Consolidated Water 18Q1 Update

CWCO reported first quarter net earnings attributable to stockholders $2.1 million or $0.14 cents per diluted share.  That compares with 17Q1 net income of $2.6 million or $0.18 per diluted share.  Revenues declined 2.2% to $15.7 million.

The decline in revenues was due almost entirely to CWCO’s Manufacturing business.  There, revenues fell 60% from $1.38 million to $553,000.  The decline was due to “the timing of order bookings and the allocation of a portion of [its] manufacturing capacity to internal component production.”  The business produced approximately $700,000 worth of components for the refurbishment of CWCO’s Bahama Windsor Plant.  Including those components, the implied total sales of manufacturing were $1.25 million, still down 9.4% from the prior year.

Despite the 60% drop in revenues, Manufacturing’s operating loss widened only modestly from $401,000 to $515,000.  A 66.4% drop in gross profit to $114,000 was partially offset by a 15% decline SG&A expenses to $629,000.

With the production of internal components now complete, CWCO said that it anticipates year-over- year revenue growth for its Manufacturing segment for the rest of the year.  By my calculations, revenues in each of the three remaining quarters of 2018 would have to exceed the prior year level by more than 14% for the Manufacturing segment to show revenue growth for the total year.  Thus, it is likely that revenues for the Manufacturing segment will be down for the full year in 2018.

CWCO’s Retail business reported revenues of $6.43 billion, down 0.7%, and operating income of $523,000, down 32.9%.  On the revenue side, a slight increase in the volume of water sold was more than offset by a shift in sales in Grand Cayman to its larger customers who pay lower rates.  Gross profits declined 3.2% to $3.67 million, while gross margin declined by 150 basis points to 57.1%.  G&A expenses increased 4.4% to $3.15 million.

The Bulk business saw revenues increase 7% to $8.23 million, while operating income increased 4.9% to $2.5 billion.  The sales increase was due to higher volumes and diesel fuel pass-through charges in the Bahamas.  G&A expenses increased slightly from $301,000 to $342,000 or as a percent of revenues by 30 basis points to 4.2%.

Services revenues were essentially flat at $124,000 and its operating loss declined from $715,000 to $662,000.  Most of the decline in the operating loss was due to a decrease in project development expenses in Mexico.

CWCO previously reported that it has executed a subscription agreement for the equity funding required to construct and operate its proposed desalination plant and water pipeline in Rosarito, Baja California, Mexico.  Under this agreement, CWCO will hold 35% and its partner, Greenfield SPV VII, a Mexico company managed by an affiliate of a leading U.S. asset manager, will hold the remaining 65%.  The parties also granted an option to acquire 20% of the project’s equity to a subsidiary of SUEZ International, which will design and construct the desalination plant and pipeline.  If SUEZ chooses to exercise this option, the equity stakes of CWCO and Greenfield will each be reduced by 10%.  Once completed, the plant will be managed by a 50-50 joint venture between CWCO and SUEZ.

As of March 31, 2018, CWCO has recorded a total net investment of $23.4 million in the Rosarito project, including a $20.6 million investment in land, $1.3 million in right-of-way deposits, $1.8 million of equipment and other assets, offset by $0.3 million of liabilities.  In addition, CWCO expensed $24.3 million of project development costs from 2010 through the 2018 first quarter (averaging $3.0 million per year from 2013 to 2017).  It expects to incur significant additional expenditures for the balance of 2018 and beyond (perhaps at the same $3.0 million annual level), until the project receives funding and construction commences.

CWCO expects to contribute its $23.4 million investment in the net project assets (and presumably get credit for the accumulated project development costs) to fund its required equity contribution to the investment joint venture.  It therefore hopes to convert its expenditures into permanent equity of the project without making an additional cash contribution.

There have been claims from former Mexican partners of CWCO seeking to reverse actions taken by CWCO or approvals granted by regulators and courts on the Rosarito project.  These are presumably attempts to secure an interest in the project or force CWCO into a settlement.  So far, CWCO has prevailed in the courts but the matters are not completely resolved.

The progress made by CWCO in bringing the Rosarito project to life is encouraging, but there are still considerable uncertainties and, as CWCO itself notes in its disclosures, it may not be successful in completing this project.

In Bali, CWCO’s plan to shut down the plant has been on hold due to a lawsuit that has been filed by its sole remaining customer to keep the plant open.  The customer has sued for damages because of CWCO’s alleged breach of its water supply agreement from CWCO’s planned cessation of operations.  In April 2018, a district court in Bali ruled that it had no authority in the case because the supply agreement requires all disputes to be handled through arbitration in Singapore.  The plaintiff has appealed.  CWCO management says that the company is incurring about $300,000 in costs annually to continue to operate the plant.

Management also reported that negotiations with the new utilities regulation and competition office (OfReg) of the Government of the Cayman Islands toward renewing CWCO’s operating license there have been progressing and are hopefully near a conclusion.

Having followed CWCO for more than five years now, I have both positive and negative impressions of management as well as a reasonable understanding of the risks and opportunities facility the company and its shareholders.

On the positive side, it is clear to me, even though I have never toured any of CWCO’s facilities or talked to its regulators or customers, that CWCO is a good operator of (small-size) desalination plants.  For example, the Water Authority-Cayman (WAC), which operates other desalination plants on the island, has relied upon CWCO often to keep certain of its plants in good working order.  The company has also extended its expertise to other areas in the Caribbean, including the Bahamas, Belize and the British Virgin Islands.

