Equipment stocks lose their shine

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Utilities performed well in the US but last year's star performer didn't live up to expectations.

Last year was an outstanding year for investors in most of the dozen publicly traded domestic water utilities including Consolidated Water of Grand Cayman. Betting on equipment manufacturers in 2005 was a different story. Their stellar performance in 2004 was all but undone last year. Both providers of water and their equipment vendors should be prepared for a bumpy ride in 2006.

“The fundamentals are great – demand and growth are there,” said Debra Coy, senior analyst at Stanford Research Group, referring to the industry in general, regulated utilities and equipment suppliers. The initial optimism was followed by a more sombre analysis of the US water industry, which concluded it was unlikely that share price growth could be sustained by the regulated utilities in the near term. Coy was no more sanguine about prospects for most equipment and service suppliers to the industry.

The 12 publicly traded private US water companies (including NASDAQ-listed Consolidated Water of Grand Cayman) averaged 16.8% stock appreciation in 2005. This is all the more impressive when compared with the broader indices. Morningstar reports the S&P500 grew 4.9% including dividends, while the Dow gained only 1.7% (excluding dividends, the Dow actually dropped 0.6%).

California-based water utilities did better than those on the East Coast
As a group, California-based water companies performed better than their East Coast peers. California Water Services, San José Water, Southwest Water and American States Water had an unweighted average year-on-year stock price growth of 16.6%. San José water outgunned its western neighbours with a 30% jump.

East Coast water companies fared less well. Excluding Aqua America, which is not limited to the east coast, regulated water utilities gained an average of 8.75%. With Aqua America’s 56% run-up, the East Coast group finished the year with a betterthan 12% gain.

Although state regulators have routinely allowed private water companies a 9% to 11% profit, in recent years California rate regulators had adopted a strong bias against private utilities. They required water companies to prepare detailed revisions of documentation and participate in a prolonged public review process when filing for a rate change. Cases often took longer than a year to complete and resulted in rates that disappointed applicants and discouraged investors.

Following his election, Californian governor Arnold Schwarzengger began 2005 by replacing commissioners on the Board of Public Utilities with industry friendly candidates. Rates cases last year were settled at levels that helped compensate for earlier decisions, and California water companies’ earnings and stock prices immediately benefited.

East Coast water utilities soldier on
Companies on the East Coast were less fortunate in rate case decisions and stock price appreciation. Connecticut Water Services’ share value slid 8%, New Jersey-based Middlesex Water lost $4 a share and the small and struggling Birmingham Utilities ended the year down $7.

Pennichuck Water in New Hampshire spent most of its surplus earnings battling the City of Nashaua’s attempts to use its power of eminent domain to buy the company. Still, on expectations of success in the law courts and the court of public opinion, Pennichuck’s stock rose by 7.7%. Artesian Water, of Maryland, experiencing sustained organic growth in wealthy satellite communities of Washington DC, enjoyed an 8% price appreciation.

There were a few outstanding gains in the east. York Water of Pennsylvania grew its customer base after completing a major investment in a water tunnel under the Susquehanna that allows water supply to vacation homes and retirement communities. York Water\'s share price reflected the opportunities for continued growth with an outstanding 40% share price increase.

Water utility rock stars
The US industry even has a couple of “rock stars” that seem to benefit as much from being who they are as from what they do.

Aqua America was again the focus of media attention and retail buyer interest. It topped our chart with an impressive 56% increase in stock price for 2005.

Aqua America credits its growth to favourable rate decisions, advantageous acquisitions and organic growth in its newer service areas. The company has been moving aggressively into the sunbelt to capitalise on its population growth, greater wealth and tolerance to rate increases.

Aqua America is a tough act to follow, even for Aqua America. The company that grew by acquisition seems to be having a tougher time finding suitable candidates. Aqua America’s latest acquisitions, and there have been about 30 in 2005, are systems of only a few hundred customers. And, contrary to his oft-stated strategy, CEO Nick DeBenedictis has begun buying wastewater treatment plants. While these may some day be relabeled water recycling facilities it does demonstrate a marked departure for what used to be a narrowly focused company.

With Aqua America’s earnings growing less than 20% in 2005 (fully diluted closer to 16%) and revenue growth a more modest 14%, it is difficult to see how 2006 will not retake some of the 56% gain of 2005. As CEO DeBenedictis warned in a statement last month: “Our long-term goals have consistently been 7% revenue growth and 10% net income growth. While we are pleased that the favourable comparisons have allowed us to exceed these targets yearto- date, our long-term objectives remain the same.”

For all regulated US water utilities there is a very real limitation on growth rate. Regulators allow rate increases of about 10% per year averaged over several years. Companies must create greater earnings from population growth of their service territory or through acquisition. And it has been acquisition that has driven Aqua America’s outstanding growth rate of 1000% in the past ten years. Growth through acquisition now has serious limitations. In the US, only 15% of drinking water is sold by private water companies. The 11 publicly traded companies account for more than half of that 15%. The remaining 7% of private water is supplied by over 17,000 privately held companies and tens of thousands of private wells.

