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Jubak's Journal
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Wring profits from the coming water shortage
If demand continues to outpace supply, water may be the next oil -- and the next big growth industry. Here are four picks for drenching your portfolio in profits.
By Jim Jubak
Theres a precious resource we cant do without. Because of growing demand, the world already faces spot shortages that are likely to get worse. Efforts to increase supply are running up against years of underinvestment. Increased pumping threatens to damage existing underground reservoirs. The price of this commodity is rising and looks likely to keep on climbing.
And it isnt oil.
Its water. If the long-term supply/demand imbalance for commodities such as oil or nickel has convinced you to add stocks in those sectors to your portfolio, you ought to own a water stock or two. Projected demand for water is clearly outstripping increases in usable supply. For example, in its latest survey, the U.S. Government Accountability Office found that the majority of state water managers expected water shortages in their states within the next decade, even without a drought. Some of the fastest-growing U.S. states -- California, Florida, Arizona, Texas and Nevada -- are also the countrys driest.
And thats just in the United States. Overseas the supply/demand problems range from lack of clean drinking water in China and India to shortages in parts of Africa and China that are experiencing rapid desertification.
Factor in consumer and business demand for better-quality water in the developing world and water clearly becomes a growth industry with even more potential than the oil sector.
Look past producers
So how do you pick the right water stocks? Unfortunately, the water stocks that are the sectors equivalent of the oil industrys BP (BP, news, msgs), Exxon Mobil (XOM, news, msgs) and Apache (APA, news, msgs) arent particularly good investments. Most water producers, the companies that pump and then sell drinking and industrial water, are regulated utilities with rates of profit that are capped by state regulators who are reluctant to raise the rates paid by consumers. A utility such as American States Water (AWR, news, msgs), for example, shows average annual earnings growth of just 3.2% over the last five years, largely because the company has had to deal with the very tough rate environment in California.
So instead of looking at the stocks of water producers, investors should look at water companies that are the equivalent of the oil sectors drilling equipment and production services. These are the companies that sell the gear and services that filter water, turn sea water into drinking water, purify water for high-technology industries or for the healthcare sector.
Ive found four water equipment stocks that I think fit the bill, and Ill be adding one to the Jubaks Picks portfolio with this column.
Watts gets water where it needs to go
Watts Water Technologies (WTS, news, msgs) makes the equipment that water utilities use to deliver water to their customers: water pressure regulators, temperature and pressure valves, pumping systems, water filters and purification systems, and backflow valves that prevent contamination of drinking water. Legislation introduced in the U.S. Congress last year identified a need for $4 billion to $7 billion a year in low-cost loans so cities could upgrade their water and sewer systems. In a December 2003 survey by Water World Magazine of 200 water and wastewater systems operators, 30% said they planned to upgrade the filtration systems on their drinking water systems, 45% planned to upgrade their storage systems, 45% their pump systems and 53% their pipe systems. And guess what theyll buy to upgrade those systems? The pressure regulators, valves and filter systems that Watts Water Technologies makes. The Wall Street consensus projects revenue will climb by 11% in 2004 and 9% in 2005.
But the most interesting kicker for Watts may be its still-evolving business in China. The company recently gained total operating and financial control over its Tianjin China manufacturing joint venture. That should give the company the ability to realize the lower costs that it moved some of its manufacturing to China to achieve and gradually create a base for growth in the internal Chinese water infrastructure market. According to the Chinese Ministry of Water Resources, 90% of Chinas water supplies are severely polluted. In addition, the demand for water is growing as the country develops: Chinese per capita water use is only about 20% of that in the United States. Water shortages, especially in the fast-growing coastal cities, are already common.
Ionics: Turning sea water into fresh water
Ionics (ION, news, msgs) is in the business of creating new supplies of usable water from water that is too salty, too contaminated or too full of industrial waste. The company is a global leader in desalinization, the process of turning sea water into fresh water, but the company is by no means a one-trick pony. Ionics stable of filtration technologies runs from osmosis to ultra filtration to ion exchange, so the company can tackle just about any problem from supplying ultra-pure water to a high-technology factory to removing giardia from city drinking water.
But what is unique about Ionics is the companys participation in joint ventures with local utilities to build and then operate water plants. That means Ionics risks more capital than it would if it merely supplied equipment or built the plant for a client, but the completed plant and joint venture in exchange supply Ionics with a steady stream of revenue. To date, Ionics owns joint ventures to build and operate water plants in Trinidad, Kuwait, Israel and Algeria.
The company clearly plans to expand this model, and the worlds thirst for more water gives Ionics the opportunity to do just that. Spain, for example, has just announced a $4.6 billion plan to build 15 to 20 desalinization plants along its southeastern coast to supply the growing tourism industry along that stretch of the Mediterranean. As the operator of a desalinization plant in the Canary Islands, Ionics has a track record that should enable it to nail down a piece of this new construction. Investment research from Needham puts the short-term internal rate of return from a project such as this at about 10% and notes that in the long term, the return rises to about 30%.
