Consolidated Water (CWCO) Update

Consolidated Water reported net income attributable to stockholders of $2.23 million or 15 cents per share for the 2015 second quarter ended June 30. This was below last year’s $2.76 million or $0.19 per share and also a penny short of the consensus estimate.

Revenues of $14.5 million were down from $16.9 million and also below the consensus estimate of $16.4 million. Management said that most of the decline in earnings was attributable to lower pass-through charges on retail water rates due to the decline in diesel fuel prices which reduced electricity costs. However, CWCO also reported that bulk water sales in both its Bahamas and Cayman operations declined by 9% and 5%, respectively, which was attributed to water conservation and loss mitigation efforts and excess rainfall that reduced demand for non-potable water.

Notable developments in the quarter included:

  1. Continuing slow growth in sales volumes and operating losses in Bali.  The company recorded an operating loss of $142,000 in Bali, wider than last year’s loss of $86,000.  Yet, management was pleased that water volume increased 45% year-over-year from 8.0 million gallons to 11.6 million gallons.  Even with the increase, the Bali desalination plant is only operating at about 17% of capacity.  This has obviously been a slow ramp.  Management says that potential customers are very cost conscious and prefer to draw water from on-site wells, even though that practice risks compromising the underground aquifers that serve the island.  The government of Indonesia apparently is not worried enough yet to force the issue.  Despite the slow uptake, CWCO is still optimistic about its long-term prospects in Bali.  It does acknowledge, however, that continued losses there may eventually force it to take an impairment charge against its $3.3 million investment.
  2. Continued progress in obtaining approvals in Mexico.  CWCO reported that it has met with the Public-Private Association Project State Committee of the state of Baja California which has been charged with evaluating and authorizing the company’s plan to build a 100 million gallon a day desalination plant at Rosarito Beach.  It now awaits the committee’s decision.  If it receives the Committee’s authorization and state approval, the project will be subject to a public tender which may involve competing bidders, but CWCO should have an advantage because of its first mover status.  CWCO incurred roughly $1.0 million of expenses to pursue this project in the first half of 2015 and plans to spend another $1.1 million in the second half.  It also has a remaining balance of $8 million on its demand loan, down from $10 million, through which it financed the purchase of land for the proposed site of the plant.  At this point, if it obtains all necessary approvals and permits, it will probably be several years before construction on the project begins; but CWCO’s stock will respond positively as approvals are obtained.
  3. The company incurred another $275,000 impairment charge against the carrying value of its investment in OC-BVI, its joint venture in the British Virgin Islands.  This brings total charges year-to-date to $585,000.  These charges were taken in response to reduced profitability at its Bar Bay plant.  That plant is subject to a license renewal in February 2017.  CWCO also awaits completion of an appraisal to confirm the amount awarded by the court for the government’s takeover of its Baughers Bay plant in 2010.  Its valuation of its investment in OC-BVI assumes that the BVI government will extend the Bar Bay operating license for another seven years and also that it will receive amounts due on the Baughers Bay plant.  However, it believes that the reduction in profitability of the Bar Bay plant is permanent and expects to take similar charges in the second half of the year.
  4. In March, CWCO received a letter from the Ministry of Works in the Cayman Islands affirming the Water Authority of Cayman’s authority as CWCO’s regulator.  The company has apparently dropped its opposition to this arrangement and now awaits WAC’s proposal for a new operating license and a start date for the commencement of negotiations.  WAC has extended CWCO’s operating license in the Caymans by six months to December 31, 2015.

Commentary: The second quarter shortfall in earnings, though modest, may still be significant because a portion may represent a permanent decline due to the success of efforts in the Bahamas and the Caymans to stem leaks and other losses in their water systems. However, higher rainfall also contributed to the drop in bulk water sales.

The continuing loss in Bali was not a surprise, but the company’s disclosure of a possible future impairment charge was nevertheless disappointing. Still, management remains optimistic about Bali’s future prospects, as noted, because the existing water supply there remains under pressure. Government action could eventually produce a quick turnaround in the Bali plant’s profitability; but it may be several years before that happens.

It was a relief to see that the company has apparently dropped its opposition to the appointment of WAC as its regulator, but also a concern that WAC has not yet submitted a proposal to CWCO for the renewal of its operating license. (WAC said back in September 2014, nearly a year ago, that it would submit a draft license to CWCO.) Besides the Caymans, CWCO faces potential losses or adverse changes to its operating licenses in Belize and the British Virgin Islands. Although it might be argued that these situations are beyond its control, there is no evidence that the company is pressing its cases with either the courts or regulators to resolve them.

At the current price around $12, CWCO is valued at 21 times consensus projected 2015 earnings of $0.57 and 19 times projected 2016 earnings of $0.64. Those multiples are consistent with those of other water utilities, yet those other utilities do not face nearly the same risk of loss of or unfavorable changes to their operating licenses. It is also difficult to see how the company will be able to achieve 12% growth in earnings from 2015 to 2016 without a quick turnaround at Bali, which looks unlikely at this time.

It might also be argued that the potential gain from the Rosarito plant should give CWCO a higher multiple, because it offers prospects for long-term growth that are better than other water utilities. But evidence of tangible success for this project may not be forthcoming for several years. In the meantime, Rosarito will continue to be a drain on CWCO’s profitability that may increase over time.

Some might also argue that adjusted for the net cash of $2 per share on its balance sheet, CWCO is cheaper than its peers; but investors may not rely on that $2 because it may be used to finance Rosarito’s development.

In my original report on CWCO, which was published on Seeking Alpha 18 months ago in February 2014, I set a four year target price of $24 for CWCO’s shares. That price target was based upon projected earnings of $1.34 per share valued at 18 times earnings. The $1.34 projection consisted of earnings of $0.54 per share from the base business, $0.12 from Bali and $0.68 from Rosarito. With only two-and-a-half years to go, there are still no earnings prospects at Bali and the Rosarito project will likely not get up and running for several more years.

Consequently, I am lowering my 2018 price target for CWCO to $15, which assumes earnings of $0.83 per share also valued at 18 times. The $0.83 estimate is aggressive, because it assumes compounded annual earnings growth of 13% in 2016, 2017 and 2018. It is unlikely that the company will be able to achieve that rate of growth without a positive and significant contribution from Bali. Conceivably, the company could also achieve a $15 share price (or higher) with lower earnings but with tangible progress on Rosarito.

An important prerequisite for this $15 price target (and my willingness to buy the stock again) is tangible progress on license renewals, especially in the Cayman Islands. If the Rosarito project continues to progress, CWCO will incur additional expenditures which could drain its cash reserves and draw upon the profitability of its base business. I believe that CWCO has the potential to become a major global player in the desalination business, but it will need to protect the profitability of its core operations to get there.

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