Water has long been touted as the next big investment opportunity, with some going so far as to call it “the next oil.” That analogy seems appropriate for a commodity so essential to human health, but several characteristics have kept water from becoming a breakout investment category. These include its low price, the regulated nature and conservative business culture of the industry, and the highly fragmented structure of the market. Despite these challenges, investors recognize the value proposition inherent in both this increasingly scarce commodity as well as the looming need for associated infrastructure improvements that eventually must be addressed. As a result, there has been steady merger and acquisition (M&A) activity in this market, in both the water utilities segment and the infrastructure equipment and services sector, with more activity expected as the need for capital investment is becoming critical and appropriate funding options are limited.
Acquisition activity in the water utilities sector is driven by the fact that the market is highly fragmented, resulting in opportunities for efficiencies through consolidation. The U.S. water and wastewater utilities industry is composed of approximately 52,000 community water systems and approximately 16,000 community wastewater facilities, the majority of which are very small, serving a population of 500 or fewer. This industry composition results in inefficiencies, since smaller utilities often lack the operating expertise, financial and technological capability, or economies of scale to provide services or raise capital as efficiently as larger utilities.
Investor-owned utilities, which typically have greater access to capital, are generally more capable of making necessary infrastructure upgrades to their systems. In addition, larger systems are able to spread overhead expenses across bigger customer bases, thereby reducing the cost to serve each customer. As a result, these consolidated companies have the potential to improve operating efficiencies, lower unit costs, and improve service all at the same time.
Investor-Owned Utilities are Active Buyers
With the strong underlying rationale for infrastructure investing as a backdrop, investments in the water utilities segment have grown in recent years, with consolidation efforts led by such large, public companies as American Water Works Company (NYSE: AWK), Aqua America (NYSE:WTR), Connecticut Water Service (NasdaqGS:CTWS), United Water Resources (owned by Suez Environment Company S.A. - (ENXTPA:SEV), American States Water Co. (NYSE:AWR), and California Water Services Group (NYSE:CWT). Many of these buyers are implementing a growth-through-acquisition strategy, targeting small water and wastewater systems operating in adjacent markets and tucking-in these additions to their overall systems.
For example, Aqua America, one of the largest U.S.-based, publicly traded water utilities, has made nearly 200 acquisitions and growth investments in the last 10 years. Through September, the company completed nine regulated utility acquisitions in 2014 and expects to close several more transactions through the end of the year. Aqua America has the technical expertise to operate water and wastewater systems efficiently. It also has access to capital funds to invest in infrastructure; with its low cost of debt and low operating cost structure, the company plans to invest over $1 billion in the next three years, including more than $325 million in 2014.
In another example, American Water Works Company has also been on an acquisition spree and has allocated nearly $750 million for acquisitions over the next five years. In addition, American Water invests substantially to upgrade its utility infrastructure, planning $1.1 billion in capital expenditures in 2014, with a significant portion of this outlay aimed at improving its water and wastewater systems. These projects are funded by cash generated from operations, borrowings under a revolving credit facility and commercial paper programs, and the issuance of long-term debt and equity securities.
Benefits of Public/Private Partnerships
Capital expenditures related to municipal systems are typically funded by water and wastewater rate hikes, taxes, or the issuance of bonds. However, raising large amounts of funds is challenging for municipal water utilities because of consumer resistance to covering the increased costs needed to repay the borrowings. Consequently, in order to meet their capital spending challenges, many municipalities are examining either outright privatizations or partnerships with the private sector, with such partners offering operations and maintenance; design, build and operate; and other services to public utilities.
Leveraging public-private partnerships for water infrastructure improvement can be mutually beneficial. Private sector investors can add billions of dollars to finance new infrastructure as an alternative to unpopular rate and tax increases or deficit spending. With investor-owned utilities, their desire to protect their capital investment by maintaining system functionality aligns with the common good better than rate or tax increases, with consumer mentality solely preoccupied with keeping costs low. Economies of scale, technological expertise, and access to low-cost capital support the private sector’s large capital improvement programs, and billions of dollars in privately sourced capital is sitting on the sidelines looking for worthy public infrastructure projects.
Even with the many acquisitions occurring in water utilities, government-owned systems still make up the vast majority of U.S. water and wastewater assets, accounting for approximately 84 percent of all community water systems and approximately 98 percent of all community wastewater systems, indicating vast room for additional M&A activity or public/private partnerships in this highly fragmented market.
Water Infrastructure Companies
This sector includes engineering and consulting companies and numerous other fee-for-service businesses such as the building and operating of water and wastewater utility systems, system repair services, lab services, water infrastructure and distribution products (such as meters and pipes), and other products and services. While there is no doubt a huge need for infrastructure investment, with spending remaining curtailed, M&A activity in this sector has been active, but selective. We are witnessing very strategic acquisitions, wherein buyers are methodically building their product and service offerings so as to be best prepared to win their share of the work that does become available. In other words, with too many companies chasing too little money, the competition for projects is so tight that buyers are moving across the spectrum of products and services, trying to build a compelling and encompassing offering.
While this has limited the number of M&A transactions in the industry, it has opened up opportunities for middle market companies in a diverse variety of businesses in the sector, as bigger companies look to fill holes in their product and service portfolio, which can often be achieved through the add-on acquisition of a smaller firm. Buyers that feel the pressure to build out their business lines often believe they can achieve such goals faster if they buy, rather than build, the needed products and services.
With a series of water crises, from serious drought conditions to major infrastructure failures, capturing news headlines, combined with the well-documented fact that the nation’s infrastructure is old and in need of repair, capital projects remain a critical issue. In the long run, companies that provide infrastructure products and services are expected to benefit. But for now, municipal spending remains stifled and reactive and most markets remain reluctant to raise taxes in order to meet the problem head-on. As a result, many major metropolitan areas do not have the money to invest properly, and their capital spending plans extend out for multiple decades, just to meet today’s needs.
In the near term, we expect M&A activity in the water infrastructure industry to remain selective, with good results for companies that meet a particular buyer’s unique and specific needs. This close matching of buyers’ needs with a seller’s strengths underscores the need to utilize a professional M&A process.
Ted Polk is Managing Director and head of the Infrastructure practice at Capstone Partners LLC, an award-winning investment banking firm dedicated to helping business owners maximize the value of their business via a sale, recapitalization, or growth financing. For more information on M&A activity in the water industry, or to receive Capstone’s complimentary bi-annual newsletter that discusses valuation trends and outlines M&A transactions in the industry, contact Ted at firstname.lastname@example.org or 312/674-4531.