Monday, October 16, 2006
The Lure of Liquid Assets
By CHRISTOPHER C. WILLIAMS
http://online.barrons.com/article/SB116078723139892727.html
WALL STREET IS PUMPED ABOUT WATER, and for good reason. Globally, the $365
billion business is burgeoning as countries spend billions to repair and
build infrastructure to funnel clean water to people and industry. Some
experts think $1.5 trillion in capital spending could flow into the sector
in the next five years, promising a steady stream of business for a host of
companies, from pump makers to water utilities. The market, which
encompasses residential and industrial water and wastewater treatment and
services, is growing by 4% to 6% a year in developed countries, and as much
as 15% in emerging markets, estimates Goldman Sachs.
Less than 1% of the planet's water is drinkable. Yet, demand has been rising
steadily. A Unesco study estimates world consumption could reach 2,764
billion cubic kilometers by 2025, up from 2,182 billion in 2000.
To some degree, water stocks reflect the industry's bright prospects. The
Stanford Washington Research Group Water Index of 20 U.S. and international
stocks has returned 131% in the past five years, versus a puny 4% gain in
the Standand & Poor's 500 stock index. Much of the easy money has been made,
but investors willing to cast their nets a bit wider can find compelling
bargains.
Conglomerates such as General Electric (ticker: GE) and ITT (ITT) are a
growing presence in the water sector, but water is a relatively small piece
of their operations. European giants Suez (SZE) and RWE (RWE Frankfurt) have
been dominant players, but are retreating from the market. RWE, the German
electric utility, is planning to sell its American Water Works subsidiary to
the public through an initial public offering some time next year.
Among smaller companies, however, investment opportunities are rife. In the
U.S., Aqua America (WTR), the country's largest water utility, and equipment
makers Pentair (PNR) and Watts Water Technologies (WTS) look particularly
attractive. In addition to being well positioned to benefit from increased
water spending, all are viewed as potential takeover targets.
Paris-based water utility Veolia Environnement (VE) provides exposure to the
global water market, including China and Latin America, where water
shortages, huge spending on infrastructure and increasing regulations are
making water a hot business.
More direct plays on emerging markets include Companhia de Saneamento Basico
do Estado de Sao Paulo, or Sabesp (SBS), Latin America's largest water
utility, and Sinomem Technology (SINO Singapore), a small Singapore-based
membrane-technology company with a dominant share of China's pharmaceuticals
business. "In the medium to long term, some of the most desirable
opportunities will be in the international arena," says Francesca McCann of
Stanford, citing cheaper valuations and higher growth opportunities.
All six companies, profiled below, offer relatively direct plays on water,
as they garner at least 35% of their revenue from water-related products.
They sport an appealing price/earnings multiple of 15 times expected
earnings, on average, and most are growing by more than 10% a year. Fans see
at least 15% upside in each of the stocks. An impending catalyst: American
Water Works' prospective IPO.
The run-up in water shares leaves these companies little room for error,
even as investing in emerging markets presents significant economic risks.
But there is some justification for bulls to trumpet H2O as the oil of the
21st century. "The long-term story of water is as compelling as anything in
the investment world," says John Dickerson, president of Summit Global
Management, a West Coast manager specializing in water investing. "There's a
fixed supply and exploding demand."
Aqua America
The U.S. water-utility industry, composed of 55,000 separate water systems,
has been consolidated in the past decade through mergers and acquisitions,
many involving foreign water conglomerates. Today, only 11 independent,
publicly traded companies remain, half the number of 10 years ago.
Water World: The planet's awash in the stuff, yet under 1% of the world's
water supply is drinkable. Rising consumption, particularly in developing
economies, is making fresh water increasingly scarce.
Aqua America of Bryn Mawr, Pa., is the largest among the survivors,
providing water and waste-water services to 2.5 million customers in 13
states. Some industry analysts, such as Deane Dray of Goldman Sachs, think
Aqua eventually will be snapped up, as its stock-market capitalization is a
modest $3 billion. But CEO Nicholas DeBenedictis says Aqua "wants to be
independent." In fact, it has thrived as the leading acquirer in the sector,
buying more than 100 companies in the past five years.
Aqua and other utilities, including American States Water (AWR), have
benefited from a healthy rate environment.
