On Thursday, SJW Group (NYSE:SJW) and Connecticut Water Service (NASDAQ:CTWS) announced plans to merge, which would create the third-largest investor-owned water and wastewater utility in the United States.

Connecticut Water stock soared to a closing gain of 9.7% on Thursday, and has tacked on another approximately 3.5% on Friday, as of 12:30 p.m. EDT, with shares hovering around $59.67. SJW Group stock closed down 4.1% on Thursday, though it has climbed back on Friday, with shares up 3.6% in midday trading. 

After several years of robust performance, including outperformance by the larger players in 2017, most water utility stocks have pulled back sharply since late last year. Given this fact and the considerable benefits of size and geographic diversity in this space, there could be more mergers in the industry ahead. 

Here's what you should know.

Droplets of water coming out of a faucet and forming a body of water.

Image source: Getty Images.

Terms of the proposed merger and the combined company

Under the terms of the all-stock deal, Connecticut Water shareholders will receive 1.1375 shares of SJW Group common stock for each share of Connecticut Water common stock they own, the equivalent of $61.86 per share, or a total of about $750 million, based on SJW's closing stock price on Wednesday, March 14. Connecticut Water stock closed at $52.57 per share on Wednesday, so the buyout price includes a premium of 17.7%. Following closing of the transaction, SJW shareholders will own about 60% of the combined company, and Connecticut Water shareholders will own approximately 40%.

The combined company brings together San Jose-based SJW's operations in California and Texas with Clinton, Connecticut-based Connecticut Water's operations in its namesake state and Maine, and will serve more than 1.5 million people. (While Connecticut Water is a rather typical water and wastewater utility, SJW has fairly sizable market-based real estate operations.) It would have revenue of about $496 million and recurring net income of $74 million, based on 2017 pro forma results. The press release states that the combined entity will be the third-largest investor-owned water and wastewater utility in the U.S. based on pro forma enterprise value and combined rate base. From a market capitalization standpoint, as of today, it would be roughly tied with California Water Service ($1.9 billion) for No. 3, behind American Water Works (NYSE:AWK) ($14.6 billion) and Aqua America ($6.0 billion).

SJW Group CEO Eric Thornburg will serve as CEO of the combined company, while Connecticut Water CEO David Benoit will become President, New England Region. The merger is expected to close by year-end 2018, and is subject to customary closing conditions and approvals.

The financial and strategic benefits of the proposed merger

The anticipated benefits to profitability are robust. The combined company is expected to be accretive to each company's stand-alone earnings per share (EPS) in the first fiscal year following the closing, and accretion in EPS should increase to mid to high single digits over the next couple of years. Moreover, a beefier balance sheet "will result in a stronger financial foundation and increased capital markets access yielding a lower cost of capital, which will better enable the new organization to compete for attractive growth opportunities on a national level," according to the press release.

Indeed, I've been advising water utility investors for years to more heavily focus on larger companies with broader geographic footprints as they have a huge benefit over other players in this space. Larger size typically brings more financial resources to make acquisitions. Less obviously, greater geographic diversity expands a company's pond for fishing for attractive acquisition candidates, as it's much more cost-efficient for water utilities to expand in areas near where they already operate. This is largely why I've long trumpeted American Water as the best play in the water utility space. The company's market cap is more than twice as large as that of the industry's second-largest player operating in the U.S., Aqua America, and it has regulated operations in 16 states, versus Aqua's eight states.

Along with receiving an attractive premium to the value of their stock, Connecticut Water shareholders will receive another benefit from their East Coast company's marriage to its West Coast suitor: a dividend boost. The new company is expected to set a dividend at least equivalent to SJW Group's announced 2018 annual dividend of $1.12 per share. This represents an immediate dividend hike of about 7% for Connecticut Water shareholders.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.