Water, Water, Everywhere . Forever?

Unlike electricity or phone service, water is actually essential for life. Yet we dump it down the drain every day and give nary a thought to whether we might ever run out. The United States is relatively blessed with plentiful fresh water, but it's not hard to envision a future where rising demand and pollution lead to discussions of limited supplies, akin to what we hear today with oil, coal, and natural gas.

Though electrical utility stocks have long been popular with the buy-and-hold income crowd, and gas utility stocks have attracted more interest with the recent spike in energy prices, water stocks have not attracted nearly as much attention.

Now's the time to change that.

A limited resource
Although we live on a blue planet, less than 2% of the world's water is unfrozen fresh water. Technologies exist to produce fresh new water, but those efforts are still modest, and the amount of fresh water in the world is in any event relatively fixed. But like practically every other natural resource, water is under increasing pressure from both residential and commercial demand.

The residential growth is simple to understand -- every day there are more people on Earth, and each adult needs at least 20 liters per day for drinking and hygiene. Nevertheless, only 8% of water demand is for household use. Agriculture accounts for about 69%, and 23% goes to industry. Some kinds of industrial use are obvious (beverage makers, for example, use a lot), but enormous amounts of water are used in power generation and in industries like paper, mining, and chemicals.

Though there have been notable improvements in water efficiency and reclamation -- particularly on the commercial side -- it's an ongoing race between the ever-growing demands of commerce and the ability to use that water more effectively. Whether the user is a farmer or a plant owner, people continue to use more water.

Beware of brown
Pollution is one of the biggest problems with the fresh water supply; pollutant counts rise every year. Industrial and agricultural runoff has contaminated many rivers, lakes, and underground aquifers, rendering the water either unfit to drink or unsafe without treatment. Unfortunately, it is far, far easier to pollute a water source than it is to clean one up, especially sources that lie deep below the surface.

Residential consumers want pollution-free drinking water. But so do businesses, since contaminants in water can wreak havoc on sensitive machines and shorten their operational life. And in industries like semiconductor manufacturing, chipmakers use ultra-pure water in the production process to make sure their products work.

A word to the Foolish
With that basic information in mind, we can turn our attention to the companies that ply the water trade. As is the case with any industry review, the discussions are necessarily brief and limited to only a handful of companies. You should always do your own due diligence and view this as more of a launchpad for your own research.

Utilities
Water utilities are going to be the first place that most investors look for investment ideas related to water, and that certainly makes sense. Water utilities are in the business of selling water and should logically stand to benefit from both increasing demand and increasing rates.

Before diving in, investors should consider a few additional points. Virtually all utilities are constrained by local rate controls. They cannot raise prices without approval -- a sometimes lengthy and contentious process. What's more, the weather can affect business from quarter to quarter, be it too much rain or too little.

Water is the most fragmented of all of the major utilities. There are approximately 50,000 municipal water services in the country, and about 84% of them serve 3,300 customers or fewer. Similarly, 16,000 different wastewater treatment facilities serve about 72% of the country. To me, that suggests a ripe opportunity for industry consolidation.

The world's two largest water utility players are both French -- VeoliaEnvironnement (NYSE: VE  ) and Suez SA (NYSE: SZE  ) . Both pay reasonable dividends but have high debt loads. They are also focused on global expansion -- largely in Eastern Europe and the Asia-Pacific region, but also in North America and Africa.

Both have operations in water and energy, but Veolia is more dependent on the water business -- about 40% of revenue, vs. 28% for Suez. What's more, Veolia is somewhat further along in its capital investment process, suggesting that Veolia will see more positive cash flow leverage sooner than Suez will.

Aqua America (NYSE: WTR  ) is the largest publicly traded American water utility, serving more than 2.5 million people in 12 states. The company generates about half of its revenue in Pennsylvania but has made a commitment to expansion by acquiring municipally owned water utilities.

Aqua America traditionally has had the lowest operation and maintenance costs of the domestic water utilities. That does come at a price, though: Aqua America has the highest valuation and lowest dividend yield of the major water utilities.

American States Water (Nasdaq: AWR  ) and SJW (AMEX: SJW  ) are smaller fish in the sea. Both are largely focused on California (American States in the south, SJW around San Jose), though American States is looking to expand by providing water services to U.S. military facilities.

Both companies pay a reasonable dividend and have manageable levels of debt. Although SJW is slightly more compelling by the numbers, both are interesting options. Investors should realize, though, that both companies are highly geographically concentrated, and both purchase a large percentage of their water needs -- important risk factors that shouldn't be ignored.

Filtration, treatment, and production
Utilities aren't the only ways to make a play in water. Numerous companies handle filtration, treatment, transport, and other facets of the water business.

Pentair (NYSE: PNR  ) is a player both in pumps and filtration systems with strong brand leadership. While residential demand makes up the majority of sales, Pentair serves both the municipal and commercial/industrial markets. Over time, the food service industry could prove to be a major growth opportunity; filtration, water softening, and fluid handling are all important aspects of consistent high-quality food and beverage preparation.

Nalco (NYSE: NLC  ) is the market leader in water treatment chemicals. That's a significant accomplishment, given that No. 2 is GeneralElectric Water Technologies. Nalco sells a variety of chemicals that help control corrosion and prevent build-up, scaling, and microbial fouling of water-handling equipment.

Importantly, Nalco has long-term relationships with customers -- more than 80% of the largest customers have been doing business with Nalco for more than 10 years -- and helps them prolong the life of their productive assets and conserve energy and water. As the quality of available water declines, this business should be in ever-better shape.

Consolidated Water is the smallest company I'll mention here. Consolidated Water produces fresh water for several countries in the Caribbean -- including the Caymans (where the company is based), Belize, and the Bahamas -- using desalination facilities. Consolidated Water has the benefits of steady demand (like a utility) but without the regulatory issues, since the company enters into long-term contracts with escalators that cover potential increases in energy or other operational costs.

Even though Consolidated Water is poised to continue its growth, investors need to remember that it's quite a small company. Future expansion will likely be centered in the Caribbean/Central America region -- an area known for both shaky political regimes and nasty hurricanes.

As I said, these were only a few of the many water-related companies out there. Investors can also look amongst the likes of California Water Service, Middlesex Water, ConnecticutWater, Mueller Industries, Layne Christensen, Barnwell, CalgonCarbon, Pall, and Watts Water Tech -- all of which are publicly-traded on U.S. exchanges.

In conclusion
Despite ongoing efforts in conservation and water recycling, there is inexorable demand pressure on this resource. Africa and Asia have already seen tensions regarding water rights. Unfortunately, it's probably just a matter of time before a shooting war breaks out somewhere over a water dispute.

No one should expect to make quick money from any water business (or any other stock, for that matter). But in this business, it's highly unlikely that technology is going to create a substitute product. Over time, that should mean steady growth for the quality players and their investors.

There's nothing watered-down about these Foolish Takes:

Fool contributor Stephen Simpson has no financial interest in any stocks mentioned (that means he's neither long nor short the shares).


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