Update on Consolidated Water (CWCO)

Shares of Consolidated Water (CWCO) have struggled over the past several months, extending a period of underperformance vs. peers that stretches back for more than a year. Year-to-date (through 12/9), CWCO has posted a loss (including dividends) of 6.4%. That compares with the total return of 12.9% for the S&P 500 and an estimated total return of 18.0% on the Dow Jones U.S. Water Utility Index.


The most recent declines have followed the company’s third quarter earnings report. CWCO reported a loss of $0.13 per share compared with income of $0.12 per share in the 2015 third quarter. The loss was due to pretax impairment charges of $4.625 million taken against three assets: $2.0 million against its desalination plant in Bali, Indonesia, $1.75 million against its 51% stake in Aerex Industries and another $875,000 reduction in its 43.53% equity stake in the OC-BVI joint venture, which currently operates the Bar Bay desalination plant in the British Virgin Islands. Together, those impairment charges reduced EPS by an estimated $0.31 per share.

Aerex Industries. The biggest surprise in the quarter was the $1.75 million impairment charge taken on Aerex. CWCO purchased this equity stake on February 11, 2016, so the impairment was recorded after only seven months.

Aerex manufactures products and provides a wide range of services for municipal water treatment and industrial water and wastewater treatment. CWCO CEO Rick McTaggart said that this investment was the first step of the company’s planned expansion into other water-related industries and markets. It represents a vertical integration into products and services that CWCO uses to conduct its own operations and provides a platform in the United States to expand its customer base and product lines.

CWCO paid $7.7 million for this 51% equity stake, so the impairment charge equals 22.7% of that original investment. That is a big reduction in value in a short period of time. The company says that the write-down was prompted by a significant decline in business from a major Aerex customer, a decline which CWCO believes will not likely be reversed anytime soon.

In the 2016 third quarter, Aerex posted a loss of nearly $1 million on revenues of $1.4 million. Since the date of the acquisition, Aerex has lost $1.28 million on revenues of $3.3 million. CWCO determined its impairment charge using the discounted cash flow method, based upon its revised expectations of Aerex’s future performance.

Before acquiring its stake, CWCO was aware of Aerex’s customer concentration and the potential risk of a loss of business from its major customer. That drove its decision to purchase a 51% stake, rather than acquiring Aerex outright. The seller of that 51% stake, Aerex founder Thomas Donnick, Jr., reportedly wanted to retain the remaining 49% because he thought that the company would be worth significantly more in the future.

Accordingly, the two parties entered into a put-call agreement, where CWCO would have the right to purchase Mr. Donnick’s 49% stake in Aerex and Mr. Donnick would have the right to compel CWCO to buy that 49% stake based upon the fair market value of Aerex in 2019, three years after CWCO’s original investment.

Bali, Indonesia. The $2.0 million impairment charge taken against the carrying value of CWCO’s investment in Bali was not much of a surprise. CWCO started up operations in the Nusa Dua section of Bali, a major tourist area, in late 2012. It expanded the plant’s capacity from 264,000 gallons per day to 790,000 gallons per day in 2014. Since inception, the Bali operations have generated little revenues and consistent operating losses. In 2015, CWCO sold 44 million gallons of water, which equates to only 15% of its available capacity. Bali’s 2015 sales volume declined 18.5% from 54 million gallons in 2014. Thus, CW-Bali reported revenues of $368,000 and a loss of $484,000 in 2015. The carrying value of CW-Bali was $3.0 million at December 31, 2015.

By all indications, Bali looked like a promising project. With its large tourist operations and limited availability of local fresh water sources, the new desalination plant should have been welcomed by government officials and private hotel operators. Yet, CWCO was unable to obtain a government mandate, a local investment partner or long-term contracts from customers before construction began to ensure early success. CWCO consequently decided to build the plant first in order to demonstrate the quality and reliability of its water to potential customers.

Nevertheless, since the plant opened, CWCO has been unable to obtain contracts from local hotels and resorts. Most hotels use their own supply from wells located on their properties that tap into the local aquifer. This is a much cheaper alternative for hotel operators, but a risky proposition for the island and the government, because the large water draw risks permanent damage to the aquifers. Despite the risk, the government has so far refrained from compelling the hotels to buy water from CW-Bali.

