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Growth Safety Income Reliability

Utility Forecaster
Fragmented Industry

Roger Conrads

Roger S. Conrad, Chief Investment Strategist

Liquid Gold Rush

How to Profit from the Boom in Water Consolidation
The Most Critical Resource

lean, cheap and plentiful: Thats what America depends on when it comes to water, our most critical natural resource. Unfortunately, clean and cheap water is no longer something we can take for granted. Unlike in days of yore, when obtaining supplies in most of the country was as simple as digging a well, todays water is threatened by droughts, industrial overuse, overdevelopment in watershed areas and wetlands, runoff from farms, acid rain, microbial contamination and scores of other hazards. In addition, the reservoirs and pipes that bring water to homes are showing signs of wear and tear. The result is water supplies are increasingly at risk and water scares are becoming alarmingly common. Residents of the Washington, DC, area were told to avoid any use of water for several days in the mid-1990s, as facilities operated by the US Army Corps of Engineers were contaminated with harmful bacteria. Increasing public concern about water supply risks has led to lawsuits in California and other states. And pressure has risen on governments to boost safety standards and enforcement. The Environmental Protection Agency (EPA), for example, is dramatically turning up the heat on a variety of industries to clean up their acts. The result: The cost of owning and operating a water system is rising at a breakneck pace. The EPA estimates that $300 billion will have to be spent upgrading US water infrastructure during the next few years. For the 40,000 or so water systems serving fewer than 3,000 people, thats too much to pay. But for the handful of investor-owned utilitieswhich together serve less than 10 percent of the populationit spells a once-in-a-lifetime opportunity for explosive growth. For their shareholders, it adds up to increased total returns.

Unlike the European water industry, which is dominated by huge conglomerates, the US water system remains extremely decentralized, with nearly 8 percent of the population still using well-based systems. Driven by the belief that water belongs to everyone and shouldnt be provided for profit, municipalities operate some 80 percent of water systems and 90 percent of wastewater systems. Investor-owned utilities, in sharp contrast to the electric and communications industries, control only a sliver of the market. The cost crisis is altering that balance in a big way. Small systems simply arent large enough to pay the cost of upgrading their pipes and building necessary water treatment facilities. And given the cash-strapped state of most municipalities, theyre not equipped to meet the challenge, either. Enter investor-owned utilities, the only industry players with experience meeting clean water regulations and the access to capital to pay for it. Water utes are profiting in two major ways. First, theyre acquiring the smaller systems that cant meet clean water requirements. Second, theyre taking over management of many municipal systems that lack the capability to meet the requirements. This adds up to double-digit profit growth for the best water companies well into the 21st century. On the acquisition side, most buyouts are being completed at prices close to the book value of the acquired systems, making adding them immediately to the acquiring companys earnings. Systems can often be integrated with utes existing infrastructure at minimal cost. And regulators, anxious to ensure clean water supplies, have been very supportive, granting speedy approval of takeovers and rate increases to pay for system improvements and integration. As a result, water utilities such as Aqua America (NYSE: WTR) are able to grow earnings at double-digit rates simply by making acquisitions. The system management business is a more palatable alternative for many municipalities, preserving public ownership while turning over operations to utilities more-adept management. The value of these deals depends on how well the managers can improve productivity as well as the price negotiated for their services, which generally depends on how much competition they have for the contract.

*For the most up-to-date advice and pricing, go to www.UtilityForecaster.com or check your latest Utility Forecaster issue.

Liquid Gold Rush

By and large, however, these deals are sparking huge increases in profit growth for the better operators, including Southwest Water, which was taken private at $11 a share in September 2010. With water use per person actually in a long-term decline because of conservation measures, acquisitions and system management are two explosive roads to growth for water utilities. And with the water business destined to remain a monopoly for at least the foreseeable future, that growth is about as safe and assured as you can get. Throw in an average dividend of about 3 percent and youve got an investment in line for ultra-safe, annual total returns of 8 percent to 10 percent well into the next decade. Near-term returns could be even more explosive, should merger mania resume. Acquirers in the past have included other investor-owned companies, as was the case with the 1999 takeover of Consumers Water by Philadelphia Suburban (now Aqua America) and the 2000 merger between California Water Service (NYSE: CWT) and Dominguez Services. Other buyers have come from outside the country. French conglomerate Suez, for example, bought out United Water Resources, at the time the third-largest US water utility. Meanwhile, Britains Kelda Group (NSDQ: KELGF, London: KELL) bought out Connecticut-based Aquarian, and Thames Water bought E-Town Water, only to be acquired by German giant RWE (OTC: RWEOY) later. Both have since divested these operations. But the properties have only gained in value.

