GWRS - Global Water Resources Is Well-Suited To Deal With Arizona's Water Scarcity

2023-06-08 09:37:59 ET

Summary

• Phoenix and Tucson area utility Global Water Resources has seen its shares fall in 2023.
• Arizona faces the possibility of water shortages and regulators are seeking to slow the pace of development in the Phoenix area.
• Here's why Global Water's business model should prosper amid Arizona's changing regulatory environment.

I've been a shareholder of Arizona water utility Global Water Resources ( GWRS ) for the past four years. Shares have slid over the past few months amid the general weakness in smaller-cap companies and rate-sensitive sectors such as utilities.

In addition, there has been recent headline-grabbing moves to limit some new developments in the Phoenix area due to potential water shortages. Between the dip in the stock price and the uncertainty around these regulatory changes, it's a good time to revisit the Global Water thesis.

The Recent News

Arizona regulators have recently made moves to limit the permitting of some new development projects in the Phoenix area if they lack sufficient supplies of water. As Global Water's business is entirely based in the Phoenix and Tucson metro areas, this sounds like it could be a significant factor to the company's outlook.

Here's Seeking Alpha's coverage of the news:

"In what might be a harbinger for the housing boom in the American West, Arizona is limiting approvals for new developments within the Phoenix area.

A study found that around 4% of the area's demand for groundwater, close to 4.9M acre-feet, cannot be met over the next century, threatening to damper the explosive development that has made the city one of the fastest growing metropolitan regions in the country.

While the announcement wouldn't affect developments that have already been approved, or get their water sources from elsewhere, it could impact Phoenix's outer suburbs, where developers have been keen on building new subdivisions (or push construction towards cities like Tempe and Scottsdale)."

There are two key points here. One, already approved developments won't be affected. And second, this mostly impacts areas near Phoenix. As noted, the new regulations could push development out toward other cities such as Tempe and Scottsdale.

The thing is, Global Water's main service areas are way outside of Phoenix proper.

It's 11 miles from downtown Phoenix to Tempe, and 12 miles to Scottsdale. By contrast, it's 33 miles from Global Water's primary service area, Maricopa, to Phoenix. It's a full 47 mile drive from another key GWRS city, Casa Grande, to Phoenix. This is to say that Global Water isn't primarily serving Phoenix or its inner suburbs but rather far-flung areas well outside the current urban core.

In addition to having less water stress, some of these farther-out areas are promising since they can support more industrial development that would be hard to permit in Phoenix proper. For example, a cluster of electric vehicle companies has been developing in Casa Grande which should drive significant water usage both from their direct operations and also from the building of houses, schools, retail, and so on to serve all the new workers at these Casa Grande factories.

Zooming out, however, it's important to consider Global Water's broader business plan. The company was designed with water scarcity in mind, and thus items such as the recent news about permitting takes on a different perspective.

Global Water Is Built For Arizona's Resource-Scarce Market

In my original investment thesis for Global Water from back in 2019, I noted how Arizona has a unique regulatory market. I won't rehash that whole discussion here, but the quick takeaway is that Arizona has long had weak local and regional governments.

Some policy experts referred to what's called "shadow governments" that have sprung up in places like Phoenix. With limited central authority, non-governmental organizations emerged that managed much of Arizona's affairs as it relates to regional planning and water usage.

Long story short, this created a ton of tiny water utilities tied to one town, subdivision project, industrial site, or other such entity. In the absence of strong centralized planning, a developmental free-for-all ensued.

And yet, there are these pressing concerns around water usage in particular and cohesive regional development more broadly. It appears that Arizona and the Phoenix area specifically will need to apply a more structured approach to regional planning and resource management to keep the state's economy growing in the decades to come.

Global Water was built for these very conditions. Management realized that it was not practical for Arizona to have hundreds of tiny subscale water utilities. Given the challenges facing the state, Arizona will need bigger water operators that can invest in projects for securing, conserving, and recycling water.

And thus Global Water came about with the mission of aggressively using M&A to create a large utility that can carry out these aims.

Here is CEO Ron Fleming on the most recent conference call explaining this very point:

"It will be another incredible year for Global Water as we continue to advance our mission of growing and aggregating water and wastewater utilities, so that our customers can realize the benefits of consolidation, regionalization and environmental stewardship in the face of water scarcity, challenging regulations and aging infrastructure ."

