Consolidated Water Provides Growth And Dividends

| About: Consolidated Water (CWCO)
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Consolidated Water Co. Ltd. (NASDAQ:CWCO) operates seawater desalination plants and water distribution systems in the Virgin Islands, Belize, the Cayman Islands and the Bahamas. The company operates in three segments; Retail, which provides services to residential end users, Bulk, which supplies water to government utilities and Services, which designs, constructs and sells desalination plants to third parties and offers plant management and operating services. The company's desalination technology can produce fresh water from seawater which makes it extremely valuable in coastal regions with little or no fresh water available. Shares have nearly doubled since last November on strong operating results but still sit at less than half of the company's all-time highs. At this point, with the dividend roughly equivalent to the 10-year Treasury yield, investors may be wondering if there is any further value in CWCO shares. I'll argue here that long-term tailwinds should continue to drive the stock higher but that a pullback would provide some margin of safety.

Before we begin our discussion of CWCO's business I think it is instructive to understand what analysts think about the company's earnings prospects. I'll use these and other inputs in my earnings model, which you can read about here in greater detail, in order to compute a fair value for CWCO shares. My inputs and sources are as follows: 1) reported earnings, 2) earnings growth rate, 3) current dividend rate and 4) current book value, all from Yahoo! Finance, 5) perpetual growth rate of 3%, 6) discount rate of 9% and 7) dividend growth rate of 4%, all of which are my numbers.

 

2012

2013

2014

2015

2016

2017

2018

Earnings Forecast

             

Reported earnings per share

$0.67

 

$0.55

$0.61

$0.73

$0.88

$1.05

x(1+Forecasted earnings growth)

 

-17.90%

10.90%

20.00%

20.00%

20.00%

20.00%

=Forecasted earnings per share

 

$0.55

$0.61

$0.73

$0.88

$1.05

$1.26

               

Equity Book Value Forecasts

             

Equity book value at beginning of year

 

$9.50

$9.75

$10.05

$10.46

$11.00

$11.70

Earnings per share

 

$0.55

$0.61

$0.73

$0.88

$1.05

$1.26

-Dividends per share

 

$0.30

$0.31

$0.32

$0.34

$0.35

$0.36

=Equity book value at end of year

$9.50

$9.75

$10.05

$10.46

$11.00

$11.70

$12.60

               

Abnormal earnings

             

Equity book value at begin of year

 

$9.50

$9.75

$10.05

$10.46

$11.00

$11.70

x Equity cost of capital

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

=Normal earnings

 

$0.86

$0.88

$0.90

$0.94

$0.99

$1.05

               

Forecasted EPS

 

$0.55

$0.61

$0.73

$0.88

$1.05

$1.26

-Normal earnings

 

$0.86

$0.88

$0.90

$0.94

$0.99

$1.05

=Abnormal earnings

 

-$0.30

-$0.27

-$0.17

-$0.06

$0.06

$0.21

               

Valuation

             

Future abnormal earnings

 

-$0.30

-$0.27

-$0.17

-$0.06

$0.06

$0.21

x discount factor(0.09)

 

0.917

0.842

0.772

0.708

0.650

0.596

=Abnormal earnings disc to present

 

-$0.28

-$0.23

-$0.13

-$0.04

$0.04

$0.13

               

Abnormal earnings in year +6

           

$0.21

Assumed long-term growth rate

           

3.00%

Value of terminal year

           

$3.53

               

Estimated share price

             

Sum of discounted AE over horizon

 

-$0.64

         

+PV of terminal year AE

 

$2.11

         

=PV of all AE

 

$1.47

         

+Current equity book value

 

$9.50

         

=Estimated current share price

 

$10.97

         

As you can see, the model produces a fair value of about $11 given the inputs I described above. That would imply that CWCO shares are slightly overvalued based upon current book value and economic value added. I don't disagree with this as I think CWCO shares have gotten a little ahead of themselves following the massive rally that has been going on for the last 10 months or so. However, CWCO has a great long term business model and enormous room for growth in addition to strong and growing demand for its product. Thus, because CWCO may be slightly overvalued as of now, a pullback would be a welcome opportunity to get long. However, the current price still affords a good entry point.

