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Crumbling water system a big opportunity
The next big infrastructure crisis: the nations decrepit water and sewer systems. These 8 companies will do much of the repair and reap much of the profit.
By Michael Brush
As disturbing as it was in August to learn that a giant section of the U.S. electricity grid could flicker off without warning, the national infrastructure problems dont stop there.
The countrys water system -- much of it installed during the early 1900s -- is crumbling, too. The decay isn't as noticeable (yet) as unexpected darkness, but it's no less troublesome. Across the United States, bursting pipes flood subways and create perilous sinkholes more frequently than most people realize. During rainstorms, many sewage systems overflow, contaminating rivers, lakes and underground drinking-water supplies. Our tap water is murkier than we'd like to believe, too, thanks to ancient treatment plants, pesticide runoff and the thoughtless dumping of home chemicals down storm sewers.
Its pretty bad, because we have underinvested in the water-distribution system for so long, says Debra Coy, water industry analyst with Schwab Washington Research Group. The politicians are starting to pay attention, like this is the next big infrastructure crisis waiting to happen.
The Environmental Protection Agency has noticed, too. Since 1986, the EPA has tripled the number of contaminants it regulates, bringing the total to 94. It has tightened standards on others, like arsenic and cryptosporidium, a potentially-lethal protozoa that survives chlorine and shows up in water supplies.
Because of these risks, EPA inspectors are aggressively monitoring and citing water systems -- mostly run by local governments or mom-and-pop operators, neither of which has the money to fund the upgrade of water systems. From its perch, the EPA estimates we need to spend $500 billion over the next 20 years. Thats $250 billion to replace pipes, tanks, valves and treatment plants in the water infrastructure, and $250 billion to upgrade the sewage system.
In short, were potentially at the start of a massive spending cycle -- always an interesting place for investors to hunt for long-term investment plays.
Waters a bargain -- for now
Given that local governments are already raising taxes to make up big budget shortfalls, you might be skeptical about the likelihood theyll raise taxes (or water and sewer rates) even more to cover this kind of spending. But the fact is, we dont pay terribly much for water -- $16 per month on average per family of four. So slipping in, say, a 10% increase wouldn't overstress most homeowner budgets. In short, there probably wont be too much resistance to water-rate increases to fund the upgrade.
Which companies will benefit from this big wave of spending? On the surface, you might think water companies would be the worst off, as theyre the ones footing the bill. But theyre actually winners, because of a plot twist well get to in a moment. So for starters, the spending should be a boon for stockholders of public water companies such as Philadelphia Suburban (PSC, news, msgs), American States Water (AWR, news, msgs), California Water Service Group (CWT, news, msgs) and Connecticut Water Service (CTWS, news, msgs).
Other potential winners include pick-and-shovel plays such as Insituform Technologies (INSU, news, msgs), Watts Industries (WTS, news, msgs), Calgon Carbon (CCC, news, msgs), Ionics (ION, news, msgs) and Tetra Tech (TTEK, news, msgs). These companies either make the hardware used in the water system upgrades or offer engineering know-how on the best way to do it.
Heres a closer look:
The water companies
You might think that publicly traded water companies such as Philadelphia Suburban, would be the wrong place to be -- given the amount of money theyll be spending on plants, pipes and valves over the next two decades.
Youd be wrong for two reasons.
As regulated utilities, water companies get what amounts to a guaranteed return on their investments. Sure, there are legal disputes over rate increases. But in the end, the government always lets them increase rates enough to make a decent profit. They get almost a guaranteed 10% return on equity, says Coy. That is not the biggest return on equity anyone has ever heard of, but it is dependable. These companies grow earnings just through their capital spending alone.
Theres more to the growth story. Remember all those mom-and-pop water systems? They were typically put in by builders to supply the houses in their developments. Then the builders just ran them as cash cows. Like the local municipalities, these small operators dont have the money to buy expensive engineering talent, nor the new plants and pipes needed to keep the nasty stuff out of our water these days. But the EPA is all over their cases, anyway.
How are they going to deal with the pressure? Many will throw in the towel and sell to the likes of big water companies such as Philadelphia Suburban. (Nation-wide, in fact, private companies provide about 15% of our water service.)
