An In-Depth Look At Basin Water's IPO (BWTR)

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Includes: BWTR, CCC, ROH, SHAW, WTR
by: Bill Simpson

On May 6th, Bill Simpson wrote an analysis of Basin Water (BWTR). The company's shares priced at $12 a share on May 11th, the high end of the range which was increased from the original $8-10 range prior to the IPO. The shares gained 40% up to $16.65 on their first day of trading, and are currently trading at $15. The text of Mr. Simpson's original writeup follows.

BWTR, Basin Water plans on offering 5 million shares at a range of $8-$10. Janney Montgomery is lead managing the offering, A.G. Edwards co-managing. Post-offering BWTR will have 17.7 million shares outstanding for a market cap mid-range of $159 million. Approximately 1/3 of the IPO proceeds will be going to fund capital expenditures, 1/3 to repay debt, and 1/3 for general corporate purposes. President and CEO Peter L. Jensen will own 16% of BWTR post-IPO. Mr. Jensen is not selling any stock on the offering, nor will any insiders.

From the prospectus:

We design, build and implement systems for the treatment of contaminated groundwater.

BWTR is involved with water treatment at the well level. According to the company, they've developed a proprietary, ion-exchange treatment system that reduces groundwater contaminant levels in an efficient, flexible and cost-effective manner. Ion-exchange is a process that treats contaminated water by using resins to chemically bond with specific contaminants, thus removing them from the treated water. BWTR's process uses multiple beds of ion exchange resins through which the water flows until it meets appropriate contaminant levels. The system is installed at the well-head and is scalable to treat various volumes.

BWTR possesses 3 current patents to protect this system.

The EPA has estimated that water contaminant treatment projects in the United States will require $53.2 billion in investment over the next 20 years. Groundwater is the main source of drinking water for approximately 50% of the US population. Population growth estimates forecast an increasingly greater need for groundwater supply going forward. Much of that potential groundwater supply is contaminated, and services from companies, such as BWTR, figure to be in increasing demand going forward. There is actually a decent level of 'barriers to entry' here due to government regulation. To be put into use a process needs the EPA designation of 'best available technology' a designation BWTR's process/ system has received.

They market their system to utilities, cities, municipalities, special districts, real estate developers and other organizations that supply water. The purpose is for use in treating groundwater sources that do not comply with federal or state regulations due to the presence of chemical contaminants. BWTR has focused on ridding groundwater of three contaminants: arsenic, nitrate and perchlorate. Not so coincidentally, these three contaminants have been a focus of the EPA (Environmental Protection Agency) and state governments. For example, the 2006 EPA guidelines call for a sharp reduction in the groundwater arsenic MCL standard from 50 ppb to 10 ppb. Also the State of California and Commonwealth of Massachusetts have recently called for a reduction in perchlorates.

While BWTR began business in 1999, they're currently still in post start-up phase as they've only begun generating any revenues in 2002. They currently have 50 systems delivered in California and Arizona with an aggregate installed capacity of approximately 86,800 acre-feet per year or approximately 28.3 billion gallons per year. BWTR's business to date has focused on only the southwest US, one of the swiftest growing regions of the US and characterized by a shortage of readily obtainable drinking water to sustain said rising population base.

Customers include American Water, a division of RWE AG, California Water Service Group and American States Water Company, three of the largest investor-owned water utilities in the United States based on population served. Top 4 customers accounted for 71% of 2005 revenue. Contracts typically have a term of five or more years and/or are sold outright to customers. In 2005 outright sales accounted for over 80% of revenue and system sale prices ranged from $100k to over $4 million apiece.

BWTR feels it has advantages over the competition dues the small size of their system that can easily be placed at the wellhead and process large volumes of water. Apparently many traditional systems have been bulky and deployed at water facilities not the wellhead. The size and relative ease and speed of implementation have given BWTR a cost advantage, according to BWTR.

Financials

  • $1 1/2 per share in cash, no debt.
  • 3 X's book value at $9 per share pricing.
  • Well I've buried the lead in this analysis piece. BWTR's financials for 2006 and beyond will look nothing like 2005 and previous. Two recent and very significant developments are the cause.

    In December, 2005 BWTR entered into a strategic sales and marketing agreement with Shaw Environmental, an affiliate of The Shaw Group (SGR) to market BWTR's arsenic treatment system on an exclusive basis to water providers in 18 states. Secondly Aqua America (NYSE:WTR), the largest U.S.-based publicly-traded water utility, is in late stage negotiation to co-market BWTR's system. Under the terms of the proposed strategic relationship, Aqua America and Basin Water would work together to treat and recover sources of water supply that have been impacted by nitrate and arsenic.

    These two deals give BWTR credibility and geographic expansion. In 2005 they marketed their system solo to 2 states. With the SGR deal alone their system will now be marketed in 20 states, with SGR marketing only their treatment system none other. In addition these deals will significantly raise BWTR's 2006 revenue. BWTR goes into great detail about why their system is an attractive solution. For me the fact that SGR/ WTR are interested in them as an exclusive solution/ partnership counts for far more. These are very important deals for a small company like BWTR. Very important.

    The Shaw agreement is for 2 years. BWTR has agreed to sell SGR their systems at a discount. SGR will maintain sales exclusivity in 18 states provided revenues from BWTR's system sales top $2 million annually in each state. If lower then $2 million in any state, BWTR will be free to either sell directly in said state or locate other strategic partners. The term of the deal is 2 years with an option for SGR to extend assuming revenues from SGR for BWTR's system top $19 million total in the 2nd year. SGR has agreed to purchase a minimum of $5 million worth of BWTR product in 2006.

