Sludge Watch ==> Wall Street and Water - the Lure of Liquid Assets

[Maureen Reilly]

Monday, October 16, 2006


The Lure of Liquid Assets

By CHRISTOPHER C. WILLIAMS

WALL STREET IS PUMPED ABOUT WATER, and for good reason. Globally, the $365 
billion business is burgeoning as countries spend billions to repair and 
build infrastructure to funnel clean water to people and industry. Some 
experts think $1.5 trillion in capital spending could flow into the sector 
in the next five years, promising a steady stream of business for a host of 
companies, from pump makers to water utilities. The market, which 
encompasses residential and industrial water and wastewater treatment and 
services, is growing by 4% to 6% a year in developed countries, and as much 
as 15% in emerging markets, estimates Goldman Sachs.

Less than 1% of the planet's water is drinkable. Yet, demand has been rising 
steadily. A Unesco study estimates world consumption could reach 2,764 
billion cubic kilometers by 2025, up from 2,182 billion in 2000.

To some degree, water stocks reflect the industry's bright prospects. The 
Stanford Washington Research Group Water Index of 20 U.S. and international 
stocks has returned 131% in the past five years, versus a puny 4% gain in 
the Standand & Poor's 500 stock index. Much of the easy money has been made, 
but investors willing to cast their nets a bit wider can find compelling 
bargains.


Conglomerates such as General Electric (ticker: GE) and ITT (ITT) are a 
growing presence in the water sector, but water is a relatively small piece 
of their operations. European giants Suez (SZE) and RWE (RWE Frankfurt) have 
been dominant players, but are retreating from the market. RWE, the German 
electric utility, is planning to sell its American Water Works subsidiary to 
the public through an initial public offering some time next year.

Among smaller companies, however, investment opportunities are rife. In the 
U.S., Aqua America (WTR), the country's largest water utility, and equipment 
makers Pentair (PNR) and Watts Water Technologies (WTS) look particularly 
attractive. In addition to being well positioned to benefit from increased 
water spending, all are viewed as potential takeover targets.

Paris-based water utility Veolia Environnement (VE) provides exposure to the 
global water market, including China and Latin America, where water 
shortages, huge spending on infrastructure and increasing regulations are 
making water a hot business.

More direct plays on emerging markets include Companhia de Saneamento Basico 
do Estado de Sao Paulo, or Sabesp (SBS), Latin America's largest water 
utility, and Sinomem Technology (SINO Singapore), a small Singapore-based 
membrane-technology company with a dominant share of China's pharmaceuticals 
business. "In the medium to long term, some of the most desirable 
opportunities will be in the international arena," says Francesca McCann of 
Stanford, citing cheaper valuations and higher growth opportunities.

All six companies, profiled below, offer relatively direct plays on water, 
as they garner at least 35% of their revenue from water-related products. 
They sport an appealing price/earnings multiple of 15 times expected 
earnings, on average, and most are growing by more than 10% a year. Fans see 
at least 15% upside in each of the stocks. An impending catalyst: American 
Water Works' prospective IPO.

The run-up in water shares leaves these companies little room for error, 
even as investing in emerging markets presents significant economic risks. 
But there is some justification for bulls to trumpet H2O as the oil of the 
21st century. "The long-term story of water is as compelling as anything in 
the investment world," says John Dickerson, president of Summit Global 
Management, a West Coast manager specializing in water investing. "There's a 
fixed supply and exploding demand."

Aqua America

The U.S. water-utility industry, composed of 55,000 separate water systems, 
has been consolidated in the past decade through mergers and acquisitions, 
many involving foreign water conglomerates. Today, only 11 independent, 
publicly traded companies remain, half the number of 10 years ago.


Water World: The planet's awash in the stuff, yet under 1% of the world's 
water supply is drinkable. Rising consumption, particularly in developing 
economies, is making fresh water increasingly scarce.
Aqua America of Bryn Mawr, Pa., is the largest among the survivors, 
providing water and waste-water services to 2.5 million customers in 13 
states. Some industry analysts, such as Deane Dray of Goldman Sachs, think 
Aqua eventually will be snapped up, as its stock-market capitalization is a 
modest $3 billion. But CEO Nicholas DeBenedictis says Aqua "wants to be 
independent." In fact, it has thrived as the leading acquirer in the sector, 
buying more than 100 companies in the past five years.

Aqua and other utilities, including American States Water (AWR), have 
benefited from a healthy rate environment.

