When most CFOs think about liquidity, they're calculating how fast they can turn assets into cash. But Aqua America finance chief David Smeltzer is just as likely to be concerned about how smoothly water is flowing through the 10,000 miles of pipes his company owns. As the largest among a handful of publicly traded companies in America that are in the business of purifying and delivering tap water, Aqua America has operations in 13 states from Maine to Texas. Having kept up a steady pace of acquisitions — 25 to 30 per year for the past five years — Smeltzer says his company will continue its aggressive expansion. "There are unlimited targets out there," he says.

Water, a utility that most people take for granted, is suddenly hot. "It's not usually looked at as a sexy industry, but its long-term prospects are probably more favorable now than they've ever been," says Stewart Scharf, an equity analyst for Standard & Poor's. Cash-strapped municipalities need help in updating and operating their aging waterworks, and deep-pocketed companies like Aqua America are offering their services. Most of the pipes and other infrastructure in this country are in dire need of replacement, requiring an investment of around $500 billion from 2000 through 2019, according to Environmental Protection Agency (EPA) estimates.

Despite its rapid growth, Aqua America, with a market cap of $3 billion, will likely soon be displaced as number one in the market by American Water, whose parent company is planning to spin it off in an initial public offering in the range of $4 billion to $6 billion this year. Investors are so eager to get into the space that price/earnings ratios have doubled from 10 to 20 over the past two decades, as the industry's 20-year returns outperform Exxon, Wal-Mart, and Home Depot. Private-equity firms are making their first forays into the industry, with AIG Highstar buying Utilities Inc. in 2005 and Australian giant Macquarie Bank currently awaiting regulatory approval for the purchase of Connecticut-based Aquarion Water Co.

Those companies that successfully make the plunge into the water business are likely to produce "above-market growth for a number of years to come," says Debra Coy, an analyst with Janney Montgomery Scott. Once they dip a toe in the water, they can look forward to a virtual monopoly for as far as their pipes will stretch.

But it isn't easy getting started. Most waterworks are owned by municipal governments, which tend to be fiercely protective of their franchises since water is viewed more as a birthright than a salable commodity. "Municipalities need the outside help, but from a customer standpoint, some don't feel as comfortable turning to the private sector," says Scharf. When they do seek help, most prefer to have private companies operate their systems without owning them, a business model that typically carries lower profit margins than owning the assets. Still, many analysts think cities and counties may loosen their grips as investment needs become more pressing.

Wringing Out Returns
How water companies produce profits and shareholder returns is much more complex than the product they deliver. First, they must pour millions of dollars into capital expenditures. American Water, currently a division of German utilities conglomerate RWE, spent about $600 million to upgrade systems last year and expects to maintain or increase that amount going forward, according to senior vice president and CFO Ellen Wolf. Aqua America plans to spend at least $250 million per year over the next five years, says Smeltzer, and more depending on what future acquisitions require.

"It's such a capital-intensive industry that it's always negative free cash flow," notes Coy. Indeed, "we have to invest $3.45 for every $1 [in revenue] we get back," says Peter Cook, director of the National Association of Water Companies (NAWC), an industry group for private water companies. That compares with $1.61 of revenue per dollar of investment for electric utilities, $1.11 for telephone, and 94 cents for natural gas, according to a 2006 report by AUS Consultants.

This model of spending money before you have it is hard for outsiders to grasp, says Coy, but ironically, it's what keeps shareholders interested. "Positive cash isn't a point we look forward to, because then it's harder to get growth in net income," explains Smeltzer.

That's because water companies recoup their investments and earn profits through various types of rate increases that come only after the money is spent. And rate increases must be approved by state utilities commissioners, a process that varies from state to state and can take up to a year. However, unlike most municipalities, private companies rely on appointed, rather than elected, officials for rate increases, which generally makes it easier to get the requested boosts. "If you couldn't rely on regulators to let them keep raising rates, the business model wouldn't work," says Coy. (Not surprisingly, this is also why most towns balk at privatizing their pipes.)

Currently, experts say that regulators in many states are favorably disposed toward rate hikes in exchange for infrastructure improvements. "We've never had a regulatory commission disallow a [reimbursement for] capital expenditures we've made, meaning we've never had to argue over whether the money we put in the ground [for pipes and other equipment] was prudent," says Wolf of American Water, which operates in 29 states. While nothing is guaranteed, says Pennsylvania Utilities Commission chairman Wendell Holland, "we generally grant all prudently incurred costs." In about 12 states, including Pennsylvania, companies can even take a portion of their costs through surcharges, giving them some cash up front.

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