Water Purification IPO landscape

HaloSource‘s $80m IPO on London’s AIM market marks another interesting listing. Origo Partners and Masdar Clean Tech Fund are among some VC funds that were able to orchestrate a nice (partial) exit in this difficult economic period. Net proceed raised are some £28.9m. Other selling shareholder include Unilever Swiss Holdings AG, Britannia Holdings Ltd, and Washington Research Foundation.

We like to look back on the thesis for the water industry in general and with regards to Water Treatment and Purification in particular. Arthur D Little published a report back in 2008 title ‘The Water margin: How strategic management of water can grow business value‘.

ADL’s report cites Foster’s brewery in Australia. Foster’s embarked on a programme to minimize water consumption per unit of output without compromising quality. ‘Foster’s Yatala Brewery, the most water efficient brewery in the world, uses just over 2 litres of water for every litre of beer which is less than half the international standard of 5 litres.’ Moreover, the brewery doubled its capacity but water consumption only increased by 10-15%. The key observation that is drawn is that ‘water management needs to be embedded throughout the organization. This may require behavioural change, process innovation, systems innovation, skills development and more.’

We agree and would add that any change is difficult and the cultural backdrop important. Australian’s have learned to adopt to their natural water supply levels whereas many Western Europeans and Americans are still ignorant and lavishly use water. As this example shows, corporates do worry about water efficiency and addressing it itself leads to a competitive advantage. Whilst the West is concerned with efficiency, the company HaloSource is concerned about getting clean water to people in the first place.

Thus HaloSource addresses different markets. Markets that notoriously are challenged to get access to safe and clean drinking water. We note that the firm’s revenue mix is somewhat concentrated and water clarification is currently the firms core product accounting for some 87% (YE2008) of group revenues. Core clients are Eureka Forbes and Pool Corp, which represent 28% of group revenues.

The latter firm mainly operates in the seasonal swimming pool business whereas Eureka enhances the life of many poorer communities especially in India. We consider Eureka be a risk factor as product substitutes are ample. The question is whether there will be any margin pressure on HaloSource going forward. Euraka is owned by Shapoorji Pallonji Group. Pool Corp. business is very seasonal and we could not make out whether HaloSource is hedging this business with derivatives to reduce the likely volatility in revenues.

To date, HaloSource has accumulated operating losses of $46m whilst revenue are growing at a reasonable rate. With 2009 gross profit of around $5.8m there is likely to be a significant J-curve before HaloSource will ever be profitable. The business risk is still significant as the order books is still relatively dependent on a few core buyers. Should anyone switch product this could materially affect the performance of HaloSource.

To conclude, HaloSource is a company worth watching. We have seen big corporates buying up assets in this space and HaloSource may become a target for one larger player if it can proof to be profitable in medium term. Previously we reported on Zenon which was snapped up by GE for a reported $650m. Other players that are active in this market are Dow Chemical and 3M.

Liquid Assets – Media Update

We just saw CNBC’s Liquid Assets – Big Business of Water (opens CNBC video, 42:43min). Although very US centric, the overall message is pointing in the right direction. The cost of water is simply too low. As Peter Gleick puts it: “An oil tanker filled up with oil may be worth $200m – $300m. The same tanker filled with water would be worth just $400’000 – $500’000.”

Another CNBC report looks at Water stocks. Debra Coy is giving her views (opens CNBC video: 04:00min). The discussion briefly touches on water rights also. Two companies mentioned are Cadiz Inc. and Pico Holdings.

Water – Where is the money?

Deutsche Bank’s piece on the Water sector (World Water Markets, pdf) presents an interesting read. Following on from our research Water Scarcity – An investment Opportunity, Deutsche Bank echoed some of our thoughts. In particular, two areas stand out.

First, the agriculture sector plays a vital part within the water value chain. We maintain our view that ‘water efficiency‘ remains the primary factor in extending the use of fresh water. Further, the challenge with respect to putting a price on water is discussed in the DB paper although no clear recommendations are being made how to overcome the conundrum.  We previously looked at tradeable water rights, Full Cost Recovery, and Polluter Pays Principle and suggested areas for thought how to establish a market mechanism.

