Summary
- $338.0 million market cap Global Water Resources is a roll up water utility that owns 25 different water, wastewater and recycling systems in Arizona.
- The company benefits from water demand exceeding supply and strong population and business growth in its service areas.
- Financial performance is improving due to acquisitions, favorable rate increases and cost control.
- Valuation is stretched. GWRS is trading at a 60-plus P/E and at least 40% above my best estimated value of about $9.48 per share.
- It is a very interesting company, however, and while I suggest investors pass for now, let's put it on the watch list.
If you live in the Arizona desert, the importance of water and electricity is hammered home to you every summer when the temperature hits 100 degrees and stays there for weeks. Without both, life in Phoenix, Tucson and their outlying areas would quickly become impossible. Let’s consider one of these necessities, water, in the form of grandly named small cap Global Water Resources, Inc. ( GWRS ). With a market cap of approximately $338.0 million, GWRS, per the latest 10Q , is a “water resource management company that owns, operates, and manages water, wastewater, and recycled water utilities in strategically located communities, principally in metropolitan Phoenix, Arizona.” A water utility in the desert? Sign me up…
Strategy: A Classic Roll Up Company
GWRS was organized in 2003. Since that time the company has acquired 25 different water, wastewater and recycling systems in four Arizona regions; Maricopa/Casa Grande – 40 to 50 miles south of central Phoenix, West Valley – the far western suburbs of Phoenix along I-10, Sun Corridor – the area between Phoenix and Tucson along the I-10, and Pima County/Tucson. GWRS’s service area now looks like the following:
After acquiring a water utility GWRS implements its “Total Water Management" program. Per the 3Q 2022 10Q , the program is a “comprehensive approach to water utility management that reduces demand on scarce non-renewable water sources and costly renewable water supplies, in a manner that ensures sustainability and greatly benefits communities both environmentally and economically.” The program incorporates various types of state-of-the-art water recycling with advanced technology supported by regional planning, educational initiatives and strategic partnerships.
The Arizona water utility market is very fragmented with 300-plus investor-owned water and wastewater utilities in the state, providing GWRS with a significant number of roll up targets. Since acquired water utilities are typically small and older, the application of the company’s systems and procedures results in the achievement of scale and technological efficiencies.
As of 3Q 2022, GWRS’s active service connections increased 4,176 or 8.0% to 56,134 compared to 51,958 as of 3Q 2021, due largely to organic growth plus the 1,100 active water service connections acquired through the purchase of Las Quintas Serenas Water Company located near Tucson. In spite of numerous small acquisitions, GWRS’s business is heavily concentrated in the Maricopa /Casa Grande region where approximately 91.0% of the company’s 56,134 active service connections are serviced by the company’s 100%-owned water and wastewater/recycled water subsidiaries, Global Water - Santa Cruz Water Company, Inc. and Global Water - Palo Verde Utilities Company, Inc., respectively.
The risk associated with this concentration is mitigated by the Arizona Water Resources Board granting GWRS a Designation of Assured Water Supply Certification in the Maricopa/Casa Grande service territory for approximately 22,900 acre-feet of water use compared to the current usage of about 7,700 acre feet per year. The certification is associated with Arizona’s 1980 Groundwater Management Act which stipulates that new subdivisions cannot be built within an Active Management Area (Prescott, Phoenix, Pinal, Tucson and Santa Cruz) unless they can prove they have access to a 100-year water supply. In order to receive this certification GWRS had to prove that, among other rigorous requirements, water would be physically available to meet demand in the service area for 100 years considering growth, drought and climate change.
A Growth Market
Arizona continues to experience rapid population and business growth, but there are clouds in the desert sky. The Phoenix MSA, GWRS’s primary service area, has experienced tremendous growth over the past decade. Per the latest 2020 U.S. Census Data , the MSA’s population increased by 16.7% to 4.9 million over the decade ending in 2021. According to the University of Arizona’s Business Research Center (“UABRC"), the MSA can expect even faster short-term population growth looking forward with an estimated 8.2% increase to 5.3 million expected by 2025. As a whole, per the latest 2020 U.S. Census Data the state’s population increased by 12.5% from 6.4 million in 2010 to 7.2 million in 2020. According to the UABRC , the state’s population will reach 7.7 million by 2025, a 6.9% increase in five years.
