Water's Cup Still Runneth Over

06/30/2009 1:00 pm EST


Roger Conrad

Chief Analyst/Managing Partner, Capitalist Times

Roger Conrad, editor of the Utility Forecaster and associate editor of Personal Finance, says spending on water projects will rise dramatically, helping two water utilities.

The Environmental Protection Agency (EPA) estimates the US will have to spend $335 billion over the next decade to keep the taps turned on, given aging [water] infrastructure and supply degradation. And the projected US requirement is dwarfed by the trillions of
dollars China and India will spend to support rapid urbanization and prevent the outbreak of waterborne epidemics.

Service providers are the highest-percentage way to play growth in global water spending. Demand has proven steady even during deep recessions, including this one. Water utilities’ earnings are based on the size of their rate base—the reservoirs, treatment centers, water mains, and distribution pipes they use to provide service. The more money invested, the more the rate base grows, which generates higher revenue, earnings, and dividends.

The catch is that government regulators must pass through the cost of [water companies’] investment into rates. Like all utilities, regulated water companies generally don’t get all
they ask for, particularly during recessions. Water rate hikes, however, are still much easier to push through than requested increases for electricity.

As a result, US water utes have continued to get most of their requests in a timely way this year. In fact, a number of states have launched pipe replacement programs, for which investment is recovered as incurred.

American Water Works (NYSE: AWK) and Aqua America (NYSE: WTR) are also growing via acquisitions. Some 85% of the US is still served by cash-strapped municipal water systems. Moreover, some 40,000 systems [are] too small for needed investment in
treatment required by ever-tightening regulation.

The alternative is to be acquired and absorbed by larger water utilities that can better spread out costs and enjoy vastly superior access to capital. In 2002, German utility RWE (Germany: RWE, OTC: RWEOY) bought out American Water Works
at several times book value. Since 2007, however, it’s been selling off its holdings at barely book value.

Their loss is our gain. RWE still owns 49% of AWK shares, which is likely to weigh on the market for a while. American, however, has a thriving business managing municipal systems and continues to pursue new contracts, as well as outright acquisitions in the 32 US states it serves, as well as Ontario, Canada.

AWK yields a safe 4.2% and is a Buy up to $22. (It closed above $19 Monday—Editor.)

Unlike American, Aqua owns 100% of the infrastructure it operates. The company has
completed hundreds of acquisitions since former Pennsylvania regulator Nick DeBenedicitis took the reins in the early 1990s. This year, it’s taken over another half a dozen, including a small municipal system in the Keystone State that could be the harbinger of more muni buys in the 13 states it serves.

Aqua’s earnings growth has been a picture of consistency for years. And with the company on track to invest a record $300 million in 2009, there’s more ahead. Buy Aqua America up to $23. (It closed below $18 Monday—Editor.)

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