Second, Deutsche Bank raises the issue of how to find credible investments in the water sector. KPMG, also, put out a research report that looked at private investments in water infrastructure (2008, pdf). Although the primary investment focus in both reports is on water infrastructure, we are not comfortable with the likely returns that may be earned in this space. Specifically, the requirement for sewage plants may be interesting but the returns to be earned will likely mimic utility and/or project finance like returns. The high up-front capex is something we normally shy away from. Rather, we look at the technology side of the investment theme and focus on efficiency plays. Deutsche agrees: “A large range of technologies is needed. The demand for efficient irrigation technologies, seawater desalination and sewage treatment facilities, technical equipment (e.g. pumps, compressors and fittings), filter systems or disinfection processes (e.g. using ozone or ultraviolet light) and efficient sanitation facilities will probably pick up sharply.”

Another area that we explored a while back are the business and management issues for companies based in India and China that lack access to fresh and/or clean water. For investors who like to look at the state of the Chinese Water sector and how to potentially participate, we recommend KPMG’s report ‘The Water Business in China – Looking below the Surface.’ In a nutshell, the report explores ways to participate in the urbanization and how to invest in Joint Ventures at the Municipal level. JPMorgan explored business risks associated with water access in their report ‘Watching Water – A Guide to Evaluating Corporate Risks in a Thirsty World‘ which extends our thoughts from our Water Scarcity piece above. We mentioned a glass and pharmaceutical company which admitted that they were accessing ground water deeper and deeper under ground every year. At which point, does this become a clear cost and business risk issue?

We note that Fidelity Investment Managers has put a note out on the their take on the water sector; better late than never one might say. There isn’t anything new or jaw-dropping in the report, Fidelity lists the usual investment ideas such as Veolia, Hyflux, Doosan Heavy Industries, Jain Irrigation Systems, General Electric, HaloSource (recently IPO‘ed) and RusHydro as potential investment targets. We previously eluded to the fact that although GE only generates a single digit portion of their group revenues from water, in absolute terms these revenues ($2.5bn+) still rank them as a Top 10 water investor and supply chain player in the world.

Update: A list of some water ETFs can be found here.

Climate Equity Selection and Climate Opportunity

HSBC released a recent report on their Climate Equity Opportunity list (pdf), or short ‘CEO’-list. The list comprises 88 companies that derive 20% plus from their low carbon energy, energy efficiency and storage, or water and waste.

HSBC sees the fastest growth for Renewable Energy in Emerging Markets and proposes that Energy Efficiency makes up the largest opportunity, about 53%. Overall, HSBC estimates that the total market size could be around $2.2trn. Sizing the Climate Opportunity accompanies HSBC’s Climate Equity Opportunity research piece.

HSBC’s report ‘includes five key segments: transport efficiency (USD677bn, CAGR 18%), building efficiency (USD245bn, CAGR 10%), industrial efficiency (USD183bn, CAGR 6%), energy storage (including fuel cells) (USD66bn, CAGR 15%) and smart grid (USD23bn, CAGR 8%)’.

However one sector stands out. HSBC suggests that the electric vehicle market will grow more than 20x by 2020 to reach USD473bn. This based on the assumption that the grow will be back-loaded, i.e. the growth will be faster in the second half of the decade as input prices fall and the industry starts to see scale. Importantly, the report estimates that battery costs will come down from about USD1000/kWh to about USD350/kWh. Underlying the assumptions are global electric vehicles (EV) sales of 8.65m units and sales of 9.23m plug-in and hybrid electric vehicles (PHEV). The average prices for PHEV gasoline and diesel vehicles in 2020 will be 5-10% lower than average EV prices (USD27,500).

Source: HSBC, September 2010

Saft Groupe makes an interesting appearance in the HSBC report. According to the analysis, 75% of Saft’s sales comes from markets where it ranks sector leader. More importantly, sales are diversified across other industries including the military. We mentioned Saft Groupe back in February 2010 when we advocated that the automotive industry will change forever. But not without an improvement in the Energy Storage sector. We connected our argument to the Lithium-Ion market. Overall, we continue to rank Saft Groupe as a very interesting play on the interconnection between EVs and Energy Storage. However, HSBC prefers Energy Efficiency over Energy Storage. We cannot agree more, in the near-term anyway.

