Value Play: SJW Corp. (NYSE: SJW)

The water sector offers powerful, assured growth, the world’s safest yields and hype-free values. Within the next two generations, water is expected to become the most important commodity in the world, easily surpassing oil.

– Investing Daily

There are only a handful of publicly-traded water utilities and they provide water to about 10% of Americans (most water systems are government-run). Water may sound boring, but it is a natural resource essential to life and water utilities have generated consistent and growing cash flows that have made investors rich.

SJW Corp. Has An Incredible Dividend Streak

As it so happens, one of this handful, SJW Corp. (NYSE: SJW), is a 149-year-old company that just three months ago (January 28th) increased its annual dividend for the 48th consecutive year. Wow, now that’s what I call consistency! In fact, there are only 18 U.S. companies that have increased their dividends for more consecutive years than SJW Corp. Dividends are cool because they put cash in your pocket and tell you that management is shareholder-friendly. SJW’s solid and steady growth is pretty typical for the better-run utilities, which is why so many people like to own them! Given the zero-interest-rate world we currently live in, the company’s 2.5% dividend yield isn’t bad, especially considering its safety. 

Water is not a Boring Investment

What could be more boring than water? It has no flavor and restaurants don’t even charge you for it. It’s so plentiful that it covers 70% of the earth’s surface. 

Hmm…70% is also the percentage of the human body consisting of water. Coincidence?

Anyway, 97% of the world’s water is salty, undrinkable sea water. A little more than 2% is locked up in glaciers and permafrost, leaving less than 1% drinkable.  Less than 1% . . . and this figure doesn’t take into account fresh water that has become polluted. No wonder a third of the world’s population suffers from water shortages! Furthermore, water shortages are only projected to get worse over the next 15 years, when almost two-thirds of humanity will not have enough water. Two-thirds! In global terms, China offers the best opportunity in water investing because of its exploding need for potable water to satisfy its huge population and industrialization efforts. 

Water suddenly doesn’t sound so boring anymore.

The United States Has a Drinking Problem

The U.S. is certainly not immune from the global water shortage. It’s common knowledge that the Western U.S. is in trouble. Over the past three years of 2012-2014,  California is suffering its worst drought in 1,200 years. Over the past few months , the cable channel MSNBC has run several stories discussing the California crisis, including here and here. California has enacted a comprehensive water plan to promote conservation and upgrade water infrastructure. A key part of the plan is  “Update 2013,” which discusses the need for substantial economic incentives to upgrade California’s water infrastructure. According to the update’s press release:

Update 2013 focuses on the need for stable, effective funding sources to invest in water innovation and infrastructure (natural and built). With much of California’s water supply and flood protection infrastructure aging and outdated, inadequate and unstable funding has put our water systems at greater risk. Local entities – such as water and flood districts, counties, cities, and utilities – already spend about $18 billion a year on water, matched by roughly $2 billion annually from the State and federal governments – a significant portion of which goes for operation and maintenance, not new infrastructure.

Update 2013 explains why it will take hundreds of billions of dollars of additional investments over the next few decades to reduce flood risk, provide reliable and clean water supplies, recover overdrafted groundwater basins, and restore degraded ecosystems – in other words, to achieve sustainable water management. Update 2013 includes a new finance planning framework and describes potential revenue sources including federal grants and loans, general obligation bonds, revenue bonds, assessment districts, rate-payer, user and impact fees, private investments, public-private partnerships, and more.

Chapter 28 of Volume 3 of the update plan is entitled “Economic Incentives — Loans, Grants, and Water Pricing” and this is the exciting part for California’s water utilities because it promises hundreds of millions of dollars in funding for infrastructure upgrades — a significant portion of which will generate additional profits for utility shareholders. And keep in mind that the money spigot will not just flow to water utilities from California’s state coffers but from the Federal government as well. The reason is that the entire country relies on California for food so it is in the entire nation’s interest to fund a solution for California’s water crisis:

The single most important statistic in understanding the current crisis is this: 80% of California’s surface water supports agriculture, largely the farms and ranches of the Central Valley.  It seems bizarre that a region like the Central Valley with just six million people — barely more than 10% of the state’s population — should use so much of the water. But then you realize that the vast majority of people benefiting from that water don’t live in California at all. The Central Valley takes up only 1% of the landmass of the United States, but it produces 25% of the food we eat, and almost half of the fruits or nuts we consume. California is running through its water supply because, for complicated historical and climatological reasons, it has taken on the burden of feeding the rest of the country. The average New York Times reader sneering at those desert lawns from the Upper West Side might want to think about the canned tomatoes, avocados, and almonds in his or her kitchen before denouncing the irresponsible lifestyles of the California emigres. Because the truth is California doesn’t have a water problem. We all do.

