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Friday, March 5, 1999

An Investment Opinion
by Warren Gump

Keep Your Eye on Ionics

I have been intrigued by the prospects for companies associated with the water industry for quite a while. This fascination comes from the prospects of the increasing need of high purity water for manufacturers in the semiconductor and pharmaceutical industries. In addition, as clean fresh water becomes a scarcer resource, national and local governments will need to spend massive amounts of money to upgrade their water and wastewater system infrastructures. Rounding out the opportunities for growth is the soaring demand for bottled water.

Last December, I commented on U.S. Filter (NYSE: USF), one of the leaders in the water infrastructure and distribution business. That company emerged into its leadership position through an acquisition spree over the past several years, culminating with last year's huge purchase of Culligan. While posting strong earnings excluding one-time charges, U.S. Filter's cash flow statement has not been quite so strong. During the quarter ending December 31, the company posted net income of $63 million, yet it only had cash flow from operations of $12 million -- and that was one of its better quarters from a cash flow perspective! The company also has a fairly leveraged balance sheet, with $1.9 billion in total debt and $1.7 billion in equity.

I've found another water purification company that does some of the same things U.S. Filter does, yet has much better cash flow and virtually no debt. This strong financial structure is a result of the company's focus on using internal growth rather than acquisitions as a primary driver of growth. Earnings for this company declined 24% last year, but that follows 12 consecutive years of record earnings and revenue. During this growth streak, the company grew revenues and earnings at a compound annual rate of 17% and 30%, respectively. The end of this streak was brought about by the severe downturn in the market for ultrapure water by semiconductor manufacturers.

Ionics (NYSE: ION), headquartered in (of course) Watertown, Mass., manufactures membranes and related equipment for the purification, concentration, treatment, and analysis of water and wastewater. The company also supplies purified water, food and chemical products, bottled water, and home water purifiers. Operationally, the company can be broken down into three business segments: Membranes and Related Equipment; Water, Food, and Chemical; and Consumer Products.

The Membranes and Related Equipment division, accounting for 47% of revenues and 44% of gross margin in 1997, makes membrane-based systems for the industrial and municipal markets. Systems sold by this division accomplish various tasks including water desalinization, wastewater processing, and ultrapure water filtering (where impurities are measured in terms of parts per billion or trillion!). During the first nine months of 1998, sales and gross margin for this division increased a modest 3%. Strength in wastewater treatment offset weakness in the ultrapure water segment. (Although full-year 1998 earnings have been reported, divisional results are only available through September 30.)

The Water, Food, and Chemical division uses Ionics' technology to produce products that are then sold to customers. In many cases, the company will set up and operate filtration systems at the customer's site. The water side of the business produces ultrapure water and drinking water. The division also produces chemicals and food products, such as demineralized whey, which utilize Ionics' membrane technology in their manufacturing process. Accounting for 32% of revenues and 28% of gross margin in 1997, this division was the laggard during the first three quarters of 1998. Revenue declined 23% and gross margin fell 21% because of reduced demand for ultrapure water.

The Consumer Products division sells bottled water under the Aqua Cool brand name, as well as home filtration systems under the HYgene brand. The bottled water business, which primarily sells 5 gallon bottles, has over 120,000 customers around the world. This segment accounted for 21% and 27% of 1997's sales and gross margin, respectively. During 1998, the division saw sales increase 10% and gross margin rise 11%. The year-over-year improvements reflect a growing customer base and higher average prices.

Earlier I mentioned that Ionics has significantly better cash flow relative to earnings than U.S. Filter. In 1997, the company had net income of $28 million and cash from operations of $48 million. The high level of cash flow is derived from large depreciation and amortization charges, as well as only modest increases in accounts receivable and inventory. During the first nine months of 1998, the company had net income of $16 million and cash from operations of $25 million. As noted earlier, U.S. Filter had net income of $63 million and cash flow of $12 million last quarter. These figures indicate that Ionics is a much better manager of working capital.

Another strategy of Ionics that I like is its continued focus on research and development (R&D). Many companies will reign in R&D spending dramatically during a downturn to help boost earnings. Despite the weakness of the first nine months of this year, Ionics increased R&D spending 24%. This indicates the company's management team recognizes the importance of R&D. I would much prefer a company to have weak earnings for a few quarters and continue to invest in worthwhile research projects than risk its leadership in technology by throttling back R&D expenditures to meet Wall Street expectations.

Ionics should be interesting to watch in the years ahead. While the First Call consensus EPS estimate for Q1 is down, a rebound to 20%+ growth off of last year's weak results are projected for the rest of the year. Analysts are projecting a long-term growth rate of 15%. With the increasing demand for cleaner water worldwide, such prospects seem reasonable, if not conservative. The earnings downturn over the past few quarters does remind investors that while enjoying long-term secular growth, this industry is affected by the economy. Investors in such a business should be rewarded by finding a company with strong management, a technological focus, and a solid financial structure. Ionics easily makes it through those filters.

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