costs. Regulators will be under increasing pressure to keep rates low, likely resulting in more writeoffs for unlucky utilities. Finally, the fact that most have generally low market capitalizations means that trades by big institutions often have a disproportionate effect on the stocks. For example, stocks can soar or fall for basically no reason other than some fund manager has decided to buy or sell. Wise stock selection, therefore, remains critical to making money in the water industry, just as it is with any other. Heres my rating system for water companies: Financial SecurityCompanies should have Standard & Poors bond ratings of at least BBB+, or cash flow should cover capital costs. Preferably, companies will feature both criteria. Dividend SecurityCompanies dividends should be no more than 80 percent of earnings over time. I use both the three-year payout ratio and the most-recent 12-month payout ratio (dividends as a percentage of earnings) as my guide. Cost ControlsCompany-owned water supplies should meet at least 80 percent of annual demand to ensure purchased water costs dont crimp profit margins. Utes should also have at least 400 customers per employee, ensuring productivity and efficiency. Good Regulatory RelationsHow well a company gets along with the officials who set its allowed returns, monitor its merger activity and control its growth is critical. Having multistate operations can be a plus by diversifying this risk. Companies with substantial unregulated operations are exposed to other risks. To come up with the overall Utility Forecaster Safety Rating, I use eight criteria, with two drawn from each of these four categories. The rating depends on the number of criteria met. For example, a company meeting all eight would draw an 8 rating. A ute meeting seven would earn a 7 rating, six criteria earns a 6 and so forth down to zero. The water utilities drawing a rating of 5 or higheri.e., meeting most of these criteriaarent guaranteed success, but theyre the best positioned for it. Consequently, theyre generally the best stocks to buy and hold for long-term returns, as well as short-term gains from potential mergers. In the following pages, I analyze each of the major US-based, investor-owned utilities on a number of criteria, including their Utility Forecaster Safety Ratings and the systems components. I also give my current outlook and advice on each. Note, however, that my current trading advice will depend heavily on the share prices of the companies. I provide information on these facts in each issue of Utility Forecaster, along with buy/sell/hold advice.

The Risks
Despite their compelling case for growth and the crucial nature of their productwhich remains in demand no matter what happens to the economywater utility stocks do carry some risks. Many companies, especially in California, must purchase 50 percent or more of the water they sell, rather than producing it from owned sources. When drought strikes, theyre vulnerable to steep, margin-cutting spikes in the price of water. Unlike the deregulating energy and communications industries, water utilities profits remain heavily regulated, with their returns set by state regulators. If officials refuse to allow full recovery of costs in rate hikesincluding higher prices for purchased waterthe shortfall will come straight out of company profits. Several companies still have major capital expenditures ahead to comply with clean water regulations, making them especially vulnerable to cost disallowances and damaging writeoffs. And although water rates are still relatively low nationwide, theyll certainly rise over time to reflect higher

*For the most up-to-date advice and pricing, go to www.UtilityForecaster.com or check your latest Utility Forecaster issue.

www.UtilityForecaster.com

Pick and Pans

American States Water (NYSE: AWR)
UF Safety Rating: 8, Regulated Service Area: Nationwide
states is a plus, as is the fact that the company is again under US-based management.

ing approach, i.e., buying adjacent systems cheaply and adding them to its own system at very little cost. This strategy has enabled rapid growth, and the company has enjoyed tremendous regulatory support throughout its territory.