Cuno wins big by going small
Cuno Inc. (CUNO, news, msgs) operates at the other end of the size scale in the water-purification market. If Ionics builds big, Cuno goes small, supplying water filters for refrigerators and similar appliances. Thats not Cunos only business, but it is the companys fastest-growing segment and one that will represent an even larger part of the companys revenues after the recent acquisition of WTC Industries (WTCO, news, msgs), a supplier of water filters to the appliance divisions of General Electric (GE, news, msgs) and Maytag (MYG, news, msgs). After the deal, the potable-water segment of Cunos business will account for about 55% of the companys sales, up from 46% before the acquisition. Revenues from that business grew by 14.5% in the most recent quarter, and about 45% of those revenues were from the appliance segment.
Besides supplying filters to appliance makers, Cuno has recently moved into selling filters under the Whirlpool (WHR, news, msgs) brand directly to consumers at do-it-yourself centers such as Lowes (LOW, news, msgs). Cuno also is selling filters directly to consumers in Asia through a joint venture with NuSkin, a multi-level marketer. (Cuno was one of blue chips that youve never heard of in my recent column, 5 stealth blue-chip stocks.)
Pentair the pure play
Pentair (PNR, news, msgs) is turning itself into something like a water pure play. The company sold its tools business to Black & Decker (BDK, news, msgs) for $775 million and will close its acquisition of Wicor Industries, the pump, pool, spa and water-treatment equipment subsidiary of Wisconsin Energy (WEC, news, msgs) this summer. The result will be a company with a fast-growing enclosures business where sales of high-security enclosures for sensitive controls grew by 23% in the most recent quarter, and an even faster-growing water business where sales are projected to grow by almost 25% in 2005.
That restructuring is likely to increase the companys earnings growth and the multiple that investors are willing to pay for shares. The tools business, which was 40% of sales, produced just 30% of operating income, while the water business produced 52% of operating income on just 39% of sales. Im adding Pentair to Jubaks Picks with a May 2005 target price of $39 a share.
These arent the only stocks that have exposure to the supply/demand trend in water. Millipore (MIL, news, msgs) goes head to head with Cuno in the health-care segment. Pall (PLL, news, msgs) is a major player in filters for life sciences and industrial uses. ITT Industries (ITT, news, msgs) and Esco Technologies (ESE, news, msgs) both have water business.
But the four Ive highlighted in this column have the advantage of more pure exposure to the water business and the possibility of dominating one segment of that business. And that makes these water stocks float my boat.
Changes to Jubaks Picks
Buy Pentair
With the sale of its tools division and the purchase of Wicor Industries, a pump, pool, spa and water-treatment company, Pentair (PNR, news, msgs) moves significantly closer to being a pure play on water. (The remaining non-water business, called the enclosure division, specializes in high security enclosures for sensitive controls, itself not a bad business in this security-conscious age.) Why is this restructuring important? First, the water business is growing faster than the tools business; projected 2005 sales growth for the water business is 25%. Second, the water business has better profit margins. Third, and this is the one that most interests me as an investor, pure-play water companies get higher multiples from the stock market. Pentair is now trading at 16 times the Wall Street consensus earnings per share estimate for 2005. The average for pure-play water stocks is 20. Im adding the shares to Jubaks Picks with a May 2005 target price of $39 a share.
New developments on past columns
Manufacturing is back: 3 winners
Shares of Rogers (ROG, news, msgs) plunged after the company announced second-quarter 2004 earnings after the close of the market on July 21, falling by more than 20% at the open. As has been so common in the market recently, the culprit was guidance. Rogers announced second-quarter earnings of 68 cents a share, 113% above the 32 cents earned in the second quarter of 2003, but still 3 cents a share below Wall Street projections. That alone would have taken the stock down, but the real killer was guidance for the third quarter: Rogers projected earnings of 59 cents to 67 cents a share for the period, up 61% (at the midpoint) from the third quarter of 2003, but a significant 9 cents a share below Wall Streets estimates of 74 cents.
The problems are centered in the companys Durel division, a former joint venture with 3M (MMM, news, msgs) that Rogers acquired at the end of 2003. Sales of polymer materials and components, Durels specialty, dropped 15% from 2003 levels, and Rogers reported that the decline is expected to continue into the third quarter before improving in the fourth quarter with the ramp up of new keypad products. At this point, I think the problems at Rogers are specific to one, relatively small part of the business and they are fixable. At recent prices, the stock now trades at just 18 times my lower new estimates of 2004 earnings per share of $2.65 and 15 times my new estimate of $3.20 a share for 2005. Thats very cheap for a company of this quality, and so I see no reason to sell this stock here. The companys balance sheet is certainly not impaired in any way: Rogers has $34 million in cash and no debt. As of July 23, Im setting a new target price of $61 a share by May 2005, down from my previous estimate of $73 by December 2004. (Full disclosure: I own shares of Rogers.)
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned shares in the following equities mentioned in this column: Rogers. He does not own short positions in any stock mentioned in this column.
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