Water Water Everywhere...
I have found water utilities to be exceptionally attractive investments over the past several years. I believe that water utilities are able to preserve their earnings, pay fair and growing dividends to shareholders and provide a margin of safety during periods of market turmoil - for investors cultivating low expectations, these are often attractive propositions. I also think that water utilities will begin to enter a period of consolidation in the coming years due to their highly fragmented and regional distribution, providing shareholders with a potential catalyst for significant profit. One of the utilities I am interested in is the San Jose Water Corporation (NYSE:SJW). The SJW Corporation operates in both California and Texas. In addition to its core business in the potable and wastewater sectors, the company owns a portfolio of real estate and has paid a dividend that has increased every year for over four decades.
A cursory assessment of the water utility sector reveals a significant amount of companies under $1 Billion dollars in market capitalization. If regulatory hurdles can be overcome, I believe that a company can acquire several of these smaller regional concerns given the chance to make a purchase at a fair price due, in part, to the consistent and dependable cash flows produced by water sales. I believe that the SJW corporation is one of the more attractive companies on the market given its long dividend payment history, stable stock price, growing business in Texas and its real-estate holdings across the United States.
The Numbers on SJW Corporation
Currently priced at $27.78, with a P/E of 23.25 and a market capitalization of $556 Million - SJW is a small but hardy company that fared well during the financial crisis of 2008-2009 and was able to both pay and increase its dividends, which now yield 2.68% annually, during this volatile period. The company has a payout ratio of .60 - which would normally be considered at the upper limit of sustainability for many types of businesses - except for utilities, particularly water utilities. Currently investors are paying a premium for the shares of the company, given that the book value is $14.62 and the cash per share is $0.11, something that is not out of the ordinary when it comes to assessing water utilities - especially regarding the small size of the company's current cash position due to the predictable nature of the cash flows from operations.
Geographic Diversity
SJW provides water to both San Jose, California and more recently locations in Central Texas. I believe that these are advantageous markets given the fact that California and Texas are prone to drought. In periods where rainfall is significantly reduced, consumers must purchase more water.
Furthermore, the expansion of operations into Texas through the Canyon Lake Water Company will provide moderate growth over the medium to long term. SJW entered the Texas market in 2005 and since then has both expanded its customer base for water sales and established a wastewater business. I believe that central Texas will provide opportunities for expansion in the future as the company builds out its coverage network for drinking and wastewater.
Attractive Expansion Possibilities
One of the reasons that I am very interested in regional water utilities is because of their expansion potential in the near to medium term. As I mentioned in another of my articles about water utilities, when municipalities struggle under their pension other budgetary obligations they have been forced into selling off assets to satisfy their short term commitments. I believe that companies that are engaged in providing basic services like Artesian and SJW will emerge from this trend as clear winners in the long term. They are able to acquire assets and build out their coverage area while benefiting from both experience and economies of scale in their infrastructure. In addition, capital expenditure in this area is much less risky given the predictable nature of the cash flow produced by the underlying assets. Though these types of purchases from distressed municipalities are not totally risk free, as there are often concerns about the long term demographic trends in the area, they move at a snails pace in comparison to other spheres of industry. I like slow and steady.
What About the Real Estate?
I enjoy looking for companies that have hidden assets, especially assets that I believe will be either sold or spun off as they comprise a different business or are in geographically disparate areas. The SJW Corporation through its subsidiary, the SJW Land Company, has real estate holdings in California, Texas, Connecticut and Tennessee and Arizona - while some utility company's hold real estate it is usually vacant land and is used for the future needs of core operations.
In addition to some undeveloped land, the company has warehouses and commercial buildings which are leased on a long term. In the past two years, SJW Land has been selling off assets in Florida and Connecticut in a manner that coincides with the expiry of customer leases on the properties. Examining the terms of the leases on the remaining buildings, the SJW company has leased these properties over a long term period and as a result will be able to enjoy predictable cash flow, complementing the stable cash flow of the core water business.
I believe that in the future there is the potential for the company to further liquidate its real-estate portfolio and either reinvest the capital into acquiring and developing more municipal water assets in the areas of its two utility divisions or to simply pay a special dividend to shareholders. Either outcome I believe is satisfactory and not negative.
The city of San Jose has experienced remarkable growth in the past several years as a result of the development of the technology sector in California. I believe that this could potentially lead to significant appreciation of real estate and thus a corresponding increase in the value of SJW's land.
From reading the company's annual report, I believe that the commercial real-estate assets of the company are likely to be liquidated after the expiration of the company's long term leases - which are contractually fixed for a decade or more.
The company also has a stake in another public utility company, the California Water Service Group (CWT), amounting to 385,120 common shares - at current market prices of CWT common, this investment is worth slightly more than $8 Million dollars in addition to yielding 3% annually.
Potential Risks
As with any company that operates in the water utility segment, there is seasonal volatility in earnings related to rainfall. The company also faces significant regulatory risk given the essential nature of the service it provides customers and must maintain certain water quality standards or face state and federal fines. SJW's operations in California have the potential of being impacted to by seismic activity and an earthquake of significant magnitude could produce disruption or permanent impairment of services in addition to damaging or destroying the commercial real estate the company holds in San Jose, California.
Inflation and the ability of the company to increase its dividend to protect the investment of income oriented shareholders is an important thing for prospective investors to consider. As the utility portion of SJW's business operates in a regulated environment, there is a limit to the degree with which SJW can match inflationary pressure. Despite having increased its dividend every year consecutively for over 40 years, investors may want to explore other options if they are especially concerned about retaining the purchasing power of their future income streams.
Acquisition Potential?
As I have previously stated, I believe that regional water utilities represent an attractive area of future consolidation. I believe that a likely candidate for acquisitions, a dominant player in the water space currently is Aqua America (WTR). The company has been engaged not only in purchasing assets from municipalities and acquiring water companies, it also has a history of selling assets to state and local government authorities. I believe that the SJW company represents a fair potential acquisition target given the predictable nature of its underlying assets, moderate growth prospects as well as its real estate and marketable securities.
Final Thoughts
While it is important for investors to be appraised of the risks inherent in investing in highly regulated industry, for investors looking to obtain stable and growing income with a margin of safety, future acquisition potential and a "little something extra" by way of assets and subsidiary businesses - I believe that the SJW Corporation merits a closer look. Furthermore, given the high level of insider ownership in the company, I believe that should SJW be sold or liquidate and distribute the proceeds from its assets, that minority shareholders will have their interests well protected.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
