The Crisis & Opportunity in the Exciting World of Sewage Pipes...

The unfolding water crisis has thematic ties to a widening nexus of related issues – including energy, global infrastructure and food supply…and yes, sewage pipes. Chris Mayer explains…

I’ll start in the tiny Swiss resort of Davos, the site of the World Economic Summit’s annual conference. Davos has long been a popular place with the well-to-do and those suffering from respiratory ailments. The writer Robert Louis Stevenson wintered here back in 1880. Many others have since.

Today, Davos is a popular spot for world improvers to get together and offer solutions to the world’s many ailments. By world improvers, I mean political types and people with lots of money to throw at endowments and rock stars who like to talk about ending poverty. At Davos, you could easily run into Bill Clinton, Bill Gates and Bono.

I normally don’t pay much attention to this sort of thing. But the topics that garnered the spotlight were of interest to me. And the fact that these topics figured so prominently in this year’s conference means something. If nothing else, it is another marker along what has been a long road to recognition.

I’m talking about the unfolding water crisis and its thematic ties to a widening nexus of related issues – including energy, global infrastructure and food supply. As the Financial Times reported: "a central theme of this year’s forum: the growing scarcity of resources, from clean water to affordable food to accessible oil."

UN Secretary-General Ban Ki-moon told the assemblage at Davos: "What we did for climate change last year, we want to do for water and development in 2008." He warned that water stress was a link between rising food prices, disease and conflicts such as the one in Darfur.

According to the FT, "Water has displaced climate change as Davos delegates’ chief worry outside the U.S. economy, with no fewer than nine water-related events on the program, compared with just one last year."

The ties to food prices are probably obvious. The agriculture industry is normally the biggest consumer of water in any country. The growing scarcity of fresh water is a contributor to higher food prices. The World Food Program says that the pressure in global food markets is so intense that for the first time in its history, the program is finding it hard to procure supplies.

I thought that was an interesting anecdote from the summit. Here’s another: PepsiCo has launched a partnership that will help bring clean water to Africa, China, Brazil and India. For soft drink makers in particular, and food producers generally, having a reliable source of water is absolutely critical. So this partnership will raise funds used to fund long-term water projects, improve sanitation and provide access to clean water.

Every week, I read something about people getting sick in China because of exposure to contaminated water. Most recently, I came across this from Water Tech News: "Water quality is an ongoing issue in China, where recent government figures show that 90% of the country’s groundwater and 70% of its surface water is contaminated, according to a Jan. 16 AFP report."

I’m not going to get into depth about the issues addressed at Davos. My main point here is to show how this issue has begun to get serious attention – finally.

And of course, I always like to remind people that this is not just an issue limited to faraway international markets. We’ve got serious water issues developing here in the U.S.

The most recent report out of the EPA in January outlined needs for $202 billion to control wastewater pollution. The problems are the usual suspects: an old and leaky system. Plus, we continue to ask more and more of these overburdened systems as population grows.

The latest issue of the trade journal Water Efficiency confirmed this: "In North America, many new municipal water systems went in after World War II, in the ’50s and ’60s. Now as these systems reach their half-century mark, they need more and more attention… With the average age of systems now being 40-50 years, but with a design life of 25 years, there is a major challenge looming with water systems. Corrosion is a main culprit."

The pipes start to leak… and that can cause sinkholes as the pipes absorb sediment, creating air pockets that eventually give way and swallow up sections of road, buildings, etc. Or sewage can leak out, causing illness and spreading disease and contamination.

It’s been an issue for several years now. For investors, there is an easy way to profit from this: You simply buy one of the handful of companies involved in water pipe replacement and rehab.

It can get tricky, because many water pipe companies also have exposure to the housing cycle. The replacement business grows nicely, but not nearly enough to offset the lost business in housing. At some point, that will reverse. Then earnings will recover rapidly.

The link with housing can sometimes be subtle. For example, you wouldn’t think that maintenance expenses would track new housing construction. But it turns out that new housing construction – through tap fees – funds a large part of the basic maintenance infrastructure. So as new construction dried up, so did those tap fees – and so did funding for basic replacement and maintenance.

Hard to believe, but true. Most of our infrastructure seems to operate on the principle of "Don’t worry about it until it breaks."

There is another company I’ve long followed. It was always too expensive and well loved for me to recommend. But I really liked the business. It depends somewhat on municipal spending for pipe replacement. And even though it has a great product and solution to the pipe problem, it seems municipalities are having a hard time finding the dollars for it.

As a result, the market also hammered this stock recently, as revenues and earnings came in light. Then there was a self-inflicted wound when the company’s CEO left. Today, the company operates with an interim CEO.

Doesn’t sound like a buy, does it? But these bad news items are all temporary and I think the selling is overdone. It is bad news like that that gets you the pricing you want. So for the first time in a long time, this business looks cheap enough to take a shot at. When the company finally finds its new CEO, I think that will be one catalyst for the stock price to move higher.