Arizona continues to benefit from great natural beauty, excellent weather, large and growing universities, an increasingly diverse employment base and relatively low taxes. While Arizona remains a top retirement destination, the state increasingly attracts major businesses, supporting the UABRC’s prediction of 10.3% growth in nonfarm employment from 2020 to 2025. The low wage call center relocations of the 1980’s have been replaced by high-wage tech and service businesses.
What are the clouds in the desert sky? Ironically - and perhaps profitably for GWRS - one is water, the other, a new factor in Arizona’s future, is housing affordability.
Arizona’s state government has been proactively managing the state’s water resources for decades, but the 20-year drought in the western U.S. combined with explosive population growth has raised new challenges. According to the KYL Center for Water Policy at Arizona State University, the state’s water comes from the Colorado River (36%), groundwater (41%), in-state rivers (18%) and reclaimed water (5%) – all but recycled water sources are heavily impacted by drought. While the low level of the Colorado River garners the most press, the Salt, Verde and Santa Cruz Rivers within the state have all suffered major declines in water flow due to drought and high levels of groundwater use . There are already areas where concerns have become reality:
- 500 residents of Rio Verde , an unincorporated part of Maricopa County, had relied water trucked from the city of Scottsdale, but were cut off beginning January 1, 2023. More telling, another 200 residents occasionally relied on trucked in water because their wells were running dry.
- In Pine-Strawberry , in the northern part of the state, 26 of the local water utility’s 40 wells are no longer producing.
- In the south eastern Arizona community of Wilcox , wells have been drying up as the water needs of huge dairy farms deplete the basin’s aquifer.
With an assured source of water in its major service territory, GWRS may reap short-term profits from the state’s developing water crisis, but, more importantly, the company’s progressive use of recycled water will position it to be part of the long term solution.
The second issue clouding the state’s future is housing affordability. Long a big plus for Arizona in drawing residents from higher-cost states, the most recent statistics place housing affordability in Arizona well below the national average. Nationally, the National Association of Home Builders /Wells Fargo Housing Opportunity Index latest release for 4Q 2022 indicated that affordability had fallen to 38.1%, its lowest level in more than 10 years. Arizona metropolitan areas experienced the lowest affordability since the current series began in 2012. The share of homes affordable to those earning the median family income for selected areas in Arizona were 35.0% in Tucson, 18.6% in Prescott-Prescott Valley, 18.3% in Phoenix, and 15.6% in Flagstaff. If housing affordability eventually slows Arizona’s population growth, GWRS may experience less demand for water and water recycling.
Pre-SPAC Circuitous IPO Path
GWRS took a circuitous path to become a publicly-traded U.S. company. In 2010, predecessor companies Global Water Resources, LLC, a company formed to own water and wastewater utilities in the southwestern region of the U.S., and affiliate Global Water Management, LLC, formed to provide management services primarily to its sister company, were combined and the resulting entity completed an IPO on the Toronto Stock Exchange. In 2016, the company reorganized as a U.S. company and completed an IPO.
Financial Results 2020 – 2021
As a regulated utility, GWRS has grown revenues at a respectable 6.1% average annual rate for the past five years largely due to its numerous acquisitions. This is still a small company, however, with 2022 revenues of just $41.9 million. Unfortunately, 2021’s financial results were not inspiring.
In the table below we see that revenue increased a healthy $3.3 million or 8.5% between 2020 and 2021, driven mostly by the 9.1% increase in wastewater and recycled water services – marked in green. The increase was primarily the result of higher rates granted by regulatory authorities. Local governments in Arizona have consistently approved favorable rate increases for wastewater treatment and recycling services of the type provided by GWRS that create “grey water” for irrigation purposes.
There was a $2.4 million or 19.1% increase in general and administrative costs - marked in yellow - between 2020 and 2021; 50% consisted of the increase consisted of $1.2 million in employee-related expenses for compensation and benefits. The resulting $3.3 million or 11.6% increase in operating expense swamped the increase in revenue and produced a 4.9% drop in operating income in 2021.
