How to Invest in Water

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Includes: BMI, DGWIY, DHR, ERII, GE, ITRI, ITT, LNN, RINO, SBS, SIEGY, VEOEY
by: Mark Situ

Everybody knows that water will be next oil and has long term value. However, how to invest wisely? This post tries to identify a few subsectors for those who are interested in investing in water.

Water: A Defensive growth sector

The global water sector, which is estimated to be a $425 billion market, remains at the forefront of industrial, geopolitical, and social agendas because of worsening supply/demand imbalances at regional and national levels and the heightened megatrend catalysts of water scarcity, quality, and safety issues. We are bullish on the global water sector’s defensive long term growth potential.

The Next Oil

The demand for water – the life-sustaining natural resource that has no substitute – continues to escalate at an unsustainable rate, fueled by population growth and industrial expansion. The world’s fresh water supply is also shrinking due to pollution, draining of underground aquifers, and climate change. As a result, we expect to see a sustained focus and investment in the global water sector for years to come.

Above Average Growth Outlook

The US has an estimated backlog of $300 billion-$1 trillion of infrastructure replacement/upgrade that should have 3%-5% growth potential, which is slightly above expected long term GDP growth. Developing countries, especially China and India, should continue to see 10%+ growth as they build out basic water and wastewater systems.

Investment Outlook

Potential M&A targets

Several of the top Multi-Industry companies, including GE, Danaher (NYSE:DHR), ITT, and Siemens (SI), have market-leading water equipment businesses, but revenue is only small part of its total revenues. As the sector is growing, a good play may be potential takeout candidates.

Surge in new equipment & services

As the demand for cleaner water and the increasing water shortage, new technologies and equipments are being developed in recent years aiming to increase the efficiency of water usage and water treatment. These technologies not only focus on fresh water but also on sea water, which comprises of 97% of the total water body on the planet.

Risks

Water businesses are predominantly less cyclical and product cycles are relatively modest and incremental; the key risks would be mostly execution, M&A-related, and regulatory compliance.

Scope

The water market is composed of at least ten distinct subsectors, including the equipment, and services for pumps, valves, water test, filtration/desalination, drinking water, wastewater, industrial water treatment, infrastructure, automation, and consulting/engineering services.

Each of these subsectors has its own demand drivers, embedded technology, competitive dynamics, etc. In developed countries, such as the United States, the estimates for the backlog associated with upgrading the US water infrastructure range widely from $300 billion to $1 trillion (and two-thirds of that spending is for distribution network/pipes/pumps). For developing countries, the expected 10%+ growth is driven mostly by installing water infrastructure for the first time. Many sectors of China’s water system should see 20%+ growth over the next several years.

Investment Strategies

Focus on the higher growth, higher technology segments of water

With regard to what areas of the water sector are especially attractive, we suggest investors focus on the higher-technology segments of water equipment and services, including filtration, ultrafiltration, desalination, reuse, and water testing. These businesses should see the highest growth with stronger pricing and higher barriers to entry.

These technologies include desalination, filtration, water treatment, waste water treatment, and consulting firms providing solution to water usage. As it might be hard to find firms that have similar technologies for a specific field, these firms can usually charge high prices to maintain high profit margins.

In contrast, the lower-tech, more commodity products, such as pipes, pumps, and valves are becoming commoditized.

Focus on vertically integrated companies

Although water is not replaceable, it is very hard for utility companies to raise water prices in reality. So the water industry does not strictly follow the basic supply/demand rule. Most utility companies need government subsidy to be profitable, which squeezes profit margins of utility companies. Water infrastructure contractors are usually those traditional infrastructure firms. Because of the low profitability of project owners, it is hard for them to increase their profit margins. Although the stimulus package will generate revenues for them, most value will be captured by other players on the value chain.

It is expected to see further investment and consolidation in the water sector over the next five to ten years, when a global water oligopoly should emerge. Importantly, the consolidation has started first among the traditional leading equipment manufacturers, including GE and Siemens, but we are now increasingly seeing more of a presence by the top service companies such as Veolia (VE) and Suez. Large firms like Veolia and Suez are vertically integrated, they provide solution, service, financing, and engineering to end customers by partnering with equipment manufacturers to build desalination plants. These firms will have economies of scale, capture value along the value chain, and reduce costs along the life cycle of water projects.

Focus on emerging markets companies

Most large scale infrastructure projects are more or less invested by government, which means a country with such a low government spending on capital investment as India is not likely to provide too many opportunities. China, Malaysia, Singapore, Brazil and South Africa, provides the best opportunity with high capital investment growth as well as high government spending on capital investment, these markets show a promising future with high growth potential.

China

Due to rapid growth in population, urbanization and industrialization in China, the country faces severe water shortages and water resource pollution. The average annual water resource volume in China is estimated to be approximately 2.8 trillion cubic meters, which is the fourth largest source of water in the world. However, only 2,200 cubic meters of water is available per person in China compared with the average global water availability of 8,800 cubic meters per person, ranking China 88th in the world.

