By Steve Guy
The water industry has been a frequent topic of conversation for years, from water shortages and conservation issues in the western United States to the lack of clean water for global population growth. Home-owners, businesses and governments worldwide are focused on this basic and essential resource, creating a global market that most analysts estimate is in excess of $300 billion annually. The growth possibilities in the water industry have at times appeared limitless, but history has proven that actual water supply has fallen short of worldwide water needs.
Investors, too, are well aware of this enormous, yet loosely defined and fragmented industry. Countless businesses of all sizes worldwide are participants. In the U.S., an assortment of publicly traded companies have varying levels of water interests, ranging from U.S. water utilities to manufacturers of water treatment equipment. The “Drinking Water Dollars” column in the July 2004 issue of WC&P lists a handful of recent acquisitions in the water industry and identifies many of the strategic drivers behind those transactions. This article seeks to explain valuation in the marketplace for companies with water assets.
Stock price valuations
First some basics on how equity securities (i.e. stocks) are valued in the marketplace. Stocks tend to trade at a multiple of expected earnings (the price-to-earnings ratio, or PE), and the multiple typically imputes and reflects the expected intermediate term growth rate for a given company’s earnings. For example, a public company may have a $30 stock price and management may have given “guidance” to analysts and investors to expect $2.00 in earnings for next year. This implies a forward PE multiple on the company’s stock of 15x ($30.00/$2.00). As the stock price changes (without any new guidance from management or other material news that might radically change investors’ collective expectations), the company’s forward multiple will also vary.
Often a public company’s PE multiple approximates its earnings growth rate, so that a company with a 15x PE is expected to grow earnings 15 percent annually over the next three to five years. This ratio, called a PE to growth or PEG ratio, is useful in roughly assessing whether a stock is trading above or below its expected growth rate, which to some investors implies either a buying or selling opportunity. Analysts also set price targets for stocks in line with expected earnings growth. Using the example above, the analysts may expect the $30 stock to increase to $34.50 (+15 percent) over the next year, based simply on the expected earnings growth of the company and a constant multiple. Also, there are varying premiums and discounts applied to a company’s stock price based on, but not limited to, the size of the company, its trading liquidity, and other financial considerations such as debt ratios.
Because there are so many different ways to participate in the water industry and participants’ business models vary greatly, it is difficult if not impossible to generalize about the value of “water assets” through stock price analysis. However, the Wall Street research community does follow the most significant companies with water assets and does endeavor to isolate the water businesses within the large diversified players. Analysts focus on major themes impacting the industry’s expected growth, such as environmental regulations and enforcement, water infrastructure spending, and the pace of privatization. International growth opportunities (and risks) may also fundamentally impact how analysts view a water company’s overall growth prospects and valuation.
Without question, certain subsectors of the water industry are growing faster than others, and thus are generally more attractive to investors interested in higher growth. For example, the more mature subsectors of delivery equipment (pumps, pipes and infrastructural supply) are probably growing revenue in the low single digits. By comparison, high growth markets include contract operations, filtration and instrumentation, all of which are growing in the mid to high single digits. Below is a representative cross section of participants in the water industry. Beyond this list, there are other players and large, diversified companies with significant interests in the water industry such as, GE, ITT and Danaher.
As indicated in Table 1, the median PE multiples for the group of water stocks are directly in line with those of other industrial manufacturing companies and the Russell 2000 Index. Does this mean that investors place no higher premium on water stocks? Not necessarily. Analysts expect the water stocks to grow a little faster than other industrial companies. But looking at the PEG ratio for the water group, which is a gauge of whether a stock is trading at a premium or discount to its expected growth rate, the market seems to have valued the group beyond the intermediate term expected earnings growth (the median is 1.25) provide by analysts. This PEG ratio is higher than the 1.20 and 1.10 of the comparable indices.
Why is this so? Apparently, investors collectively believe that the group’s growth prospects are much more sustainable than other companies, and that the group will grow earnings faster than even what the Wall Street analysts’ expect. Perhaps this implies widespread optimism about the fundamentals driving growth in the water industry. Excluded from the mean and median totals are the two water utilities: energy utilities pay significant dividends, grow at lower rates and tend to trade on different metrics.
As every investor ought to know, past stock price performance is not a reliable indicator of future performance. Nevertheless, it is relevant to review historical stock price performance, as some conclusions can be drawn on how investors have fared and why certain stocks performed the way they did. As a group, the water stocks have had a good run of late, as many have been trading at or near 52-week highs, as Table 2 indicates.