Beneficial Biofuels and the Trilemma

Robert Socolow, Princeton

Robert Socolow, Princeton

We saw a recent article published by www.sciencemag.org, co-authored by Robert Socolow. The following quote stood out: “The search for beneficial biofuels should focus on sustainable biomass feedstocks that neither compete with food crops nor directly or indirectly cause land-clearing and that offer advantages in reducing greenhouse-gas emissions.”

The bio-fuels and ethanol discussion is certainly not new. Yet, we agree that the ‘trilemma’ between a need for a reduction in green-house gas emissions, increased transport and the wealth effect (leading to higher consumption of protein rich meats etc.) conflict. We previously addressed the issue in a post ‘Crop per Drop‘ which looks at the global pockets that could drive yields. We reiterate here that Deutsche Bank’s report on the agricultural sector is relevant for anyone looking at the food chain and vis-a-vis at the biofuels/ ethanol market.

Agricultural output is only possible and yield enhancing methodologies can (only) work if access to water is procured and secured. We looked at the water play in the ‘Water Scarcity‘ post. To round up, if one plays the bio-fuels and ethanol market, one invariably plays also in the water sector: ‘Why invest in water‘.

Water scarcity – an investment opportunity

The Water Investment Market
Investing in water is not an easy task. The stock universe is limited and liquidity is an issue also. The public equity funds we looked at by and large invest in the same stocks. The bigger the fund, the more likely the fund is to deviate from a ‘pure play’. Some funds invest in GE as a water play which may be dubious.

Source: Goldman Sachs

Source: Goldman Sachs, 'Americas: Multi Industry' (2008)

To defend the funds that do, Goldman Sachs’ primer on water identified that although GE only generates a small % of revenues from water (<2%), in absolute terms ($2.3bn, 2007E) GE does generate significantly more sales than many of its pure play counterparts. We wrote about this previously and also elaborated in this water piece by Matthew.

Challenges of Water Scarcity
“By 2025 over 40% of the world population could be living in water-scarce regions” (UNEP, ‘Challenges of Water Scarcity’). It becomes more and more apparent that as investors, a significant part of due diligence needs to be devoted to the aspect of water. It plays a critical role in the manufacturing process. Historically economies that had access to water have prospered and that is unlikely to change. It is imperative therefore that an assessment of firms sustainability planning takes water and water rights into consideration. Anecdotally, a glass manufacturer in China once mentioned to us that they had to drill 12m down to get access to groundwater. That is up from 4m the previous year. The information was not disclosed in any corporate material but came to light during a visit of the manufacturing facilities. The implications are enormous.

Water infrastructure Issues
The water sector has been chronically underinvested for decades. Simply put the incentive structure simply was not there (see ‘The economics of water‘). According to Brennan Investment Partners “[t]he US has an estimated backlog of between $300 billion – $1 trillion in water infrastructure replacement and upgrade requirements that should drive an annual rate of 6% – 8% spending growth”. The challenge for investors is to identify the right play: via public market equities, debt, venture capital and technology investments? The alternative: to pass and simply let public (or quasi) deal with the infrastructure element or engage via Public Private Partnerships. Until the subsidies for water are reduced, it makes for a difficult investment thesis. Fact is, water is an input factor to many industries. Reducing the subsidy on the price of water will make the cost curve for some firms relatively less attractive. Kinetics launched a fund that focuses on Water Infrastructure Investing (see below ‘The Funds’).

CO2 and GHG – again
The link between CO2/MH4 and water is important. It comes to no-one’s surprise that agriculture contributes significantly to the increase in CO2 and GHG. Methane is 21x as potent as CO2 and with the demand for more protein comes higher methane output – a dangerous and vicious circle. If earth temperature rises as predicted so will the demand for water to achieve the same yield. We wrote a separate piece on Water and the Food Chain – Crop per drop.

