Lukewarm on Water Utilities


By Sam Stovall I was flipping through my 52-week relative strength charts of sectors and subindustry indexes in the Standard & Poor's Composite 1500 (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600 stock indexes) -- as I usually do when I'm in search of a Sector Watch story -- when a particular subindex caught my eye. It was the one for the S&P Water Utilities, and its price performance looked constructive to me.

As a reminder, the jagged blue line represents the subindex' rolling 52-week price performance, vs. the 52-week performance of the S&P 1500. Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the subindex' 14-year mean relative strength.

The subindex consists of two companies: American States Water (AWR

; S&P investment rank, 3 STARS, hold; recent price, $25) and Aqua America (WTR

; 4 STARS, buy; $24). During 2004, this subindex advanced 10.0%, exactly the same as for the S&P 1500. Aqua America -- the larger company in the index -- was the real driver, surging 11% last year, vs. American States' 4% rise. After these gains, the question arises: Is it still time to invest in water utilities?

LONG-TERM POSITIVES. To help answer this question, I turned to Stewart Scharf, S&P's Water Utilities analyst. Scharf is neutral on the group for the coming 12 months, but he has a more favorable outlook beyond that.

Scharf's neutral outlook comes amid some challenges: Tight municipal budgets, rising interest rates, and lingering droughts in parts of the Southwest. Following the Federal Reserve's five interest rate increases last year, S&P believes additional hikes are likely through 2005. However, Scharf continues to believe increased demand for improved water quality, along with aging systems, will translate into positive long-term prospects for water-infrastructure upgrades.

Water utilities are expanding geographically in the U.S., while seeking -- and being awarded by their respective state commissions -- rate hikes to offset rising infrastructure costs, as municipalities turn toward privatization to repair their decaying water systems.

DIVIDEND BOOSTS. Scharf expects Congress to allocate $35 billion to water companies over the next five years for infrastructure upgrades, while the Environmental Protection Agency believes $150 billion will be needed over the next 20 years, with $250 billion more for wastewater systems.

Scharf sees major growth in desalination -- a process by which salt is removed from seawater, making it potable -- especially in Nevada, Arizona, California, and Texas, where the population continues to expand, and droughts have hurt water supplies.

In addition, Scharf anticipates further consolidation in the industry, as the major U.S.-based investor-owned water utilities continue to acquire regional water operations. He expects these companies will try to offset the effects of adverse weather through geographic diversification. Also, Scharf believes water utilities will continue to raise dividends. True to form for a utilities group, the water suppliers sport a weighted average dividend yield of 2.6%, vs. 1.7% for the S&P 500.

FEDERAL FUNDING. With 85% of the population getting its water from government entities, S&P believes municipalities are eager to find cost-effective private-sector solutions for their water-services needs, as facilities and pipes age. Under federal water infrastructure funding legislation called Water-21, water municipalities and operators would receive $57 billion over five years to help make up a funding gap in capital outlays.

So there you have it. In S&P's view, the subindustry's momentum looks favorable, but the fundamentals don't support an aggressive stance in the coming year.

Industry Momentum List Update

For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), their proxies (the highest STARS-ranked companies in the subindustry index -- tie goes to the largest market value) as of Jan. 14, 2004.

Industry

Company

Ticker

STARS Ranking

Recent Price

Agricultural Products

Archer-Daniels-Midland

ADM

3

$22

Commodity Chemicals

Lyondell Chemicals

LYO

3

$29

Consumer Electronics

Harman International

HAR

3

$127

Fertilizers & Agr. Chem.

Scotts Co.

SMG

4

$70

Homebuilding

Standard Pacific

SPF

5

$66

Hotels, Resorts & Cruise Lines

Carnival

CCL

4

$57

Internet Retail

eBay

EBAY

3

$105

Internet Software & Services

Yahoo!

YHOO

4

$37

Managed Health Care

PacifiCare

PHS

5

$61

Oil & Gas Refg., Mktg. & Trans.

Valero Energy

VLO

4

$48

Steel

Nucor

NUE

3

$52

Wireless Telecom. Svcs.

Nextel Partners

NXTP

4

$21

Required Disclosures

5-STARS (Strong Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index and share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.

As of December 31, 2004, SPIAS and their U.S. research analysts have recommended 26.5% of issuers with buy recommendations, 61.3% with hold recommendations and 12.2% with sell recommendations.

All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's, 55 Water Street, New York, NY 10041.

Other Disclosures

This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"), and may have been provided to you either by: (i) Standard & Poor's under a license agreement with The McGraw-Hill Companies, Inc., which holds the copyright to this report; or (ii) a Standard & Poor's client who is granted a sub-license by Standard & Poor's. This equity research report and recommendations are performed separately from any other analytic activity of Standard & Poor's. Standard & Poor's equity research analysts have no access to non-public information received by other units of Standard & Poor's. Standard & Poor's does not trade in its own account. SPIAS is affiliated with various entities, which may perform services for companies covered by the recommendations in this report. Each such affiliate is operationally independent from SPIAS.

Disclaimers

This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Stovall is chief investment strategist for Standard & Poor's


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