Water for Profit

By Alix Nyberg Stuart

CFO Magazine, February 01, 2007

When most CFOs think about liquidity, they’re calculating how fast they can turn assets into cash. But Aqua America finance chief David Smeltzer is just as likely to be concerned about how smoothly water is flowing through the 10,000 miles of pipes his company owns. As the largest among a handful of publicly traded companies in America that are in the business of purifying and delivering tap water, Aqua America has operations in 13 states from Maine to Texas. Having kept up a steady pace of acquisitions – 25 to 30 per year for the past five years – Smeltzer says his company will continue its aggressive expansion. “There are unlimited targets out there,” he says.

Water, a utility that most people take for granted, is suddenly hot. “It’s not usually looked at as a sexy industry, but its long-term prospects are probably more favorable now than they’ve ever been,” says Stewart Scharf, an equity analyst for Standard & Poor’s. Cash-strapped municipalities need help in updating and operating their aging waterworks, and deep-pocketed companies like Aqua America are offering their services. Most of the pipes and other infrastructure in this country are in dire need of replacement, requiring an investment of around $500 billion from 2000 through 2019, according to Environmental Protection Agency (EPA) estimates.

Despite its rapid growth, Aqua America, with a market cap of $3 billion, will likely soon be displaced as number one in the market by American Water, whose parent company is planning to spin it off in an initial public offering in the range of $4 billion to $6 billion this year. Investors are so eager to get into the space that price/earnings ratios have doubled from 10 to 20 over the past two decades, as the industry’s 20-year returns outperform Exxon, Wal-Mart, and Home Depot. Private-equity firms are making their first forays into the industry, with AIG Highstar buying Utilities Inc. in 2005 and Australian giant Macquarie Bank currently awaiting regulatory approval for the purchase of Connecticut-based Aquarion Water Co.

Those companies that successfully make the plunge into the water business are likely to produce “above-market growth for a number of years to come,” says Debra Coy, an analyst with Janney Montgomery Scott. Once they dip a toe in the water, they can look forward to a virtual monopoly for as far as their pipes will stretch.

But it isn’t easy getting started. Most waterworks are owned by municipal governments, which tend to be fiercely protective of their franchises since water is viewed more as a birthright than a salable commodity. “Municipalities need the outside help, but from a customer standpoint, some don’t feel as comfortable turning to the private sector,” says Scharf. When they do seek help, most prefer to have private companies operate their systems without owning them, a business model that typically carries lower profit margins than owning the assets. Still, many analysts think cities and counties may loosen their grips as investment needs become more pressing.

Wringing Out Returns

How water companies produce profits and shareholder returns is much more complex than the product they deliver. First, they must pour millions of dollars into capital expenditures. American Water, currently a division of German utilities conglomerate RWE, spent about $600 million to upgrade systems last year and expects to maintain or increase that amount going forward, according to senior vice president and CFO Ellen Wolf. Aqua America plans to spend at least $250 million per year over the next five years, says Smeltzer, and more depending on what future acquisitions require.

“It’s such a capital-intensive industry that it’s always negative free cash flow,” notes Coy. Indeed, “we have to invest $3.45 for every $1 [in revenue] we get back,” says Peter Cook, director of the National Association of Water Companies (NAWC), an industry group for private water companies. That compares with $1.61 of revenue per dollar of investment for electric utilities, $1.11 for telephone, and 94 cents for natural gas, according to a 2006 report by AUS Consultants.

This model of spending money before you have it is hard for outsiders to grasp, says Coy, but ironically, it’s what keeps shareholders interested. “Positive cash isn’t a point we look forward to, because then it’s harder to get growth in net income,” explains Smeltzer.

That’s because water companies recoup their investments and earn profits through various types of rate increases that come only after the money is spent. And rate increases must be approved by state utilities commissioners, a process that varies from state to state and can take up to a year. However, unlike most municipalities, private companies rely on appointed, rather than elected, officials for rate increases, which generally makes it easier to get the requested boosts. “If you couldn’t rely on regulators to let them keep raising rates, the business model wouldn’t work,” says Coy. (Not surprisingly, this is also why most towns balk at privatizing their pipes.)