Aqua, which is generating about $500 million in revenue, is seeing between 
3% and 5% annualized rate increases. As the industry leader, the company 
also is well positioned to benefit from heavy spending on water 
infrastructure -- about $280 billion over the next 20 years, according to 
Environmental Protection Agency projections.

Aqua trades for 23 a share. For a stock in a regulated industry, it looks 
pricey at 27 times analysts' estimated 2007 profits of 84 cents a share. 
Yet, the shares are cheaper than they've been in a while, trading well below 
their 52-week high of 29.79.

William Brennan, manager of the Praetor Global Water Equities Fund, has been 
buying the shares, and says the company should have little trouble meeting 
management's long-term goals of 7% annual revenue growth, 10% earnings 
growth and a 5% dividend yield. (The stock currently yields 2.03%.) If the 
company stays on course, its shares could appreciate more than 20% in the 
coming year -- continuing a decade-long trend of 25%-plus annual gains.

"Investors will pay up for earnings consistency, and a business model that 
represents a growing customer base coupled with guaranteed rate increases," 
says Brennan.

Pentair

One of the most compelling turnaround stories in the water sector is 
Pentair, a Golden Valley, Minn., maker of fluid-handling systems and 
industrial products. The stock has lost 16% in the past 12 months, after 
several quarters of earnings misses, and now trades for 29, or 14 times 
estimated 2007 earnings of $2.12 a share. Earnings per share this year 
should drop 10 cents, to $1.82.

Pentair is struggling to integrate parts of Wicor Industries, a pump and 
pressure-tank maker it bought in 2004. In addition, pool-business profits 
are down due to weakness in housing. The sale of water and waste-water pumps 
to commercial and residential customers accounted for 74% of last year's 
sales of $3 billion, while electrical and electronic enclosures chipped in 
the rest.

Table: Water Companies1Pentair CEO Randall Hogan says the commercial water 
segment is "booming."

Pentair is celebrating its 40th birthday this year, but some investors are 
betting it won't be around to see many more, as the dominant player in the 
$50 billion water-components market could attract buyers. Brennan of Praetor 
Global, a shareholder, sees a deal within a year.

Pentair is boosting its share-buyback program, streamlining management and 
expanding in markets such as China. "Next year. we expect to get back on 
track with margin expansion even if the residential market stays weak," says 
Hogan.

If so, earnings could rebound sharply and push the stock back to the 
mid-30s. "They have fixable issues," says Brennan.

Watts Water Technologies

Like Pentair, Watts is benefiting from annual growth of 4% to 6% in the $87 
billion U.S. water market, as increasing consumption and infrastructure 
spending spur demand for its valve and flow-control products. Also like 
Pentair, North Andover, Mass.-based Watts relies on acquisitions for growth. 
But the similarities end there.

While Pentair is suffering indigestion from its acquisitions, Watts has 
feasted on deals and doubled its business in the past five years. The 
company posted a 12% increase in earnings per share last year, to $1.67, on 
$924 million in revenue.

Watts showed organic growth of 8% in its most recent quarter. The company 
recently reported a 32% increase in total second-quarter sales, continuing 
its habit of beating analysts' quarterly projections. Earnings per share 
could jump to $2.16 this year, and grow by 15% in each of the next three 
years. Watts has been expanding overseas, and gets more than 30% of its 
business from Europe and China.

A protracted downturn in housing could depress Watts' consumer business. 
Higher copper and materials costs may also pose problems, but the company so 
far has been able to pass these along to customers.

Watts trades at about 35, or 16.3 times this year's expected earnings. 
Needham & Co. analyst Mark Grzymski upgraded the stock to Buy in early 
August with a 38 price target, notwithstanding the "lingering possibility of 
gross-margin compression due to the inflationary environment." Watts hit a 
52-week high of 40.03 in May.

Veolia Environnement

Swiss investment bank Pictet & Cie. estimates Europe will need to spend $600 
billion to $700 billion in the next 20 years on water investments. Many 
water-industry players will benefit, including United Utilities (UU) in the 
U.K., Geberit (GEBN Zurich), a Swiss plumbing and plastics-technology firm, 
and Suez. But 150-year-old Veolia, the world's largest water utility, is a 
more direct play than Suez, which is merging with the power utility Gaz de 
France.


