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Utilities

Liquid Assets: Make Green by Buying Water Utilities on Red

By Roger S. Conrad, on Oct. 23, 2014

According to the Water Research Foundation, the 30 largest US municipal water systems will need to spend $88 billion on infrastructure over the next decade to ensure safe water supplies for the communities they serve.

And this estimate doesn’t include the capital expenditures needed to maintain and expand the roughly 50,000 systems that provide potable water and wastewater services to the other 75 percent of the population.

These outlays represent a crushing burden to state and local governments, and by extension taxpayers, who also ratepayers.

Based on the Water Research Foundation’s breakdown of the expenditures needed, investors can profit from two major areas of opportunity.

Feature Article -- US Water CAPEX -- Pie Graph

First, companies that provide construction, engineering, contracting, equipment and communications services to water systems stand to reap a windfall.

The group has suffered a severe shakeout in recent years, as municipalities have balked at placing work orders. But with standards tightening and risks of untreated water growing, the work can’t be put off much longer. And the survivors will reap the spoils.

Second, the handful of investor-owned water utilities will benefit from a growing rate base as they increase their level of investment. And with cash-strapped municipalities looking to monetize assets, these publicly traded companies have ample opportunity to grow via acquisitions.

Suez Environnement (Paris: SEV, OTC: SZEVY) and Veolia Environnement (Paris: VIE, NYSE: VE) already control a huge share of the global water-services market and stand to profit the most from growing investment in these systems.

But water systems are only one piece of the pie for these environmental-services giants, which also generate a hefty portion of their revenue from waste management, mainly in Europe.

The European Central Bank’s efforts to stimulate economic activity by cutting interest rates and buying bonds should help both companies, though conditions in France remain challenging.

Suez Environnement also risks losing its largest drinking-water contract if it can’t meet local authorities’ bid requirements.

Trading at 50 percent of sales, Suez Environnement’s American depositary receipt (ADR) rates a buy up to US$10 for risk takers. Veolia Environnement remains on our Endangered Dividends List and continues to rate a hold.

Investors looking for exposure to this side of the water business should consider Aegion Corp (NSDQ: AEGN), a company that provides technologies and services for pipeline protection (70 percent of profit), industrial facilities (25 percent) and commercial structures (5 percent).

Recurring revenue accounts for about 60 percent of the firm’s sales, with the remaining 40 percent coming from specific projects. This revenue mix is a far cry from 2008, when its predecessor, Insituform, relied entirely on pipeline rehabilitation projects.

Aegion’s customer base has also evolved and includes upstream (exploration and production), midstream (pipelines and processing) and downstream (refining and marketing) energy companies in the US, South America and the Middle East.

The company has targeted annual earnings growth of 15 percent over the long haul—a mark that the firm will exceed this year if net income comes in at the low end of management’s guidance for $1.50 to $1.65 per share.

Achieving this goal will require a big second half. In the first six months of 2014, Aegion posted earnings per share of $0.47—up 9.3 percent from year-ago levels, but still off the pace set by management. The sizable short interest in the stock—7.4 percent of its float—suggests that the market remains skeptical.

In a conference call to discuss Aegion’s second quarter, management cited a 62.5 percent jump in the company’s backlog over the past 12 months and the non-recurring nature of several first-half expenditures as reasons to expect strong third and fourth quarters.

If Aegion’s third-quarter results confirm that the company is on track, short sellers will feel the squeeze.

The firm’s niche business, low market capitalization of $833 million and undemanding valuation also make it a takeover target. The lack of a dividend will deter some, but Aegion Corp is a buy up to $24 per share for investors seeking growth.

“Water Utilities: A Question of Value” highlights the names in our Utility Report Card that own and operate water systems.

Feature Article -- Water Stocks -- Table

Although these companies continue to grow and have their financial ducks in a row, elevated valuations (price to book value) have kept us on the sidelines.

Our buy targets reflect two factors: The risks associated with each name, as encapsulated by our proprietary Quality Grades (A is best); and prospective return, or yield plus dividend growth over the past 12 months.

A-rated companies have buy targets that imply an annual return of about 10 percent; names with lower Quality Grades have a higher hurdle.

Low yields and slow payout growth have doomed many of these companies to be perpetual holds; these names aren’t expensive or risky enough to warrant a sell rating, nor are they high-returning enough to be buys.

But concerns about rising interest rates and widespread profit-taking have brought even the highest flyers down to more reasonable levels.

These stocks have exhibited scant correlation to interest rates over the past two years; the recent pullback gives investors an opportunity to buy and hold the best of these names for the long term.

But not every water utility is a buy; some of the names in our table entail too much regulatory risk and offer insufficient upside potential.

Subscribe to Conrad’s Utility Investor today to learn about my favorite water stocks  for building sustainable wealth–and which names have no place in any investor’s portfolio.

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