I wrote a large piece on water with respect to Intrepid Potash back in early September. The fact of the matter is only 3 people viewed the post, so I thought it worth the while to copy and paste the research about water, and the potential shortage that is most likely to come if recent trends continue. The report follows:
Let’s talk about water, good ol’ H2O. Water isn’t a commodity you can physically invest in like gold, silver, or wheat. Because of this, we have to look at ways to invest in water indirectly. What are some of the options? Right off the bat there’s public utility companies such as American WaterWorks; followed by agricultural businesses that produce food; finally you have potash companies that use their recycled water byproduct as a means to sell to other companies that are in need of it.
One of these companies that could expose a portfolio to water is Intrepid Potash Inc (IPI). Intrepid Potash produces and sells potash and potash byproducts in two main product segments: Potash and Trio. The Potash segment produces and sells potash to the agricultural industry as a fertilizer input, the industrial market as a component of oil and gas drilling fluid, and the animal feed market as a nutrient supplement.
The Trio segment produces and sells specialty fertilizer that consists of potassium, sulfate, and magnesium, and is mined from langbeinite ore. The vast majority of revenue is generated in the United States, which is also the location of the firm’s production facilities. Here’s the other cool thing about IPI, it sells water. Taking a look at the third page of their last 10-K it reads, “We also have water rights in New Mexico and Utah under which we sell water primarily for industrial uses such as in the oil and gas services industry”. But it isn’t enough to know that IPI sells water. It isn’t enough to know where they record their water sales on their balance sheets. It’s important to know why water matters, and what could drive its demand.
Why Water Matters
Water is used for almost everything we humans do in the world. Its one of the essential building blocks of life for crying out loud! Now before I get scientists shouting, “the world is 70% water you idiot, how could we run out?!” You’re right. The odds of us running out of water are almost zero. However, the water that humans need is fresh water. Freshwater accounts for around 2.5% of the overall water population. This means we have 8 billion people fighting over 2.5% of a resource.
According to the World Resource Institute, water use is expected to rise by 50% by 2025 in developing countries, and 18% in the developed world. A really cool website I found for those that are nerds like myself, is http://www.worldometers.info/water/. Worldometers.info records in live time the amount of water consumed per year (in millions of liters) along with some statistics. According to Worldometers, “population is rising about 80 million per year, and energy demand is also increasing around the world, with corresponding implications for water demand” (Worldometers.info).
Now that we know how much water humans are working with, it’s important to understand just how we use that water in our society. Going back to our worldometers.info statistics, “agriculture accounts for 70% of all water consumption, compared to 20% for industry and 10% for domestic use” (Worldometers.info). Another cool site to check out if you’re interested in water usage / risk is http://www.wri.org/applications/maps/aqueduct-country-river-basin-rankings/#x=147.30&y=8.70&l=2&v=home&d=bws&f=0&o=171. This website displays what the WRI calls an “Aqueduct Water Risk Map”. This map rates country from 1 – 5 (1 being less at risk, 5 being severely at risk) for water shortages. Along with providing the average score for the country, the map breaks it down into the three major industries: domestic, agricultural, and industrial.
Take a look at the Baseline Water Stress Score, which is the ratio of total annual water withdrawals to total available annual renewable supply. Examining the developed nations we find the following scores (remember, its 1 – 5, with 5 being the worst scenario and 1 being no worries):
- United States – 2.9 Average (3.5 Agriculture, 2.8 Domestic, and 2.5 Industrial)
- Canada – 1.2 Average (2.4 Agriculture, 0.9 Domestic, and 1.2 Industrial)
- Mexico – 3.5 Average (3.7 Agriculture, 2.9 Domestic, and 2.9 Industrial)
- Brazil – 0.9 Average (0.9 Agriculture, 1.1 Domestic, and 0.9 Industrial)
- Argentina – 2.5 Average (2.9 Agriculture, 2.2 Domestic, and 1.8 Industrial)
- South Africa – 3.2 Average (3.2 Agriculture, 2.7 Domestic, and 3.3 Industrial)
- Every Country Average > 4.0
So now that we have a clearer understanding of the world in terms of water usage, supply, and shortage worries, let’s get more granular and find out just how water is used in the industrial industry, which is where Intrepid Potash is located. The Canadian Society for Unconventional Resources has a great PDF describing the uses of water for the oil and gas industry, an industry IPI sells their water rights and water too. I learned a ton about how water is used in the drilling process, so I’ve pasted a few quotes from the article below.
