- We estimate that two development projects, Bali and Baja California, have the potential to more than double CWCO's earnings over the next 4-5 years.
- CWCO's current valuation is consistent with its peer group; so the potential of the Bali and Baja California projects is not currently reflected in CWCO's share price.
- If successful, these development projects could more than double CWCO's share price, producing a compounded annual return of about 20%, which would be realized over time as each project achieves its milestones.
- These projects are highly speculative. In addition, CWCO's core business faces certain challenges to which investors should pay attention.
Based in the Cayman Islands, Consolidated Water Company (CWCO) develops and operates desalination plants and water distribution systems in places where supplies of potable water are insufficient to support the needs of the local population. The company owns and operates (directly and also through a joint venture) 14 reverse osmosis desalination ("ROD") plants with a combined capacity of 26.8 million gallons of water per day (g/d). All of these plants are located in the Caribbean.
CWCO is looking to grow its business by developing new plants (either on its own or through joint ventures or strategic alliances) in areas where (1) fresh water supplies are inadequate, (2) a high proportion of end users are tourists, (3) the population and local economy are growing, and (4) the regulatory and tax environments are favorable. The company currently has two early stage projects, one in Bali, Indonesia (750,000 g/d), the other in Baja California, Mexico (100 million g/d). CWCO has completed construction of a pilot plant in Bali capable of delivering 250,000 g/d. The Baja project is still in its very early stages and, even if it achieves the necessary milestones, it will probably not begin construction until 2015 or later and begin operations until 2018 or later.
Consolidated Water classifies its operations into three business segments: Retail Water Operations, Bulk Water Operations and Services.
In the Retail segment, CWCO functions as a water utility, producing water from 3 ROD plants and distributing it to residential and commercial customers in two of the most populated areas on Grand Cayman island: the Seven Mile Beach and West Bay areas. For the first nine months of 2013, Retail Water Operations accounted for 36% of total consolidated revenues and 20% of consolidated operating income.
In the Bulk segment, from its own ROD plants and from ROD plants owned by others, CWCO produces and supplies water on a bulk basis to government-owned distributors (e.g. the local water utilities). The company currently conducts its Bulk business in the Cayman Islands, Belize, the Bahamas and (through a 50%-owned affiliate) the British Virgin Islands. Bulk water operations accounted for 62% of revenues and 119.4% of operating income in the nine months ended September 30, 2013.
In the Services segment, CWCO provides engineering and management services for desalination projects. These services include (A) designing and constructing desalination plants and (B) managing and operating desalination plants owned by others. These operations generated 2% of 9 month 2013 revenues and -39.2% of operating income.
Bali, Indonesia: CWCO, through a 95%-owned subsidiary, is currently constructing a 750,000 g/d ROD plant in the Nusa Dua section of the island of Bali, Indonesia, a popular tourist destination. Although rainfall is plentiful, the company believes that the island lacks the infrastructure to serve the growing number of tourists that visit each year. Some hotels will treat their own water for their own needs, such as filling swimming pools. CWCO believes that the island will eventually suffer fresh water shortages that can be best solved by constructing a few moderate-size ROD plants over the next several years. In order to address this opportunity, it has concluded that it must demonstrate to potential customers both the viability and desirability of fresh water supplies derived from reverse osmosis technology and also its own capabilities and expertise. Accordingly, it has decided to build a pilot plant in Nusa Dua before obtaining contracts for its production.
CWCO has estimated an initial capital investment of $5.0 million for a 750,000 g/d plant (that could be expanded to 1.5 million g/d in stages). Through the end of the 2013 third quarter, the company had capitalized $3 million of costs and generated $67,000 in revenues. The pilot plant is now up and running, although construction is not yet complete. There have been expressions of interest from potential customers (i.e. the local hotels), but most are approaching this opportunity cautiously, in part because their current water costs are quite low (and well below the price that CWCO is quoting for desalinated water).
Nevertheless, the company remains confident in its ability to sell the production from this plant. Once it has signed contracts for the plant's output, it will begin to pursue opportunities for other plants on this island.
