Water Utilities: Time to Wade In?

The group has had a top relative strength ranking for months. But takeover speculation -- not fundamentals -- is driving the shares

By Sam Stovall

The S&P Water Utilities industry index has held the highest relative strength ranking of "5" -- meaning it is in the top 10% of all industry groups based on trailing six-month price performance -- for several months. (See the table below for the top-ranked industries as of Sept. 28, 2001.) And yet none of the stocks in this group covered by S&P has a favorable STARS ranking.

What's the story? I asked Stewart Scharf, S&P's Water Utilities analyst, about this and he said that stocks in the group have been driven higher by takeover speculation, not fundamentals.

Scharf says water utilities are expected to benefit from an estimated $10 billion of water system infrastructure improvements over the next 10 years, as well as the possibility of additional acquisitions by non-U.S. companies (for example, Philadelphia Suburban is nearly 20% owned by France's Vivendi Environment). However, Scharf says weak economic conditions have tempered S&P's near-term investment outlook for the industry.

It does seem that foreign water companies' thirst for prime U.S. utilities has yet to be satisfied. Following the recent terrorist attacks in New York City and Washington, D.C., the largest, publicly traded, U.S. investor-owned water utility, American Water Works (AWK ) -- which accounts for 68% of this index's market capitalization -- announced that it would be acquired by German-based utility RWE AG. The deal is expected to close by late 2003. Sparked by a more than 20% rise in AWK's stock price on the news, the industry index has risen 24% year to date, versus a 21% drop for the S&P 1500 (the composite of the S&P 500, S&P MidCap 400, and S&P SmallCap 600).

Looking forward, Scharf notes that water utilities continue to focus on expanding their geographic diversity in an effort to reduce the impact from adverse weather conditions. The utilities are also seeking rate hikes from state regulatory commissions in an effort to offset rising infrastructure costs and, in some cases, to recover power costs.

And he notes another trend: With about 85% of the population getting its water from government entities, municipalities are eager to find cost-effective, private-sector solutions for their water services needs, as facilities and pipes continue to age.

Regulations governing water quality, however, may become less stringent under the Bush Administration, notes Scharf. The administration recently withdrew a new standard intended to reduce arsenic levels in drinking water to 10 parts per billion from 50 ppb. President Bush also plans to shift clean water issues to local and state agencies to resolve. Under the new plan called WATER-21, water municipalities and operators would receive $57 billion in grants and loans over five years to help make up a funding gap in capital outlays. Scharf also expects government partnerships and industrial outsourcing to play a larger role in this fragmented industry."

Sub-Industry Company S&P STARS Rank
Consumer Electronics Harman International (HAR) Not Ranked
Distributors Brightpoint Inc. (CELL) Not Ranked
Gold Barrick Gold (ABX)
Health Care Distributors & Services McKesson Corp. (MCK)
Health Care Facilities HEALTHSOUTH (HRC)
Household Products Procter & Gamble (PG)
Meat, Poultry & Fish Tyson Foods (TSN)
Metal & Glass Containers Pactiv Corp.(PTV)
Office Electronics Xerox Corp. (XRX)
Trading Cos. & Distributors Fastenal Inc. (FAST)
Water Utilities Amer. Water Works (AWK)

Stovall is senior sector strategist for Standard & Poor's

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