A potentially bad year was saved by a $3.1 million positive swing in the grab-bag other expense between 2020 and 2021 – marked in yellow. The improvement was primarily attributable to a $1.5 million gain on the sale of a wireless communication tower and related easement rights and a $1.2 million increase in ongoing payments due GWRS in connection with the “stipulated condemnation” (essentially a forced sale) of two of the company’s properties to the City of Buckeye.
Due entirely to these items, GWRS reported a relatively huge $2.5 million or 226.6% increase in net income with diluted ESP increasing from $0.05 to $0.16 per share. The bottom line fooled no one, however, as GWRS’s stock promptly headed south.
Let’s see if a comparison of YTD 3Q 2022 and 2021 shows any improvement.
Financial Results 3Q 2022 vs. 3Q 2021
Operations did improve YTD 3Q 2022. Revenue increased $2.0 million or 6.4% while operating expense increased $1.1 million or 4.3%, the recipe for a $916,000 or 16.1% increase in operating income – all marked in green. Revenue increased primarily due to the impact of the 1,191 active water service connections acquired with the 2022 purchases of Las Quintas Serenas Water Company of Tucson, Rincon Water Company, Inc. in Pima County, Arizona and Twin Hawks Utility, Inc. in Pinal County, Arizona.
Revenue will receive a boost over the next two years from a favorable regulatory rate decision. In July 2022, GWRS received approval from the Arizona Corporation Commission to raise rates for 96% of the company’s active service connections. The higher rates will be phased-in over approximately two years and are expected to increase revenue approximately $2.2 million on an annualized basis.
The bottom-line result was an increase in YTD 3Q 2022 net income of $1.4 million or 43.5% to $4.7 million from $3.3 million in 2021 – marked in green. Diluted EPS increased to $0.20 per share from $0.14 per share for the prior period.
Earnings Estimates: Suspiciously Conservative
Analysts from two firms; Roth Capital Partners and Janney Montgomery Scott, cover GWRS. Both Roth and Janney Montgomery Scott have BUY ratings on the stock (and Janney has a $17.00 price target!) – but identical $0.23 per share 2022 EPS estimates! A disaster would have to occur for GWRS to not beat that estimate by at the very least $0.04 per share by simply equaling 3Q 2022’s $0.07 EPS which was diluted by the August 2022 share offering discussed in the following section. Roth Capital was the bookrunner on GWRS’s 2016 U.S. IPO and the 2022 offering. Per Seeking Alpha, the consensus of these analysts is $0.23 per share for 2022, $0.25 for 2023 and $0.33 for 2024. To emphasize the point, unless something terrible happened to GWRS in 4Q 2022, the company should easily beat the consensus for 2023.
Capital
Roll up companies depend on ready access to capital to keep rolling. There are typically three sources, stock, debt and company operations.
In August 2022, GWRS completed a public offering of 1,150,000 shares of common stock at $13.50 per share. The company received net proceeds of approximately $14.9 million. Certain directors and/or their affiliates purchased a total of 652,000 shares of common stock - an incredible 56.7% of the entire offering - at the public offering price. The offering is largely responsible for the company’s 3Q 2022 cash balance of $15.6 million.
As of 3Q 2022 GWRS carried $106.8 million in total debt, a debt to equity ratio of over 250%; there’s not much room for more debt. In addition, GWRS has $15.0 million of undrawn capacity on a revolving line of credit. In comparison, the venerable York Water Company ( YORW ), with about $58.7 million in TTM revenue, also issued stock during 2022 rather than add to debt. After the stock offering, YORW had total debt of $125.0 million, but had successfully lowered its debt to equity ratio to a conservative 61.1%.
Cash from operations YTD 3Q 2022 was $19.7 million, but capital expenditures were $25.3 million – and GWRS is a very capital-intensive business. The ratio of capex to depreciation and amortization runs about 3.0 for water utilities and GWRS’s YTD 3Q 2022 ratio was 3.2, further validating the conclusion that the company had negative free cash flow after capital expenditures. Small utilities, however, are known for wide swings in their capital expenditure budgets. GWRS touts “Historically low maintenance CAPEX” in one section of its GWR Corporate Presentation December 2022 and “Increased CAPEX possible due to new service areas and upgrades of acquired utilities” in another. Investors should pick a high number.