Baja California, Mexico. Through its now 99.9%-owned subsidiary, N.S.C. Agua, S.A. de C.V ("NSC"), Consolidated Water is pursuing a project to build, own and operate a 100 million g/d ROD plant to be located in northern Baja California. This would be among the largest desalination plants and roughly twice the size of the Carlsbad Desalination Project, currently under construction to serve the San Diego metropolitan area. CWCO has engaged two engineering groups with sufficient regional and technical experience to develop the project plan and is seeking to partner with Doosan Heavy Industries and Construction, which has experience building large-scale desalination plants. The project also includes the construction of a pipeline to deliver water to the local (Mexican) water system and to the U.S. border. The company has signed a letter of intent with the Otay Water District in Southern California to deliver between 20 million and 40 million gallons per day.
CWCO has estimated the total cost of the project at $700 million. (The total cost of the Carlsbad Desalination Project is estimated at $1 billion, but high distribution system costs also figure into that project's high price tag.) CWCO anticipates that it will eventually raise roughly a third of the project cost ($200-$250 million) in the form of equity and reduce its ownership stake to a minority position of probably around 20%. Another CWCO subsidiary will operate the plant (presumably under a long-term contract). KPMG has been retained as CWCO's financial advisor on the project.
To date, from the inception of the project in 2010 through the end of the 2013 third quarter, the company has expensed $8.6 million in costs related to this project ($2.2 million YTD 2013 and $1.7 million in 2012). At September 30, 2013, the net carrying value of the project on its balance sheet was $3.36 million. So its total "investment" in the project so far is about $12 million. In 2011, the company entered into a purchase agreement for 8.1 hectares of land at a total cost of $8 million, $7 million of which is due to be paid in May 2014. It has also agreed to acquire another 12 hectares of land for $12 million, $10 million of which will be paid also in May 2014.
Although it is more of a merchant water company than a water utility, CWCO's valuation metrics are most often compared with those of other U.S.-based water utilities. On that score, its stock is priced at a modest premium to its peer group on forward earnings, as shown in the chart below:
Consolidated Water's stock trades at a modest discount to peers on current earnings, but at a slight premium to its peers on consensus 2014 estimates. Consensus estimates for CWCO anticipate that earnings will be flat going forward: $0.60 in 2013 and $0.60 in 2014. We believe that the 2013 estimate reflects a $0.06 benefit for its share of the receipt of a court-mandated payment from the British Virgin Islands related to the government's takeover of the Baughers Bay plant. Excluding the payment, the 2013 consensus estimate is effectively $0.54; so the consensus estimate does anticipate some earnings growth for CWCO's base business in 2014.
As presently situated, the revenue and earnings growth potential of CWCO's Retail and Bulk businesses depends upon both economic factors, primarily related to the strength of the tourist businesses in all of the markets that it serves and also the weather. These should generally be viewed as stable businesses. There may be opportunities to grow within each business, by acquiring or constructing new plants and/or agreeing to take over new territories from the local government (or their utilities), but there is also the risk that CWCO could lose business through government takeovers of their plants or pressure to reduce prices (more about that below). The valuation given by the market to CWCO's shares assumes that CWCO's business will generate relatively stable earnings.
Consolidated Water is pursuing new growth opportunities and the possible increases in revenues and earnings from these ventures does not appear to be reflected in its stock price at this time.
By our rough estimates, the Bali project, which we estimate could result in the construction of three desalination plants with a total capacity of 2.25 million g/d could add a total of $0.12 in earnings by 2017, with a ramp up beginning in the second half of this year. (We are assuming revenues of $0.0175 per gallon and net margins of 13.5%, which are roughly in line with CWCO's base business, adjusted for corporate G&A expenses and our guess about potential taxes due on profits in Indonesia.)
The greatest potential upside is from the Baja California project. Assuming that the project goes all the way to completion, our back-of-the-envelope estimates suggest that the project will generate $220 million per year in revenues (based upon the sale of 100 million g/d at an assumed bulk rate of $0.006 per gallon) and realize operating margins of 30%. Our estimates also assume a total project cost of $700 million, financed with $500 million of debt and $200 million of equity. (CWCO and its financial advisors will need to raise that equity either privately or through a public offering.) At an assumed average interest cost of 5% and a tax rate of 25%, the project would generate $31 million in annual net income, good for a 15% return on equity.