The Funds
We looked at a number of water ETFs and funds.

Dickerson’s Summit is certainly one that has been around for some time. John Dickerson is a little apocalyptic. However we recommend his water investing primer. His most recent paper makes a case for water investing in 2010.

Source: UNEP, Vital Water Graphics

Source: UNEP, Vital Water Graphics

A newer firm, Brennan Investment Partners LLC, has launched a Water Infrastructure Fund in 2007 and as of Dec 31, 2009 has about $23m assets under management (AuM). Brennan wrote an investment primer that should make for a good read. His February 2010 conference call note can be found here. The fund size is relatively small still. As per December 31, 2009 Top 10 holdings include URS Corp, Ameron International, Geberit, Lindsay Corp, Armtec Infrastructure, Veolia Environment, Northwest Pipe, Guangdong Invest, Tetra Tech, Itron. Brennan Investment Partners is closely linked to Kinectics (Mr Brennan runs both funds). Kinetics, aside from the Mutual fund, runs the Water Infrastructure Fund. The presentation uses a UNEP chart that is informative albeit a little out of date (see on the left).

Credit Agricole Funds Aqua Global has about $31m AuM. The press release stated that the fund would make investments in companies that derive at least 25% from water relative activities. In a narrow sense, we are not sure whether this is true for the current top 10 holdings. The holdings include Nalco, Cia Saneam Minas Gerais-Copasa, Pentair, Sabesp, Suez Environment, American Water Works, Torishima Pump, Geberit, Calgon Carbon, and ITT.

The Aqua Resources Fund, managed by FourWinds Capital Management, appears more diversified with respect to regional merit. Have a look at their Q4/2009 Newsletter. It is a closed-end fund.

CLSA launched a Water and Waste Management fund out of Singapore. A strong proposition. A more holistic piece on investing in Asia’s water sector was published by the Association for Sustainable & Responsible Investment in Asia.

UPDATE1: KBC offers a Water Fund that currently has about €240m AuM (retail). Top 10 Holdings as per Jan 31, 2010 include Agilent Technologies, American Water Works, Pentair, Danaher, Flowserve, Kurita Water, Suez Environment, Toray Industries, Nitto Denko, and Millipore Corporation. The institutional KBCAM Eco Water fund has about €720m AuM. As per 31/12/2009 the portfolio owns about 50 stocks and has a PE of 17.2x with a P/B 2.2x. Average market cap of portfolio holdings is about $3bn.

UPDATE2:  Calvert’s Global Water Fund is managed by KBC’s team.

In contrast, Pictets Water Fund has some $3.1bn in assets. Per January 2010, Top 10 holdings include Veolia Environment (5.4%), Suez Environment, American Water Works, Geberit, Kurita Water Industries, Sabesp, Severn Trent, United Utilities Group, Pennon Group and CEMIG (3%). Therefore, Pictet has about $170m invested in Veolia.

There are other funds but across the universe, the funds appear to invest in the same stable of stocks. Given the concentration around the relatively small universe, it is somewhat difficult to decide which horse to back. Pictet, although with a broader mandate, certainly will have a marginal impact on the daily trading activity. If one is invested in one of the smaller funds, this may impact the NAV of the funds – both up and down.

Water and the Food Chain – Crop per drop

The food chain
Food prices are bound to explode. Not only do we face a rise in population but we also are confronted by the need to improve our biofuel and ethanol feedstock (Unecsco – Institute for Water Education, ‘Water footprint of bio-energy and other primary energy carriers‘, 2008). No doubt the correlation between soft commodity indices, equity markets and major currencies has increased. The drivers are somewhat clear: increased speculation in the various futures markets. It is commonly known that agriculture consumes the most water across the globe. Technology and irrigation management have played vital roles for decades aiming to maximize yield. Horticultural projects such as maximizing yield of strawberry output in the UK are common practice for example.

