SouthWest Water’s private future

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Water Asset Management has taken advantage of the investor-owned utility’s accounting irregularities to make an offer for the company. Private ownership may be the best thing that has happened to the California-based company.

While many have cast longing glances at the comely assets of California- based SouthWest Water, its acquisition by JP Morgan Water Asset Management and Water Asset Management LLC still took water investment experts by surprise.

Matt Diserio, co-founder of Water Asset Management, called the chance to buy SouthWest a ‘unique opportunity’, as it opens up a customer base both in California and Texas, with both regulated and unregulated customers in its portfolio. “The opportunities in the Western US are attractive,” explained Diserio. “SouthWest is a company that we have known for a long time.”

The offer of $11.00 per share values the equity at $275 million, and the assumption of $152 million of outstanding debt implies a total enterprise value of around $427 million. SouthWest Water (SWWC) shares, which had closed at $7.07 the day before the acquisition was announced, shot up to $10.38 following the news.

The deal is a healthy jump up from the fair value estimate of $8.00 per share accorded to SouthWest by Debra Coy of Janney Montgomery Scott. Coy said that the price offered by Water Asset Management and JP Morgan was “a bit of a surprise”, explaining that their valuation is at a premium relative to where other stocks in SouthWest’s peer group are trading. “Our estimate of the rate base of the regulated utility is somewhere around $220 million. Two times the rate base seems like a relatively high valuation to us.”

SouthWest’s stock tumbled in November 2008 after the company announced that it would review its quarterly results from 2005 through June 2008 in the wake of an accounting error (see chart, right).

Michael Gaugler, an analyst with Brean, Murray, Carret, sees the acquisition as giving Water Asset Management a broad range of future opportunities. “SouthWest’s multi- state operations and the relatively small size of the company probably made it attractive as a platform-builder,” said Gaugler. “If I had to look at what makes it different, it would be the expertise and the broad array of business lines they are in.”

SouthWest has both regulated and unregulated divisions, with customers in California, Texas, Alabama, Mississippi and Oklahoma. Its growth strategy throughout the last decade has been based on acquisitions, both on the regulated and nonregulated sides of the business. It is these which have given the company a wide array of expertise in different areas of the water industry, as well as a unique business mix when compared to its peers.

While SouthWest’s services business has been struggling to generate the earnings needed to fund capital expenditures for acquisitions, the infusion of private capital that Water Asset Management and JP Morgan will provide will make up for this gap. “This [deal] supports our plans to continue to spend capital on infrastructure,” confirmed SouthWest’s CEO Mark Swatek on a conference call on 3rd March.

In order for the deal to be completed, it needs to be approved by state commissioners in all five states where SWWC is active, a process which could last up to 18 months.

“California’s process tends to be the most detailed in terms of what they look at,” explained attorney Wesley Strickland, a partner at Brownstein Hyatt Farber Schreck, which represented Water Asset Management in the negotiations. “Their process includes a built-in examination of any proposal of any type within the California Division of Ratepayer Advocates – they look at any proposal to make sure that it will be fair.”

Water Asset Management is under no illusion that patience will be the key. “The extra value is going to be realized over a long period of time,” said Diserio. “We are long-term investors.”

* Christopher Gasson writes: Water Asset Management brings two things to South- West which could accelerate change in the US investor-owned utility sector. The first is that it is an entrepreneurial company. It is unlikely to sit back and live off rate cases once the deal goes through. Instead, it will be out there knocking on doors in search of municipalities with big water challenges, and empty bank accounts. The second thing is that Water Asset Management knows about the water rights market. Three years ago, it bid $25,000/AF ($20/m3) in the Prescott Valley wastewater auction (see GWI November 2007 p22). It doesn’t take a lot of creative thinking to see how someone who can put a price tag as high as that on water might be able to see a lot of value in saving the resource. The fund manager could be just the partner California needs to drive water efficiency in the state.