But there is a bigger story here…

Recently, the company just won two big contracts. The two contracts totaled $35 million from an Indian municipal board. The Delhi Jal Board awarded the contract as part of a three-year plan to spend about $1 billion to upgrade its sewer system, which serves nearly 14 million people.

Then the company followed that announcement in November with another in January. The company reported it had more than $13 million in contracts in Hong Kong – the largest in company history. It’s a drinking water pipeline rehab project involving more than 19 miles of pipe in Nathan Road in Kowloon.

The company began work in January in India and Hong Kong. All told, it has nearly $50 million in hand in projects in Hong Kong and India.

The company’s technology is perfectly suited for Hong Kong, it turns out. "Our efforts to develop new products for the drinking water market are paying off in these growing markets," said Alex Buehler, vice president of marketing and technology. "The company’s trenchless technology is perfect for the work in Hong Kong, one of the most densely populated cities on Earth, where digging to rehabilitate water lines is not an option in many cases. The city has embarked on a large program to rehabilitate its aging drinking water system, and [our] new products meet this demand."


Chris Mayer
for The Daily Reckoning
April 10, 2008

P.S. I think the company is on its way back. The stock seems to have put in a bottom somewhere around $11 per share. As I write, it just crossed $14 on a good day in markets. Its old high is nearly $30 per share. I think we’ve got lots of upside and little downside here. All the bad news is out and the company is now starting to get traction again. Most importantly, it looks like the biggest markets are overseas.

Chris is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer’s essays have appeared in a wide variety of publications, from the Daily Article series to here in The Daily Reckoning. He is the editor of Mayer’s Special Situations and Capital & Crisis – formerly the Fleet Street Letter.

Chris also recently wrote a book: Invest Like a Dealmaker: Secrets from a Former Banking Insider.

We are way out in the high desert with no access to the news. This gives us a chance to think.

What we’re thinking about is that we have entered a much more dangerous and troublesome period in world financial history. The planet was leveraged up. Now it is going to be de-leveraged.

We have been talking about the battle between the forces of inflation and the forces of deflation. It is not clear which way it will go…or when. The feds – who favor inflation – seem to have the upper hand one week. The next week, Mr. Market – who seems to have thrown his lot in with the force of deflation – seems ahead on points.

Meanwhile, many of the foot soldiers are lost, separated from their units…shooting at their own men…and often blowing themselves up. Many don’t know which side they are on and are willing to switch sides at any minute. But in the fog of war you always get a lot of people bumping into one another. That’s why we get such peculiar reports from the front – such as when the feds cut short rates (which is inflationary)…but long rates nevertheless go up (which is deflationary). Or when the unemployment numbers go up (which is deflationary)…causing the dollar to fall (because investors expect another inflationary rate cut!)

No, we don’t know exactly which way it will go (so don’t ask us when gold will hit $2,000…or when the Dow will break below 10,000). But it scarcely matters. Because, we’re like the innocent civilians caught in the crossfire. Sooner or later, our assets are going to be shot down…and our liabilities are going to blow up. In other words, dear reader, this is not a war in which you should try to speculate on which side will win…this is a time to keep your head down.

It’s a Liquidation War…in which mistakes will be corrected BOTH by inflation and deflation. Take stock prices, for example. Our guess is that they’ll be taken down – either by inflation or deflation, or both. Prices will fall either in nominal terms, in other words, or relative terms. Already, adjust the Dow to the price of gold, or wheat, or oil, or copper and you get a very different picture. Instead of being flat over the last 10 years…the Dow is down a half to two-thirds.

"It’s the Greater Depression," said Doug Casey at dinner Monday night, with a satisfied look on his face. "I’ve been expecting it for a long time. I was a little early. But now, it seems to be finally getting going."

What happens in a Greater Depression? We don’t know, but we think we’re going to find out.

And we imagine its most important feature will be a general markdown of debt and the relative value of Western assets – stocks, houses, currencies, and labor. The East and developing world is on the rise; even if it stays put, the West, in relative terms, will sink.

Some assets will go into default – which is what is happening in the financial industry lately. UBS (NYSE:UBS) alone has lost 38 billion. Hedge funds are going broke. And the captains – present and past – of the financial industry are pointing fingers at each other.

Many people say we’ve seen the bottom for equities, and the financial sector in particular. Maybe in nominal terms. And maybe in the East and the developing world. But in America, in real, inflation-adjusted terms, we’d expect more of a selloff. The S&P is still selling for more than 18 times earnings; there is still plenty of room on the downside.

