While Baltimore was spared the brunt of the recent storms, flooding has ravaged much of the surrounding suburbs and counties. And although water seemed to be everywhere, it wasn’t where it was needed most of all.

Many water and wastewater treatment plants are built close to a water source such as a river. So when major flooding occurs, these facilities can end up under water, or worse yet, spilling sewage into rivers and streams.

A quick Google news search using the terms “flooding treatment plants” yielded scores of news items from Pennsylvania to Massachusetts, detailing how many of these contaminations and plant shutdowns occurred.

So as many cities dipped into their emergency water reserves last week when local water facilities were forced to give way to rising floodwaters, it became painfully clear how even during a great storm, water (or at least clean drinking water) can be scarce.

Three Ways to Play It

I laid out a lot of facts last week to stress the magnitude of the growing water crisis. Here’s a short refresher: One out of five people in the world are without access to safe drinking water and half of the world’s population lacks adequate water purification systems. On top of this, the United States’ aging infrastructure will need a $1 trillion overhaul over the next 20 years.

(If you missed last week’s column, you can view it here.)

Now, I’ll lay out three different ways you can bet on water along with a potential small-cap play for each category.

Our first category is water utilities. These are the companies that bring water services to countless cities and towns across the country.

If you run a quick screen for water utilities with a market cap under $1.5 billion, you’ll find less than 15 companies. One of them is American States Water Co. (AWR: NYSE).

American States is a holding company that controls Golden State Water Company, American States Utility Services, and Chaparral City Water Company. These divisions provide water — and in some cases electricity — to one out of 30 Californians located within 75 communities throughout 10 counties in California. This makes up about 252,000 customers, according to American State’s corporate website.

This is a $568 million company has a multiple of 21, while the average P/E for water utilities is around 29.5. It trades for a little more than $34 a share, and has paid a consistent dividend of about $0.90 a year for quite some time.

The biggest blemish on this company’s balance sheet is its $268 million in long-term debt. It’s enough to make me give pause, however, because revenues have been steadily increasing and consolidation in the industry could be a major factor in American State’s future.

Stanford Group analyst Francesca McCann told The Wall Street Transcript this month that she expects the consolidation trend to continue among water treatment, services and equipment companies. The target companies will probably be smaller private companies, she said.

“We also could see some action from the California water utilities, California Water Service Group (CWT: NYSE) and American States Water (AWR: NYSE),” McCann said. “They haven’t been in acquisition mode for quite some time, largely due to an unfavorable regulatory environment. Now that we are seeing changes in that environment at the CPUC, we could see a little bit more action there. Again, the targets would likely be smaller, privately owned systems.”

Equipment

Water needs to get where it’s needed or else it’s useless. Which leads us to your second option for playing the water crisis: water pipes, pumps and other equipment.

One such company is the $1 billion water equipment provider Watts Water Technologies (WTS: NYSE). Watts sells everything from flanges, filters, fittings, connectors and other water safety controls. And according to one analyst, this is now one cheap stock.

Citigroup analyst David Smith told the Associated Press a couple of weeks ago that he’s not sure why shares of Watts have wandered from its recent 52-week high. The stock sells for around $33.50 a share now, down from a recent high of $40.

Smith’s take is lower copper prices will improve Watts’ bottom line, since the company spends 36% of its raw materials budget on the metal. And with growing revenues and earnings, Watts could have one heck of year ahead of it. The company earned $0.46 a share in the first quarter, up from $0.37 only a year ago.

Consulting and Engineering

The water-consulting field is probably not something that would come to every investor’s mind. But there is a small-cap company out there that does just that.

Tetra Tech, Inc. (TTEK: NASDAQ) is essentially a water consulting and engineering business. This $1 billion company performs most of its work for the government, and also does work for commercial clients in the United States and overseas. It trades for about $17.80 a share.

And the CEO is expecting some growth in the coming years…

“We are currently number one in water technical services, but we are looking to expand our market leadership geographically and to fill out technical niches. Over the long term, we want to grow our top line annually at approximately 15% — with about half of that coming from organic growth, and half of it from acquisitive growth,” Tetra Tech’s CEO and COO Dan Batrack is quoted in a company release.

So there you have it. Hopefully, this will give you some ideas and maybe even lead you to some companies I haven’t mentioned. If you like the looks of these businesses, or if you have some water-related plays of your own, don’t hesitate to e-mail us at thesleuth@agorafinancial.com.

Best,
Gunner
July 3, 2006

The Water Crisis was originally featured in the Penny Sleuth.