Aqua, which is generating about $500 million in revenue, is seeing between
3% and 5% annualized rate increases. As the industry leader, the company
also is well positioned to benefit from heavy spending on water
infrastructure -- about $280 billion over the next 20 years, according to
Environmental Protection Agency projections.
Aqua trades for 23 a share. For a stock in a regulated industry, it looks
pricey at 27 times analysts' estimated 2007 profits of 84 cents a share.
Yet, the shares are cheaper than they've been in a while, trading well below
their 52-week high of 29.79.
William Brennan, manager of the Praetor Global Water Equities Fund, has been
buying the shares, and says the company should have little trouble meeting
management's long-term goals of 7% annual revenue growth, 10% earnings
growth and a 5% dividend yield. (The stock currently yields 2.03%.) If the
company stays on course, its shares could appreciate more than 20% in the
coming year -- continuing a decade-long trend of 25%-plus annual gains.
"Investors will pay up for earnings consistency, and a business model that
represents a growing customer base coupled with guaranteed rate increases,"
says Brennan.
Pentair
One of the most compelling turnaround stories in the water sector is
Pentair, a Golden Valley, Minn., maker of fluid-handling systems and
industrial products. The stock has lost 16% in the past 12 months, after
several quarters of earnings misses, and now trades for 29, or 14 times
estimated 2007 earnings of $2.12 a share. Earnings per share this year
should drop 10 cents, to $1.82.
Pentair is struggling to integrate parts of Wicor Industries, a pump and
pressure-tank maker it bought in 2004. In addition, pool-business profits
are down due to weakness in housing. The sale of water and waste-water pumps
to commercial and residential customers accounted for 74% of last year's
sales of $3 billion, while electrical and electronic enclosures chipped in
the rest.
Table: Water Companies1Pentair CEO Randall Hogan says the commercial water
segment is "booming."
Pentair is celebrating its 40th birthday this year, but some investors are
betting it won't be around to see many more, as the dominant player in the
$50 billion water-components market could attract buyers. Brennan of Praetor
Global, a shareholder, sees a deal within a year.
Pentair is boosting its share-buyback program, streamlining management and
expanding in markets such as China. "Next year. we expect to get back on
track with margin expansion even if the residential market stays weak," says
Hogan.
If so, earnings could rebound sharply and push the stock back to the
mid-30s. "They have fixable issues," says Brennan.
Watts Water Technologies
Like Pentair, Watts is benefiting from annual growth of 4% to 6% in the $87
billion U.S. water market, as increasing consumption and infrastructure
spending spur demand for its valve and flow-control products. Also like
Pentair, North Andover, Mass.-based Watts relies on acquisitions for growth.
But the similarities end there.
While Pentair is suffering indigestion from its acquisitions, Watts has
feasted on deals and doubled its business in the past five years. The
company posted a 12% increase in earnings per share last year, to $1.67, on
$924 million in revenue.
Watts showed organic growth of 8% in its most recent quarter. The company
recently reported a 32% increase in total second-quarter sales, continuing
its habit of beating analysts' quarterly projections. Earnings per share
could jump to $2.16 this year, and grow by 15% in each of the next three
years. Watts has been expanding overseas, and gets more than 30% of its
business from Europe and China.
A protracted downturn in housing could depress Watts' consumer business.
Higher copper and materials costs may also pose problems, but the company so
far has been able to pass these along to customers.
Watts trades at about 35, or 16.3 times this year's expected earnings.
Needham & Co. analyst Mark Grzymski upgraded the stock to Buy in early
August with a 38 price target, notwithstanding the "lingering possibility of
gross-margin compression due to the inflationary environment." Watts hit a
52-week high of 40.03 in May.
Veolia Environnement
Swiss investment bank Pictet & Cie. estimates Europe will need to spend $600
billion to $700 billion in the next 20 years on water investments. Many
water-industry players will benefit, including United Utilities (UU) in the
U.K., Geberit (GEBN Zurich), a Swiss plumbing and plastics-technology firm,
and Suez. But 150-year-old Veolia, the world's largest water utility, is a
more direct play than Suez, which is merging with the power utility Gaz de
France.
Jump In, the Water's Fine: Heavy spending on water systems and treatment
means big business for a host of companies across the globe -- and juicy
returns for shareholders. The six companies listed here are well-positioned,
and offer both value and growth investors compelling opportunities to play
the burgeoning market. Shares of some of them, namely Veolia and Sabesp,
already have had big gains, but fans believe they have yet to hit their
high-water marks.