It therefore makes good strategic sense for CWCO to pursue an expansion of its operations outside the Caribbean.  Fresh water is a scarce resource.  Saltwater is abundant (and will become more so, over time).  It seems almost certain that long-term demand for desalinated water will rise.  CWCO seems to be in a strong position to benefit from that growing demand, primarily from building and operating small-scale desalination plants and perhaps over time in large-scale plants.

So far, the problem has been in the execution.  CWCO chose to pursue a “build it and they will come” strategy in its first forays outside the Caribbean.  The company initiated project planning and development with no apparent approvals from local governments.  Yet, both Bali and the area around Rosarito have long-term fresh water needs making them logical choices for locating desalination plants; and the investments required – a few million in the case of Bali and even the $48 million spent so far on Rosarito – are within the company’s means.  CWCO could therefore handle the financial risk of launching the projects without government approvals.

Even so, Bali has been a disaster.  The plant has attracted only one customer willing to enter into a long-term supply agreement.  Operating losses continued at a moderate level after the plant was completed until CWCO made the decision to close the plant last year.  In my mind, there is still a faint hope that new customers will emerge, or the government will step in to provide some form of support, but the chances of salvaging this investment now are admittedly low.

Despite the recent equity subscription agreement for Rosarito, there are considerable uncertainties surrounding the project (as noted above), making it unlikely that CWCO will complete the project within the next few years.  With $48 million in expenditures to date, it is still uncertain when and if CWCO will be able to realize a return on its investment.

Besides these two investments outside of its core business, CWCO also bought the Manufacturing business in 2016, paying $7.7 million for a 51% interest in Aerex Industries, a manufacturer of products and service provider for desalination, municipal water treatment and industrial water and wastewater treatment systems.  Shortly after completing the acquisition, Aerex’s revenues and profits fell far short of expectations due to the loss of a major customer.  Since the acquisition, Aerex has posted a total of $5.8 million of operating losses (including nearly $3.2 billion of impairments) and $2.25 million of negative EBITDA (before the 49% allocation to the non-controlling interest).  It is surprising that CWCO has not written off its remaining investment, given the persistent operating losses.

The value of Aerex is especially relevant given the existence of call and put options created at the time of the acquisition that allow CWCO to purchase the remaining 49% interest in Aerex at fair market value and also permit the holder of the 49% interest to sell that stake back to CWCO at fair market value.  The options are exercisable on February 11, 2019, three years from the date of the acquisition.

Absent a dramatic improvement in the performance of Aerex, it is almost certain that the value of the business will be set lower than the estimated $6.2 million carrying value of CWCO’s 51% equity interest.  This would presumably then require CWCO to take another significant write-down on its investment, but it would be able to acquire the remaining 49% stake at a much lower cost.  On the other hand, if Aerex’s performance does improve – say from the return of that former major customer – then CWCO may be required to shell out several more million dollars to purchase the 49% equity stake.  (I estimate the carrying value of that 49% non-controlling interest to be just under $6.0 million.)

At this point in time, CWCO has provided no firm evidence of its ability to expand successfully beyond its core operating base.  Two of its three major investments made this decade outside its core business – Bali and Aerex – appear to be near-total losses.  While there is still hope for Rosarito, it will take both time and more investment before that project can be classified as successful.

Even more troubling, however, is the company’s failure to renew its license to operate in Grand Cayman.  In 2017, CWCO’s Grand Cayman business generated $24.9 million in revenues (equal to 40% of consolidated revenues and more than all of its retail revenues) and $7.2 million of gross profits (equal to 56% of total retail gross profits).  This is almost certainly CWCO’s most valuable asset.

CWCO has been negotiating a renewal of its operating license since 2010.  It fought early on against the appointment of WAC as its regulator and WAC’s proposed return on invested capital regulatory regime.  Over the past year, it has been negotiating with its new regulator, OfReg.  In the 18Q1 results conference call, management said that negotiations appear to be nearing an end, which I believe suggests that there should be a clear decision, one way or the other, about the license renewal within the next few months.

Even though the operating license has been extended numerous times during the negotiating process, it was allowed to expire on January 31, 2018 and the company did not disclose what steps, if any, it has taken to obtain another extension.  Although CWCO can argue that it has supported the interests of its shareholders all through the twist and turns of the negotiating process, there is no evidence that it has conveyed a sense of urgency to OfReg about completing the negotiations or insisting that the company’s interests be protected throughout the negotiating process.

The renewal of the license raises several important issues – among them: the right of the company to a superior profit after nearly 30 years of operations on an investment that is probably now carried on the books near zero, as well as the ability of the government to reduce water rates for its citizens and businesses in a slow economy or severe downturn.  (Recent efforts by the government of the United Kingdom to push down water rates throughout the country highlight the importance of this issue.)  I believe, however, that most, if not all of these issues could be addressed in a regulatory regime that protects the long-term interests of both Grand Cayman and CWCO investors.  Given CWCO’s recent and presumed planned future efforts to expand outside of its core business, it is important for the company to protect its position in Grand Cayman, which is one of the key sources of its operating cash flow.

May 14, 2018

Stephen P. Percoco
Lark Research
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246

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