Oil and gold have had a great run in the markets this year - so, too, has water

From the New York Times News Service:

While most of what flows through the nation's water taps is supplied by publicly run municipal systems, a growing number of rural and suburban water systems are owned by a handful of publicly traded utilities, like Aqua America. The shares of these companies have skyrocketed this year, and despite a sell-off earlier this fall, they still are at levels that might seem more appropriate for rarer commodities, like precious metals or petroleum.

The prices have surprised some analysts because water utilities, after all, inhabit a pokey, highly regulated universe whose infrastructure is likely to require an expensive upgrade. But investors who are bullish on the industry say that it is about to undergo a historic change - moving oceans of municipal water into the hands of for-profit companies.

New Regulations

The catalyst for the transformation will be the final draft of new water quality regulations, which the U.S. Environmental Protection Agency is expected to issue soon, says Michael Gaugler, a stock analyst at Boenning & Scattergood, a brokerage firm in Pennsylvania.

The new rules will require water systems to further reduce levels of substances like arsenic and chlorine. Many small towns will discover that they cannot afford the pricey ultraviolet reactors they will need to meet these stricter limits, Gaugler explains. But he added that the new requirements were not the only consideration.

“Some of this infrastructure has been around since World War II, and the pumps and pipes are wearing out,” Gaugler says. “But reality has not hit at the local level yet.”

About 85 percent of the nation's nearly 55,000 municipal water systems serve fewer than 3,300 homes each, and Gaugler says that many small towns had too few customers to be able to afford the infrastructure improvements. But, he said, companies like Aqua America - which is based in Bryn Mawr, Pa., and has 2.5 million customers in 15 states - could cover the costs without sharply raising rates. While large cities have continued to operate their own water systems, publicly traded water utilities tend to buy small rural and suburban water systems.

Gaugler predicts that more small towns would begin selling their water systems to the for-profit companies next year and in 2007, and that the pace might pick up as the deadlines for compliance - which range from 2011 to 2013 - drew near. He expects that the big water companies “will pay less for acquisitions as time goes on, because municipalities are going to get desperate to sell.”

Only a handful of water utilities trade on stock exchanges - and many of the companies are tiny, with market capitalizations of only a few hundred million dollars. This means that sudden changes in investor sentiment can cause big moves in the stocks.

Aqua America, the only publicly traded water company with a market capitalization of more than $1 billion, started trading this year at less than $25. The stock peaked at around $39 on Oct. 4. Then, on Oct. 12, more than four times the usual number of shares traded hands, and the stock fell to $32. It now trades at $32.92. Trading in the California Water Service Group, the second-largest water utility stock, and American States Water, the third largest, has followed similar patterns.

Investments

Such volatility is attributable in part to hedge funds and other pools of private money that have focused on water-related investments, says Ivan Feinseth, director of research at Matrix USA, a research and brokerage firm in New York.

“It's not as crazy as it was when all the Internet funds were launched,” he says. “But if you want an allocation to water, there are only so many stocks you can buy.”

Dividends were once a bigger incentive for investors in water utilities, says James Lykins, a stock analyst at Hilliard Lyons, a brokerage firm in Louisville, Kentucky. But he says he no longer finds the yield attractive after the sharp rise in share prices.

Both the California Water Service Group, based in San Jose, and American States Water, based in San Dimas, Calif., now yield a little better than 3 percent. Aqua America yields 1.8 percent, the average yield for the Standard & Poor's 500-stock index.

Both Gaugler and Lykins stopped recommending new purchases of Aqua America in early August, a week after the stock first hit $32. Lykins says he thought that the stock would be more attractive in the high $20s. Gaugler declines to say what he thought would be a fair price, but he does say he found it expensive at $32, which gave it a trailing price-to-earnings ratio of around 35. In most years, he notes, the stock has had a P/E ratio of 20 to 30.

In the past, some analysts argued that Aqua America had an advantage over West Coast companies, because the regulatory environment was more favorable in its core market of Pennsylvania than it was in California.

But Lykins said he expected the California Public Utilities Commission to make faster decisions and to grant bigger rate increases after two recent appointments by Gov. Arnold Schwarzenegger, a Republican.

So Lykins is recommending that long-term investors consider buying shares of the California Water Service Group, which serves more than two million people in California, Washington, New Mexico and Hawaii.

Last month, the California Water Service Group announced that it had put its chief financial officer, Richard Nye, on administrative leave, pending an investigation by the Securities and Exchange Commission (SEC) into his work with a former employer, CornerStone Propane Partners LP, based in Watsonville, Calif.

On Sept. 23, the SEC filed civil charges against Nye and four other former CornerStone executives, accusing them of reporting false financial results in SEC filings and press releases from June 2000 through September 2001. Because the investigation relates to Nye's work with another company - and not with the California Water Service Group - Lykins says he thought the impact on the stock would be “minimal, if any.

“Growing Demand”

There is money to be made from the growing demand for clean water - but the best opportunities are not in the water utilities, says Neil Berlant, a consultant to the water industry, who also runs a private water investment portfolio at the Seidler Cos., an investment firm in Los Angeles. He says the biggest opportunities would come from selling water filtration systems to industry.

Home water use accounts for only about 1 percent of water consumption in the United States, he notes. The vast majority is used by industry and agriculture, with most of the rest used for commercial purposes or parks.

Many industries already filter water for production, Berlant says, and some will need even purer water in coming years. For example, he describes that manufacturing a new wave of semiconductors would require water that is 15 times purer than what was needed just a few years ago.

Revenue of the water utilities will be constrained by state regulators who will keep a lid on rate increases. To add to revenue, Berlant says the water utilities will have to continue making acquisitions. But ultimately, he concludes, it is unlikely that such water holdings will prove very profitable.

“There has not been a huge growth in water consumption,” Feinseth explains. “But there's a doomsday scenario. Some people say that clean water will become a more valuable commodity than oil. Personally, I don't see how that happens.” ND