The majority of private companies available for acquisition are too small, too isolated, or too expensive to be attractive to the publicly traded companies. The low hanging fruit has been picked. Growth through acquisition now requires buying water assets from municipalities – an exceptionally difficult political transaction.

Consolidated Water Company, based on Grand Cayman, has also benefited from a lot of hope and a little hype. It shares with Aqua America the distinction of having a P/E of 40, the two highest of the regulated water companies and reminiscent of 1990s computer tech companies.

CWCO sells only processed seawater and has been aggressively marketing to other Caribbean basin nations strong on tourism but weak on freshwater reserves.

Consolidated Water bounced back from Hurricane Ivan with 19% improved retail water sales. Its bulk water sales increased 12.4% on other islands of the Caymans, Belize in Central America and Nassau in the Bahamas. But the company struggled with fouling of its reverse osmosis membranes in the Nassau plant and had to supplement service with more expensive small package RO units. Total revenue for the nine months ended 20 September, 2005 rose 4.4% but the added operating costs dragged net income to a 6% decline compared with the same period in the previous year. Nevertheless, Consolidated Water’s share price rose 42% for the year mainly on hopes of new contracts in the Bahamas and Latin America.

Equipment suppliers
This year equipment manufacturers and service suppliers to the water and wastewater industries may have their turn at profits and rising stock prices after their 2005 drubbing.

The six water/wastewater equipment suppliers regularly reviewed by GWI averaged a scant 2.3% stock appreciation in 2005. Without the strong performance of Millipore, up 32.5% for the year, the group’s valuation was down 17%, considerably worse than the flat performance of the Dow industrial index.

Millipore apparently benefited from its global presence in the narrowly focused arena of laboratory products and services. As the world economy improved, so did Millipore’s profits. The company’s specialisation in handheld and field testing equipment has been growing strongly. Millipore recently introduced a small reverse osmosis system to produce laboratory quality water in very small volumes. This exemplifies the company strategy of capturing markets in emerging nations where local producers can’t easily compete in quality. In late December, Millipore repatriated $500 million in foreign earnings.

Millipore remains a tightly managed company. Although the company\'s P/E is climbing above 30, it should benefit from the growth in demand for laboratory analysis in the high-tech industries rapidly developing in emerging markets.

Pall, a competitor to Millipore in filtration for laboratories and industrial processing, suffered a 3.5% loss in stock value last year. It, too, is growing sales in Asia but is losing some of its medical business to competitors. The company has solid filtration and purification systems and a reasonable P/E under 25. With some restructuring charges out of the way, Pall should improve its overall earnings and market performance in 2006.

Danaher, Pentair and Calgon, makers of ultra violet disaffection systems and reverse osmosis home units, disappointed investors hoping for a resurrection of the high-tech boom years.

Principally a manufacturer of activated carbon for air and water filtration, Calgon\'s stock price rocked back and forth through the year to end down almost 40% at the close of 2005. Continuing its unpredictable ways, Calgon stock rocketed 25% in the first two weeks of 2006.

Calgon is trying to change course from being a supplier of a commodity, charcoal, to high-tech ultra violet filtration. If the gambit pays off, i.e. municipalities worldwide switch from chlorine to UV and Calgon can compete against industry giants ITT/Wedeco and Danaher/Trojan, it may reward courageous investors.

Danaher, owner of Trojan, had a modestly successful year with stock appreciation of 1.2%. Although Trojan UV systems dominate the fast-growing switch from chlorine disinfection, Danaher, with a market cap of over $17 billion, has such a large range of products that its Trojan Technologies corporation can make only a small contribution to profit or loss. This year it contributed to Danaher’s visibility when it won a $700 million contract to disinfect the drinking water of New York City.

Pentair, maker of home water purification systems, badly disappointed investors in 2005. Its stock price was down 17% on earnings projected to be $1.91-$1.93 per share in 2005. Gamely, the company recently reiterated projections for 2006 earnings of $2.08-$2.18 per share.

Pentair is placing great hope in selling to the growing middle class in emerging Asian countries. However, as analysts point out, there is little to prevent Indian or Chinese manufacturers from producing ultrafiltration and reverse osmosis units for their home markets. Home water purification products may become the commodity home filtration units currently are.

In large ultra and microfiltration units, technology leader Zenon Environmental took a beating in 2005. Quarter after quarter, it failed to meet projections and failed to turn a profit.

The company blames higher than expected project costs, a manufacturing reorganisation for its water treatment products and weaker sales.

Zenon said it expects a before-tax operating loss of US$10 million to US$12 million. Zenon stock suffered a 28% loss in 2005. Cashflow was not helped by a string of patent infringement lawsuits Zenon initiated in the US and Europe against competitors.

The past year was dominated by investor enthusiasm for regulated water utilities, which drove up multiples to unsustainable levels. Equipment suppliers disappointed investors who may have defined long-term growth prospects as including those less than a year.

The market for water-related products remains strong and growing stronger but the timeline stretches at least into the next decade.

Industry watchers are monitoring the expected sale of RWE’s American Water. American is the nation’s largest private water company and would bring a major new investment opportunity, as well as greater public focus, to the private water industry.