In 2015, the Indonesian government enacted a law requiring government regulatory oversight of the nation’s water resources. When the law becomes effective, CW-Bali will have to strike a formal agreement with the local government water utility (known as a PDAM) in order to enter into contracts with customers. This could conceivably lead to CW-Bali entering into a contract to sell water directly to the local PDAM, as it does throughout the Caribbean.

CW-Bali is also operating under a temporary business license, which expired in October. After it demonstrates its long-term viability, it will be able to obtain a permanent license.

CWCO recently said that its goal of becoming profitable in Bali has also been set back by a decline in the local economy (presumably because of a decline in tourism, the only major industry there). I have not been able to confirm the company’s claim. Economic data for all of Indonesia suggests that GDP growth has been decelerating, but should still come in well above 4% in 2016 and the IMF projects growth of 5.1% for Indonesia for all of 2017.

The government of Indonesia has established a goal of expanding tourism, including priority development for 10 separate resort locations. That may provide an opportunity for CWCO to add new desalination plants in other locations in Indonesia. However, Indonesia has substantial, undeveloped fresh water resources, so it is not clear whether additional desalination plants will be needed at these 10 new resorts (or in other parts of the country).

Highlighting the potential for tourism in Indonesia, the World Bank estimated that an increase of 10 million tourists and a 50% increase in spending per tourist would bring in $16 billion of additional foreign exchange earnings annually to the country. However, in order to achieve such an expansion, the World Bank says that government will have to upgrade infrastructure, including travel hubs, roads and services; health and sanitary facilities; and waste disposal, water and wastewater systems. There is evidence that some environmental services have deteriorated in recent years. For example, a recent news report highlighted problems with Bali’s waste landfill located near a major tourist center.

The World Bank says that tourism globally is expected to increase 4% per year for the next decade; but that forecast must assume that the global economic recovery will continue uninterrupted. Tourism in Indonesia was disrupted by terrorist attacks in Bali in 2002 and 2005.

Despite the difficulty that CW-Bali has had in generating revenues and reversing losses, it still looks well positioned in the long-run to ensure the safety and reliability of the water supply at Indonesia’s main tourist spot. In the meantime, CWCO is looking for a partner for its CW-Bali operations. Unless CW-Bali is able to turn the operations around soon, CWCO will eventually write-off its remaining $1 million investment and could conceivably shut down the facility eventually to stem the losses.

N.S.C. Agua de S.A de C.V. (NSC) CWCO began to explore the possible development of a 100 million gallon-per-day seawater reverse osmosis desalination plant in northern Baja California, Mexico (known as the Rosarito project), with the acquisition of a 50% interest in NSC in May 2010. Since that time, NSC has acquired a 20-acre parcel which will serve as the site of the plant, built a pilot plant on the site to test the seawater and received approval from the state of Baja California through a competitive bidding process for a consortium to proceed with development.

The state of Baja California has awarded the Rosarito project to a consortium which includes NSC, NuWater (of South Africa) and Degremont (which is a part of Suez Environnement of France). NSC and NuWater have formed a separate company, Aguas de Rosarito (AdR), which will develop the project through a public-private partnership that includes Government of Baja California and the Public Utilities Commission of Tijuana.

AdR will build the proposed desalination plant in two phases: the first with 50 million gallon/day capacity and a viaduct that will tap into the water system in Tijuana and the second with an additional 50 million gallon/day capacity and an alternate connection into Tijuana’s water system. The first phase must be completed three years after construction commences and the second phase must be completed by 2024. The consortium will operate the plant for a period of fifty years, after which it will be transferred to the state of Baja California. The project cost is estimated to be 9 billion pesos or roughly $500 million and the revenues for the project are expected to be 1.02 billion pesos or $55 million per year.

As of the second quarter, the consortium still had to obtain certain permits and rights of way and execute certain contracts and agreements before it could raise commence construction. It also had to obtain financing for the project. AdR expects to receive Mexican peso-denominated debt financing from a consortium led by the North American Development Bank. It must also obtain equity financing, which will likely come from the consortium and other parties. Part of the equity financing could also come from Conagua, the national water commission of Mexico.

CWCO has said that it will contribute the land that NSC purchased for the project to AdR. However, it is seeking to cash out of a substantial portion of its investment when the permanent financing is raised and the project is complete. It wants to have a residual equity interest in the project and participate in the operations of the plant.