Over the last year, the best performing stock has been Water Pik, a manufacturer of a variety of water products that appears to have found its footing after a rough start with its spinoff from Allegheny Technologies in November 1999. The best performer over the last three years has been Watts Industries, up almost 100 percent over that time period, despite having much of its water assets in the lower growth subsector of delivery equipment, including valves and control equipment. Compared to the relevant indices of the Dow Jones Industrial Average, the S&P 500 and the Russell 2000, the water stocks as a basket or portfolio have performed exceedingly well, up 36.2 percent and beating the Dow -8.2 percent, the S&P -19.6 percent and Russell 25.4 percent handily over the last five years.
Is this strong relative performance the result of these companies being invested in water? Most analysts believe that this at least partly explains the collective outperformance compared to the broader market, as companies such as CUNO and Pentair are invested in water markets that are healthy and growing rapidly. Again, the industry’s strong fundamentals translate into faster growth than the overall market.
M&A transaction valuations
As most are aware, the water industry has gone through several cycles of ownership reconfiguration over the last 15 years. Many point to USFilters’ acquisition of dozens of water companies in the 1990s and its subsequent sale itself to the French conglomerate Vivendi in 1999 as an end to the roll-up phase. Then Vivendi’s dismantling of USFilter, beginning with the sale of FSG to Pall Corporation in 2002, and Suez’s sale of Nalco in 2003 seemed to reverse the trend of foreign companies acquiring U.S.-based water assets.
Typically, transaction valuations focus on the value paid for the entire enterprise (i.e., the amount paid in cash and/or stock, plus any of the target’s debt assumed). To calculate multiples, enterprise value is then divided by recent historical sales and profitability measures, such as EBITDA (earnings before interest and taxes, plus depreciation and amortization). EBITDA is simply a proxy for cash flow, a useful short hand measure of cash profitability.
The median sales and EBITDA multiples paid in 20 water-related transactions over the last three years have been 1.25x and 9.0x, respectively. It is important to note that terms are often undisclosed in transactions, as we estimate there have been more than 50 total transactions taking place over this time period. These transaction multiples are consistent with those documented over the last ten years. Companies with higher growth characteristics such as those found in the technology driven filtration and instrumentation subsectors have traded on the high end of multiples range, while companies focused on delivery equipment have traded at lower multiples.
There have been a number of large and important transactions completed in 2004, including Pentair’s $875 million acquisition of WICOR and Siemens’ $1 billion acquisition of USFilter. A smaller but interesting transaction also taking place in 2004 was CUNO’s acquisition of WTC Industries for $110 million. WTC is a leader in designing and manufacturing point-of-use water filtration products for large appliance makers, such as GE and Maytag. At the time of the acquisition, WTC had sales of $33 million and EBITDA of $7.5 million (a 23 percent EBITDA margin), making the transaction multiples 3.30x sales and 14.6x EBITDA.
At first glance, it would appear that CUNO paid a significant premium for WTC. However upon closer scrutiny, the valuation, while high by historical standards, is not unreasonable. WTC is in the midst of a very significant growth phase with strong and visible earnings growth ahead. With its knowledge of potable water trends, CUNO was able to get comfortable with WTC’s future earnings projections and pay a higher multiple for these future results. Also, with CUNO’s stock price trading at strong levels and its balance sheet primed for a deal, it was still able to offer a lower valuation than its own multiple, allowing the company to assert that the acquisition would be accretive to future earnings. In a cash transaction, such as this one, a transaction is accretive if the acquirer’s earnings per share are higher (than what they would have been without the transaction) after adjusting for the cost and structure of the acquisition.
The water industry has always held the promise of limitless needs for cleaner, more available and cheaper water, and investors continue to be allured by this upside. The complication for investors and the question to answer has been, and will continue to be, what are the practical and cost effective demands going to be in the future. Like any other tradable asset, the market for water assets and valuation is driven by differences in growth expectations. In the water industry, these expectations are high.
About the author
Stephen B. Guy is a Director in the Consumer & Industrial investment banking group at Milwaukee-based financial services firm Robert W. Baird & Company. Contact him at Robert W. Baird & Co. Incorporated, 777 East Wisconsin Ave., P.O. Box 0672, Milwaukee, WI 53201-0672; telephone (800) 792-2473 or (414) 765-3500; fax (414) 765-3633 or via email: [email protected]