Why Is Water So Hot?

Excerpt from The Wall Street Transcript's 6/12/06 interview with Stanford Group analyst Francesca McCann:

TWST: Looking from the top down, what is it about the water space that is interesting at this point?

Ms. McCann: Water is hot-so hot, in fact, that it has been tough to find value in the sector. Our water index--an equal-weighted index that tracks 25 US and international water stocks--is up about 17% this year compared with pretty dismal performance for the broader indices. Our index is up around 35% from the beginning of 2005 and, if you look at it dating back to the beginning of 2001, it is up nearly 300%. So we have seen phenomenal gains, but again, that makes it hard to find value these days.

TWST: Why is water so hot?

Ms. McCann: The scarcity premium placed on water stocks is definitely a factor. If you look at overall market cap and the number of names in the sector, both are relatively limited. There are only a few true water pure plays. We are finally seeing a couple of IPOs in the sector, but for the most part, on the M&A front, we have seen several of our companies swallowed up over the last couple of years, mainly by the larger conglomerates: again ITT Industries (ITT), General Electric (GE) and Danaher (DHR), and also 3M (MMM) when it acquired CUNO last year.

In addition, we see an increase in awareness of water and wastewater treatment issues as well as supply and demand issues. Everyone pays more attention during a time of drought, when lead is leaching into the water in the nation's capital or when beaches are closed as a result of combined sewer and stormwater overflows. On the infrastructure side, we continue to see an increasing need for upgrades to aging infrastructure, both nationally and internationally and for drinking water and wastewater. [...]

TWST: Are we likely to see consolidation, as these demands grow?

Ms. McCann: Yes. We have had a fair amount of activity over the last year and a half, primarily on the treatment/services/equipment side, and we expect to see consolidation continue, though most of the target companies will be private names. For example, Watts Water Technologies (WTS) is continually seeking growth through acquisitions. Tetra Tech
(TTEK), which is more on the consulting and engineering side, is back in acquisition mode. They have been out of that for a little while. Also, many of the conglomerates that have a water division continue to sniff around for deals.

Of the publicly traded names, rumors do continue to swirl that Pall Corp (PLL) and Calgon Carbon (CCC) will be acquired at some point. On the flip side, we have had a couple of recent IPOs: Basin Water (BWTR) and Mueller Water Products (MWA). On the utilities side, we will see Aqua America (WTR) continue its 'tuck-in' acquisition strategy. We also could see some action from the California water utilities, California Water Service Group (CWT) and American States Water (AWR). They haven't been in acquisition mode for quite some time, largely due to an unfavorable regulatory environment. Now that we are seeing changes in that environment at the CPUC, we could see a little bit more action there. Again, the targets would likely be smaller, privately owned systems. In addition, we are seeing a couple of European companies spin their US operations back out into the public market. RWE plans to do an IPO of American Water Works in the coming year which will make the utilities sector more exciting.

Related: See recent Seeking Alpha analysis on Basin Water's (BWTR) IPO here.