Although it is clear that CWCO has made substantial progress in bringing Rosarito to fruition, there are still significant hurdles to completion, including raising the permanent financing. Nevertheless, the probability of CWCO earning a significant return on Rosarito has increased significantly over the past year. In my original forecasts for CWCO, I had assumed that CWCO would retain all of the equity in the project. Now, it is clear that it is looking for a quicker and smaller payback. That reduces the potential upside that I envisioned for this project, but it is also more prudent, given the widening scope of the company’s operations, including its recent purchase of Aerex.

OC-BVI. As noted, CWCO recorded another $875,000 impairment charge on its investment in Ocean Conversions BVI, a joint venture that currently operates the Bar Bay desalination plant in the British Virgin Islands. CWCO has recorded similar charges on its OC-BVI investment for the past several years. The charges are being taken to reduce the carrying value of this investment as the February 2017 expiration date of its contract to operate the Bar Bay plant approaches. OC-BVI has had what looks like a tumultuous relationship with the British Virgin Islands government. Litigation over the government’s takeover of another OC-BVI plant, Baughers Bay, has still not been resolved after nearly a decade. Yet, OC-BVI recently made an offer to the BVI government to extend its operating contract at Bar Bay for 14 years with a reduced selling price for the water it produces.

License Renewals. CWCO has been negotiating a renewal of its contract with the Cayman Islands government, where it operates as both a water utility and wholesale water supplier, for nearly eight years. This is by far CWCO’s most profitable operation. Loss of the operating license could conceivably have a devastating effect on the company’s equity value.

CWCO has been in protracted negotiations over the terms of a new regulatory regime. At the start of the negotiations, the company objected to the appointment of the Water Authority of Cayman (WAC) as its regulator. (It sees WAC as a competitor.) Despite CWCO’s objections and after a long fight, the courts ruled that WAC would become CWCO’s regulator. WAC and CWCO have been negotiating the terms of the regulatory regime for over one year now (since the third quarter of 2015).

Meanwhile, in October 2016, the Cayman Islands government passed legislation creating a new utilities regulation and competition office. Regulation of water utilities is not included within the scope of that legislation, but the company has been informed that water will be added to the new utility regulator’s mandate through new legislation in 2017. For the moment, then, WAC is still CWCO’s regulator, but it is probably a good bet that the renewal of CWCO’s operating license will be delayed until the new regulator is prepared to negotiate terms, which may be several years away.

Since the negotiations began, CWCO has been operating under a temporary license extension, the last of which expired on June 30, 2016. CWCO has been given the right of first refusal if the government opts to transfer the operating license to another firm. Any government takeover of its assets would also require fair compensation. Still, it could be many years before such a takeover is resolved.  After eight years, renewing its Cayman Island operating license should be CWCO’s top priority.

CW-Belize. A similar situation exists in Belize. In 2009, the government of Belize designated CW-Belize as a public utility and ordered it to submit to a regulatory regime. CW-Belize fought this ruling in court, but the court has not ruled on the matter since hearings were held in 2012.

With the exception of NSC, CWCO’s expansion efforts have so far failed to deliver any financial benefits to the company and its shareholders. Indeed, each expansion move has created a new problem which adds to the complexity of managing the company. From the shareholders’ perspective, this has become a very complicated company to follow, more complicated in fact than many companies whose market capitalizations are more than ten times greater than CWCO. Most companies seek growth; but in order to achieve profitable growth, each major new project should be brought to profitability and its operations stabilized before taking on new and often greater challenges. In CWCO’s case, each new project seems to be a new anchor weighing it down. As an analyst, I wonder whether management’s preoccupation with putting out these new fires may be taking its attention away from other matters that are at least as important, such as managing core operations.

In my last Seeking Alpha article on CWCO (I have provided the link to the article but it is now behind SA’s pay wall), I advocated selling CWCO (with some caveats) for many of the reasons outlined in this article. Since then, the new problem at Aerex combined with continuing problems at CW-Bali and the lack of real progress on license renewals strengthens the case to sell the stock, even though the progress made at Rosarito and the possibility of a positive resolution at CW-Bali act as a counterweight to that sell recommendation. Although I recommended selling CWCO in the SA article, I held on to a small position in it in the model portfolio of my newsletter, Income Builder. At this time, I have decided to put a time limit on this holding. I will continue to monitor the company’s performance and if no progress is made in the next 6-9 months or if its situation deteriorates, I will “sell” my position at that time.

December 10, 2016

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

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