CWCO could therefore earn $6 million per year on its 20% equity investment. It will also earn a fee for the ongoing management of the project. A fee of 2%-3% of revenues works out to $4.4-$6.6 million in annual revenue. At the midpoint of that range and assuming $1.5 million of associated expenses, the company would realize a net of $4 million annually.
So, using our very rough assumptions, CWCO could conceivably generate $6 million annually from its 20% investment and $4 million for managing the project. That $10 million addition to earnings works out to $0.68 per share, which is more than the company is projected to earn for all of 2014. According to our analysis, therefore, the Baja California project has the potential to double the company's earnings. Given all the necessary approvals and agreements necessary to get this project off the ground and an estimated three-year construction period, it is likely that the project will not begin operations until 2018 at the earliest.
Risks to Existing Operations
Consolidated Water operates on a merchant basis. It owns and operates plants that meet the critical water needs of the Caribbean nations that it serves. Desalinated water is not especially cheap and local governments (or the utilities that serve them) are always on the lookout to save costs. Some may think that they can operate the plants at lower cost. Often, however, we suspect that they find it difficult to achieve CWCO's operating efficiency. Yet, the company still faces challenges in its Caribbean business.
Cayman Islands. The company's retail license to operate expired in 2010, but CWCO and the government have extended the license several times. The current extension is set to expire on June 30, 2014. In 2011, the government passed new laws that (1) established the Water Authority-Cayman ("WAC") as CWCO's primary regulator and negotiator of CWCO's new license and (2) gave WAC the ability to set a rate of return on invested capital model as the basis of determining allowable rates under the license.
CWCO has objected to both of these developments. WAC is a bulk water customer of CWCO in the Caymans and also a competitor. WAC has taken over one of CWCO's bulk plants, the Lower Valley plant, and may try to take over others in time. It could also presumably use the license negotiating process to pressure CWCO to sell its Grand Cayman retail operations.
CWCO objects to the return on invested capital model because it does not believe that such a model would promote operating efficiency and ultimately could lead to higher rates for its customers.
In October 2012, the Grand Court of the Cayman Islands notified CWCO that it has agreed to consider the issues raised in its petition. The Court has pledged to hold a trial, in which company, WAC and the Cayman Islands government will each have an opportunity to present their positions. As far as we know, no date has yet been set.
A court ruling would clear the way for a final resolution of the status of CWCO's license. Conceivably, if WAC remains the negotiator and fails to reach an agreement with CWCO, it could seek to terminate the license and offer the franchise to a third party. CWCO would presumably be entitled to compensation for the plants that it owns, but it is probably unlikely that such compensation would equal the net present value of the earnings generated by the franchise. Hopefully, CWCO will reach an agreement with either WAC or the government on the terms for its license renewal quickly.
Belize. In 2009, the government of Belize passed a law designating Consolidated Water - Belize ("CW-B") as a utility subject to regulation by the Public Utilities Commission of Belize (PUC). In 2010, the PUC filed a formal complaint with CW-B, alleging that CW-B was operating without a license. In 2011, the PUC issued an order that set a series of limits and operating requirements on CW-B's business. CW-B filed motions for a declaratory judgment and a temporary injunction with the Belize court. The court granted the temporary injunction and held an initial hearing on the matter in October 2012; but a ruling on the case is still pending.
British Virgin Islands. In 1997, an agreement between BVI's Ministry of Communications and Works and CWCO's OC-BVI joint venture granting OC-BVI the right to operate the Baughers Bay desalination plant expired. Although the Ministry said that it wanted to take over the plant, it agreed to allow OC-BVI to operate the plant on a month-to-month basis to allow the parties time to work out their differences. Over the next 10 years or so, OC-BVI continued to operate the plant and even spent $4.7 million to upgrade its capacity. In 2006, the Ministry formally notified OC-BVI of its intention to take over the plant. In 2007, the Ministry filed suit to take over the plant and notified OC-BVI that while the ownership matter remained in dispute, it would only pay what it thought were the production costs for the water that it bought. OC-BVI filed a counterclaim in 2007 to continue to operate the plant until it received the $4.7 million that it paid for the capacity upgrade and also to receive full contract prices for the water that it sold to the BVI government.
