Is private water 96% ownership and 4% expertise?
Published July 6th, 2017
Two sales in the US market over the past month make a very expressive point about where value lies in the utility sector. Both companies had revenues in the region of $200 million and managed water utilities and related assets. One of them, Severn Trent Services North America, did not own the assets it managed, and was sold for $62 million to two private equity buyers. The other, Aquarion Water Company, did own its assets and achieved an enterprise value of $1.675 billion when it was sold to Eversource Energy. It seems to imply that ownership is 96% of the value in a utility.
I can understand why the differential exists, but even so, the scale of it seems very wrong. Obviously if you own a utility rather than just operate it, you don’t have to worry about losing it when the contract comes up for renewal or squeezing your margins in order to retain it. You can also hope to make rate cases in order to increase your revenues, whereas contract operators generally expect fixed revenues over the length of a contract. That said, the relative prices of STS and Aquarion seem to suggest that the private sector offers very little value-add in terms of operational excellence, but does very well out of owning and financing a natural monopoly.
In fact there is a different dynamic at work: the dynamic of scarcity. Both contract operators and investor-owned utilities face a dearth of decently sized new market opportunities. Very few big cities are considering outsourcing their operations, while outright utility sales of a reasonable size are rarer still. This paucity of opportunity has one effect on the contract operations market and the opposite effect in the investor owned utilities market. In the contract operations market it creates massive competition for contracts as they come up for renewal, cutting margins to the bone. Those operators, like Severn Trent who want to grow the top line end up in horrible markets like the Metropolitan Utility District market which is full of tiny contracts with asymmetric risks.
In the investor owned utilities market, the lack of opportunity grows the scarcity value of existing assets to quite preposterous levels. American Water – the largest investor owned utility in the US market has seen its share price grow by 378% since its IPO in Spring 2008. The Dow Jones Industrial Index has increased by just 66% since then.
Two things will change this state of affairs. One is increased interest rates. Investor owned utilities are most attractive when interest rates are rock bottom. With rates now on an upward trend, the using investor owned utilities as a yield play will slowly become less attractive. The other thing that will change the dynamic is if private operators find ways of using technology to increase the value that they can add. This will change the perception that outsourcing is just about stretching staff more thinly across the assets and re-engage the public in the debate about how they can improve the productivity of their utility services.
The best operators are focused on developing digital utility solutions that could transform the value that they can add to a public utility. These may take another three to five years to make an impact, but once they do, it will not just be the contract operations market that sees the benefit. It will make it easier for cities which are looking to release capital from their water utility assets to justify a sale: the efficiency gains delivered by the private owner might make it possible to sell assets and cut water rates.
Let’s hope that the next time STS and Aquarion come up for sale the relative value of the two is not 1:24 but 1:5 – a multiple which would reflect a return of growth and dynamism to the private water sector.