Jump In, the Water's Fine: Heavy spending on water systems and treatment 
means big business for a host of companies across the globe -- and juicy 
returns for shareholders. The six companies listed here are well-positioned, 
and offer both value and growth investors compelling opportunities to play 
the burgeoning market. Shares of some of them, namely Veolia and Sabesp, 
already have had big gains, but fans believe they have yet to hit their 
high-water marks.
Water accounts for more than 30% of Veolia's annual revenue of €25 
billion; the company also has energy and transportation operations. Veolia 
generates more than half its business outside France, although the local 
market is robust. France's per-capita use of water is second only to the 
U.S.', and its $10 billion municipal water market has drawn the attention of 
GE, which may buy more water assets in the country.

Veolia's shares dropped sharply this summer, after management expressed 
interest in buying the Italian construction company Vinci. Analysts failed 
to appreciate the logic of the deal. But the shares rebounded after the plan 
was ditched, and now sell for €47. The American depositary receipts trade 
around 60.

If Veolia focuses on cutting costs instead of striking potentially 
disruptive deals, its shares, which sell for 16 times 2007 earnings, should 
remain buoyant, and profits could grow by 18% a year. "It's a great story 
with high visibility," says Hans Peter Portner, a manager with the Pictet 
Water Fund, who is betting his largest holding reaches 60 in three years.

Sabesp

Brazilian President Luiz Inácio Lula da Silva's economic policies have kept 
inflation low and the real strong. Both have helped the giant water utility 
known as Sabesp, which posted a 68.7% jump in net profits last year. While 
the company's results have moderated this year, Sabesp still is expected to 
grow annual earnings at a 10%-plus clip for several years, above the 
industry's average 8.5% pace, notes Morningstar.

The water market in South America should grow 4% a year, and Sabesp is one 
of the best ways to play it. The stock, which trades on the Sao Paulo 
exchange, is up 73% this year in local currency, while the NYSE-listed ADRs 
have gained 88%, to 31.

Sabesp is the largest water utility in the Americas and No. 3 worldwide, 
serving about 26 million people in the state of Sao Paulo with water and 
sewage collection. It generated sales of $2 billion last year, mostly from 
concession contracts with municipalities and is 50%-owned by the state of 
Sao Paulo. It has been winning tariffs, or rate increases, at a faster rate 
than inflation, helping it generate stable cash flow.

Despite its shares' run-up, Sabesp trades for just eight times expected 
earnings, a steep discount to U.S. water utilities -- a so-called 
emerging-market discount. Investors also worry about state ownership, and 
the possibility that the government could enact policies detrimental to 
shareholders.

Still, they are not risking much to bet that the Brazilian government 
continues to allow the utility reasonable rate increases. "This is a 
conservative way to take a chance on Brazil," says John Maloney of New 
York-based M&R Capital Management. "As water companies go, it's a true 
growth story and very reasonable value." Maloney values the ADRs at 37, some 
20% above current prices.

Sinomem Technology

Throughout Asia, dynamic economies are straining against inadequate water 
infrastructure. A fourth of China's 1.3 billion population is without 
adequate drinking water, says Goldman Sachs. This has prompted the 
government to pledge around $125 billion for water treatment and 
infrastructure in the next five years. The Asian water market is expected to 
grow 13% a year, says Frost & Sullivan, while the Chinese market is 
increasing by 20%.

To increase investment, China is opening its water market to the private 
sector, and companies like water-treatment provider Sinomem have jumped in. 
Formed in 1996, Sinomem provides membrane-based separation and purification 
technologies, mostly to the pharmaceutical industry. Headquartered in 
Singapore with production facilities in China, it is one of the few 
pure-play treatment companies in Asia.

Sales and profits have grown steadily in recent years. Sales reached 81 
million Singapore dollars ($51 million), last year, and Goldman says the 
company has better margins than similar concerns. The knock on Sinomem is 
that it's tiny, with a market value below $300 million. It trades on 
Singapore's exchange for S$0.91, up 30% this year, but Goldman has a S$1.09 
price target.

John Dickerson of Summit Global recommends that investors buy a basket of 
Singapore-listed water-related stocks, including Sinomem, Hyflux (HYF 
Singapore) and Bio-Treat Technology (BIOT Singapore). Hyflux is pushing into 
the Indian water market, and Bio-Treat's business pipeline is good.

THE YEAR-OLD PowerShares Water Resources Portfolio (PHO), an exchange-traded 
fund, is a basket of global water stocks; it's up 15% on the year. 
Stock-picking may be the wiser approach these days, however, as merger 
activity in the sector, which once lifted all boats, abates. The six stocks 
above are a good way to get your feet wet, without getting soaked.


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