Current economic conditions do not favor equity or debt offerings, and in the case of debt, GWRS may be at its limit. In addition, the company’s stock - relatively illiquid and somewhat volatile - does not appear to be a particularly attractive currency in lieu of cash. For the next year or two, GWRS’s growth may slow as the company will have to depend on cash on its balance sheet and internally-generated capital for growth.
The capital issue is extremely important for GWRS as it must balance the capital requirements of its roll up strategy with maintenance expenditures. There is a bright side, however, as according to S&P Global Market Intelligence :
The water utility sector's largest investment has been, and continues to be, upgrading the nation's aging distribution systems. Utility regulators largely understand the high level of investment needed to replace aging infrastructure and have supported water and wastewater utility capex budgets at levels significantly above annual depreciation.
Increased regulation by the U.S. Environmental Protection Agency could drive further expansion of water utility capital spending programs. Municipal systems overwhelmed by increased water testing and treatment requirements may look to sell their water and wastewater systems, providing an acquisition opportunity for the investor-owned utilities. Continued expansion of water utilities' operational footprints and capital expenditure programs are likely to support further earnings growth.
As a final thought on capital, the $0.30 per share dividend, a 2%-plus yield and an annual $6.8 million use of capital, may be too high considering the increasing pressure on the company’s cash flow.
Valuation
At this point, the market value of GWRS indicates a “story stock.” What’s this particular story worth? All water utilities are currently trading at extreme valuations. YORW, for example, in business since 1816, is trading at a 33-plus PE in spite of its revenue growing at a pedestrian 4.05% 5-year CAGR. It could be “theme” investing or a crowded ESG trade, but the valuations do not appear sustainable.
As I observed in my recent article on Hagerty ( HGTY ), another small "unicorn" company, it's obvious that no one is valuing GWRS based on GAAP earnings or EPS. In order to attempt a valuation I’m going to be forced to make a lot of assumptions. The schedule below presents three alternate ways to derive a value for GWRS per diluted share.
Seeking Alpha, GWRS 3Q 2022 Form 10Q, Herding Value Analysis
I prefer the price to cash flow result of $9.09 per diluted share as it is based on the ability of the company to generate cash flow and requires minimal manipulation of reported earnings, but an argument could be made for the $11.80 average of the three methods. Let’s check to see if we can validate it with my “quick and dirty” DCF model:
Seeking Alpha, GWRS 2021, 2020, 2019 & 2018 Form 10Ks, Herding Value Analysis
I derived the free cash flow per share as annualized YTD 3Q 2022 operating cash flow less 5-year average capex as an estimate of run-rate capex. The 10.01% cash flow growth rate is the year-over-year percentage increase in EBITDA (TTM-based). The 16x terminal multiple is the long-term PE of the market per S&P. The 10% discount rate is my personal hurdle rate for stock investments. The result, again cash flow-based, is $9.87 per share.
Conclusion
As a “story stock” GWRS has a pretty good story, but as with any company, there are merits and considerations to an investment in GWRS.
Merits:
- A roll up strategy in a highly fragmented market.
- Total Water Management; a progressive approach to providing an absolute necessity.
- A rapidly growing market with demand exceeding supply.
- Compliant regulatory agencies.
- A path to increasing net income and EPS.
Considerations:
- Access to capital will be a developing issue due to changing economic circumstances.
- Unless cash from operations increases relative to capex, growth will slow or shareholders will face dilution.
- The dividend payout ratio was 110.0% YTD 3Q 2022.
- The PE is a stratospheric 61.57, a level merited only by potential, not actual results.
GWRS is trading at a 60-plus PE and at least 40% above my best estimated value of about $9.48 per share (averaging the two results). I am almost certain GWRS will beat the stale $0.23 per share 2022 EPS estimates. Let’s say it earns $0.30 per share. The PE drops to 44.8, not much of a value. As a value investor I appreciate the potential of GWRS - and I know investors recently paid $13.50 per share - but I am not willing to pay the current price for so much to-be-created future value. It is a very interesting company, however, and while I suggest investors pass for now, let's put it on the watch list.
For further details see:
Global Water Resources: Great Potential But Pass For Now