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Finally a turning point in water infrastructure investment?

Samuel Madden, CFA of Interactive Buyside

The Big Picture

Over the past five to ten years, the age of the U.S.’s water infrastructure has started to get some attention, and for good reason. Some of the more notable issues and estimates that the EPA and other agencies have released are quite startling. By the year 2035, over $1 trillion will need to be invested in U.S. water infrastructure, which could cause household water bills to triple in many big cities. Keep in mind, the average household water bill is by far the cheapest utility cost for Americans. The nation’s annual investment level is expected to increase from $13 billion (in 2010) to almost $30 billion per year by the time 2040 hits. This does not include population growth, but simply replacement/upkeep costs. Replacement needs will account for 54% of the gross national total, but if we factor in the remaining 46% which is attributable to population growth, the aforementioned $30 billion per year will actually reach $50 billion by 2040. All these investment dollars will go to fixing pipes, valves, sewer systems, water reuse facilities, and other capital equipment. The EPA has estimated that 240,000 water main breaks occur each year. In addition, 75,000 sewer overflows occur annually, discharging up to 10 billion gallons of untreated wastewater in and around U.S. cities. The Sandia National Laboratory calculates that many municipal water pipes lose up to 40% of the water flowing through them. So the question becomes, “When will this infrastructure replacement cycle start to ramp up?” and the answer now could be sooner rather than later.

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Recent Dynamics

Currently, most Americans pay about $3.75 for every 1,000 gallons of clean water they use in their homes, which is less than most other developed countries. The Labor Department reports that costs for sewer and water maintenance across the U.S. rose 5.3% in 2011, up from 3.3% in 2000. In September of this year, water and sewage maintenance costs jumped 6.6% vs. 2.0% for CPI, which is one of the bigger increases ever seen. Fitch reported that water utilities are having a record year with rate cases, having increased utility rates 7% year-to-date through November. The extended drought in 2012 led some soils to shift which caused the rise of water main breaks across the midwest. Even shifting populations bringing significant growth to some areas in the U.S. that are not water-rich (e.g., CA and NV), have required large and expensive pipe networks to be built and maintained. For the rest (and majority) of America, the average age of water infrastructure is about 50 years. From an investor’s standpoint, the question then becomes, “How do I invest in this theme?”

How to Invest?

Water utility companies:

  • Rising upkeep costs are encouraging more U.S. cities to sell municipal water systems to invest-owned (and publicly traded) companies. Only about 15% of water utility systems in the U.S. are owned and operated by the private sector. Many water utilities are money-losing operations to local municipalities, so selling operations to eager buyers immediately improves the municipality’s liquidity situation, and gets a large expense off its books. For the buyer, these tuck-in acquisitions are typically accretive due to a low purchase price multiple and the introduction of synergies as a result of rolling the smaller operation into a bigger network of utilities.
  • Two of the bigger water utilities are American Water Works (AWK) and Aqua America (WTR, IB report available).

Water infrastructure companies:

  • Companies with broad product offerings in the water infrastructure sector will benefit heavily from an extended upswing in the water replacement cycle. Offerings include pumps, pipes, flow control units, metering systems, filtration devices, and other distribution infrastructure. Firms that focus on new and proprietary infrastructure which reduce costs and improve water efficiencies will benefit the most
  • A few names include Pentair (PNR, IB report available), Flowserve (FLS), Roper Industries (ROP), and Xylem (XYL).

Over the past couple of months the Utility Sector (XLU) has been quite volatile. Some of the reasons for this uncharacteristic volatility have been the threat of rising interest rates, concerns over future CAPEX spending and some profit taking after a nice sector run. Having stated that, this recent volatility can provide some excellent opportunities, if you wish to invest or add to your investment in the utility sector. American Water Works Co. Inc. (AWK) is a utility company worth further investigation. Besides acquisitions, the company is also making regulated investments, taking steps to develop and maintain its infrastructure and introduce new services to help drive earnings. As the main focus for the company is the inorganic growth strategy, American Water Works has a fixed long-term earnings growth target in the range of 7% to 10%. These strategic acquisitions are all geared toward achieving this goal.

Primarily due to weather, the company experienced decreases in revenues and earnings per share (EPS) for the second quarter of 2013 compared to second quarter of 2012, mainly driven by decreased customer demand during the quarter, as compared to increased demand in the same quarter of 2012 due to the hot, dry weather conditions.

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The Market Realist Take

Water utility stocks benefited in 2012 from the hot dry summer in Northeast of the United States, which drove an increase in consumption, and also due to regulations in terms of rate increases. These stocks offer stability, as their performance is consistent and they’re also known to pay above market dividends. The companies in the sector are mostly monopolies, and the segment would see an increase in demand due to the scarcity of water as a resource. With the Fed pledging to keep interest rates down until unemployment levels fall below 6.5% and inflation remains under 2.5%, the situation seems to favor utilities as a whole. Apart from American Water Works (AWK) and Aqua America (WTR), American States (AWR), which has operations in agricultural areas, and California Water Service (CWT) are some of the stocks that could be of potential interest in this segment.

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