Management: Above average. Management has taken

Regulatory Relations: Average. The wider range of

its clustering strategy to another level, implementing it in 15 other states

Management: Average. The company has always had strong management. The big challenge is dealing with post-RWE spinoff debt. Advice and Outlook: This is one of the largest US water utilities, but it will need further rate relief to keep growing profits. The return of Jerry Brown to the governors mansion means a tougher regulatory climate in California, where rates might not keep pace with costs. The stock is pricey, too. Sell American States Water.*

Advice and Outlook: This is a rapid-growth water company thats minimized the risks to itself and to shareholders by sticking to a conservative strategy. Little stands in the way of continued double-digit profit growth well into this century. Buy Aqua America.*

Artesian Resources (NSDQ: ARTNA)

UF Safety Rating: 7, Regulated Service Area: Delaware, Maryland. Regulatory Relations: Average. Delaware has ulti-

American Water Works (NYSE: AWK)

UF Safety Rating: 8, Regulated Service Area: Nationwide; Ontario, Canada Regulatory Relations: Above average. American Water

mately granted most requested rate relief for the companys expansion projects and acquisitions. However, it hasnt been able to eliminate the financial impact of the utilitys need for purchased water supplies, and temptation is growing to force the company to bear more of the burden for rising costs. The company is looking for acquisitions.

has won a series of rate cases in states such as California and New Jersey. The company is also expected to get the lions share of its rate requests in a series of cases this year.

Management: Average. Plans for expansion through

acquisitions continue to progress in a state mostly divided into unsustainable small systems.

Management: Above Average. The largest water ute in

the US is a great bet for a weak economy. One of American Waters major growth avenues is managing systems owned by municipalities and military bases. Two recent contracts will add $677 million in military business over 50 years, as American continues to use its unmatched reach to snare business.

Advice and Outlook: Like every company investing heavily in infrastructure, American Water faced challenges getting capital last year. With that crisis now easing, the shares should begin to enjoy a sizeable premium to stocks in other industries, translating into solid capital gains. And a greater focus on safe drinking water standards helps investor-owned utilities such as American Water in two ways. First, it earns a return on capital spending. Second, it can more easily take over smaller and weaker systems that cant comply with tougher rules on their own. Buy American Water Works.*

Advice and Outlook: This little-known company continues to implement its plans for growth while maintaining a very conservative financial structure. The biggest risks are its heavy capital budget and lack of owned water supplies, along with regulatory lag in increasingly tough Delaware. But in a monopoly industry, its likely to overcome these hurdles. Still, droughts continue to pose a threat because of the rising costs of purchased water. Buy Artesian Resources.*

California Water Service (NYSE: CWT)

UF Safety Rating: 8, Regulated Service Area: California, New Mexico, Hawaii Regulatory Relations: Average. Californias hostility to Management: Average. Plans for rapid expansion and

utility consolidation and under. Costs are now being regularly recovered. acquisitions depend heavily on the success of future takeovers.

Aqua America (NYSE: WTR)

UF Safety Rating: 8, Regulated Service Area: Pennsylvania, 15 other states Regulatory Relations: Above average. Unlike other

multistate water companies, Aqua has pursued a cluster-

Advice and Outlook: This slow-growth, highly regulated company is a strong takeover candidate in its own right for the industrys larger players as long as California remains favorable for utilities, a question in light of Jerry Browns reelection to the governors seat. At current levels California Water Service rates a sell.*

*For the most up-to-date advice and pricing, go to www.UtilityForecaster.com or check your latest Utility Forecaster issue.

Liquid Gold Rush

Connecticut Water Service (NSDQ: CTWS)

UF Safety Rating: 8, Regulated Service Area: Connecticut, Massachusetts, New York Regulatory Relations: Above average. Connecticut is

SJW Corp (NYSE: SJW)

UF Safety Rating: 4, Regulated Service Area: California Regulatory Relations: Average. California has historiManagement: Average. The company has expanded in

actively promoting industry consolidation as a way to ensure clean water supplies in a state with myriad tiny systems. The company has historically been granted adequate rate relief for new construction, and acquisitions have been routinely approved. So should any potential takeover of the company.

cally been hostile, keeping a tight leash on allowed returns. Jerry Brown may change that.

