrastructure because of the general run-down state of many water systems in the United States.  In fact, none of the publicly traded water utilities generate free cash flow (defined as cash from operations less capital expenditures) because they spend so much money on infrastructure and dividends.  The companies therefore constantly have to access the capital markets to raise additional capital which can dilute existing shareholders. 

Many investors also assume that water utilities are a play on the "scarcity of clean water."  However, much like some electric utilities have to purchase natural gas to make electricity, many water utilities have to purchase a significant portion of the water they re-sell to residents and businesses.  In this case, water utilities are essentially distributors.  Therefore, in drought years, the price of water increases for water utilities.  And because it takes time to get approvals for rate increases, the water utility companies often get squeezed when water becomes scarce. 

While the water utility business has been billed as a growth sector, it’s far from being a "high-growth" sector.  The organic growth rates of the water utilities aren’t much better than overall growth in GDP.  Even with acquisitions, revenue growth for the water utility group as a whole is only expected to be up 4% this year and earnings are expected to be up 6%. 

Given these growth characteristics, the water utility stocks are trading at very high valuations.  Most of them trade at 30x earnings vs. electric utilities which trade at around 16x forward earnings.  No stock can sustain a double digit P/E multiple on low single digits growth.  The following chart shows that despite the recent correction, water utility stocks are still trading at relatively high historical valuations.

Aside from the hype generated by the numerous news articles about the upcoming water crisis, several other factors have contributed to the high valuations in the group.  First, many of the existing public water stocks are themselves trading at take-over premiums.  Several of the smaller publicly traded utilities, such as Connecticut Water (CTWS) and Southwest Water (SWWC), are considered perennial takeover targets. 

Second, most of the investors in water utilities are small retail investors that are holding or have held the stock for long periods of time.  The overall trading floats for the smaller publicly traded utilities causes any additional share buying to drive up the price.  In fact, institutions only own 36% of the largest publicly traded water utility, Aqua America.  The rest is owned by retail investors who don’t trade the stock aggressively. 

So with those caveats, let’s take a quick look at the publicly traded water utility companies.

Aqua America (WTR)

Aqua America provides water or wastewater services to customers in Pennsylvania, Ohio, North Carolina, Illinois, Texas, New Jersey, Florida, Indiana, Virginia, Maine, Missouri, New York and South Carolina.

Aqua America is currently the only stock that is "institutional-quality", in my opinion.  The company has an experienced management team, good historical results and trades over 1.0 million shares a day.  The company used to be called Philadelphia Suburban until it became more aggressive in its efforts to consolidate the fragmented water utility industry.  It subsequently changed it’s name to Aqua America to reflect its growth outside of PA. Now, the Company only generates 56% of its operating revenues in PA.

The company began aggressively making acquisitions of small regional water utilities in 1999. Since that time, the company has made over 125 acquisitions of smaller public water utilities.  The company generally buys companies at book value, which means that at 3x book value (where the stock is trading currently) all the acquisitions are automatically accretive.  WTR is in essence a turnaround specialist.  It invests in small, poorly run utilities, injects capital and provides professional management.  Many times, WTR can increase rates shortly after purchasing a smaller utility because regulators actually welcome WTR’s approach to the business.   

WTR has grown in the fastest growing parts of the country.  It is well positioned geographically in the SouthEastern US in Virginia, North Carolina and Florida.  In addition, WTR has recently entered the Texas market.

The customer growth rate in 2003 was 23.8%, and reflects the additional customers obtained in the AquaSource acquisition on July 31, 2003. In 2004, the customer growth rate was 11.5% and reflects the additional customers added through the Heater and Florida Water Services acquisitions. In 2005, the customer growth rate was 3.5%. Overall, for the five-year period of 2001 through 2005, Aqua America’s customer base increased at an annual compound rate of 8.9%.

Finally, I like WTR because it doesn’t pay for much of its water because it owns most of its water resources and treatment facilities.  Therefore, its margins are steady and higher than most of the other companies in the group. 

All in all, the company is easily the leader in the industry and is the most attractive stock in the group.  However, this is fully reflected in the stock’s valuation.  Trading at over 30x earnings seems expensive even for an industry leader, especially one that grew revenues and earnings less than 10% in the past year.  I would wait for an even more significant correction before becoming interested in WTR.

San Jose Water

San Jose Water is a public utility provides water service to a population of approximately one million people in the metropolitan San Jose area.  The company has experienced steady, strong growth because of the rapid expansion of the San Jose area.  SJW has growth revenues and earnings at approximately 10% over the past five years, which is almost double the organic industry growth rate.   

Another interesting aspect of San Jose Water is the SJW Land subsidiary.  SJW Land Company owns and operates parking facilities, commercial buildings and other undeveloped land primarily in the San Jose metropolitan area, and certain properties in the states of Florida, Connecticut and Texas.   SJW sold a parcel of land last year for about $3 million, which it reinvested in properties in Texas.  However, it’s difficult to estimate the value of the land from the information in the 10-K.  The book value of the land assets on the balance sheet is $38 million.  I would estimate that the land holdings are probably worth about 50% to 100% more than book value, which would add $40 million of unrecorded value. 