The financial sector looks particularly bad; there’s probably a lot more bad news coming. And since it was the big winner for the 25 years, it probably needs a bear market of at least 5 or 10 years. At the beginning of the boom in finance, which began roughly during the first Reagan Administration, people still wanted their children to grow up to be doctors, lawyers and businessmen. At the end of it, every mother’s son was encouraged to into ‘finance.’

But now, the bubble in finance is over. It will probably take many years before values appear and prices begin to rise – just look at what has happened in the NASDAQ. Or look at our favorite example – Japan. Many people thought Japanese stocks were a once-in-a-lifetime bargain after the Nikkei Dow crashed in 1990. Well, they’re an even bigger bargain today!

*** "Señor Bonner…I have to tell you. I won’t be able to work here any more."

Francisco, who has been our ranch foreman, quit. He explained why:

"There’s no money in cattle now. So my father sold our ranch over in Angustura. We’re buying a big farm in Bolivia. It’s about 7,500 acres. Very rich. And with lots of water. It’s not in the high part of the country. It’s out on the eastern plain, where the Amazon begins.

"The place we’re getting is practically virgin land. It was farmed many years ago, and then abandoned. I don’t know why. And we’re going to plant soybeans. You just stick the seeds in the ground; three months later you have a crop you can market. And with prices this high, we can’t resist.

"Farming soybeans is about the easiest farming there is. You only have to go out to the farm a couple of times. And you don’t need any labor – it’s all mechanized. Labor is cheap in Bolivia, but it’s still a lot easier when you don’t have to deal with farm labor. And now with these genetically modified plants, it makes it easy to kill the weeds. We just spray herbicide from the air; it kills everything but the soybeans, because they’ve been modified to resist it.

"We’re going to plant about 1,000 acres this spring. Then, we’ll add another 1,000 next year. Some of the land is still covered by jungle. It’s just the opposite of here. Here it never rains. There, they get plenty of rain. We would plant more land, but the Bolivian government has banned clearing any more jungle. At least, there’s some restriction on it.

"And in Bolivia, the government lets you sell your crop on the world market, without taking half of it. [He was referring to the Argentine government’s 49% tax on soy exports].

"Everybody is planting soybeans. But I’m not worried about the price going down. It can fall in half, and we’d still make money."

*** We took a look at farm prices. Even with the huge recent increases most farm prices are still much lower – in real terms – than they were 100 years ago. What made them go down? Technology…cheap, abundant water and fuel…and huge new areas of the world became accessible to mechanized agriculture.

We’re just wondering if those advantages have been pumped out.

As to technology…breakthroughs don’t always come when you want them. Except for parts of Africa, there are few areas that haven’t already been introduced to the plow. Australia…Brazil…Russia…North America…Argentina – millions of square miles were brought into service during the last two centuries. Much of this land is less fertile today than it was 100 years ago – requiring higher inputs of fertilizer. Some of it has been taken for cities and highways. Some has been made unusable by overwork or contamination. If we haven’t achieved it yet, we assume we are getting close to maximum usage of the world’s arable surface area. As to new technology, we doubt that mechanization has much more to offer. And genetically-modified plants may lead to much higher yields, but who knows at what price? But it may be the constraints imposed by water and fuel that really hobble agricultural output in the future.

Colleague Byron King has some thoughts on this subject:

"For 200 years, the material wealth of the world has improved because of increased access to ancient stores of energy. We are mining the Devonian Era, the Pennsylvanian, the Permian, the Jurassic…hundreds of millions of years of stored energy, to release it within a span of two centuries or so. It’s been fun while it lasted, eh? And the whole concept of ‘economics’ rests on that upward – ever upward – trend. Heck, cheap oil made it all look easy. Any damn-fool, poorly-run, hodge-podge of a country could act like a ‘nation state’ in the realm of world affairs, or how else to explain Mexico?

"But now we have reached the plateau in ‘easy’ energy…the best of the coal, the oil, the natural gas, the uranium…it has all been drilled and mined, and now we are going for the lower quality stuff, worse EROEI. Costs are going up. Quality is going down. The currency is degrading, so you cannot even do long term planning any more – in what denomination, pray-tell? You know the drill. Can the world transition to something else? Well, the key point in this is that we are not ‘running out of oil,’ but we are running out of time."

Running out of time? Aha! Here is the sense of urgency. Every day is a lost day. One day closer to…well…to what?

We can’t see any farther ahead than Byron or anyone else. But when we read in the paper about food riots breaking out in various countries, we think we are getting a peek.

Until tomorrow,

Bill Bonner
The Daily Reckoning

P.S. Don’t miss out on Byron’s latest report. In it, he details a breakthrough technology that can squeeze oil from landfill trash – using just pennies of electricity to make $5 of fuel and other products.

P.P.S. Addison’s book, Demise of the Dollar, has recently been updated and re-released. When the book was originally released in 2005, its tense was mostly future. But many of the things he forecasted two years ago came to pass in a way that surprised even us.

The Daily Reckoning