Just Let It Flow

I came across this article by J. Alex Tarquinio in the Times on water stocks. Here are some excerpts:

OIL and gold have had a great run in the markets this year. So, too, has water.

While most of what flows through the nation's water taps is supplied by publicly run municipal systems, a growing number of rural and suburban water systems are owned by a handful of publicly traded utilities, like Aqua America. The shares of these companies have skyrocketed this year, and despite a selloff earlier this month, they are still at levels that might seem more appropriate for rarer commodities, like precious metals or petroleum.
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[I]nvestors who are bullish on the industry say that it is about to undergo a historic change - moving oceans of municipal water into the hands of for-profit companies.

The catalyst for the transformation will be the final draft of new water quality regulations, which the Environmental Protection Agency is expected to issue later this year, said Michael Gaugler, a stock analyst at Boenning & Scattergood, a brokerage firm in West Conshohocken, Pa., near Philadelphia. The new rules will require water systems to further reduce levels of substances like arsenic and chlorine. Many small towns will discover that they cannot afford the pricey ultraviolet reactors they will need to meet these stricter limits, Mr. Gaugler said.
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About 85 percent of the nation's nearly 55,000 municipal water systems serve fewer than 3,300 homes each, and Mr. Gaugler said that many small towns had too few customers to be able to afford the infrastructure improvements. But, he said, companies like Aqua America - which is based in Bryn Mawr, Pa., and has 2.5 million customers in 15 states - could cover the costs without sharply raising rates. While large cities have continued to operate their own water systems, publicly traded water utilities tend to buy small rural and suburban water systems.

Mr. Gaugler predicted that more small towns would begin selling their water systems to the for-profit companies in 2006 and 2007, and that the pace might pick up as the deadlines for compliance - which range from 2011 to 2013 - drew near. He predicted that the big water companies "will pay less for acquisitions as time goes on, because municipalities are going to get desperate to sell."
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Aqua America, the only publicly traded water company with a market capitalization of more than $1 billion, started trading this year at less than $25. The stock peaked at around $39 on Oct. 4. Then, on Oct. 12, more than four times the usual number of shares traded hands, and the stock fell to $32. It now trades at $32.92. Trading in the California Water Service Group , the second-largest water utility stock, and American States Water, the third largest, has followed similar patterns.
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There is money to be made from the growing demand for clean water - but the best opportunities are not in the water utilities, said Neil Berlant, a consultant to the water industry, who also runs a private water investment portfolio at the Seidler Companies, an investment firm in Los Angeles. He said the biggest opportunities would come from selling water filtration systems to industry.
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He likes two companies that are now primarily manufacturers of water treatment systems - Pentair, in Golden Valley, Minn., and Watts Water Technologies, in North Andover, Mass. Both companies' stocks have fallen this year. Pentair trades at $31.33 and is off 28 percent for the year, and Watts is at $26.62, down 17.4 percent. Mr. Berlant, who said that he consulted for both companies in the past but does not do so now, holds both stocks in the separate accounts that he manages for institutional and wealthy individual investors.

Some thoughts and points:

Government will intervene on behalf of its constituents on essentials. Water availability and pricing epitomizes "essential".

A highly-regulated market can be dangerous to profit-seeking shareholders. Small market caps and their attendant volatility and risk are also noteworthy.

Analysts are finding the water stocks expensive after their run-ups. With those run-ups, the dividend yield has shrunk to below the S&P 500 average. Slow-growth companies, like utilities, historically attract investors with generous dividend yields.

This ship has already sailed on water, if I'm reading about it in the paper of record. The recent pull-back of the largest water stocks doesn't seem all that relevant to me, in that the entire market seemed to pull back over October. The Conshohocken analyst predicts profitable changes for the water industry between 2006 and 2013. I'm not investing anything based on a prediction that spans eight years, and is so dependent on governmental action/inaction.

One small-cap water stock caught my attention after I checked out the competition to WTR on Smartmoney.com. Beside the other big players, CWT and AWR, was ARTNA. Let's take a quick look:

ARTNA, Artesian Resources Corp, services approximately 232,000 people in Delaware. Its PEG, at 2.32, is significantly lower than its competitors (CWT=3.19; WTR=3.92; AWR=4.02). Its Price/Book ratio is 1.8, versus 4.2 for WTR, 2.3 for CWT, and 2.1 for AWR. And its dividend yield is around 3%, like AWR and CWT, but double that of WTR. While ARTNA has a comparable ROE to its competitors, its ROA and ROIC lag behind.

Fine, I admit it. I just can't get excited about investing in Delaware water. Maybe I should leave them all behind. If I want to invest in a boony commodity, I'll take Albertan oil sands.

The end of the piece discussed an alternative to straight-up water stocks, water treatment systems. Is this where a value-minded investor can get exposure to water?

Pentair (PNR) and Watts Water Technologies (WTS) look pretty good (data from Smartmoney.com):
ROE - (PNR)12.65%; (WTS)10.24%
ROA - 5.95%; 5.43%
ROIC - 8.43%; 7.42%
PEG - 1.09; 1.47
Dividend Yield - 1.6%; 1.15%

PNR has had free cash flow go from $6.9M in 1995 to $85.4M in 1999 to $219.3M in 2003. However, in the trailing twelve months, that FCF has dropped to $128.2M, according to Morningstar. WTS has positive free cash flow, but it declined from $43.5M in 2000 to $19.2 in 2004. In the trailing twelve months, FCF has increased to $25.4M.

I think this data warrants doing a bit more research on these two companies: