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Is it time to buy Pennsylvania water stocks?

Pennsylvania's Act 12 was a game changer for private water utilities in the state.

Joe Stafford of Upper Chichester (left), Bill Barber of Chester (center), and Ron Navin Upper Chichester protest outside before a meeting of the Chester Water Authority board, which is split among members from Chester City, Delaware County, and Chester County on Nov. 21, 2017.
Joe Stafford of Upper Chichester (left), Bill Barber of Chester (center), and Ron Navin Upper Chichester protest outside before a meeting of the Chester Water Authority board, which is split among members from Chester City, Delaware County, and Chester County on Nov. 21, 2017.Read moreStaff

Pennsylvania's water industry is drawing more attention from Wall Street, and investors thirsty for income and price appreciation may want to examine water stocks for their portfolio.

There are a few factors at play. Pennsylvania's Act 12, signed into law in 2016, allows investor-owned utilities to charge ratepayers for the appraised fair-market value of an acquired system, rather than its lower depreciated cost, as my Inquirer colleague Andrew Maykuth reported recently.

The law has triggered a spate of acquisitions by for-profit water companies. Aqua America already closed two deals, adding 27,000 customers in Pennsylvania and Illinois, which also has a fair-value law. It has more in the pipeline, including Cheltenham, which would be its largest acquisition since 1998.

"I would say, in my more than 25 years at the company, I've never seen this level of activity in municipal sector," Christopher Franklin, chief executive of Aqua America, said on an earnings conference call.

The Bryn Mawr-based utility has operations in eight states, including five with fair-value laws.

"Since the fair-market legislation has begun to pass in various states, we've just not seen this level of interest and activity for many, many years," Franklin said. The firm, which projects 2 to 3 percent customer growth in 2018, posted second-quarter revenue up 4.2 percent, and earnings-per-share growth of 8.8 percent over the prior year's second quarter. Aqua also raised its dividend by 7 percent, the 28th increase in 27 years.

Yet, the acquisition frenzy isn't without risk. Political factors could make some deals uncertain.

After Pennsylvania American Water bought the assets of the Scranton Sewer Authority (SSA) in 2016, the money paid was divided between the city of Scranton and the borough of Dunmore. But Scranton now faces numerous lawsuits by ratepayers, including one filed in October 2017, alleging that the SSA asset sale violated the law by turning over proceeds to Scranton and Dunmore general funds.

The lawsuit seeks the return of all monies from the SSA asset sale, Conrad O'Brien partner Kevin Kent wrote in the Legal Intelligencer, noting that "monetizing the SSA's assets for use in Scranton and Dunmore's general funds was not part of the mission or purpose of the SSA."

The suit seeks to have the money from the sale placed in trust. So the funds Scranton earmarked to balance its budget could be tied up for years or depleted by litigation.

Chester Township wants a new police facility paid for in part with $29.5 million from the sale of its sewer system to Aqua Pennsylvania Wastewater, agreed to in 2016.  Since then, the sale has been delayed, most recently in June, when the township, its sewer authority, and Aqua America agreed to extend the date of the sale by nearly two years.

In addition, Warminster Township drew howls of protest from residents after trying to hire a valuation firm for its water authority this year. A sale wasn't even on the table.

So what's an investor to do?

Focus on those public companies with current earnings and dividend growth for now, said Ryan Connors, equity analyst with Boenning & Scattergood, in Conshohocken.

"These investor-owned utilities want to grow, expand earnings, and drive the stock price over time. There's always been talk about privatization as a potential growth angle," he said. So while there will continue to be deals, he added, the "Act 12-driven privatization push in our state may moderate over the next two to three years."

Among the universe of 14 water and water equipment companies he follows, Connors points to a few companies that would be interesting for long-term buy-and-hold investors: Aqua America (WTR), a water utility, and Ecolab (ECL) and Xylem (XYL). As noted, Aqua America pays a healthy dividend, and its Aqua Pennsylvania subsidiary, with 1.4 million customers in 32 counties in the state, recently filed for its first rate hike since 2011. Aqua America also in July bought the 5,400-connection wastewater assets of Limerick Township for $75 million, marking Aqua Pennsylvania's first acquisition to close under the fair-market valuation law.

Ecolab and Xylem aren't utilities, but instead sell equipment such as water treatment instrumentation, meters, smart pumps, and other innovative products.

"Ecolab and Xylem may offer more stock price appreciation going forward" than some of the other more stable, slower-growing water utilities, Connors said. He's required to disclose that his firm may seek investment banking business with companies in his reports, and he does not personally own shares in any companies mentioned.

Aqua America closed at $38.02 a share Friday with a 2.3 percent dividend, while EcoLab finished at $157.12 a share, and Xylem at $80.93 a share. Connors' price target for the three stocks, respectively, are $43 for Aqua America, $215 for Ecolab, and $90 for Xylem.

Water Stocks

A.O. Smith Corp. (AOS)

Advanced Drainage Systems (WMS)

American Water Works (AWK)

Aqua America (WTR)

Badger Meter (BMI)

Ecolab (ECL)

Franklin Electric (FELE)

Lindsay (LNN)

Mueller Water Products (MWA)

Tetra Tech (TTEK)

Valmont Industries (VMI)

Watts Water Technologies (WTS)

Xylem Inc. (XYL)