Water Ways for Flowing Profits

11/07/2003 12:00 am EST

Focus:

Roger Conrad

Founder and Chief Editor, Capitalist Times

"I think the water industry offers some great opportunities," says Roger Conrad, editor of The Utility Forecastercontributing editor to Personal Finance, and leading industry authority on the various sectors of the utility industry, from energy to telecom. Here, he explains the water sector and offers his top picks.

"Basically, there are three major facts that make the investment case for the water industry. One is that it is still a monopoly, which has allowed it to avoid some the chaos seen in other utilities sectors. Water is not an asset that can be moved around easily and consumers don’t want multiple water lines running into their homes. So the business is a natural monopoly and will likely remain so.

"Number two, the ownership of the nation’s water systems is very diffuse. We have about 50,000 water systems out there, many of which serve under 3,000 people. Water has always been very cheap and plentiful in most of the country, so there hasn’t been any real impetus for economies of scale. In telecom, about 90% of the industry is run by investor-owned companies, and in energy, this figure is 80%. But investor-owned companies represent only 10% of water systems. Most are municipally-owned.

"The third thing about the water system that is important is the environmental cost. While water has been plentiful for centuries, in recent decades pollution has caught up with us. We have seen increasing pressure to clean up water systems. As a result, water systems are spending more and more money and operating a water system is no longer a matter of just sticking a pump somewhere; you have to have treatment facilities that meet stringent requirements. And an alarming number of systems don’t meet these requirements.

"So a monopoly position, diffuse ownership, and sharply rising operating costs due to environmental issues, add up to a very simple case. Small systems can’t meet the environmental costs on their own. If a small system of 3,000 people requires a $10 million plant to meet regulations, it would result in a huge rate increase for consumers. But to hook up with a larger system that serves 100,000 makes these expenses less of a problem. In addition, many municipalities are in pathetic financial shape and can’t afford to make these adjustments to provide clean water. The only ones who can do the job are the investor-owned companies–and regulators are supporting this trend. So the investment case is that you have a small group of companies that little by little are taking over ownership of the water system.

"There are three types of investments we see in this sector. The first group is acquiring small monopoly systems that can’t meet the financial demands of providing safe water. The best play in the first group is Philadelphia Suburban, which recently changed its name to Aqua America (PSC NYSE) to reflect its expansion. It was a small local utility in the early 1990s. By acquiring small systems, it has become the nation’s largest regulated independent water service provider and is expanding in 15 states in the eastern half of the country. Suburban’s A+ credit rating was recently affirmed by Standard & Poor’s and the firm enjoys solid relations with regulators.

"The second type of investment are companies which can manage water systems for municipalities that don't want to give up political control but are in dire need of outside expertise. The best play in this area is Southwest Water (SWWC NASDAQ). Its niche is targeting multi-year contracts with munis serving less than 10,000 people in the southern tier of the country. This market is less competitive and allows the company to utilize its vaunted political skills as well as limit exposure from losing contracts. Results are exceptional: During the past four years, assets more than doubled, sales grew 81%, and earnings were up 94%. In the long run we think this is a very lucrative path to growth.

"The third type of water investment is in water technologies that both make money now and promise strong future growth. Reverse osmosis is a process that essentially converts seawater into safe drinking water. The surest bet is Consolidated Water (CWCO NASDAQ), which serves the Caymans, British Virgin Islands, Barbados, Belize, and the Bahamas. These island states have a finite amount of water and need lots more when giant tourist ships come to port. Consolidated Water bridges the gap by converting seawater to fresh via a reverse osmosis process. The stock has gotten a little rich in price recently, but it is a steady, strong, niche business.

"One other interesting technology that is related more to waste water than drinking water is Insituform (INSU NASDAQ), the sole licensee for a process to rehabilitate sewers and other pipelines without digging them up. In brief, a synthetic fiber is injected into the host pipe and set by a range of means including heating, hardening even old decaying pipe. This eliminates the need for costly digging and disruption, resulting in substantial savings. The potential market for Insituform is massive and the stock is a solid speculation."

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