Water Works

12/17/2004 12:00 am EST

Focus:

Neil George

Editor-in-Chief, Income Publication and Products, Agora Financial

"Millions are told every day that their water is unsafe," says Neil George, editor of Personal Finance. "And we're not talking about Third World countries, but rather here at home in our major cities." Here, he looks at the problem and the investment implications.

"EPA reports have found that more than 60 municipal water systems around the US have contamination levels that are near, at, or above federally mandated levels. And of the hundreds of water services around the country, nearly 300 have reportedly been in violation of clean water standards. And according to industry insiders and past EPA managers, many water treatment and services companies are fudging their mandated reports to the EPA. So the depth of the problems has yet to be truly plumbed. And t hose are just the challenges faced by the US. The rest of the world has similar, if not worse, water woes. From various countries in the newly expanded European Union to Latin America and Asia, clean water is far from reality.

"Take China, for example. The government has recently disclosed that not only do millions have water shortages, but more than half of its entire population doesn't have access to clean water. It doesn't take a genius to figure out what's going wrong with water systems around the world. Little money has been invested in maintaining, developing, and expanding water treatment and distribution systems and services. This is why we continue to press our case for investing in water. Infrastructure investment in general and water system upgrades in particular will increase simply because they have to. Top tier economies such as the US and transitioning economies like China need clean water to survive. You can't run a competitive economy if your citizens are plagued by diarrhea, schistosomiasis, round and guinea worm, and lead poisoning.

"Water is a global, not local, commodity, just like oil and other precious natural resources. This means you can't just look at the domestic market when you start hunting for the biggest and best water companies. In fact, if you look at the industry broadly, the top water companies, which provide their services in the US, Asia and beyond, aren't based in the US. They're in Europe. These companies will be on the vanguard when it comes to fixing the water systems of the world, including in the US. The reason is simple: The size and scope of water system infrastructure is so vast you need to be very big to make the most out of providing clean water at an affordable price and still make a profit for shareholders.

"Let's start with one of the biggies of the world, based in Essen, Germany. RWE (RWEOY pink sheets) has water and other core essential service operations around the world. Currently, it's the #3 water company worldwide, providing treatment and fresh water service as well as waste water treatments through its various divisions, including Thames Water in the United Kingdom and American Water Works in the US. The company continues to build its revenues by investing for the long haul in key infrastructure sectors where it can dominate the market. Revenues are climbing at a recent growth rate of near double digits and margins are healthy enough to continue to bolster operating profit gains of nearly 30%. Yet, despite its core water reserves and its treatment and services units, the company's shares still trade at a deep discount to trailing revenues at nearly half. This makes it a key long hauler for your portfolio

"Next is the biggest, Paris-based Suez (SZE NYSE). Yes, the name is familiar as it's on one of the crucial canals of the world, which the company engineered. The company is now one of the world's biggest water treatment companies, with assets on all continents. Revenues are growing a bit more slowly than our German favorite, but remain steady is operating profits. And while it might be slow and steady for now, it pays to wait for the bigger long-haul gains, as it continues to pay its shareholders a steadily rising dividend. It's currently yielding more than 4%. Suez is a buy as well.

"There are the two other leading water firms also based in Paris. Veolia Environment (VE NYSE), better known as Vivendi, was formed in the mid-1800s to provide clean water to the French Empire's capital city. It has continued to expand, outlasting the empire of Napoleon, with assets that the sun never sets upon. It had a bad time, as past management dallied in diversification into entertainment. But after being spun off and changing its name, it's gone back to its roots and is now profitable. Revenues are gaining by more than 15% as demand for more water treatment services around the world is expanding its solid book of business assets. It's a buy with a dividend to boot up to $35 a share.

"The final French water works company is Bouygues (BOUYF pink sheets). The company is a conglomerate of massive construction, services and even some telecommunications. Revenues are expanding globally at a faster pace, aided by some of its more near term exciting business units, including its broadcasting businesses. But water still works for the company. As the world will need construction projects for water treatment and distribution, Bouygues is one of the very few that will be able to meet the demand. It also pays a bit of a dividend, enabling us to be patient. Bouygues is a buy for the longer-haul battle for cleaner water (on top of its other core assets). And if it does spin off its water unit, that's all the better as we'll recognize a nice windfall to boot.

"Not all of the water companies of the world are overseas. Consolidated Water (CWCO NASDAQ) continues to develop its own niche in providing clean water at an efficient and profitable level despite the challenges. While freshwater sources are among the rarest in the world (accounting for reserves at barely 1% of all known planetary water), saltwater is quite abundant (at more than 97% of the overall supplies). There are many projects underway to purify saltwater for consumption; and though few are profitable now, expansion efforts continue. Consolidated Water operated primarily in the Caribbean, providing desalination and purification of saltwater for markets throughout the region, including territories of the US. Contract revenues continue to build at a recent average annual rate of more than 19%. And with greater size comes greater efficiency, as operating profits continue to expand. The company is still small, but it's not cheap. The shares trade at more than five times trailing revenue. But in a world thirsting for clean, potable water, there's a price to be paid and Consolidated might be worth it as a small buy for the more speculative investor."

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