Currently, experts say that regulators in many states are favorably disposed toward rate hikes in exchange for infrastructure improvements. “We’ve never had a regulatory commission disallow a [reimbursement for] capital expenditures we’ve made, meaning we’ve never had to argue over whether the money we put in the ground [for pipes and other equipment] was prudent,” says Wolf of American Water, which operates in 29 states. While nothing is guaranteed, says Pennsylvania Utilities Commission chairman Wendell Holland, “we generally grant all prudently incurred costs.” In about 12 states, including Pennsylvania, companies can even take a portion of their costs through surcharges, giving them some cash up front.

Expenses for interest on debt used to finance the projects are also covered, usually without much debate, since they are easily quantified. Still, regulators like to see that “we are getting the best possible borrowing rates,” says Smeltzer, making it important to maintain strong credit ratings and to mine opportunities for tax-free or low-interest-rate borrowing through towns and counties. Aqua America’s weighted average cost for the $917 million it carries in long-term debt is below 6 percent, thanks to about $300 million borrowed tax-free at 5.2 percent and another $80 million at a 2.1 percent interest rate funded through the Pennsylvania Infrastructure Investment Authority. That’s down from 7.4 percent in 1999.

At Connecticut Water, CFO David Benoit says that “virtually all our debt has been issued through the Connecticut Development Authority as tax-free debt,” making for a weighted average cost of 4.9 percent on its $77 million in long-term debt.

Floating New Shares

But rate hikes that just cover operational expenditures and interest costs are not enough, since that would bring a water utility only to the break-even point. A crucial element in making a profit is to have equity in the mix, since most state laws allow for a “fair” or “reasonable” rate of return on equity, or the cash that companies use for projects.

“The purpose of the equity return is to compensate investors for taking a risk,” says Smeltzer. While the definition of “fair” is debated, it usually translates into about 10 to 11 percent on the cash portion of the investment. “Private water utilities are not going to be allowed to earn outrageous returns,” says the NAWC’s Cook. Indeed, Connecticut Department of Public Utility Control commissioner John Betkoski says all of a company’s expenses, from executive salaries to T&E budgets, are rigorously scrutinized by auditors before any decisions about returns are made.

With the equity return the sole opportunity for profit, at least in terms of the regulated business, a CFO’s ability to work the capital markets can be the lifeblood of a water company. Aqua America has done eight equity offerings in the past 10 years, with the last one for $80 million using an innovative structure known as a forward sale. That structure means that Aqua America’s banking group, led by UBS Warburg, converts a set number of shares to cash, which it turns over only as the company needs it, thus minimizing share dilution. It also helps Aqua America’s debt ratings, says Smeltzer. “We’ve got the money sitting there, so if S&P asked how we’re going to finance the $51 million acquisition of New York Water, I could say I’ve done it already.”

Clearly, American Water’s giant impending IPO could saturate investors’ demand for water stocks, making it harder for other companies in the industry to raise funds. Smeltzer says he’s hoping the $80 million from the forward sale lasts until 2008 so that he won’t be in direct competition for capital. Connecticut Water’s Benoit says he has managed to avoid a secondary offering for more than 11 years and doesn’t foresee the need to issue stock, although with a 45/55 debt-to-equity ratio, he would likely have to tap the markets again in order to do a major acquisition.

So far, though, it seems investors can’t get enough of water. California Water, another publicly traded utility, initially filed to float 1.8 million shares for its October 2006 equity offering, according to CFO Marty Kropelnicki, but since the deal was “well oversubscribed,” the company ended up issuing a total of 2.3 million shares.

For water companies, growth options beyond capital investments and rate hikes are limited, since most customers aim to conserve water, not use more of it. Hence the race to acquire companies, ideally in areas that adjoin existing operations to provide economies of scale.

Both Aqua America and American Water say they aim for between 20 and 30 acquisitions per year. Smaller players are more targeted. California Water looks at 30 to 50 potential deals per year, Kropelnicki says, but pulls the trigger on only 1 or 2. The targets are usually other private companies, mostly nonpublicly traded, that are perhaps too small to make infrastructure investments (some mobile-home parks have their own water utility) or that have been poorly run. In a highly fragmented industry, such targets are easy to come by, say water CFOs, giving acquirers growth potential for years to come.