As soon as the EPA knocks on the door or the pipes start breaking, all of the sudden, they have to put money up, and they ask, Why am I in this business?' says Nicholas DeBenedictis, chief executive of Philadelphia Suburban. Most of them will never be able to afford the capital they need. So we are buying them.
Thanks to about 70 acquisitions, DeBenedictis company now serves 2.5 million people in 15 states from Maine to Texas, compared with 750,000 10 years ago. It is changing its name this month to Aqua America, to reflect its national scope and status as the largest water company in the country. (The ticker symbol will be WTR.) Philadelphia Suburban recently branched out into the Southeast through an acquisition. The company expects 4% customer growth, 7% revenue growth and 10% earnings-per-share growth annually going forward. Some of the earnings growth from acquisitions has come from cost-cutting, including the slashing of union jobs when it takes over municipal systems.
To be sure, a lot of water companies arent actively expanding. Middlesex Water (MSEX, news, msgs), serving parts of New Jersey, fits into this category. Unless it changes its tactics, this low-growth water utility looks less attractive as an investment.
But a couple of California water companies -- American States Water and California Water Service Group -- look interesting because a new regulatory environment in that state may favor bigger rate increases, says Coy. Besides, population growth in California assures revenue growth for these companies.
And Kelley Wright, managing editor of the newsletter Investment Quality Trends, likes these two for another reason: Each pays a decent and reliable dividend. American States carries a dividend of about 3.5%, and California Waters is 4.5%. Philadelphia Suburban has a dividend of 2.5%, which it expects to increase by about 6% each year.
Water companies turn dividend policy into an art, says Dave Schanzer, a water sector analyst at Janney Montgomery Scott. I dont remember a water company that has cut its dividend. Indeed, American States has the astonishing record of increasing its dividend every year for 50 years running.
As safe as these stocks sound, they face one major risk, says Mario Gabelli of Gabelli Asset Management, which owns several water utilities. Thats inflation. If inflation goes to 7% and interest rates go to 8% or 9%, you are stuck because they cant change their rate base very much, he says.
The pick-and-shovel plays
Predictably, many of the companies selling the parts that will be used in the sprawling water-system upgrades do so many other things that the income they get from this trend will be, shall we say, a drop in the bucket.
A few, however, are more focused plays, such as Watts Industries, the largest maker of back-flow valves and other water-system equipment, and Calgon, which sells systems for treating water.
Another is Tetra Tech, an engineering consultant that advises municipalities and water companies on the design of water-treatment plants and water-distribution systems. The company gets about 40% of its revenue from water-related projects, says Coy, who owns a position in the company. It also works on defense and telecom projects. The stock has had a nice run recently; its up 215% over the last year. Patient investors may want to wait for a pullback.
Another infrastructure play is Ionics. It supplies water treatment and purification equipment. The company, for example, is building a water filtration system, which Minneapolis has to put in because of tighter EPA guidelines. It also makes systems that provide ultra pure water for use by semiconductor manufacturers or utilities that use steam for power generation. Ionics also puts in desalination systems in places like the Middle East and the Caribbean. The use of desalination systems is growing because the cost of installing the systems has come down substantially.
Value investors, meanwhile, should consider Insituform Technology, which refurbishes leaky sewer pipes without digging them up. Instead, the company will run a resin-filled sleeve through a pipe and then let it harden, creating a lining inside. Its classic infrastructure replacement, says Coy.
Insituform has had a spate of trouble recently, which explains why its a value play. (The stock is off 59% from its 2001 high.) Project cost overruns, a poor safety record that ran up insurance costs and a couple of hard-to-manage acquisitions have plagued the company. And their technology has come off patent, so they face some pricing pressure, says Coy.
That said, the demand for their services will be huge. One of the real horror stories is that the sewer infrastructure is so decrepit and dilapidated, says a money manager at a major mutual fund company. Something like 30% of all sewer effluent will not make it to the plant. It leaks out and makes it into the watershed. It is the real deal, and the EPA has had it with this.
Insituform recently changed course by bringing in top management with hands-on experience in running construction companies, replacing a management with more of a technical background, says Chief Financial Officer Joe White. In July, it brought in construction veteran Tom Rooney as chief executive, for example. He has carried out successful turnarounds in his last three positions, say sell-side analysts. I think the stock is interesting here because it has pulled back so much, says Coy. I think we will see a period of recovery over the next year and a half.
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