“The purpose of the equity return is to compensate investors for taking a risk,” says Smeltzer. While the definition of “fair” is debated, it usually translates into about 10 to 11 percent on the cash portion of the investment. “Private water utilities are not going to be allowed to earn outrageous returns,” says the NAWC’s Cook. Indeed, Connecticut Department of Public Utility Control commissioner John Betkoski says all of a company’s expenses, from executive salaries to T&E budgets, are rigorously scrutinized by auditors before any decisions about returns are made.
With the equity return the sole opportunity for profit, at least in terms of the regulated business, a CFO’s ability to work the capital markets can be the lifeblood of a water company. Aqua America has done eight equity offerings in the past 10 years, with the last one for $80 million using an innovative structure known as a forward sale. That structure means that Aqua America’s banking group, led by UBS Warburg, converts a set number of shares to cash, which it turns over only as the company needs it, thus minimizing share dilution. It also helps Aqua America’s debt ratings, says Smeltzer. “We’ve got the money sitting there, so if S&P asked how we’re going to finance the $51 million acquisition of New York Water, I could say I’ve done it already.”
Clearly, American Water’s giant impending IPO could saturate investors’ demand for water stocks, making it harder for other companies in the industry to raise funds. Smeltzer says he’s hoping the $80 million from the forward sale lasts until 2008 so that he won’t be in direct competition for capital. Connecticut Water’s Benoit says he has managed to avoid a secondary offering for more than 11 years and doesn’t foresee the need to issue stock, although with a 45/55 debt-to-equity ratio, he would likely have to tap the markets again in order to do a major acquisition.
So far, though, it seems investors can’t get enough of water. California Water, another publicly traded utility, initially filed to float 1.8 million shares for its October 2006 equity offering, according to CFO Marty Kropelnicki, but since the deal was “well oversubscribed,” the company ended up issuing a total of 2.3 million shares.
For water companies, growth options beyond capital investments and rate hikes are limited, since most customers aim to conserve water, not use more of it. Hence the race to acquire companies, ideally in areas that adjoin existing operations to provide economies of scale.
Both Aqua America and American Water say they aim for between 20 and 30 acquisitions per year. Smaller players are more targeted. California Water looks at 30 to 50 potential deals per year, Kropelnicki says, but pulls the trigger on only 1 or 2. The targets are usually other private companies, mostly nonpublicly traded, that are perhaps too small to make infrastructure investments (some mobile-home parks have their own water utility) or that have been poorly run. In a highly fragmented industry, such targets are easy to come by, say water CFOs, giving acquirers growth potential for years to come.