However, “we’d like to consolidate the municipals as well as small private companies,” says Wolf. Indeed, if the municipally owned waterworks that serve 85 percent of Americans were to open up to privatization, the horizon for private water companies would expand exponentially. Such privatization deals are rare but not unheard of. For American Water, taking over municipal systems represents less than 1 percent of annual growth, according to Wolf.

Enter Private Equity

Publicly traded water companies are not alone among the private entities vying for the public systems. A private-equity arm of Macquarie Bank has already added Thames Water in Britain to its utilities portfolio, even as it awaits approval to take over Aquarion, which operates in four New England states. Highstar, an AIG private-equity fund, acquired Utilities Inc. with a similar strategy in mind. “We have long considered water infrastructure as an attractive investment opportunity and an excellent complement to Highstar II’s existing energy-infrastructure portfolio,” said AIG Global Investment Group chairman and CEO Win J. Neuger in a public statement regarding the purchase.

Not surprisingly, industry veterans are wary of such buyers, which are often known for pumping and dumping companies. “There’s a [business] model mismatch,” says Smeltzer. Not only equity firms usually budget for, the debt-heavy capital structure favored by most firms would reduce their profit potential in any case. “You usually capitalize a water utility with 50 percent debt and 50 percent equity, but private-equity firms tend to use only 20 percent equity,” Smeltzer says, and given that profits hinge on equity, they would likely be cut by 50 to 60 percent using that structure.

As with all potential buyers, when it comes to private-equity firms, regulators are “concerned about whether they’re adequately financed, whether they have managerial and technical experience, and most important, whether they’re in it for the long haul,” says Holland of the Pennsylvania Utilities Commission, which ultimately approved AIG Highstar’s bid for Utilities Inc.‘s Pennsylvania properties. Connecticut Department of Public Utility Control commissioner Betkoski says that Macquarie’s decision to keep current management at Aquarion, along with its investment in other U.S. utilities, was a factor in his decision to approve its purchase of the Connecticut-based water company.

Some in private equity agree that they’re not a good match with the business model. Paul Schaye, a managing director of Chestnut Hill Partners in New York, says his firm has looked at large water companies but decided not to buy. Unlike manufacturing, where plants can be consolidated, “you can’t relocate water. The only way to grow is through acquisition of other water utilities, so your added value is not as great” as it could be in other industries, Schaye says.

Private equity may yet have a role to play in revamping America’s water system, though, if Michael Deane has anything to do with it. In a newly created position at the EPA, which sets the standards for water quality, Deane describes his mission as “developing innovative, sustainable, and market-based solutions for infrastructure financing and management.”

“We’re looking at what can be done to open up more capital,” he says, “particularly as private equity comes into this space not just buying companies but investing in projects, like a massive pipe-replacement plan.” He cautions that the EPA is in the early stages of working with private equity but is hopeful that it can find some new sources of capital.

In fact, some believe that municipally owned waterworks will learn how to finance their systems without turning to new owners. “Public utilities have greater flexibility in the way they can finance infrastructure” than for-profit firms, says Tom Gould, national technical director of finance and rates for HDR, an architectural, engineering, and consulting firm. That’s thanks to their easy access to low-interest state loans, known as state revolving funds, and to the possibility of raising rates or borrowing funds in advance of, rather than in reaction to, a big capital investment. Unfortunately, Gould says, the public utilities “look at [rates] from a political perspective, and that’s why we’re in the hole that we’re in, because locally elected officials are afraid to raise local rates by $1 a month.”

That may change, says Deane. He thinks water rates need to go up across the board to cover the full costs of investments, regardless of a utility’s ownership structure. “As a scarce resource, water should be priced to the markets, so people understand the value of what they’re getting,” says Deane. Highlighting the true value of tap water can only help publicly traded water utilities when it comes to rate boosts and possibly even acquisitions. “The fact that people can’t live without it creates a pretty good economic incentive” to be in the business, says Cook of the NAWC.

As more investors pour money into the sector, look for companies to grow and consolidate even further, with privatized water becoming more common. With a seemingly endless stream of available “tuck-in” acquisitions and investor-friendly regulators, water companies like Aqua America and American Water are riding the crest of a wave that shows no sign of crashing.

Alix Nyberg Stuart is senior writer at CFO.