San Jose Water also owns approximately 1.1 million shares of California Water Service Group (CWT) which currently trades for about $38 per share.  That’s an additional $41 million of value that’s not recorded on the balance sheet. 

So of the $550 million market cap, over $80 million can be attributed to assets that aren’t related to the water utility.  That makes SWJ much cheaper than it initially appears.  If you subtract $80 million of value off the market cap of $550 million, the stock trades at a much more reasonable, but still expensive, 20x earnings. 

Offsetting these positives are a couple major negatives.  First, unlike WTR, San Jose has to purchase a significant amount of water each year.  Purchased water provides approximately 40% to 45% of San Jose Water Company’s annual production. This makes SWJ’s operating expenses much more variable than some of it’s competitors.  Surface supply, which during a year of normal rainfall satisfies about 6% to 8% of San Jose Water Company’s annual needs, provides approximately 1% of its water supply in a dry year and approximately 14% in a wet year. In dry years, the decrease in water from surface run-off and diversion, and the corresponding increase in purchased and pumped water, increases production costs substantially.

Second, SWJ faces significant capital expenditures in the upcoming five years.  According to the company’s 10-K, SWJ will spend $225 million over the next five years.  That will put a dent into the company’s capital structure.   

SWJ’s land and stock holdings make it one of the more interesting companies in the group.  In addition, the company is located in a perennially fast growing area of the country.  But even subtracting the land and CWT stock holdings, SJW’s stock still trades at 20x earnings, which I feel is expensive for any utility. 

American States Water

AWR is a public utility engaged principally in the purchase, production, distribution and sale of water in California. The company also distributes electricity in several California mountain communities.

One of the more interesting aspects of American Water are its efforts to enter the US government water management market.  In fact, AWR was one of the first utilities to win a water service outsourcing contract from the military.  This business has allowed AWR to expand outside of the California region. The company entered into agreements to operate and maintain the water and wastewater systems at Andrews Air Force Base in Maryland, Fort Story, Fort Eustis, Fort Monroe and the wastewater system at Fort Lee, in Virginia and Fort Bliss in El Paso, Texas.

The company has generally been successful receiving rate increases from regulators but had a minor setback in one of its operating regions.  The California Public Utility Commission actually imposed a 10 basis point reduction in AWR’s previously allowed ROE of 9.9% to encourage cost cutting, improve efficiency standards, and develop better procedures for planning, constructing, and documenting significant plant upgrades. 

Like the other utilities, AWR has a massive capital budget.  Over the past three years AWR has invested more than $200 million in its regulated utility business. And capital expenditures for its water supply and distribution facilities are expected to total $72 million in 2006.

The company’s balance sheet has not been one of the best in the industry.  While the company still has an A- S&P rating, the company was only recently removed from negative rating watch. 

American States Water is one of the more attractively valued companies in the industry.  However, the company’s Utility business is growing slower than the industry.  While the government outsourcing contracts will provide additional growth in the upcoming years, at 24x 2006 estimated earnings, I believe the stock is still too expensive to own at current prices. 

Southwest Water

Southwest Water owns and manages the operations of rate-regulated public water and wastewater utilities in Alabama, California, New Mexico, Oklahoma and Texas. 

Southwest Water has a high growth Service business which is also very attractive. The company operates municipal drinking water and wastewater systems under a contract basis for cities, public agencies, and other utility asset owners.   It also provides ancillary services, such as sewer pipeline cleaning, drinking water and wastewater laboratory analysis.  This "outsourcing" business is a nice growth business and gives Southwest "first dibs" in buying the operations, if the asset owner is willing to sell.  The drawback to the Service division is that margins are much lower than in the Utility division. The Services Group generates approximately 60% of the company’s revenues but only 30% of the company’s profits. 

In addition to the service business, Southwest has grown through several acquisitions.  In March 2005, Southwest Water acquired the assets of Novus Utilities, Inc., a Birmingham, Alabama-based contract operations company. In September 2005, the Company acquired the assets of a wastewater collection and treatment system located in Shelby County, Alabama.  And in October 2005, Southwest Water acquired all of the stock of Midway Water Utilities, Inc., a small water utility serving approximately 370 connections located in Denton County, Texas.

Southwest is a good micro-cap stock in the water utility industry.  However, it’s strong execution has already been reflected in the price of the stock.  SWWC trades at a premium multiple to the group, which I believe is already overpriced.   

California Water

California Water Service provides water utility and other related services in California, Washington, New Mexico and Hawaii through its wholly owned subsidiaries. California water operations account for 95% of the total customers and the company provides water service from Los Angeles to Sacramento.   

