Water Drinking Water Dollars

The Metacatalyst: A Private Equity Perspective of Water

By Christoph Lueneburger catalyst (kat l-i st) n. A substance that initiates or accelerates the speed of a reaction between other agents without changing itself in the process. gate. And indeed, a look at a basket of Identifying sectors two dozen stocks1 of companies in the One approach from the private eqbroader water business reflects the funuity perspective is to focus on specific damental strength of this sector. Figur e families of applications. Compartmental1 compares the water basket to the Dow izing the water industry as illustrated in Jones Industrial Index over the past 15 Figure 2, we can both place existing comyears and illustrates that the mean daily panies and envisioned services in a comgain of the water basket is not only petitive space along transportation, inforgreater than that of the Dow, but its volamation and process dimensions. tility (measured here in terms of stanNeil Berlant, a gray (but vibrant) dard deviation) is also less. Compared eminence of the water industry for two to the Dow, in other words, a small-er decades, recently suggested over lunch number of stocks generated a greater rethat in order to understand what a real turn with lower volatility. That is true water solution looks like, one should both over the entire 15 years and durspend a month on the loading dock of ing the relatively calm five-year period any plant that requires water for its coolstarting in 1992. Given that the fundaing, processing or injection applications mentals of this industry are continuand record all deliveries that relate to ously intensifying, it is no wonder that water, be it filters or chemicals, har dware investors are taking notice as the long-term Figure 1. Historic performance of water stocks growth of the water bas- 100x ket is certain to continue Water Basket (R = 0.075%, StDev = 0.85%) unabated. Alas, I dont Dow Jones Indx (R = 0.040%, StDev = 1.01%) have the worlds land to sell youthink bigger. Among the candidates for thinking bigger 10x about contributing to the creation of value in this industry is the private equity investor. Because the water industry has 1x evolved based on local supply and demand over 1990 1992 1994 1996 1998 2000 2002 2004 2006 decades (and centuries), it is a highly fragmented industry with or software. A true solution bundles the many competitors concentrating on set of equipment and services that unfailniche segments. And even though lar ge ingly meets the facilitys demand for waplayers such as Siemens and GE are culter at the right purity, pressure, temperativating incr easingly imperial water ture and price. portfolios, the space is far too immense Keep in mind that the majority of to allow a comprehensive wheelhouse industrial applications that rely on waof goods and services for all thirsts. ter do not yield goods that contain waNor is universality a r equirement ter. Water, in most of these industries, is for success in this vast industry. The proa critical part of the process, but not of cess of building a presence in the br oadthe product. Therefore, most manufacturest range of competencies can as easily ers do not think of themselves as being diffuse a companys competitive posiin the water businessyet more often tion as it can substantiate it. than not they are responsible for manag-

Introduction
I recently discovered an emerging product targeted at industrial, agricultural and domestic applications. Demand is global, elastic and growing. The product is under-priced and there are no substitutes, and if you have read this far, you may expect me to sell you some land. I am talking about water, of course and I admit I have not just recently discovered itI am an obsessive user. Water has been around for quite a while and like oil, it is essential to industrial processes. Unlike oil, however, it is equally essential to virtually all other processes on the planet, from any organic reaction to the drilling and processing of oil, yet it is not, itself, consumed as it is used. Water may become polluted, it may transition phases, but it can always return to a state of liquid purityit is the ultimate catalyst of evolution, whether biological or industrial. This article argues that significant opportunities for value creation await the strategic private equity investor throughout this enormous industry. One path to success begins with assembling full-service solutions tailored to specific demand segments by concentrating on competencies that are currently not cohesively integrated.

Water stock
Perhaps it is because the evaporation-condensation-precipitation cycle has been impressively reliable for eons that we have only recently begun to think of water as a precious commodity. Much has been written about the influx of investments into private and public equities in the water industry. The July 2005 issue of the Global Water Intelligence Report speaks eloquently of the hoards of explor ers waiting at the
1

Because no exchange-traded fund for water exists today, the ad-hoc basket used herein contains tickers AMN, AWR, BMI, CCC, CLC, CLX, CWT, DHR, DNEX, FELE, FLS, GLK, INSU, LNN, MIL, MSEX, PNR, RBN, SWWC, TMO, URS, VMI, WTR and WTS. All of these have been listed at least since Q2-1990.

