The Trade of the Century

When you think about hot commodities right now, you probably don’t think of water. Yet the price of water in some parts of the world is rising…sometimes very quickly. Take California, for example.

Mark Swatek is CEO of Southwest Water Co., a water utility that serves California and the Southwestern US. You may accuse him of talking his book when he says: “One of the fastest growing commodity prices is the price of metropolitan water [in Southern California].”

It may be an exaggeration, but not by much. Since 2007, the Metropolitan Water District of Southern California has increased its water rates from $574 an acre-foot to $781 an acre-foot – a 36% increase. (An acre-foot is the amount of water needed to flood a plain of one acre to a depth of one foot – or about 326,000 gallons.)

More increases are on the way. The MWD has approved an increase to $811 an acre-foot by January 2010 and another increase to $985 by 2011. That would mean a 71% increase in five years. Despite these increases, water is still too cheap in Southern California.

“This is a resource that has been underpriced for 50 years,” says Keith Brackpool, CEO of Cadiz, a water development company based in LA. (More on Cadiz below.) Even with the increases, a consumer might pay $10 a day for power and only $3 for water. “You pay more in Manhattan, and Manhattan isn’t a desert.”

Speaking of Manhattan… As I write these words, I’m at the Grand Hyatt on 42nd Street in Manhattan, near Grand Central Station. I’m here for the Gabelli Water Investment Summit, where about 10 different companies in the water business make presentations to a roomful of analysts and money managers.

These presentations give you a good look at what’s happening in water – everything from water utilities to desalination, from irrigation to flow valves. It’s hard to listen to these companies and think there isn’t a water crisis unfolding. It may be under the radar in some places, but in others it’s already a full-blown crisis.

California is a good case study where the water crisis is in bloom. Brackpool pointed out a number of challenges California faces. Here are three:

• Supply limitations – In 2007, a federal judge put limits on the amount of water taken out of the Sacramento-San Joaquin Bay Delta. The problem was as the water flows down from the Sierra Mountains, it also flows through an estuary before it reaches the state’s water supply. And the estuary was depleted due to excessive pumping, which endangered some fish native to the river. In any case, the system is delivering only 40% of capacity now. At this point, even several wet years won’t get it back to 100%

• Drought – This is pretty well-known, but California just had its third consecutive dry year. Current reservoir levels are at all-time lows

• Aging infrastructure – The system is no longer capable of supporting the increased population without significant investment.

To combat these problems, the state has done a number of things, including those price increases I mentioned above. Yet because water is still so cheap, the increased water rates have not had much of an effect on water use so far. There is also an $11.1 billion water bond that will provide funds for storing water. And there is a search for new supplies of water. But as Brackpool says, “We’ve picked all the low-hanging fruit. The next frontier requires a large extension ladder.”

This is where Brackpool’s company, Cadiz, comes in. Brackpool was quick to say that there was no single solution to the water crisis. Instead, there will be many ideas – conservation, desalination and more. “Assets like ours have a role to play in the quiver full of arrows called solutions.”

Cadiz has an interesting story, and one that could be very rewarding for shareholders. Cadiz owns 45,000 acres – about 70 square miles – in eastern San Bernardino County. Its property lies at the base of a 1,300-square-mile watershed. It sits on top of one of Southern California’s largest natural reservoirs. Rain and snowfall drain down the Fenner Valley to Cadiz’s property. The water continues its journey to two natural dry lakes… and eventually evaporates.

Cadiz has a plan to capture this water – to basically conserve the water before it evaporates in the dry lakes. The Cadiz water project will store the water and deliver it to Southern California users via a conveyance pipeline and pumping station. It’s a $240 million project that will conserve 50,000 acre-feet of water per year.

The quality of the water is superb. “Better than most bottled waters,” Brackpool says.

For 20 years, Cadiz has been growing melons, squash, peppers, grapes and more in the fertile soil nourished by the groundwater under its property. This 1,600-acre farming operation is impressive in photos. You see these big squares of green in the middle of a desert, almost as if they’ve been painted on the earth. You can actually see them when you’re flying in and out of LAX. However, the real value creation story here is not in farming, but in monetizing the water assets.

Cadiz as a water play, though, is still a young bird yet to fly. Construction of the project won’t begin until the first quarter of 2011, at the earliest. The company won’t finish completion until the third quarter of 2012.

That’s a little distant for my tastes, and there are still some environmental hurdles Cadiz must clear before it can proceed. Nonetheless, I like the story and the asset. It’s well worth keeping an eye on, as I intend to do. The ticker symbol is CDZI.

At the conference, I also heard Robert Sprowls speak. Sprowls is the CEO of American States Water, another California utility. His firm owns groundwater resources of 118,000 acre-feet of water. Asked to put a value on that portfolio, Sprowls said that water rights in the region go for $3,000–$7,000 an acre-foot. He ventured a guess of $5,000 per acre for his company’s water rights – in the middle of that range – which would yield a value of $590 million for the water rights portfolio.

As American States Water – which has substantial assets beyond the water rights – is worth only about $930 million in the marketplace, this piqued my interest. However, it is difficult to turn these water rights into cash when you are a regulated utility. It’s not likely the regulators are going to let shareholders walk off with a haul without sharing it with the ratepayers.

“It’s a difficult issue,” Sprowl conceded, “but we’re still thinking about it.” In any event, Sprowls’s benchmark valuation for water rights was useful information if only to show how valuable water rights are.

The best way to own water rights is to own PICO Holdings (NASDAQ:PICO). It owns water rights mostly in Nevada and Arizona, some worth as much as $45,000 per acre-foot. I estimate PICO’s water rights alone are worth $700 million – and you get rest of the company for practically nothing, as the market values PICO only for $732 million as I write. It has nearly $200 million in cash. So just cash plus water rights more than cover your investment. And these water rights appreciate in value over time. PICO’s stock price simply does not reflect the intrinsic value of its assets.

California, by the way, is no longer a hostile state for the water utilities as far as rates are concerned. Those water increases I quoted up top ought to be evidence enough of that. In 2005, California made major changes to its policies, which I won’t detail here. The end result: “California is great now,” as one analyst – a 10-year veteran of water utilities – put it to me. “It is more likely now that water utilities will earn good returns on capital.”

The handful of publicly traded California water utilities may well be good investments now. Most trade below the acquisition multiples paid for the last 10 significant takeovers of water utilities. The low end of that range is about 2.5 times book value. The nearby chart shows you the discounts in these stocks based on this estimate of private market value, or PMV:

Water worries extend far beyond just California and the American West, as you know if you’ve read this letter for any length of time. Beyond the ideas mentioned above, the summit served to reinforce my view that water will be a good place to be in the years ahead.