California Water Service has been one of the least aggressive utilities in the group.  The company under-invested in capital projects in the early part of the decade.  As a result, the California Public Utility Commission didn’t give the company nearly the level of rate increases it asked for.  In addition, the company has not made significant acquisitions despite the fact that it is the second largest publicly traded water utility in the US.  Over the past three years, the company has only made about $1 million in acquisitions. 

Finally, the company seems to be more affected by weather changes than its other peers in California.  The company has very wide swings in earnings and costs relative to its comparable companies, which causes the company to wildly miss or exceed earnings estimates from time to time.  CWT purchases an average of 48% company wide and up to 100% of its water in areas such as Los Angeles and San Fransisco, which accounts for the lower than average gross margins and higher variability in earnings.

The company does have land holding which it continues to sell off.  Relative to the company’s market cap, however, these real estate holdings seem rather small.  For instance, in 2005 the company recorded gains of $2.2 million, and $4.6 million in 2003. CWT is also facing a lawsuit which claims that the company is not re-investing the proceeds into utility projects as it is mandated to do.  I have therefore not given the company additional credit for its land holdings.    

CWT is showing signs that it is waking from its slumber.  The company’s capital expenditures have increased from $49 million in 2004, to $68 million in 2005, to $85 million in 2006.  This, in addition to a friendlier regulatory commission, should allow the company to increase its growth rates and become more consistent in growing the company. 

While it is one of the cheaper stocks in the water utility group, I believe the company is one of the less dynamic companies, as well.  Therefore, it’s discount is probably warranted.  And at 27x earnings, it’s still much too expensive to be considered a value stock. 

Connecticut Water

Connecticut Water Service’s water infrastructure consists of 28 non-contiguous water systems in the State of Connecticut.  Approximately 88% of the Company’s earnings were attributable to water activities carried out within its three Connecticut regulated water companies.

The Company’s water companies own various small, discrete parcels of land that are no longer required for water supply purposes. As of December 31, 2005, this land totaled approximately 370 acres. During 2005, Connecticut Water Service, Inc. sold 74 acres of land in Bristol, Connecticut for approximately $500,000.  Land holdings on the balance sheet are listed at $4.5 million.  If you assume that the book value is understated by 100%, the total land holdings could approach $9 million, which represents about 5% of the company’s market cap. 

The company expects earnings to be significantly lower in 2006 because the Company completed the sale its Barnstable Water Company to the Town of Barnstable, Massachusetts.  In addition, the company has been seeking a rate increase because of higher operating expenses.  The company believes that it can return to prior levels of profitability but obviously, any delays in rate increases will negatively affect the earnings. 

Connecticut Water is one of the most attractively valued companies in the sector.  This, along with it’s relatively small size, makes it an interesting takeover candidate.  For patient investors who don’t mind owning small, illiquid stocks, I believe CWTS makes one of the most attractive investments in the group.

Consolidated Water

CWCO is a different type of water utility.  The Company provides water services in areas where the supply of potable water is scarce.  Currently, CWCO uses its desalination technology to provide water to countries in the Caribbean basin. 

The Caribbean is an attractive market because these countries have (1) little or no naturally occurring fresh water; (2) limited taxes allowing for higher returns than most highly regulated countries and, (3) a large proportion of tourist properties, which historically have generated higher volume sales than residential properties.

The stock is attractive to investors for other reasons.  The company is not tied to regulators like the other water utilities.  That frees up the company’s capital budget to make acquisitions and develop new desalination technology.  However, the company still has long-term contracts with the government to provide water services much like the water utilities based in the US.  The company really enjoys the best of both worlds. 

While the growth and business model are attractive, the company does face certain special risks.  As mentioned, its distribution pipes and desalination plants can be severely damaged by hurricanes.  However, I would generally use weather related losses as a buying opportunity for CWCO. In addition to the volatile weather, the company also faces very volatile political risks.  The company has entered into long term contracts with several governments in the Caribbean, Mexico and Latin America but there’s no assurance that the governments will last as long as the contracts.   

The differentiated strategy and high growth rates have earned the stock a well-deserved premium.  Revenues have grown between 10% and 30% in the past three years and earnings have grown by up to 80%.  The company did have a down year in 2004 because of damage sustained from Hurricane Ivan.  CWCO should be able to grow revenues and earnings in the mid-teens.   This strong growth outlook is already reflected in the share price.  CWCO is currently trading at 35x this year’s earnings estimates and 29x next years estimates, which makes the valuation full, in my estimation.  However, investors should keep an eye on the stock in case of sharp pull backs and traders can always swing in and out of this relatively volatile stock.

Summary

As a whole, I can’t find much value in the water utility industry right now.  The dividend yields are too low and the P/E ratios are too high and, even after the recent correction, the stocks still trade at record high multiples.  I would therefore avoid the group in favor of some other stocks in the water infrastructure sector.  I’ll cover some of those names, later in the week.