Should You Take the Splash Into Water Utilities?

The record drought in Texas and the blowout quarter recently reported by irrigation manufacturer Lindsay (NYSE: LNN  ) both highlight the importance of having reliable and efficient access to water, even in a developed country like the United States. Water may seem like an infinite resource, but the truth is that only about 2.5% of the world's water is fresh water, and less than 1% of that is available for human use. An obvious way to profit from this fact is by investing in water utilities, but are they really good investments?

A fragmented industry
The trouble with water utilities is that the industry is highly fragmented, and not many of the individual companies are public. Here are five of the biggest:

American Water Works Company Market Cap Stock Chart

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Some of these serve a very broad area, like American Water Works (NYSE: AWK  ) , which serves people across 30 states and parts of Canada, or Aqua America (NYSE: WTR  ) , which serves 13 states. Others serve a more limited area, like American States Water (NYSE: AWR  ) in California and Arizona, California Water Service (NYSE: CWT  ) in four states, and San Jose Water (NYSE: SJW  ) , which only serves the San Jose, Calif., area.

Fragmentation alone isn't necessarily a bad thing, as it can mean that each company has a lot of potential room to expand.

Growth drivers
On the upside, water utilities have room to grow even within their own regions. While population growth will naturally drive an increase in water use, the real growth driver is agriculture.

Agriculture accounts for 80% of consumptive water use in the United States, and up to 90% in some Western states. In some sense, water utilities in the United States are a way of piggybacking on global growth in general and especially growth in developing countries like China and India. As these countries grow, they will have an increased demand for certain agricultural products for which the United States is one of the top producers, such as corn, soybeans, and cotton. Studies have shown that irrigation has an enormously important effect on crop yields, so as farmers come under pressure to meet growing demand, their water use is likely to increase dramatically.

This helps to explain why, over the past few years, revenue growth at these water utilities has greatly outperformed Exelon (NYSE: EXC  ) , one of the biggest electric utilities in the United States. It also explains why San Jose Water hasn't performed as well as other water utilities, as its area of service is mostly urban.

American States Water Revenues (TTM) Stock Chart

Revenues (TTM) Stock Chart by YCharts

The caveats
The problem is, a lot of that revenue growth goes to shareholders as dividends, but the companies can't necessarily afford it. Utilities in general are a capital-intensive business, and water is no different. As a result, capital expenditures take up a pretty hefty chunk of gross income, with American States Water averaging the lowest expenditures over the last five years, but still clocking in at 27.5%, and San Jose Water spending an average 66.5% of gross income.

American Water Works Company Capital Expenditures % Stock Chart

Capital Expenditures % Stock Chart by YCharts

Consequently, almost all of these companies have been consistently free cash flow negative over the entire five-year period.

American Water Works Company Free Cash Flow TTM Stock Chart

Free Cash Flow TTM Stock Chart by YCharts

The cumulative free cash flow losses over this period are huge, almost the entire current market cap for most of these companies. Despite generally having a monopoly on their regional area, state regulations don't allow these utilities to raise their rates much, and typically not enough to cover these costs. This has required them to issue more debt and equity to fund upgrades, repairs, and expansions to continue meeting their customers' needs.

American Water Works Company Liabilities Stock Chart

Liabilities Stock Chart by YCharts

Foolish bottom line
Water utilities certainly have a lot of growth ahead of them and have already displayed strong revenue growth compared to other utilities, but this growth comes at a great cost. Investors typically look to utilities for dividends, but these companies have been steadily losing cash and must take on more and more debt to pay shareholders and maintain their business at the same time, which isn't a sustainable situation.

Fool contributor Jacob Roche holds no position in any of the stocks mentioned. Check out his Motley Fool CAPS profile or follow his articles using Twitter or RSS. The Motley Fool owns shares of California Water Service Group. Motley Fool newsletter services have recommended buying shares of California Water Service Group, Exelon, and Aqua America. Motley Fool newsletter services have recommended creating a covered strangle position in Exelon. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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