The water sector offers powerful, assured growth, the world’s safest yields and hype-free values.
— Roger Conrad, Utility Forecaster
As I wrote last year in Water is the New Sexy, oil is not the only natural resource facing high demand and short supply. My colleague Ben Shepherd has uncovered a promising water utility and I’m happy to provide his investment analysis below. — Jim Fink
Supply and demand conditions in oil markets receive ample attention from the mainstream and financial media, reflecting the commodity’s role as the lifeblood of the global economy. But water–critical to life itself–receives scant notice from the domestic media and even shorter shrift from US investors.
Whereas most Americans simply turn on a faucet for a glass of clean drinking water, potable water is in short supply globally. According to the World Health Organization, in 2004 only 18 percent of the global population had access to clean drinking water. The problem is particularly acute in rural areas.
As residents of the Southwest can attest, this region of the US has long struggled with water shortages. Battles have raged for years over how to use water in the Colorado River basin, as drought and population growth continue to ratchet up the pressure. With five of the 10 fastest-growing US cities situated in this basin, the demands on this dwindling resource will only increase.
The region will need to address this issue sooner rather than later, but with desert metropolises such as Phoenix and Las Vegas firmly entrenched, there are no easy solutions.
PICO Holdings (NasdaqGS: PICO) is well-situated to benefit from the area’s tightening water supplies.
With a market capitalization of $675 million, Pico is a mini-conglomerate that operates in four distinct segments: water resources, real estate, insurance and corporate, which focuses on business acquisitions and financing.
PICO conducts its real estate operations (16 percent of revenue) through two subsidiaries: Nevada Land and Resource Company (NLRD) and UCP. With 440,000 acres, NLRD is one of the largest private landowners in the state of Nevada, while UCP focuses on acquiring bargain-priced developable land and partially developed or finished lots in parts of California that were hit hard by the real estate bust.
PICO’s insurance segment (54 percent of revenue) consists of Physicians Insurance Company of Ohio and Citation Insurance Company, both of which are in run off. That is, the two companies handle claims on expired policies but no longer write new policies. Although this business offers zero growth potential, it still contributes to the top line. Both subsidiaries maintain reserves to meet potential obligations and invest this cash in a mix of stocks and bonds. After meeting expenses, the return on these investments accrues to PICO.
PICO’s corporate segment generated approximately 19 percent of the conglomerate’s total revenue in 2010. Like a private-equity fund, this division acquires undervalued businesses outright or takes a large enough ownership stake to be able to influence their operations and unlock value.
Vidler Water Company, which accounts for about 10 percent of Pico’s overall revenue, owns extensive water resources and rights in Nevada, Arizona, Colorado and Idaho. Not a regulated water utility, Vidler develops new sources of water for municipal and industrial use, and builds and operates infrastructure to store and distribute water. Land purchases are typically involved in the acquisition of water rights and, as a result, the division owns more than 14,000 acres of real estate which is primarily leased for agricultural purposes.
This segment primarily serves real estate developers whose projects don’t have access to existing municipal systems. Vidler also operates a 35-mile pipeline that delivers about 2.6 billion gallons of water annually to the northern reaches of Reno, Nev.
In January 2010 Vidler boosted its water holdings in the Phoenix metropolitan area to 343,000 acre-feet of water–an acre-foot is equivalent to 326,000 gallons–with the acquisition of 126,000 acre-feet for $15.75 million. All told, Vidler holds the rights to more than 1 million acre-feet of water, including recharge rights.
Given the diversity of Pico’s operations–particularly after the firm closed a deal to build and operate a canola oil production and processing facility in Minnesota–evaluating the mini-conglomerate is a formidable challenge. The hodgepodge of businesses in Pico’s portfolio also makes it exceedingly difficult to calculate reliable earnings estimates. The company’s acquisition activities are yet another obstacle for analysts and as a result it doesn’t attract much attention from sell-side analysts; only two currently cover the stock.
While accurate estimates are a challenge to build, management’s conservatism provides a certain margin of safety. The firm follows Warren Buffett’s model of purchasing viable businesses at low valuations and wringing maximum returns from these acquisitions. And with cash and equivalents accounting for roughly a sixth of the company’s value, the firm has plenty of dry powder and liquidity.
As a result mutual funds and other institutional investors are fond of PICO Holdings, owning more than 80 percent of the company’s shares. Not surprisingly, the majority of funds that own PICO shares have employ a value bent to their investment strategies.
The company continues to aggressively augment its water rights in the Southwest, investments that should appreciate in value as the region’s water resources become more stretched. With the National Weather Center’s Climate Prediction Center forecasting that the drought afflicting the Southwest will intensify, the value of Pico’s water rights should increase in 2011. And with more than 1 million acres of canola planted within a 100-mile radius of the plant, the firm’s canola operations should also post strong growth.
Finally, should real estate values begin strengthen in the back half of the year, as many analysts have predicted, expect PICO’s book value experience a nice jump, further enhancing its value.
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