It is estimated that China’s population will grow to 1.6 billion the mid-21st century, the per capita water resource is expected to decrease to 1,760 cubic meters.

The water utilization rate is approximately 60% in 2007 for five major rivers in China. By comparison, international average utilization rate is between 30% and 40%.

To address those issues, the Chinese government has enacted stricter environmental standards and invested significantly in water treatment projects to promote sustainable economic growth and to provide its population with affordable, purified water. Accordingly, the demand for water treatment equipment has experienced and is expected to continue to experience rapid growth.

Brazil

Brazil’s major and medium size metropolitan areas face increasing problems of water pollution. Coastal cities such as Rio de Janeiro, São Paulo and Recife suffer effects of upstream residential and industrial sewage contaminating feeder rivers, lakes, and the ocean. In 2000, only 35% of collected wastewater received any treatment.

For example, according to the environmental sanitation company of the state of São Paulo, Cetesb, the Tietê River, which runs through the São Paulo metropolitan area (17 million inhabitants), has returned to its 1990 pollution levels. Despite the support from the IDB and Caixa Economica Federalin, a US$400 million clean up effort, the level of dissolved oxygen has returned to the critical level of 1990 at 0 mg per liter due to increased levels of unregulated sewerage, phosphorus, and ammonia nitrogen discharged into the river. Although the city of São Paulo treats 63.9% of the collected sewerage, the surrounding cities of Sao Bernardo (19.7%), Diadema (11.3%), and Guarulhos (0%) treat much less. The state water company Sabesp projects that a minimum of R$3 billion would be necessary to clean up the river.

Singapore & Australia

Both countries have some strong water companies and the most advanced water treatment technologies in Asia-Pacific regions. However, major companies of these two countries are being traded at pink sheet market.

So emerging markets, we can focus on China and Brazil.

Next Big Things in water

The key issues on the water sector horizon for investors to monitor range from supply/demand imbalances, to regulatory shifts, further market consolidation, and emerging companies and technologies. Following are a few next big things in this sector.

Water reuse

The practice of pumping the treated wastewater back into the ground or into rivers is becoming increasingly attractive of new water supply for many inland and coastal regions for irrigation, heating, cooling and other non-direct potable uses.

New technologies such as membrane filtration, will further convert water into potable water. Although most of these technologies are still in its infancy stage, we can keep these on our radar screen.

Desalination systems

Given continuing trends in emerging market urbanization and industrialization, desalination (“desal”) is gaining recognition as an economically justified solution to address growing water scarcity in coastal regions globally.

Desal operating costs are 3X-4X lower than 30 years ago. While desal has traditionally been focused in water-scarce regions like the Middle East, North Africa, and Spain, we have noted increased investment in new desal capacity in nontraditional markets like the United States (15 new plants under construction), China, and India.

Filtration technologies displacing chemicals

Filtration and ultrafiltration technologies have been displacing chemical treatment, especially in industrial applications. Advances in material sciences and nanotechnology are being used to filter more complex contaminants.

Measuring industrial water efficiency

Regulators and non-government organizations such as the United Nations Environmental Program Finance Initiative (UN EPFI), are exploring ways for companies to calculate water use and efficiency. This could pave the way for industry water efficiency, conservation, and investment. Many companies in oil-producing markets, which are high consumers of water, already disclose their water usage. This should help apply more pressure on demand-side conservation initiatives.

Water testing

Today, the EPA requires the 54,000 US water utilities to test for nearly 100 known contaminants. The present water treatment systems were never intended to filter these new micro-pollutants aspirin, caffeine, and even animal growth hormones from farmland water runoff but changes need to be made. This trend directly benefits the companies providing test equipment and services.

Integrated solutions are becoming the focus for multinational water companies, like GE, Veolia, and Suez

Vertical integration can offer a customer a complete solution: plant design, planning, financing, equipment and service.

Water conservation/water-friendly products

I expect to see a proliferation of water-friendly products and services emerge addressing their conservation advantages. These products include water-free toilets, efficient irrigation systems, and try cooling technology for power plants.

Companies & Sectors to Consider

Highest growth subsectors of global water market

  • Desalination: Energy recovery (ERII) is the global leader. Total operating costs today in desal are 3X-4X lower than 30 years ago. New desal facilities are becoming cost competitive with traditional water sources, typically operating at less than $1 per cubic meter, on par with conventional water sources.
  • Membrane manufacturers include GE, Pall.
  • Water reuse: Danaher’s Trojan business is considered the market leader, followed by ITT’s Wedeco business. The market is growing 15%-20% and potentially faster.
  • Water test: Danaher is the number-one manufacturer of the equipment and consumables used to test the quality and safety of water. Danaher’s Hach business commands the leading share, estimated at about 25% globally and is about five times larger than its next closest competitor. In a razor-and-razor-blade model, Danaher’s high margin consumables drive attractive returns.
  • Automated water meters: The leaders are Badger (NYSE:BMI) and Itron (NASDAQ:ITRI).

Disclosure: Long SI, SBS, RINO.OB, BMI.