California is far from alone. According to the U.S. Government Accountability Office, 36 states expect to suffer from water shortages. The water level at Lake Mead, which provides water to Las Vegas and Phoenix, continues to set record lows and could run dry by 2021 and the Southeast U.S. (including Atlanta) is also in trouble. In 2013, the Environmental Protection Agency estimated that $384.2 billion is needed nationwide to build and upgrade water infrastructure systems necessary to continue to provide safe drinking water to the public.

Water Utilities are the Solution

Cash-strapped governments are likely to solve the water infrastructure crisis by selling off municipality-owned systems to investor-owned utilities. Such distressed deals are “money in the bank”:

They buy, make upgrades and then file for rate increases, which in turn increase revenue, earnings and dividends. And as water rates nationwide are still proportionately well below electricity and telephone rates, increases tend to be non-controversial.

Bottom line: Water shortages are the problem and water utilities are the solution. Those that own drinkable water assets sell a product that is in high and ever-increasing demand. These utilities are paid a regulated but very healthy return on their investment (i.e., their rate base) to do so.  In fact, some utilities – including those in California like SJW – are being paid not to sell water as part of state conservation programs. This payment for not selling water is called “revenue decoupling.” Water utilities are also being paid to upgrade their distribution networks to improve efficiency (e.g., less leaks). What a great business! The California drought is providing a tremendous investment opportunity for savvy investors in water utilities. Governments want water utilities to succeed and it’s always good to own a business that has the government on its side.

Recent Under-performance is the Pause that Refreshes

The superior business fundamentals and privileged regulatory position that water utilities hold in the U.S.economy has been reflected in the stock market over the long term, but the recent drought conditions have caused short-term under-performance. After all, without revenue decoupling a drought results in less water usage and lower fees to the utility. But now that revenue decoupling is becoming the norm in water utility regulation nationwide and a huge multi-billion dollar upswing in water infrastructure spending is in the offing, the traditional out-performance of water utility stocks is set to reassert itself. 

 Water Utilities Out-Perform Over the Long Term

Source: Bloomberg

SJW Knows Water

SJW Corp. is an acronym for San Jose Water. The company is based in San Jose, California and is the parent of four subsidiaries:

• San Jose Water Company, a water utility serving one million residents in San Jose and Santa Clara. This is the holding company’s primary business. Approximately 45% of San Jose Water’s water supply is purchased from the  Santa Clara Valley Water District (SCVWD).

• SJW Land Company owns commercial buildings, other undeveloped land primarily in the San Jose metropolitan area, a property in each of Florida, Texas, Arizona, Tennessee, and Connecticut, and a 70% limited partnership interest in a three-story office building in downtown San Jose.
  
  
• SJWTX, doing business as Canyon Lake Water Service Company, is a Texas water utility serving 36,000 customers in between Austin and San Antonio.
  
  
• Texas Water Alliance Limited is undertaking activities that are necessary to develop a water supply project in Texas.

Although not a pure-play on water, SJW receives 97.8% of its operating revenue from water utility services and only 2.2% from real estate services. Furthermore, it owns a 0.5% stake (259,151 shares) in California Water Service Group (NYSE: CWT), which is another California water utility.

 Tremendous Earnings Growth at SJW Corp.

Utilities typically don’t generate huge earnings growth, but SJW was the exception in 2014 as its net income more than doubled and is revenues climbed 15.5%. Part of the reason was that in August 2014 SJW finally won a long-awaited rate increase from the California Public Utilities Commission. This was much-needed rate relief that gave SJW a 9.8% rate increase for 2013 and a 5.2% increase for 2014. Collectively, the 15% rate increase bodes well for future earnings.