It's easy to look at the headlines around water regulation or scarcity in Arizona and assume it's inherently bad for Global Water.

But the truth is that Global Water's business plan was designed with these resource constraints being taken into account. In fact, Global Water should have more opportunities in M&A and in attracting new customers since it has the infrastructure and financial capacity to assure stable water supplies to customers that many of the smaller water utilities may lack. In short, Arizona had a wild west market for water, and as scarcity becomes more pressing, the industry will have to mature and consolidate. Global Water has emerged as a leading player in that process.

Robust Growth In Global Water Territories

When I last wrote about Global Water, my biggest concern was the potential for a slowdown in the Phoenix housing market. If prices drop, then that would likely diminish the rate at which homebuilders would put up new houses in Global Water's service areas.

Indeed, there was a significant decrease in new building activity in 2022. However, things have stabilized in 2023 within Global Water's service area. Here is Mr. Fleming update to investors on the conference call:

"In 2022, Metro Phoenix did experience a 23% reduction in single family home building permits over the same period of 2021. But this was still nearly 25,000 single family building permits.

In Maricopa [where GWRS' main facilities are located], we also saw a slowdown, but the city still issued 1,157 permits in 2022. Now year-to-date through April, we have seen 259 permits in Maricopa, which is more than the 245 permits we saw the entire last six months of last year. So we're seeing an uptick from last year's numbers."

It's not just housing that is creating new demand, either. Fleming went on to note that 2022 was the single biggest year of industrial investments in Arizona in that state's history. We saw huge investments in sectors such as semiconductors and green energy, including several EV companies that set up shop in or near key Global Water service territories. Additionally, Procter & Gamble ( PG ) just bought land at the Arizona Inland Port industrial area which is sited within Global Water's service territory.

Increasing Scale Driving Significant Profitability Improvement

Prior to the pandemic, Global Water traditionally traded at a P/E ratio above 50. And with the onset of COVID-19, the company saw its profitability tumble, leading to a sky-high P/E ratio. Over the past two years, however, the P/E ratio has come down dramatically. With the big jump in Q1 earnings, for example, the trailing P/E ratio dropped from 50 to 40:

In said Q1 earnings, the company's net income surged from $900,000 to $2.5 million, or a 177% increase. This worked out to 10 cents a share of earnings. Annualized, this would be 40 cents a share per year in earnings, which would put the stock at 30x earnings going forward.

Many people will look at 30x earnings and say that's still too expensive. That's an understandable impulse. That said, I first started buying Global Water stock when the P/E ratio was close to 100 and the stock price was in the $9s. Now the P/E ratio has come down dramatically even as the stock has advanced to $12. In other words, the growth story is playing out and the valuation is becoming more palatable. The Q1 earnings in particular demonstrate this with the massive year-over-year rise in net income.

I think many investors fail to appreciate what a real growth story looks like in the water utility space, since companies in this sector usually struggle to grow much faster than the inflation rate over time. The water business is known for being a mature stagnant industry that produces stable but barely improving cash flows. Paying a high P/E multiple for a stagnant business doesn't usually lead to acceptable investment outcomes.

By contrast, paying a high starting P/E multiple for something like Global Water makes more sense. The company has grown revenues more than 50% since 2017, and earnings grow more quickly than the top line as there are considerable scale benefits as a utility gets bigger and can divide its overhead costs across a broader customer base.

Global Water Resources Bottom Line

Global Water stock has always looked very expensive on a trailing earnings basis, and that's still true today. However, earnings are starting to show rapid growth as the firm's recent string of acquisitions have greatly boosted profitability.

Arizona remains one of the fastest-growing states in the country in terms of population. And with the huge industrial investments we're seeing in the state, that growth should continue. That's especially true as the Phoenix area is attracting industries such as semiconductors and electric vehicles that should be compelling growth stories in the years to come.

Arizona has some tough choices to make about water scarcity, there's no doubt about that. But the solution won't be a complete stop to growth. And where growth does occur, it will be channeled toward areas that have better water treatment and recycling practices in place. Global Water, with its large operating scale, is much better-suited to deliver sustainable water solutions to customers than many of its peer utilities, meaning that it and its shareholders will be poised to profit from continuing growth in the Phoenix and Tucson areas.

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