“During the drilling process water-based fluid (drilling mud) is used in a number of different ways including lubricating the drill bit, circulating the drill cuttings out of the hole, containing formation fluids and facilitating the operation of sophisticated formation evaluation tools.”
“Hydraulic fracturing operations which use water as the primary fracturing fluid can require thousands of cubic metres of water. These large volumes of water are required to stimulate each section of the length of the lateral and to carry the proppant material into the newly created fractures.”
So now that we have a mental model, a framework for how we see the water industry heading into the future, the next logical step is to figure out how to profit from it. Even though I wish I could, I cannot invest in Almond Farms like Michael Burry. But don’t get me wrong, if there was an ETF for almonds, I would be a huge buyer of LEAPS. With aspirations of George Washington Carver put aside, a real way to take advantage of this is to find water utility companies that are taking advantage of this imminent shortage. Intrepid Potash was a good option, and I made a nice profit on that trade before having my stop-loss hit. However, when scouring my screeners I came across a smaller water utility company sporting a 6% FCF Yield, increasing earnings, revenues, and a stable 2.56% dividend, I had to take a look. That company is Consolidated Water Co. (CWCO).
Brief Historical Overview
- All Information provided from CWCO corporate website.
CWCO started out in 1973 as a private water utility company in the Grand Cayman Islands, and obtained its first public utility license in 1979. From there, the company installed their first SWRO (just think ‘reverse osmosis’) plant in 1989 and now have more than 25 years of design insight and operational experience within this technology. In 2990, the company introduced their water production and distribution business model, which is still currently used in operations.
The company went public in 1995 and has since expanded into the Bahamas, the Caribbean Islands, and most recently Indonesia and Belize. Since 1995, the company has grown from a small production of $10M per year in revenues, to where they currently stand at $61.6M.
From a fundamental standpoint, this company doesn’t screen well for a typical value investment. The company trades at 30x earnings, 3x sales, and 1.25x book value. It trades 17x its FCF and 12.55x its operating cash flow. In other words, this isn’t going to pop up on a ‘value – screener’ if you’re really emphasizing price to earnings. However, these metrics need to be taken in terms of the company’s overall historical averages, which changes things. For instance, their PE of 30 is a lot lower from their max of 64x earnings. Price to book of 1.25 is much more affordable than the average high 0f 3.4x. Finally, price to free cash flow and price to operating cash flow haven’t been this low since the company first went public.
Balance Sheet Analysis
The company has a breadwinner balance sheet. Current assets are at their highest level over the last ten years, as well as total assets. The company is carrying around $45MM in liquid cash, which is impressive considering the modest $7MM in total liabilities. This is one of the things I love about this company. They are low-cost operators that generate consistent cashflow without the need of any increase in liability expenditure.
Year – To – Date ending from Sept. 16 – 17, the company increased revenues 8.4% to $47MM, increased adjusted EBITDA 9.3% to $4MM, and adjusted net income rose the same percentage and amount. Gross Profit increased from $19M to $20M. Operating income increased 11% to $5MM. Finally, cash flow from operations increased from $5MM to $12 over the latest YoY dates.
The company took a bit of a hit in December of 2016 but has bounced back very nicely, and it’s what I believe is the reason for the current share price consolidation / squeezing. The company is also virtually debt free with debt levels at a mere $0.39MM.
Business Deep Dive
So we know what the business does, but what exactly separates it from its competitors? CWCO divests their revenue streams into three separate Services categories: Retail, Bulk, and Engineering and Management. Let’s examine each of these.
Retail Services Business
CWCO enters into standard contracts with hotels, condominiums, and similar properties located in their areas of business. The company’s license requires them to supply water to developments within the licensed area, which means planning teams from local governments will systematically advise the company of proposed developments. This should be taken as a positive for the company because they can then scale and adjust as needed in order to meet the requirements in a timely manner, instead of being rushed to fulfill a larger order on demand.
Once the planning is done, the company addresses the installation, desalination, and conversion methods to create clean potable water. Finally, the company covers the process end to end with the installation of all meters and management of all the billing systems associated with the water supply. They bill on a monthly basis based on metered consumption. This is key, remember the water shortage problem. Bills are then typically collected within 30 to 35 days after billing date.
