Hard Assets: Water
A transcript of a presentation given by
John Dickerson, President & CEO
Summit Global Management, Inc.
Greenwich Roundtable Quarterly Volume No. 2 2004
November 3, 2004
You might remember the old Will Rogers saying, “You ought to buy land because they ain’t making any more of it”. He could have said the same thing about water. Most of us learned in school that the same amount of water exists today as existed a million years ago. We have a closed system of water on this planet; we don’t gain a drop and we don’t lose a drop – but we do gain people. We have six billion people today competing for a very scarce asset. Most of us don’t realize just how scarce fresh, potable water really is.
More than 70% of the planet is covered by water, but 97.5% of this is salt water. That leaves only 2.5% of water that is fresh, but 70% of that fresh water is frozen in the polar ice caps and Alaskan glaciers. The total supply of fresh water on the planet is 0.7%. Most of that, however, is inaccessible. It’s in places like the Amazon River basin and in deep aquifers far from populations. The U.S. Geological Survey, the National Geographic Society, and others estimate the percentage of water on the planet that is fresh, potable, and available for human consumption is 1-100th of 1%. Moreover, this scarce resource is not declining just by the 3% global population growth; rather it’s declining geometrically because we not only use more water every year, we pollute the remaining water. The candle is burning at both ends.
In effect, we have a worldwide water savings account on which we’re earning 3% interest. If you’re drawing 7% of water each year, you’re really drawing into your principal,, namely the aquifers that hold the base supply of fresh water. In many aquifers, such as the Ogallala Aquifer, the water is going to take perhaps 500 years to replace. I don’t know what we’ll do about our wheat fields and the like when the water goes away, but we’re facing some serious supply problems. The bottom line for water is exploding demand and constant limited supply.
In the U.S. we treat water as a most ubiquitous thing. Every place we turn, we find water. We really don’t think about what’s behind the pipe. But globally, only 20 % of the total population has access to running water. Half of the world’s population has no access to potable water and therefore has no sanitary facilities. More than 30% of the countries of the world are under what we call water stress. A significant part of the world’s population is actually displaced from one location to another in order to get to water, and “water wars” are probably in our future.
What we have in the U.S., though, is not so much a water supply problem, but a water allocation problem. Surprisingly, California, for example, has enough water to serve 220 million people – most of the U.S. The problem is that about 95% of it is going to agriculture, and most of that to low value and water intensive crops such a hay, rice and cotton.
The laws west of the 100th meridian in the U.S. are different than those in the East. These laws are “prior appropriation” laws that evolved after the Louisiana Purchase. In the West there’s a complete water courts systems. It’s the only category I know that has its own court system, which tells you something about how important water is. When people first went west in America, nobody owned the land. So, the first guy to get to a place and use the water – he really took it by might, literally by the point of gun – owned the water right that later got adjudicated. He had the ‘prior appropriation’ that basically says “use it or lose it”. You were the first person on the river, and you can take your three acre feet a year from the river as long as you’re putting it to a beneficial use. But if you don’t consume it by putting it to a beneficial use, you lose your right, and it passes to the next most senior person in line.
The unfortunate result of these antiquated laws is that we have a supply of water that is effectively being wasted. For example, we have rice farmers in the Sacramento River watershed area who get water for nearly free: The fee taxpayer subsidized, since the going market price for water in that area is hundreds of times what the rice farmers pay. They flood rice fields, grow rice, and sell most of it to the federal government under crop subsidy. Then it goes in a warehouse, only to be burned in a few years. But the farmers have to keep doing this because it’s a “beneficial use”. In effect, these farmers are wasting good water to hold their water rights, with an eye towards being able to eventually sell their water rights for domestic use: The old laws are encouraging massive waste.
If the regulators would get out of their own way and simply allow farmers to ‘farm water’, what’s called the ‘water market’ would develop quite nicely. Farmers in the Imperial Valley, for example, with 10 acre feet of water might put in a center pivot irrigation systems and get along with two acre feet. They could then sell eight acre feet to the nearby city, at a price that would be set by the free market, eventually lowering the costs to cities and certainly being a lower price than alternative sources such as desalination.
My view is that water sources are out there, but they haven’t been efficiently harvested yet. The technology of desalination is generally not yet there to produce water at the same efficient prices which would be produced by a free market. There’s a desal plant in Tampa, Florida at the moment, and there’s one being developed in Carlsbad, California. Still, I don’t believe desalinization will generally make much sense for a long time to come. What we need first now is an efficient system of free water marketing and allocation of our ample existing resources.
The result of the global lack of supply and rampant pollution is that the lack of clean water has become the largest single health problem in the world. Recently the World Health Organization reported that 80% of all diseases in the world are directly attributable to waterborne diseases and/or lack of water. It’s much larger than cancer, AIDS, or anything else. This is a serious problem that must be solved – which leads me to the private water industry. Clearly, companies who can help solve these intractable problems are looking at very large demand for their products and services.
