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Thirsty for Profits: The Water Distribution Industry

Monday - 8/19/2013, 7:01am  ET

Water is one of the most valuable goods for upcoming generations, and discussions already evolve around the securitization of such commodity. Hence, possibilities for profit depend on government regulation and the age of the infrastructure. Let us look at Companhia de Saneamiento Basico (NYSE:SBS), United Utilities (NASDAQOTH:UUGRY), and American Water Works (NYSE:AWK) to see how those variables will limit or push future profits.

International events and government officials

Saneamiento Basico is a Brazilian water provider that holds a monopolistic position. According to many analysts, its future outlook is obscure because debt obligations and operative costs have lately been on the rise. Those two indicators are expected to exert pressure over future profits.

On the upside, Saneamiento Basico has constantly improved service quality and capital investment in order to match growth objectives for the long term. Additionally, as the customer base continues to widen, upcoming international events to be hosted by Brazil will push demand forward securing profits for at least the following five years.

Also, government regulation has been favorable to the company because authorities want to show Brazil as a developed nation. Hence, providing services to a wider customer base, while improving the quality of services is on the mind of both, management and government officials. So, regulation will try not to distort the market, in order to entice the firm to operate a profitable long-term business.

For Saneamiento Basico´s management, the long-term goal is securing profits. Following that line of thought, sales expenses have increased in part due to domestic inflation, but also due to rising marketing costs related to upcoming events. However, those increments are small when compared to potential profits.

The financial situation of Saneamiento Basico is strong. Net income continues to improve in the back of a growing economy, and its operating margin remains above 20 points. Trading at 7.8 times its earnings, carrying a 43% discount to the industry average (13.8), the stock is undervalued. The company has plenty of upside since the Brazilian economy will continue to grow, regulation will continue to favor operations, and international events will guarantee an above average demand.

Missing targets

After a big internal restructuring, United Utilities transformed into a water utility business. Future opportunities for the company lie on the upgrade of the 200 year old water infrastructure in the United Kingdom. Major capital investment will be required, but profits will be closely watched over by government regulators.

UK regulation allows price adjustments every 5 years, and with current agreements, due in 2015, not much growth is expected in the short term. Additionally, uncertainty remains over the future performance since profits depend from invested capital and official humor.

Specifically, future profits are defined by government officials based on set targets every five years. Such concoction makes for a very risky investment for the long run, even when the firm holds an economic moat due to its monopolist position within the market. In other words, not meeting targets places the company in a weak position to negotiate with government officials, limiting price leverage and profits, as it happened in the last round of negotiations.

On the good side, United Utilities has always put an emphasis on rewarding shareholders´ positions, and reducing risks by quitting non-regulated businesses. However, not having reached government set targets have offset previous achievements, limiting future profits and investment projects.

The balance sheet for United Utilities is weak because debt triples revenue, hampering cash flow and net income. Trading at 17.6 times its earnings, packing a 26% premium to the industry average, and paying $0.34 in quarterly dividends, the stock is overvalued. It is recommended to hold because troubling finances have affected dividends, and uncertainty remains high due to government regulation.

Government regulation

American Water has recently benefited from abnormal weather in North America. Additionally, higher water prices meant a revenue increase of over $100 million. Internally, the company continues to improve performance through cost cuts, improving capital returns. In the future, a market leading position will grant the firm an advantage over peers to exploit any synergy.

The first obstacle to secure profits is government regulation. A market leading position grants advantages over the competition, but at the same time raises concerns from government regulators. This is especially true in a country where anti-monopoly laws carries great political benefits. Hence, regulation will continue to limit the firm´s ability to generate excessive profits.

Additionally, poor infrastructure means that heavy capital investment will be required in order to maintain efficiency levels, and avoid losses related to inoperative assets. However, being American Water an investor-owned company, maintenance and upgrades actually represent a great opportunity for future profits. That is, if government officials allow it.

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