Bulk Water Services
The company supplies water by their bulk operations pursuant with long-term contracts. There are three types of contractual agreements CWCO makes in their bulk water business.
- Design, Build, Finance, Operate, and Transfer
This contract the company designs a seawater desalination plant to the customer’s specific needs, as well as providing them a long-term loan to finance their purchase of the plant from CWCO. After the initial phases are complete, the company goes into the operating phase of the business, where it runs the facility and sells the water. Once final payment is made from customer to CWCO, the facility and operations transfer to the customer.
2. Design, Build, Operate & Transfer
This contract is virtually the same as the first one with the exception being the customer is the one financing the construction of the plant.
3. Design, Build, Own and Operate
The final contract is the company designs, builds, and sell the water to the customer from the plant under a long-term arrangement, but the company also retains ownership of the plant.
It’s hard to tell which contract is best for the company, because in all honesty, every contract has extreme asymmetry for the business. With the first contract, the company receives interest on its loan to the customer for construction of the plant. Then, during operation, the company sells its water for revenues. Finally, when the last dime is paid on the loan, the company sells its asset with interest, and moves on to the next contract. It’s a very efficient business model.
Engineering and Management Services
The final segment of their business has to do with the maintenance and engineering services in regards to the plant operations. These services provide customers with complete ‘design-build’ of SWRO desalination systems. They provide the customer with the industry’s most efficient facility. As an Original Equipment Manufacturer (OEM), the company is able to provide capital cost savings and greater design flexibility to its customers.
My Variant Perception
The market seems wrong on the pricing of this company. A company with increases in all areas of the balance sheet, coupled with a tremendously strong Current Ratio of 119.1, and a low-cost, extremely asymmetrically positive business model, there shouldn’t be a reason why the company is trading at roughly 6x its net cash value and 3.75x its NCAV. The market could be too worried about the narrow margins of the company, but in an industry like water utility, you don’t need tremendous margin power to become a tremendous and dominant business.
The model of CWCO is to go where clean water isn’t, and to be the company to provide that place with clean water. It’s a tremendously simple business model that exploits a ‘batteries included’ system of installment, financing, and operations. The company’s net profit growth of 27% and its Projected Net Income 5YR Growth average of 27.4% makes this company considerably undervalued to its intrinsic value.
I used a 10YR Terminal Growth DCF model with the following parameters to come up with a Fair Business Value Price Range. I used a discount rate of 8%, a perpetuity growth rate of 2%, I took its 10yr average EBITDA margin of 21.6, and applied its average 10yr revenue growth rate of 2.9% to come up with a range of $16 – $19.32. These price levels are equivalent to a 30 – 50% discount from fair business value.
Reading the Tape
The charts are showing a tremendous coiling pattern on the monthly charts. In most cases, monthly charts are a great way to see potential long-term moves in price action. Looking at the weekly charts, price is currently being supported by the 50MA. I would like to see price hold here and advance before buying a starter position. Once price breaks the $13.50 I would then seek to add additional exposure to my portfolio.
This has the makings of a very high level conviction investment. The technicals are setting up nicely, and the business is just a great run business. I would love to be part owner of this business, but for the right price at the right time. The shortage in water will eventually prove to be a huge catalyst for this company, and hopefully I am smart enough to get in when I should.
Where is My Fallibility?
Although the company is excellently run, shows signs of growth, and has basically no debt, there are still ways in which I could be wrong (there are usually more ways I can be wrong than right). However, I like to invoke Occam’s Razor when dealing with fallibility vs. my variant perception. In other words, if I have to jump to larger and larger rationalizations in order to meet the premises of my conclusions about why I could be wrong, then maybe the evidence for the company’s future success is more truthful. Either way, here are ways I can be wrong:
- The business takes on a considerable amount of bad debt to finance operations instead of using its current cash from operations.
- The company fails to execute on its business expansion plan of venturing into Asian countries.
- Another competitor comes in and under-cuts prices to the point where CWCO would have to sacrifice earnings power.
- The company’s margins shrink to the point of eating away capital.
- Elon Musk figures out a way to harvest clean drinking water from the ice caps of Mars (although this is an attempt at a joke, I wouldn’t put it past him to think of something like this … Elon if you’re reading this, please give me credit).