Water Analysis - Part III

On a global basis, there is sufficient water to go around to meet demand. However, the issue is one of demand/supply imbalance across different parts of the world. As it is, you already need to increase supply and decrease demand. The situation is made worse by the fact that demand is still increasing and supply is decreasing.

One need to note an interesting point on pricing – a demand/supply imbalance does not affect prices of water here because prices are government regulated. Generally, the price of water is below the economic cost of providing the water. Hence, there is an implicit government subsidy being provided here. Theoretically, a demand/supply imbalance should make such subsidies unsustainable, especially as the imbalance worsens and the cost of providing such subsidies increase. This is true but one must acknowledge that subsidies tend to be persistent/sticky and any expectations of rapid changes in the pricing of water need to be taken with a pinch of salt.

The demand/supply imbalance is one experienced globally across many countries. Hence, we should think global when making our investment decisions. To that end, we need to decide where to invest in particular. Ideally, the best place to invest should be:

1) facing a demand/supply imbalance – an opportunity

2) have a supportive regulatory environment which recognizes the situation and actually support that with action – increase in tariffs, favourable tax laws, PPP that lead to more investment. An important point, because this industry is largely a regulatory play. Moreover, even if an imbalances imply a need for investment, it does not necessarily translate to actual investment unless the government takes active step to. This is largely because it is a regulated industry and does not react as readily to market forces.

These are the basic criteria because a demand/supply imbalance is already serious enough in many countries and there should be cause for action to address the issue.

But to sweeten the deal, additional favourable factors should be considered

3) growing demand for water – because this will increase the utilization of your plant. So you want places that are experiencing industrialization, urbanization, etc

4) growing imbalance (e.g. supply decrease at a faster rate than reduction in demand) – so that government is compelled to act

These 4 factors should be taken into account when deciding where to invest globally.

After filtering down on the countries, we need to decide the particular segment(s) of the value chain to invest in.

In particular, we want:
1) a particular segment which is facing the most stress and which the government feels the most need for action on – favourable regulations and PPP opportunities

2) a particular segment that does not serve the public so that there will be no/low public opposition when prices are moved – so that tariffs can be raised to reflect the true economic cost with little opposition. This may not be a necessary requirement in countries where the public are generally more okay with price changes but you have the best odds when you avoid the risk altogether. Note that segments which serve the public are generally more stable as public demand is less volatility – so you may be trading higher returns from increase in tariffs for higher volatility stemming from volatility in volumes.

3) Low cost of funding environment

After deciding on the sector, you will need to do the filtering by companies
So firstly, you need to determine whether to invest in the operator or just the EPC or something between those 2 – companies with both EPC segment and a BOT/TOT segment.

Logically, an EPC might be better than an operator in an environment where regulations are unfavourable and you don’t earn enough to adequately cover your costs. But if we work backwards, we may also realize that an EPC will not do well in an environment where their client (the operator) may not make profits because few will venture into the industry if it is not profitable. And if few would want to venture into the industry, then demand for EPC works will correspondingly drop. Hence, even though the EPC will be a better play relative to operators in such environment, it may still not be such a good play overall on an absolute basis. Ideally, you want to be in a sector that works well for both types of company.

Regardless of which type of company, you need to choose one that is able to get debt and at a low cost. This is because this is a capital-intensive industry.

In particular, a company transiting from a pure EPC to a TOT/BOT operator will have greater pressure on their funding because they recover their cost over a much longer period of time than when they were doing EPC work, where they recover the cost + profit once they finished the construction. On this point, companies with the potential to improve their capital structure/ improve their financing cashflows via capital recycling through a water trust will be preferred.

In terms of size, we may want to look at mid-caps (what abt small caps?) This is largely due to the fact that contract size has reduced due to several factors – 1) companies are moving to smaller cities which are growing, need the infrastructure but need it on a smaller scale compared to the larger cities, 2) shorter payback periods for smaller plants, 3) its easier to scale up to meet increased demand than to scale down and risk having a plant running at low utilizations.

We could also switch the sequence of analysis around, look at sectors first than countries before we filter by companies. It might lead to a set of companies that are unique from the initial approach.

Filter…

§ By Countries
But following the initial approach, we see that the countries we want to invest in are likely to be emerging markets like MENA, Brazil, China and India. In particular, the list get reduced to Middle East, Brazil and China. North Africa is removed as it is unclear that clear favourable regulations exist. India may have a supply/balance imbalance but there is a surprisingly lack of coordinated effort to address that (just like their transport system). There might be other countries. Any suggestions welcomed.

I am particularly for a focus on China because I can get access to China-related stocks much more easily than companies which do Middle East or Brazil.

§ Sectors

In terms of these countries, low-priced water is a given. Hence, to expect huge tariffs hikes in these countries without the relevant public backlash might be unrealistic. Nonetheless, I note that China has proven an ability to hike prices in the recent years. More research need to be done here to ascertain the quantum of increase but it might still be better to play in segments with less risk of a public backlash.

Using our criteria list, we see that companies dealing with wastewater treatment plant and water recycling plants are the best placed to ride the trend. As water consumption increase, wastewater naturally increases. In particular, industrialization and urbanization often leads to hikes in wastewater volumes that need to be treated due to construction works. Wastewater plants may deal with the public (municipal) or it may not (industrial). Hence, you may have companies that do both and thus give you a portfolio of assets and exposures to both segments – one offering more stability (municipal), while the other offer the returns (industrial) Moreover, from a regulator’s perspective, a wastewater treatment plant kills two birds with one stone. Firstly, it helps increase supply of water as it reduces the pollution that brings water supply down. Secondly, it helps improve the pollution issue that governments are concerned with and help improve the overall standard of living.

Water recycling plants are equally attractive to a regulator because by recycling the water, you help to immediately increase the supply of water available (think x2) And recycled water is generally cheaper than other forms of new water supply (e.g. desalination) and suitable for use in industrial applications where water of high quality standards is not needed, which inevitably free up potable water for use by the general population. By the same vein, water recycling plants tend to concern themselves with the non-public sectors.

§ Companies
In these 2 sectors, I am personally for operators because I like the associated cashflow stability and the asset-heavy nature of the business. Makes it easier to value. Plus, volumes and in turn utilization should go up as demand growth is pretty rapid in emerging markets like China, especially with the rate of urbanization and industrialization which lead to increase in wastewater volumes.

However, I recognize that the true potential might lie in EPCs who are transiting to an operator model. Such companies are preferred because their earnings stream will increase in stability, and this will lead to improved valuations as investors preferred that. Hence, therin lies an opportunity but as mentioned, there is a risk here because of the financing stress which the companies might face. it is important to have a sound funding model due to increased stress on funding that comes with the change in the business model. Hence, the companies best positioned for this will be companies who already have a portfolio of assets which they can create a trust with. They could list the trust and use the trust as a capital recycling vehicle. Being able to do a trust will see a marked improvement in the financing structure and will represent a growth inflection point.

Lastly, choose mid-size (small size?) companies, with low cost of funding.

So in a nutshell, mid-cap (small cap?) Chinese water companies in wastewater and water recycling sectors, transiting from EPC to BOT/TOT model and has a portfolio of assets to create a water trust with. Need also to have a successful track record of growth/winning contracts, so that the capital raised from the water trust is able to fund growth.

Now, you just have to find that company!

"Mama say waterrrr is goooddd" - From the movie Water Boy