To give some idea of the size of the investor-owned water sector, our universe at Summit is composed of 160 companies and about $200 billion in market capitalization worldwide, so it’s pretty small. That’s one reason why you don’t see a lot of institutions in the sector – there just isn’t enough room. In that context, it’s an inefficient market, but that creates opportunities. Many people expect the sector to grow. Lehman Brothers feels the market cap will grow 500% over the next 10 years. Ultimately, we expect that there will probably be 30 or so big U.S. regional water utilities, with two or three dominant players in pipe, two or three dominant players in pumps, filters, etc.
The 160 companies in the space as we define it does not yet include General Electric, or ITT Industries, and we do not include companies that have just 5% or 10% of revenues in the water sector. We’re talking about companies where the majority of their revenues come from selling into the water space. I don’t think you want to call GE a water stock because water only accounts for a small percentage of revenues. One could look at market capitalization on a little more generous basis than we do, but the change in the water universe would not be great.
If you go to a big investment firm and look at their oil and gas research department, they have analysts covering independent drillers, integrated big sister companies, oil and gas pipeline stocks, and a whole array of things including oil and gas service stocks (Schlumberger, Halliburton, etc.). Nobody would think of calling Schlumberger a machine tool company or Halliburton an industrial products company. They are oil service companies. On the other hand, no one looks at Gorham-Rupp and Northwest Pipe as water industrial stocks; they see Gorham-Rupp as a pump maker and Northwest Pipe as a pipe maker. If anybody covers these stocks, although usually they’re not covered by Wall Street, it’s by an analyst whose main coverage is machine tools or industrial products. He doesn’t understand water or utilities; the dots are not connected. Yet these companies are selling into a business with a wonderful business model.
How do you invest in water? You invest in securities of companies in the water industry, which is something we’ve had to define ourselves because Wall Street and others don’t ‘connect the dots’. Wall Street has never really understood or paid much attention to the water industry, for the most part because it’s only about 7 % investor-owned. Ironically, the water industry, in terms of assets deployed, is one of the three largest industries in the world. The other two are the energy business and the electricity generation and distribution business. There’s a massive infrastructure in place for the water industry, but it’s still considered a small business because of only 6 % investor ownership.
Typically, water service stocks benefit from the same economics as benefits the utilities business model. Even though utilities are 93% municipal (a percentage that’s changing rapidly in the U.S.), they still have a very good business model. In the water business, you first have a customer who must have your product on a daily basis. There is no substitute for water at any price. Think about it: There’s a substitute for lots of things – gold for silver, kerosene for fuel oil, wheat for oats – but there isn’t a substitute for water. You must have water. You must have it daily.
The way our system works, the company with the pipe into your house has the only conveyance and an enforced monopoly. There are huge, impossible barriers to entry. The only way to replace that pipe is to buy the company that owns the pipe. A new company can’t come alone and put in another pipe. It’s not like having Mobil on one corner and Texaco on the other, and you can go across the street if Texaco has gas a penny cheaper.
The demand for water is unaffected by inflation, recession, or interest rates. It’s economically intensive. No one thinks, “Gee, times are tough. We are in a recession. I will take fewer showers. We’ll only do two loads of laundry a week instead of three”. The water industry has an incredibly consistent growth record in all kinds of economic conditions. Yet the underlying asset still does not reflect its true economic value, which eventually will change.
In the 1793 Farmers’ Almanac Ben Franklin says simply, “When the well is dry, we know the worth of water."
In any utility-type business model, attention to service is absolutely critical. If you’re a supplier selling to a municipal or investor-owned utility and a pump goes out, the response is to fix it right now with no interruption of service. Water companies don’t say, “Gee, we can’t fix it until Monday because we don’t want to pay overtime for the weekend”. They don’t say, “It’s not in the budget this year”. It’s fixed right now, and when they buy a spare part, they often buy two of them because they want to have a spare. The effect of the service being so critical trickles down in a positive way throughout the water industry – to the pipes, pumps, valves, filters, and all the rest of the items that must be purchased and maintained.
The dominant and most current investment driver in the industry today is consolidation and privatization. That is really driving the stocks, for both utilities and suppliers. There are some 56,000 small water utilities in the U.S. serving less than 2,500 customers. There are also many thousands more that are larger and serve larger areas. However, these 56,000 are the least able to sustain themselves independently and are, in effect, the low-hanging fruit for the consolidation of the industry. When you have just 2,500 customers, you don’t have many economies of scale. You don’t have a sustainable business in the sense of access to capital markets and maintaining environmental and regulatory standards.
It’s amazing that there are so many of these small water utilities, but they came about through the real estate development process. Here’s a typical scenario. A developer buys a few hundred acres, cuts it up into lots, puts in curbs, gutters, sewers, etc, as this infrastructure is necessary to sell the homes, and, after a couple of years of selling the lots, his development project is complete. The last thing he wants to do is run the water and sewer facilities permanently, so he has his attorney charter a municipal special district nonprofit entity. When the last house is sold, he turns the key over to the homeowners’ association.
Please remember that water assets have a very long life, but they’re not permanent. In these special districts, the local board has a meeting once a month, and gets someone to drive around the area and check the fire hydrants and the like. It goes on for a long while. Breakdowns occur in the middle of the night and that sort of thing, but it still isn’t too serious. Everything is easy.
