Water Investments: Staying on Land - For Now

Unlike oil, gold, and other such commodities, water is the one commodity we must have to live. And I don’t even think about it. I don’t have to. Clean water is delivered to my home and where I work. It’s always available, and it’s cheap. Will it always be this easy?

Living in Arizona, one of the fastest growing and driest states, I thought back to a discussion I heard on NPR about population migration. I remembered this startling prediction: the Southwest will be riddled with ghost towns when water runs out, and those looking back 50 years from now will be mystified as to why people ever wanted to live there. Last year 26% of the Southeast was covered by an “exceptional” drought – the National Weather Service’s worst drought category.

Consider these worldwide facts from the United Nations’ Human Development Report 2006:

1. Less than 1% of the world’s freshwater is easily accessible.
2. 1.2 billion people lack access to freshwater, and 2.6 billion are without adequate sanitation.

More people with higher living standards, pollution, and climate change may be pointing to water shortages down the road. A key example, China has 20% of the world’s population but only 7% of the water. Will China have enough water to support its rapidly growing urban population?

The water industry should be ripe with investment opportunities. I put together a group of 18 stocks, certainly not all-inclusive of ways to participate in the industry, to begin to find out:

York (YORW), Pennichuck (PNNW), Middlesex (MSEX), Connecticut (CTWS), Southwest (SWWC), Artesian (ARTNA), SJW (SJW), American States (AWR), Aqua America (WTR), and California (CWT) are all domestic water utilities.

Mueller Industries (MLI) - tubes and fittings used in water distribution systems.

Watts Water Technologies (WTS) – water safety and flow control products.

Nalco (NLC) - water treatment chemicals and services.

Flowserve (FLS) – flow control equipment.

Gorman-Rupp (GRC) – pumps and fluid control equipment.

Calgon Carbon (CCC) – products to purify water and air.

Veolia Environment (VE) – water treatment services based in France.

Consolidated Water (CWCO) – desalination plants and water distribution systems in the Caribbean.

I used Fast Track™ to get a quick study on the group and find potential buy ideas:

1. These are mostly small cap stocks, and they are not widely followed on the Street. Thirteen stocks have market capitalizations under $ 1 billion. Thirteen stocks are covered by 5 analysts or less, and 9 stocks by 3 analysts or less.
2. Financial leverage is high, with long-term debt to total capital averaging 40.9%, ranging from 0% for Gorman-Rupp to 74.1% for Nalco.
3. Free cash flow was negative at 10 companies in 2007, and 7 companies posted negative free cash flow in each of the last 5 years. These are all utilities.
4. Thirteen stocks had P/E’s below their high / low 5-year average. Only two stocks, Mueller and Watts, also had PEG ratios that were below both their industry and the S&P 500.
5. California Water was the only company where management was a net buyer of stock.
6. The Street is not particularly enamored with this group of stocks. There are 40 purchase recommendations out of a total of 86 ratings, so there’s room for ratings upgrades. Aqua America seems to be the darling of the group with 10 analysts following the stock and 9 recommending purchase.

Here’s my take:

1. I was disappointed to find that Flowserve was the only stock that passed my Fast Track™ screen, having failed no more than 3 categories. But Flowserve is really a play on oil and gas, which accounts for 41% of their business, as opposed to 6% for water.
2. Only 3 companies, Veolia, Flowserve and Calgon, did not report disappointing earnings in any of the last 4 quarters. But Street analysts have held their earnings estimates steady at 12 companies. Watts pre-announced an earnings disappointment for their March quarter, citing weak construction here, slowing economic activity in Europe, and even problems in China. While this could be unique to Watts, is it a harbinger of more disappointments at other companies?
3. No company in the group delivered consistent earnings growth in the last 5 years. This, and that Watts is a pure play on water makes me question whether the water industry’s growth story has really kicked in yet.

I’ve decided to stay on the sidelines for now.

Disclosure: none

Comments

[ireneult:]

Excellent article which I'm glad to see as I've been considering
investing in this sector. As with author, I'll stay on sidelines for now.
Thanks.

2008 May 21 05:53 PM

[QVM Group:]

Stuart,

Good points about water shortage issues.

The World Bank warns of "catastrophic consequences" if water use and supply are not brought into balance.

They say that worldwide we are "mining water" by pumping more water out of the ground than is being replenished -- and that once our pumping depletes the aquifers our pumping will be limited to the recharge rate (no statement about ability of desalinization to make up the difference, I suspect it can't keep up).

The impact of a future physical limits reducing water pumping rates would have direct impact on food production levels and related social unrest.

Apparently, even fossil aquifers (water trapped in geologic formations for which there is no replenishment) are being pumped in some cases.

Rivers are being diverted upstream to various uses, which causes conflicts with downstream users. Water wars are local now, but could enlarge to be between countries in the future.

About 70% of world water use is for irrigation, about 20% for industry and about 10% for residential use.

The world needs more efficient methods (such as drip irrigation instead of surface water irrigation, and recycling of industrial waste water for industrial reuse). The world also needs more desalinization capabilities.

As water shortages become more evident, there should be an increasing number of investment opportunities to benefit financially from those companies that will help solve the problem.

Utilities may not be the best option, but those technology companies that create solutions for greater water efficiency or the creation of more water supply from the oceans may be good opportunities.

Richard

2008 May 29 03:49 PM

[scott/bllngs:]

Richard put his finger on the future for water:the need for progressive breakthroughs in the development of membrane technology in the desalinization process + running those plants on alternative energy. There are several companies, like Consolidated Water, that have already shown this to be a magnificent opportunity!

2008 Jun 11 09:34 AM