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Despite valuations, analysts say water investment still safe

Fri Aug 26, 2005 09:18 AM ET
By Michael Erman


NEW YORK, Aug 26 (Reuters) - Come on in, analysts say, the water is fine.

While valuations of water utility stocks are well above their five-year averages, analysts said that these stocks are still wise investments for people who have the stomach to ride out some turbulence.

They said the companies -- a small group including Aqua America Inc. (WTR.N: Quote, Profile, Research) , California Water Service Group (CWT.N: Quote, Profile, Research) , American States Water Co. (AWR.N: Quote, Profile, Research) , and Southwest Water Co. (SWWC.O: Quote, Profile, Research) -- can provide value due to consolidation opportunities, strong earnings potential, steady dividends and increasing institutional investment.

"We think this is the best place for investors longer-term, if they can close their eyes on the roller coaster ride and have a three-to-five-year horizon," said Janney Montgomery Scott analyst David Schanzer.

There may be some near-term volatility in the sector, analysts said, as some investors will take profits or be deterred by strong valuations.

Indeed, many of the stocks have already retreated a bit from highs reached earlier in the summer. But industry experts said there are compelling reasons to invest long-term.

The industry has already been through a major consolidation: 10 years ago there were 21 publicly traded water utilities compared to about a dozen today, according to Schanzer. And the sector is poised for more, as capital spending necessary to meet new environmental regulations should create economies of scale for larger water companies.

The companies can also expect to benefit from rising rates as they pass that spending through to customers.

"With the market in its current condition -- rising rates, high gas prices, and oil at $67 a barrel -- people are starting to look around and say hey, I can park some money here," said Michael Gaugler, an analyst at Boenning & Scattergood. "This is a guaranteed growth market."

LOW RISK

Moreover, the industry has very low risk -- there really is no substitute for water -- and has benefited from the relative scarcity of publicly-traded water utilities coupled with rising demand from institutional investors.

"Only about 15 percent of the U.S. water industry is investor-owned," said Tim O'Brien, senior portfolio manager at Evergreen Investments, which owns some Aqua American shares in its funds. "As a result, there is a scarcity value to the small and dwindling universe of publicly traded investor-owned water utilities."

For this reason, he said the stocks have always commanded some sort of premium to gas and electric distribution companies, which have also had a recent rally.

Still, price to earnings ratios for the water companies are rich. For example, shares of Aqua America and Southwest Water are trading at 35 and 36 times projected 2005 earnings, respectively, well above their five-year averages of around 25 times earnings.

For investors who would like to find a way into the water sector but are nervous about the sky-high valuations, Boenning & Scattergood's Gaugler suggests investing in companies that provide pumps and pipes or other technology that are set to benefit from the environmental spending.

Gaugler said General Electric (GE.N: Quote, Profile, Research) , Consolidated Water (CWCO.O: Quote, Profile, Research) , and IDEX Corp. (IEX.N: Quote, Profile, Research) would all be good investments.

"You've got 54,000 community water systems out there, and they are all going to have to spend a lot of money on infrastructure improvement, both to fix what's there and to comply with new EPA regulations in 2010," he said. "Investors are starting to salivate on the amount of money that is going to be spent."