The stock dropped precipitously on March 25th in reaction to a ratings downgrade from “outperform” to “neutral” at the Robert W. Baird brokerage, but the target price of $35 was not adjusted and the downgrade appears to be a sector call in favor of more cyclical industries now that the U.S. economy is growing faster and the Fed is likely to start raising interest rates. SJW insiders took advantage of the price drop a day later on March 26th with directors George Moss and Robert Van Valer collectively purchasing $536,925 worth of stock at an average price of $30.37 per share. I find insider buying more persuasive than a single analyst’s opinion. This is especially true in the case of Moss and Van Valen (Chairman and President, respectively, at water driller Roscoe Moss Manufacturing) because they are large and knowledgeable shareholders who collectively own 19.9% of the entire company (page 30). Roscoe Moss Manufacturing’s relationship with SJW goes back all the way to 1978 when the company started buying up SJW stock culminating in 1992 when Roscoe Moss merged with SJW, only to become independent again in a management-led buyout in 1995.

With an EV-to-EBITDA ratio of only 7.6, SJW appears cheap both in absolute terms and relative to its five-year average. Besides its low valuation, the stock looks like a good buy given high insider ownership, accelerating earnings growth, the macro-trend towards government-aided funding of water  infrastructure investments, and California regulators’ recent approval of SJW’s petition for much-higher water usage rates.

SJW Corp. is a buy up to $35; I’m also adding the stock to my Value Portfolio.


 

Value Sell Alert

To make room for NMI Holdings, Roadrunner is selling:

• FutureFuel (FF)

Interminable delays by the Environmental Protection Agency (EPA) in finalizing 2014 volume requirements for renewable fuel standards (RFS) has severely hurt biofuels producers like FutureFuel. A federal court order requires the EPA to finalize RFS for 2014, 2015, and 2016 by November 30, 2015, but that is a long way off and FutureFuel’s stock price will continue to suffer from uncertainty until then. The regulatory uncertainty has already compelled the company to cut its dividend in half and President Lee Mikles “voluntarily” resigned.

For me, the last straw was news that Procter & Gamble was terminating an agreement to buy bleach activator from FutureFuel that is worth tens of millions of dollars, effective Dec. 31. FutureFuel received $43.9 million in revenue from PG during 2014, which represented 12.8% of total company revenue. Losing P&G’s business is a materially adverse event.

I could  tolerate uncertainty in the company’s biofuels segment because of the revenue stability in the chemicals segment, but that is obviously no longer the case.  FutureFuel’s balance sheet remains super-strong and it can easily weather these recent adverse events until conditions improve, but I can no longer say that the company is one of the 20 best small-cap value stocks worthy of inclusion in the Roadrunner Value Portfolio.

This marks the third company that I have been forced to sell from a Roadrunner portfolio because of adverse government action (HMSY and MANT were the other two). At least under the Obama Adminstration, investing in  businesses that rely on the government for timely regulations or procurement decisions is the kiss of death.

FutureFuel is being sold from the Value Portfolio.

Momentum Buy:

Paycom Software (NYSE: PAYC)

Paycom Software  is a leading provider of cloud-based human resources technology and payroll services delivered as a single Software-as-a-Service application. The company’s services enable businesses to manage the complete employment life cycle from recruitment to retirement through full-service functionality, including data analytics that lowers labor costs, drives employee engagement and reduces exposure. 

Founded in 1998 by current CEO Chad Richison and headquartered in Oklahoma City, the company went public in April 2014 at a price of $15 per share. Annual revenue and earnings are both growing 40% plus. CEO Richison owns 22% of the company’s stock and insiders collectively own 29.2%, which aligns management’s financial incentives with the average shareholder. 

• Price gain between 12 months ago and 3 months ago = 90.18% (100th percentile)
• Price gain over the past 2 months =-3.76%
• Price gain over the past month = -8.43%
• Roadrunner Momentum Rating: 110.73 – (-0.84) – (3*4.08) = 99.33

Paycom Software is a buy up to $39.50; I’m also adding the stock to my Momentum Portfolio.

Momentum Sell Alert

To make room for the new momentum stock, Roadrunner will be selling the following price laggard: 

• Super Micro Computer (SMCI)

Third-quarter financials saw both earnings and revenues miss analyst estimates for the first time in at least eight quarters. Forward guidance for the fourth quarter were also below expectations. From a fundamental valuation perspective, the company appears cheap at an EV-to-EBITDA ratio of around 10 times combined with 20%-plus earnings and revenue growth.

Super Micro Computer is being sold from the Momentum Portfolio.