In 2009, the Court determined that the Ministry was entitled to take over the plant and dismissed OC-BVI's $4.7 million claim, but it awarded OC-BVI $10.2 million for water delivered. OC-BVI won back its $4.7 million claim on appeal (plus an additional $1.42 million that the government was supposed to pay for the plant under the original 1990 agreement). The $10.2 million payment was expanded to $11.7 million as a result of court costs and other items awarded to OC-BVI. $5.0 million of the $11.7 million had already been paid by 2011. The BVI government then paid OC-BVI $4.7 million in the 2012 fourth quarter and $2.0 million in the 2013 first quarter to cover the rest. The $5.92 million due from the government for the plant and the capacity upgrade still appears to be outstanding.
Of course, CWCO faces normal business risks, including the impact of hurricanes and recessions, but the three tussles with customers described above highlight the potential impact of politics and regulation (including a natural desire by governments to lower the burden of water costs on residential populations and businesses, especially during tough economic times).
Risks on New Business Initiatives
Both the Bali and Baja California projects are exciting growth opportunities, but they also entail significant risks.
In Bali, the company has proceeded to build a pilot plant and distribution system at a cost of about $5 million, even though it has no contracts with customers for the plant's output. While that may be a good bet at this time, it is somewhat surprising that the company was unable to get formal support from the government of Indonesia, the local government on the island of Bali, or from Bali's water authority for this project. Obviously, the project would not have progressed this far without some tacit government approval. But the lack of a formal agreement also potentially leaves CWCO without legal rights to protect its position, if conditions change or the government decides to pursue other options. For its part, CWCO is betting that once its plants become operational, they will effectively become part of the island's "infrastructure," effectively guaranteeing their standing with the government.
In Baja California, CWCO has also initiated a very large project without a formal agreement with the Mexican government. In this case, because of the large size of the project, the company will have to obtain contracts for the plant's output before it will be able to obtain financing. However, it has already committed some $30 million to date - an amount equal to most of its cash on hand - to scope out this opportunity. Although the project looks promising on the surface, it is possible that it will encounter obstacles that will prove to be insurmountable. In that case, shareholders will have lost the $30 million, plus any additional costs that the company incurs.
NSC, the subsidiary formed by CWCO to pursue this opportunity, started out initially as a 50%-owned joint venture, but CWCO's partners were apparently unable or unwilling to come up with sufficient cash to maintain their equity interests. At this point, CWCO has an effective 99.9% ownership interest in NSC.
At present, Consolidated Water's stock is valued in line with its U.S. public water utility peers. Yet, none of its peers is pursuing similar growth opportunities. In our view, this suggests that either:
- The market is valuing CWCO's existing operations like those of other water utilities and ignoring the potential upside from the Bali and Baja California projects; or
- The market is assuming some deterioration in the value of the core business but giving the company some credit for its new growth initiatives (most likely for part of Bali's potential value, but not for Baja California at this time).
It is most likely that the former is true. The market is probably willing to pay for CWCO's base business, despite the potential risks; but it is not yet willing to give the stock any credit for the growth initiatives. We think that the downside risks for the base business will probably only become significant, if the economy suffers another severe economic setback. Otherwise, local governments will probably allow CWCO to operate under existing agreements and may even move to shore up those agreements or their regulatory regimes by resolving outstanding disputes before too long.
As for the growth initiatives, the market will likely give the stock credit as the company reaches key milestones, especially as it signs agreements with customers for long-term water purchases. We should know in the coming quarters whether its initiative in Bali is resonating with local hotel operators. Any sign-ups will probably give the stock a modest boost.
Of course, the big upside potential is with Baja California. Market moving news there will probably not come until either later in 2014 or sometime in 2015.
As noted above, with a base business that generates earnings of $0.54 per share and growth projects that could add an estimated $0.12 per share (in the case of Bali) and an estimated $0.68 per share (in the case of Baja California), CWCO has the potential to get to an earnings run rate of $1.34 per share within the next four years. If we assign a multiple of 18 to those earnings (which is below the current peer group average), it suggests a target price of just over $24. That's more than twice the current quote of $11.77 and represents a potential compounded annual return of nearly 20% over the next four years.
Consolidated Water is clearly a speculative stock, but if management can sustain the performance of the base business while delivering on its two big growth initiatives, shareholders will enjoy significant returns, well above market over the next four years.