The reason I am bullish long term on CWCO is simply the fact that the company has a great technology that will always be in demand. Simple population growth demands that the need for water will continue to rise which means the demands for CWCO's services will continue to rise. This is true for any water service company but CWCO provides water to arid coastal regions that have access to little or no fresh water and are currently underserved. The other long term tailwind for CWCO's services is that the amount of water on the planet is roughly constant. Thus, it isn't as though more people means more water is available; quite the opposite in fact. A quick overview of CWCO's process is below from a recent investor presentation.

While CWCO's process isn't necessarily that unique, as many companies can desalinate seawater, CWCO has a powerful market position because it is targeting coastal areas that have abundant seawater but no fresh water. In addition to this, the areas CWCO targets are typically underserved by current water service providers. This means that CWCO goes into new markets with built in demand and a captive customer base that needs its services in order to live their lives. This seems simple but it should not be overlooked; many companies would do anything for that type of structural demand.

Now, at twenty times next year's earnings you'd be forgiven for wondering aloud if this water utility is perhaps a bit expensive. While I argued above that a small pullback is desirable for margin of safety purposes, I don't consider CWCO to be "expensive" in the sense that I would completely rule out getting long at $12. Given that the company is expected to increase earnings at around 20% each year I submit that 20 times earnings isn't really unusual. There are companies that have far more risk to their respective business models than CWCO but trade at even higher valuations. CWCO is profitable and has a proven business model that can be scaled very easily to new locations.

In order to justify 20 times earnings, you'd like to see some new projects on the horizon that can provide a material boost to earnings. In fact, that is exactly what CWCO has in both its existing markets and in two major new markets. The company is already quite successful in The Bahamas and the Cayman Islands and CWCO is using that position to offer its current customers expanded services. This means that CWCO can use its existing infrastructure and simply expand or upgrade it in order to capture new revenue. And with The Bahamas and Cayman Islands becoming more popular as tourist locations as well as for permanent residents, demand for water will undoubtedly continue to increase. This means that CWCO is positioned for long term success in the Caribbean and could even expand its offerings to other islands close by.

One of the new markets CWCO is looking to enter is the San Diego/Tijuana market in Southern California and Northwest Mexico. This market fits the arid/underserved model that CWCO uses to select attractive opportunities but in a large and more affluent market. The total population of the market is about 5 million people and that number is expected to be 8.5 million in 20 years according to the company. Since this enormous number of people is largely dependent upon fresh water that is imported from rivers there is vast opportunity for CWCO's services in the region. Obviously, seawater is abundant in this market and there is a huge market for fresh water there as well. Not only does the region have a large permanent population but there is also a budding tourist industry. All of these people need fresh running water and CWCO would like to be there to sell it to them.

The biggest opportunity for CWCO in my view is its foray into Bali, Indonesia. The company currently has a demonstration plant operating at a fraction of ultimate capacity in order to prove its technology works on a large scale. The area has a permanent population of about 3.5 million people but it also is fast becoming a premier holiday destination for affluent travelers from around the world. In fact, there are more than 100 leading resorts in the area and the current fresh water supply cannot possibly meet demand in the future. Thus, CWCO has identified a top-tier market opportunity and is acting upon it in a big way. Bali has the chance to become CWCO's biggest market in the future, although we are a long way from that materializing at present. However, as of the most recent quarter the company had not lined up customers for its full capacity plant. I have little doubt this will happen eventually but it is something to be cognizant of.

Apart from these specific opportunities for new markets and expanding CWCO's reach, the takeaway is that management is very aggressive and engaged in acquiring new clients for CWCO. The technology works and management is aggressively expanding into new regions of the world as capex budgets allow. I love management that has this mentality as the share price is likely to follow the company's expansion higher.

The bottom line on CWCO is you have a company that has an in-demand technology with a captive audience in the numerous arid, coastal climates around the world. These communities are typically underserved in their water needs by the very nature of fresh water scarcity that plagues regions that fit that description. In addition, CWCO has a very clean balance sheet and clear catalysts for earnings growth in the future. Management has also proven adept at identifying accretive new markets to enter and grow the company's client list. I believe we are in the early innings of CWCO's growth and while it will undoubtedly take years (or decades) for CWCO to reach its full potential due to massive capital costs for new projects, the roadmap for growth is very clear. In fact, management has already shown us the kinds of markets it likes to enter and that the company can profitably do so. A pullback would be great for getting long but if you are okay with a bit less margin of safety, $12 is still a good long term entry point.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CWCO over 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.