In a nutshell it is possible to enhance agricultural output by enhancing yields, increase the acreage used, or by fastening the velocity of the harvesting cycle. Both Standard Chartered and Deutsche Bank have published investment reports that center on the implications of the food chain. “If the world population reaches 9.1bn by 2050, this will require a 70% increase in food production from 2005-2007 levels, including a 900m tonne (43%) increase in cereal production and a 200m (74%) increase in meat production” (Standard Chartered, ‘Special Report – Food’). The population growth implies that we add a country the size of the UK to the global population every year. The challenges continue along the food chain: “1 tonne of grain typically requires about 1’000 tonnes of water” (Standard Chartered, ‘Special Report – Food).

Source: 2030 Water Resources Group, 'Charting our Water Future', 2009

Source: 2030 Water Resources Group, 'Charting our Water Future', 2009

We observe that the need for water will rise dramatically with wealth. China and India are likely to demand higher levels of protein away from rice to chicken, pork and other meat products. To ramp up production, water will be a crucial element to satisfy the hunger of the emerging new middle class. McKinsey warns “[b]y 2030, under an average economic growth scenario and if no efficiency gains are assumed, global water requirements would grow from 4,500 billion m3 today (or 4.5 thousand cubic kilometers) to 6,900 billion m3.” The consultants continue saying that the shortfall is dramatic (see graphic).

The modern Silk Route
The Ukraine is perceived to be able to support the agricultural supply chain. It harbors significant amount of black soil, some 40% of the worlds total. However, the countries infrastructure is in desperate need for upgrading. Nonetheless, as an investment play participating in the Ukrainian agriculture may yield significant returns. Accessing the market will be difficult as will be the due diligence. We would expect that land title is difficult to secure and the rule of law needs to be assessed carefully.

While the weather appears to become an ever larger factor we can safely assume that parts of Africa, Asia and the Middle-East will be significantly affected should earth temperature rise as predicted by a number of scientists. What are the implications for these regions then? To maintain a constant agricultural yield, higher capex is likely to be an issue. To increase areable land significant upfront investment in sophisticated agriculture systems will be required.

The Food and Agricultural Organization (FAO) has recently published a new model to forecast yield and crop production. The Washington Post claimed that India is investing $4.2bn to lease land in Ethiopia supports Standard Chartered’s special report on Food which highlights (investment) opportunities for Africa. Land utilization across Africa is relatively low thus any increase in yield will be significant on a percentage and per capita basis since we are starting from a low base. Deutsche Bank takes a more holistic approach as it investigates both the demand and supply side in more detail. An interesting observation is that the “current available commodity inventories for corn is just 47 days” (adopted from USDA-NASS 2009). The report further notes that “[c]hanging precipation patterns and the shifts of regional weather to be hotter and drier in some regions while other regions become more moist will cause severe challenges to existing agricultural systems.”

Investment Opportunity
We believe that investments in water and the food chain are closely related. Agriculture projects or funds that participate in the food value chain are intrinsically linked. Further, as the soft commodity future markets are well developed we expect to see a rising correlation between water markets and the food sector.

Source: IDA, GWI, Desal Data, 'Desalination in 2008 - Global Market Snapshot'

Source: IDA, GWI, Desal Data, 'Desalination in 2008 - Global Market Snapshot'

So how to play it? Fundamentally, Venture Capital investments in bio-fuels can give an indication where the opportunity is going. Since bio-fuel does compete for arable land this space should be watched carefully. Consequently, as the competition for alternative energy increases, we expect demand for biomass and ethanol to increase which will impact water and food related investments. We recently saw a few specialist funds that aim to capture the very niche opportunity that may exist in exploiting the food (and water) value chain, in particular with respect to Africa. A further opportunity that is worth highlighting here, is the potential for desalination projects (desal). Investments in the space have moved significantly and we expect further investment dollars being deployed in this area. The Global Water Intelligence group has published an overview on the state of Desal projects that is worth having a look at. A number of funds (mutual, hedge and vc) invest in ‘Blue Gold’ or water.

Ernst & Young conducted a few interviews with people who have a vested interested in the water space including water and technology company executives, venture capitalists and investors. Worth a read to get an idea what current thought leaders are up to.