S EPTEMBER 2005

Water Conditioning & Purification

29

alerting you to any trends of interest. ing their water solution. Vulnerability versus detection More importantly, you are getting Thus, the challenge for the discernWe can survive one month without real-time security: as you draw a glass of ing private equity investor is to find spefood, three days without water and four water from your tap at 2:00 a.m. you recific segments where financial and straminutes without air. Virtually every food ceive an instant automated call informtegic resources enable the creation of product we buy in the grocery store ing you of traces of benzene in your insustainable value beyond the growth inincluding waterfeatures an expiration coming water. You also learn that your herent in the fundamentals of the water date and nutritional information; many filtration system removed the benzene, industry as a whole. Successful build-up U.S. homes have a carbon monoxide dethat the water in your glass is safe strategies will pick and stick to particular solutions, bundling all Figure 2. Conceptual sectors and competencies for drinking and that a digital alert has been sent to your muelements supporting the in water nicipal water utility, which will customer s water needs. follow up within 24 hours. What Determining which compewould a full-service offer guartencies are usually least inteanteeing not only water quantity grated in todays water market but also quality delivered to our is one potential method of estabhomes be worth to us? What lishing starting points for a buildwould it be worth to a food proup. The correlation matrix in Figcessing factory, a cosmetics plant, ure 3 delineates the business or a pharmaceutical manufacactivities of each of the competiturer? tors of the water basket in FigIntegrating the transportaure 1 into 20 industry competention, process and information cies analogous to those of Figure needs of specific demand seg2. Since these public competitors ments, we can conceive of simitend to be the largest in their lar solutions for other low-correfields, their suite of services is lation competencies in Figure 3, likely to be the most expansive, such as corrosion resistance, merevealing the dominant service tering and controls. Each of these bundles offered today. areas allows the formulation of As we can see, some competurnkey services tailored to the tencies are positively correlated: needs of established markets, virtually all companies that prowhether domestic, industrial or vide maintenance also offer billagricultural. Without a doubt, there is ing. The more interesting question, howtector to ensure we are breathing good great potential for value creation outside ever, concerns itself with negative air. But there appears to be little concern particular technological vogues such as correlations, shown in increasing shades about contaminants in the tap water we membranes and desal. of blue in Figure 3. Companies in chemiuse to not only wash and prepare our Having selected paths toward longcal processing, for example, tend not to foods but also (in lots of households) term growth, the investor will also conbe in design and logistics, while Infradrink. And while many people have retemplate potential exit scenarios five to structure players are generally weak in sorted to drinking bottled water, the coften years hence. Half of the public compurification and filtration. Summing up fee I am drinking was certainly not panies sampled in this article have priceall correlations for each competence, we screened for the presence of inorganic earnings ratios between 21x and 28x2. Alfind contamination detection to be the toxins that can endure boiling water. most insular among those represented Considering the vulnerability of our though these PE ratios do not increase in the water basket. water supply to accidental and willful with revenues in the overall industry, To further illustrate one process leadpollution as reflected by the spectrum of they are on average relatively greater in ing to the articulation of a private equity toxins, from E. coli to lead, that are roucompanies offering more competencies investment strategy, lets consider continely found in tap water, it is a staggerthat are highly correlated3 , per Figure 3. tamination detection as a competence ing fact that water is not tested a single The relevance of the competence correthat has yet to be broadly integrated into time after leaving the treatment plant. In lation is further substantiated by the fact complete solutions tailored to specific dea world of both weakening metropolithat sheer number of competencies alone mands. How could a strategic private eqtan water infrastructure and rising terhas not incited price appreciation in these uity investor help unlock value in coarorism, how much value is waiting to be companies beyond the basket average lescing a one-stop service platform? unlocked in integrated point of use consince 1990. Rather than diving into the massive intamination detection alone? You are no One implication for private equity dustrial arena, lets start closer to home: longer getting just a water bill, but a reinvestors is that while the drive toward the residential market. port documenting the health of your waintegrated water solutions is only beginter relative to U.S. EPA standards and ning, attractive exit scenarios via public markets will mature for well-assembled small- and mid-cap (rather than simply 2 A recent Goldman Sachs research note differentiated PE ratios in the water industry by + + hefty) water companies. Established, company type: pumps 16 x, automation 20x, tests and treatment 22x, filtration 23 x, UV 24x, desal 26x. The PE ratio used herein divides the market value per share of each large players in this market will present company by its trailing-twelve-months earnings per share. additional exit options as they continue 3 Example: WTR, with a cumulative competence correlation of +2.9, trades at a PE of to build their water portfolios. 34.4, while TMO with a cumulative competence correlation of -4.7 trades at a PE of 12.5.

30

Water Conditioning & Purification

SE P T E M B E R 2 0 0 5

Conclusion
Industrial and population growth drivers along with population shifting and concentration will continue to clash with treatment efficiency limits as well as pollution effects. Coupled with regulatory constraints and the capital expenditure intensity characteristic of the water industry, this conflict is certain to effect change. Successful responses to that change will bundle competencies into cohesively integrated services tailored to a clearly defined demand. Private equity players who want to participate in the creation of value in the water industry therefore must be more than financial investors. We have to be enduringly committed and strategically align ourselves with specific segments in this vast industry. We have to be willing to add value to our portfolio companies in partnering with management teams to cultivate not only operational excellence but also strategies that are both turnkey and valueadding. If we can do that, we will discover in water a metacatalyst for long-term investment success.

Figure 3. Competence correlation matrix of water companies

About the author

Christoph Lueneburger, P.E., became managing partner of Rigger+Stern Capital Management in 2002 after working for Bertelsmann Capital Ventures in New York. Leveraging his graduate background in fluid dynamics as well as his operational experience, Lueneburger is currently establishing an investment focus on the water sector at private equity house Stonehenge Partners in Columbus, Ohio. He can be reached at (877) 298-4409 or at clueneburger@ stonehengepartners.com.

S EPTEMBER 2005

Water Conditioning & Purification

31