Management: Above average. The utility continues to

the water industry but generally very slowly. Its most likely to be a takeover target, though California regulators failed to approve the American Water Works merger a few years ago. Its also making a foray into real estate.

expand via acquisitions of surrounding systems, recently Connecticut systems and BIW, minimizing its risks. And by sticking to the utility business, its limiting unregulated risks as well. The next challenge will be angling for a profitable takeover.

Advice and Outlook: Californias rate-making procedures are the biggest threat to its long-term financial health and potential. The retreat in real estate presents a risk in a weak economy. SJWCorp is a sell.*

Advice and Outlook: This is a slow-growth, highly regulated company with healthy finances and a secure business. Connecticut Water Service is a buy.*

York Water (NSDQ: YORW)

UF Safety Rating: 8, Regulated Service Area: Pennsylvania Regulatory Relations: Above average. Pennsylvania

Consolidated Water (NSDQ: CWCO)

UF Safety Rating: 5, Diversified Service Area: English-speaking Caribbean Regulatory Relations: Average. The company has

secured contracts with a number of island nations under favorable terms for the long haul. But its base in the Cayman Islands has become a little less friendly of late. The British Virgin Islands dispute also hurt the shares.

has long had the most progressive regulatory policy in America regarding water. The state has consistently supported Yorks needs for rate increases to upgrade service and meet new demand. That looks set to be the case for the foreseeable future.

Management: Average. Managements abilities have

Management: Above average. The company has taken its

innovative strategy of providing reverse-osmosis produced water to parched island nations with heavy tourist businesses. Theres a lot more room for growth, and management is taking advantage, even as it provides competitive dividend growth. Theres a focus on building something for the long-term here.

proven adequate to the task of running a water system safely and efficiently. There hasnt been a lot done to increase shareholder value, but a profitable takeover remains a possibility in the long term.

Advice and Outlook: The company has few major challenges or risks facing it during the next few years, other than running its system and making upgrades to meet ordinary demand growth. York Water is a buy at current levels.*

Advice and Outlook: Consolidated Water remains an innovative way to play the growth of water demand and shrinking supply in a region of the world where growth will only increase. Consolidated Water is a buy.*

*For the most up-to-date advice and pricing, go to www.UtilityForecaster.com or check your latest Utility Forecaster issue. IMPORTANT NOTE: The stocks highlighted in this report are believed to be accurate and represent our best advice at the time of writing. However, these reports are reviewed quarterly and may not reflect our latest advice. For our current take on any stock in this report, it is vitally important that you check the Portfolio tables on the website and confirm that the stock still earns a buy rating. Furthermore, confirm that the stock trades below our current buy target. Do not buy any stocks above our recommended buy targets. If a stocks price exceeds our target, patiently wait for a pullback or invest in another Portfolio holding that trades below our buy target. Any advice in the Portfolio tables, a recent issue of the publication, or our email alerts always trumps any advice in this special report. Markets can move quickly, so we appreciate your understanding of our protocol for delivering the most timely advice via our website. Investing Daily, a division of Capitol Information Group, Inc., 7600A Leesburg Pike, West Bldg., Suite 300, Falls Church, VA 22043. Subscription and customer services: P.O. Box 4106, McLean, VA 22103-9817, 800-832-2330. It is a violation of the United States copyright laws for any person or entity to reproduce, copy or use this document, in part or in whole, without the express permission of the publisher. All rights are expressly reserved. 2013 Investing Daily, a division of Capitol Information Group, Inc. Printed in the United States of America. ULG0313-MP. The information contained in this report has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. For permission to photocopy or use material electronically from Utility Forecaster, ISSN #1064-5373, please access www.copyright.com or contact Copyright Clearance Center, Inc. (CCC) 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400. CCC is a not-for-profit organization that provides licenses and registration for a variety of users. Disclaimer: For the most up-to-date advice and pricing, go to www.UtilityForecaster.com or check your latest Utility Forecaster issue.

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