Water accounts for more than 30% of Veolia's annual revenue of â,¬25
billion; the company also has energy and transportation operations. Veolia
generates more than half its business outside France, although the local
market is robust. France's per-capita use of water is second only to the
U.S.', and its $10 billion municipal water market has drawn the attention of
GE, which may buy more water assets in the country.
Veolia's shares dropped sharply this summer, after management expressed
interest in buying the Italian construction company Vinci. Analysts failed
to appreciate the logic of the deal. But the shares rebounded after the plan
was ditched, and now sell for â,¬47. The American depositary receipts trade
around 60.
If Veolia focuses on cutting costs instead of striking potentially
disruptive deals, its shares, which sell for 16 times 2007 earnings, should
remain buoyant, and profits could grow by 18% a year. "It's a great story
with high visibility," says Hans Peter Portner, a manager with the Pictet
Water Fund, who is betting his largest holding reaches 60 in three years.
Sabesp
Brazilian President Luiz Inácio Lula da Silva's economic policies have kept
inflation low and the real strong. Both have helped the giant water utility
known as Sabesp, which posted a 68.7% jump in net profits last year. While
the company's results have moderated this year, Sabesp still is expected to
grow annual earnings at a 10%-plus clip for several years, above the
industry's average 8.5% pace, notes Morningstar.
The water market in South America should grow 4% a year, and Sabesp is one
of the best ways to play it. The stock, which trades on the Sao Paulo
exchange, is up 73% this year in local currency, while the NYSE-listed ADRs
have gained 88%, to 31.
Sabesp is the largest water utility in the Americas and No. 3 worldwide,
serving about 26 million people in the state of Sao Paulo with water and
sewage collection. It generated sales of $2 billion last year, mostly from
concession contracts with municipalities and is 50%-owned by the state of
Sao Paulo. It has been winning tariffs, or rate increases, at a faster rate
than inflation, helping it generate stable cash flow.
Despite its shares' run-up, Sabesp trades for just eight times expected
earnings, a steep discount to U.S. water utilities -- a so-called
emerging-market discount. Investors also worry about state ownership, and
the possibility that the government could enact policies detrimental to
shareholders.
Still, they are not risking much to bet that the Brazilian government
continues to allow the utility reasonable rate increases. "This is a
conservative way to take a chance on Brazil," says John Maloney of New
York-based M&R Capital Management. "As water companies go, it's a true
growth story and very reasonable value." Maloney values the ADRs at 37, some
20% above current prices.
Sinomem Technology
Throughout Asia, dynamic economies are straining against inadequate water
infrastructure. A fourth of China's 1.3 billion population is without
adequate drinking water, says Goldman Sachs. This has prompted the
government to pledge around $125 billion for water treatment and
infrastructure in the next five years. The Asian water market is expected to
grow 13% a year, says Frost & Sullivan, while the Chinese market is
increasing by 20%.
To increase investment, China is opening its water market to the private
sector, and companies like water-treatment provider Sinomem have jumped in.
Formed in 1996, Sinomem provides membrane-based separation and purification
technologies, mostly to the pharmaceutical industry. Headquartered in
Singapore with production facilities in China, it is one of the few
pure-play treatment companies in Asia.
Sales and profits have grown steadily in recent years. Sales reached 81
million Singapore dollars ($51 million), last year, and Goldman says the
company has better margins than similar concerns. The knock on Sinomem is
that it's tiny, with a market value below $300 million. It trades on
Singapore's exchange for S$0.91, up 30% this year, but Goldman has a S$1.09
price target.
John Dickerson of Summit Global recommends that investors buy a basket of
Singapore-listed water-related stocks, including Sinomem, Hyflux (HYF
Singapore) and Bio-Treat Technology (BIOT Singapore). Hyflux is pushing into
the Indian water market, and Bio-Treat's business pipeline is good.
THE YEAR-OLD PowerShares Water Resources Portfolio (PHO), an exchange-traded
fund, is a basket of global water stocks; it's up 15% on the year.
Stock-picking may be the wiser approach these days, however, as merger
activity in the sector, which once lifted all boats, abates. The six stocks
above are a good way to get your feet wet, without getting soaked.
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