After the system is 20 or 30 years old, the board gets to knock on the door and hears, “Hello. I am from the Environmental Protection Agency. I’m here to check your water.” Often, there are problems. The EPA finds the particulate count is too high, or that there is chrome in the water, or MTBE, or too much this or too much that. The filter system is too old. The regulators state: “Unless needed updates are performed, you‘re out of compliance with EPA standards, and failure to comply will cause drastic sanctions."
The district calls in a consultant who says, “We can fix it for $5 million, and we’ll have it done in six months”. The guys on the board look at each other and say, “Oh, my God. How do we get $5 million? People want their $50 a month water bill. We’ve got $300,000 in the bank for our maintenance. How are we going to get the money?"
They call the local banker who says, “Sorry. We don’t make loans without personal guarantees, separate collateral, and a short amortization. They call the local stock-broker and ask, “How about a municipal bond issue?” He says, ”Sorry – nothing less than $100 million”. They know they’re facing an EPA fine, and the only way they’re going to get out of it is to assess the homeowners and that is not acceptable. People think it’s a God-given right to have a $50 a month water bill. They’re not going to stand for a $5,000 per household assessment.
They finally realize that they should call Aqua-America, or California Water or Southwestern Water who say, “Okay. We’ll pay you $200,000 for your system. That’s really just your closing costs. We’ll commit contractually to buy and fix the system, and we will guarantee in six months you will be in compliance. Your neighborhood will have clean water, guaranteed, forever”. The directors, of course, can’t wait to give the consolidating utility the problem and they are happy to do the deal.
It’s a win-win proposition. The community gets out of a serious problem, and the water company gets a deal by buying an asset at less than replacement cost and less than true book value. As a return on capital, these small transactions can make the returns from the best industrial companies pale in comparison. We’ve seen these little utilities go out as low as $400 per customer, which includes the acquisition cost and the cost of the repair. The last eight public companies acquired in the U.S. (by mostly foreign investors) went out at $2,400 per customer, which was 26 times earnings and three times stated book values, which shows how cheaply these very small systems can often be purchased. Again, remember there are roughly 56,000 of these entities out there and these are just the low hanging fruit.
Wall Street hasn’t noticed this opportunity because they don’t pay any attention to the performance of the industry as a whole. Among water utilities in the last five years, the average annual rate of return is over 16%, while the S&P 500 is down by around 0.5%. In the last 10 years, the water utility rate of return is 14.9%, still well above the S&P 500 at 9.3%. Interestingly, in the last 20 years, water stocks are up 17.5%, but the S&P 500 is up only about 12%.
One of the best performing stocks on the New York Stock Exchange over the 20 years ending in early 2003 was American Water Works, almost meeting the 20 year results of Home Depot, Wal-Mart, and Merck. Not very far down the list with a 16.5% average annual return was Aqua-America.
Further down the list by a couple of points more, at 15.2%, was San Jose Water in California, which outperformed American Express, Disney, McDonalds, IBM, and all the market indices. If stock groups are compared on a longer term total return basis, including reinvested dividends, water utilities have been shown to be leading performers over almost all time periods.
Clearly, water utility stocks have performed exceedingly well for a long time – in good markets and bad. The companies selling into that market, having those utilities as customers, have also very well. At the same time, because of the aging and dilapidated infrastructure in this country, the pace of consolidation and privatization (selling to an investor-owned consolidator) is picking up. For example, Aqua-America is doing a couple of deals a month, and the pace industry wide can be expected to accelerate, simply because aging systems are constantly more problematic and out of compliance. The resultant economics created are very, very interesting, and create major opportunities for perceptive investors.
The short-term domestic investment driver is consolidation and privatization. In the very long term there are huge, intractable problems around the world that have to be solved by the water industry – by the same companies that are providing the pumps, valves, and filters in the U.S. Every time one of those little deals happens, the $5 million spent to fix up the system goes to our water industrials. These will ultimately be the same companies that will fix the problems around the world.
Because of the consolidation in the water industry right now, I would compare it to the electric utility business of many decades ago. In 20 years, you’ll have 30-40 large regional utilities that have consolidated those 56,000 local utilities. Consolidation will go on in the water industrial sector too. One of the biggest industrial consolidators is GE. They say this sector is one of their five main growth platforms in the next few years. They’re up to roughly $900 million in revenues in the water sector and they’re probably the most active buyer out there.
The catalyst for moving people to invest may well be an increasing round of privatization in the municipal sector. The one asset most municipalities own that can be monetized is the water system. You can’t monetize or sell the fire department or the schools, but you can a water utility. Politicians want to get rid of the problem and nobody ever won an election running on a “pipes for the people” platform. Privatizing usually seems good for everyone.
Regulators are light on regulation, because the politicians are whispering in their ear, “Allow rates of return attractive enough to appeal to private industry. Don’t push on it so hard that nobody wants to come into the business, because then we’re stuck with the problem”. So, consolidation and privatization are being done at numbers that are extremely beneficial to the acquirer. And that’s where you’ll find the good results we’ve seen.
financialsense.com |