    A lot of numbers --- My take is that '06 revenue from SGR will be at least double that $5 million minimum, possibly triple. Why? Well SGR wouldn't agree to an option at a certain level unless they felt they'd sell well above that number the 2nd year. SGR has the advantage in this deal being the much larger entity and they will want the discretion of renewing the option or not. That threshold for 2007 revenues is $19 million, meaning SGR believes they will be purchasing a larger dollar amount of BWTR's systems in '07 then that figure. That way SGR gets to decide if they would like to continue the relationship, not BWTR. SGR simply wouldn't agree to terms on conditions other then continuing at SGR's discretion. Just the way it works.

    In December 2005 alone after the deal was signed, SGR purchased $1.6 million worth of BWTR's systems. At a full year run rate for 2006, knowing what we know about the deal, I would estimate SGR related revenue to BWTR in the $10-15 million range minimum. In 2007, $20+ million in revenue should come directly from SGR.

    It should be noted (and this is important) that the SGR deal does not cover Arizona and California, a geographic area in which BWTR has received all revenues to date. BWTR will be free to continue to market and sell their system solo in those 2 states, something they will most certainly continue doing.

    Let us look at 2005 financials and attempt to forecast '06 based on the impact of the above deals.

    In 2005 BWTR grew revenues from '04 levels of $4 million to $12.2 million. Gross margins were 42%. Margins on sales were much higher, the gross margins appear lower than reality due to 20% of revenue derived from 5+ year contract placements. Those revenues are booked over the life of the contract. SGA and R&D doubled in 2005, while revenues tripled. Good sign. Going forward as revenues grow, keep an eye on controls over these two line items. A key to BWTR's future earnings power will be for them to continue to grow these expense line items at a much slower rate then revenues. This is always a key for small fast growing companies.

    Operating margins in 2005 were positive for the first time in company's short history at 9%. Net margins (after eliminating debt paid off on offering), factoring in tax were 6%. Earnings per share for 2005 were 4 cents. Trailing PE at $9 is 225.

    2006 is very difficult to forecast. My hope is that first quarter numbers will be added to the final prospectus. If so, this portion will be updated just prior to pricing. Backlog as of 12/05 more then doubled to over $75 million. In 2005 BWTR booked about 1/3 of their total backlog. Just using those broad numbers puts BWTR's 2006 revenues in the $25 million range. Conservatively factoring in the SGR deal and the pending WTR partnership, I think BWTR can triple their revenue in 2006 to the $35 million level. This is a ballpark number. I believe gross margins will compact a bit as SGR is receiving a discount on purchased systems. However, operating expenses should decrease substantially as a % of revenue. Conservatively at this run rate I believe BWTR can lift net margins to the 10%-12% range. This would mean roughly 25 cents a share in 2006 earnings for BWTR. At $9 that is 36 X's 2006 estimated earnings.

    Competition
    BWTR does have numerous public competitors however none are quite the public pure-play of BWTR.

    Calgon Carbon (NYSE:CCC) is probably the closest while Layne Christensen (NASDAQ:LAYN) and Rohm & Haas (ROH) have segments of their business which compete with BWTR. CCC is expected to break even in 2006/ 2007 and the stock price has not done much overall the past few years. LAYN/ ROH are quite profitable overall and have seen tremendous stock performance the past 3 years. I think going forward if BWTR is able to leverage these important deals into profits, the stock will do quite well.

    Risks
    Technology seems to be the big risk here. Even though most of BWTR's business is based on long term contracts and outright sales, there is always the chance a competing water treatment technology could eventually become 'the standard.' Currently it appears BWTR's treatment process is in demand as evidenced by the deal with SGR and the pending deal with WTR. This is not a shorter term concern but one to keep an eye on.

    Note too that BWTR has had several accounting issues. This is not uncommon in a start-up without the budget for substantial accounting staff/ outsource. They've hired to remedy the situation. I suspect it will not be much of an issue going forward, still worth mentioning.

    Also expect a dilutive secondary from BWTR sometime in the first 6 -15 months public. As they expand operations swiftly with the SGR/ WTR deals, they could very well need more capital quickly for manufacturing. It is possible that IPO monies and future cash flows could provide this capital, but I suspect BWTR will be back selling additional shares in a secondary.

    Conclusion
    I like this deal. I think the SGR exclusive deal and the pending WTR deal are what makes this offering attractive in range and a few dollars above. This is the sort of small deal/ company in which there is a lot of things than can potentially go right for them over the next few years. If they do the stock price will be much higher then $8-$10. The longer term population/water trends are in their favor, plus revenues should ramp impressively in 2006. Factor in the light initial market cap and the complete absence of any leveraged buyout entities and this is a nimble deal.

    The key here is for BWTR to turn these two deals into a solid bottom line number. I think it is possible and if everything falls into place they're set-up to post an impressive number in 2007. At my expected 200% revenue growth in 2006 and 36 X's '06 estimates, BWTR is attractive. Yes, many things can/ do go awry with small/ new companies, but I like BWTR's chances. I like this deal, this is the sort of small offering with new contracts not yet recognized (a la Liquidity Services (NASDAQ:LQDT)) that have always worked in the IPO market their first year out. I suspect similar with BWTR.

    BWTR Post-IPO Performance