2011 Water Market Review: Industry Consolidation

In the last issue of UIM we outlined the key trends and developments taking place in the water market ? including the recent surge of interest by investors looking to gain a foothold in the sector. In this issue, we take a closer look at other issues shaping the water market, namely ownership changes and industry consolidation.

One impact of the exploding strategic interest in the water industry has been a trend toward industry consolidation among the key suppliers and vendors, and an on-going rearrangement of ownership of key industrial assets. At times, this has almost resembled a game of ?musical chairs? – with major international companies seeking to strategically position themselves to exploit future opportunities offered by the water business.

First, it may be interesting to review a little recent history. The widely discussed ?foreign invasion? of the U.S. water industry occurred in the mid-1990s, when British, French and German companies gobbled up many of the larger suppliers in the U.S. water business. These buyers were driven by the belief that the U.S. water utility business was entering a wave of privatization – and they bought a range of U.S. product and service companies to try to strategically position for this projected bonanza. However, the supposed trend toward widespread privatization did not, and has not happened. As a result, many of these acquisitions were either strategically misguided, ill-timed or over-priced ? and sometimes all of the above. Hence, this cycle of European investment began to reverse direction in the early 2000s.

As a result, major assets owned by these earlier foreign consolidators began to change hands again, and many were purchased the second time around by major U.S. industrial corporations. Veolia, Suez, RWE, and most of the other major European water companies retreated back to their original infrastructure services and utility management businesses ? and most of these companies have long since exited most, if not all, of their equipment businesses in the United States. Global industrial firms such as General Electric, Siemens, Danaher, ITT Corp., Pentair and 3M have emerged as new diversified water service and equipment companies. General Electric’s rapid-fire acquisition of Ionics, Osmonics and Zenon ? at very high valuations ? is the most often-cited example of this trend. Today, Severn Trent is the only major foreign water utility that still has a significant equipment business in the States

There have been fewer blockbuster deals during the past several years ? more because of a dearth of pure-play acquisition opportunities than a lull in strategic interest levels. Unfortunately, one fall-out of the high prices that GE, Danaher and other large consolidators have recently paid for water companies is that they helped to drive average valuations up, and left in their wake an unrealistic set of value expectations for hundreds of smaller technology developers, inventors and tinkerers who now all think their ?better mousetraps? should also be worth 10 to 12 times EBITDA. However, this is another trend which is in the process of being corrected by current economic conditions, meaning that the stratospheric prices paid for some of these acquisitions in the mid-2000s will probably not be seen again.

Although the number of large deals has declined over the past couple of years, smaller deals have continued apace across the global industry. Pentair, Watts, Danaher and many others continue to make smaller acquisitions. Siemens continues its strategy of adding pieces to fill out and complete its already broadly diversified equipment and service offerings. And new buyers continue to emerge all the time ? such as Home Depot (which entered the business a few years ago, and then abruptly exited), Ashland and Axel Johnson. Numerous other industrial companies, such as Idex, Roper and John Deere, seem to be interested in expanding their platform and holdings in the broad water business.

And consolidation activity in Western Europe and other parts of the world continues at an often feverish pace. Numerous infrastructure players in the United Kingdom and Europe have bought and sold very significant assets during the past year or two, with perhaps the biggest deal being the merger between Suez and Gaz de France, and the subsequent spin-off of Suez Environment.

With so many major industry assets changing hands so quickly, the competitive situation in the water industry has been very fluid. The picture is gradually becoming clearer, but it is still not clear exactly who the primary players will eventually be in this industry. Most observers are betting on the various diversified companies mentioned above ? ITT, General Electric, Pentair, Siemens or perhaps a few others who have not yet made their intentions clear. ITT?s recent division and the creation of a separate water company certainly suggests that it will be a key player longer term. But many larger strategic questions remain: how can companies like RWE that were such committed buyers a few short years ago turn in to such eager sellers? Will this same thing plague other companies in the future? What was wrong with their strategies? Will the new owners of these assets have sounder strategies? And most importantly, what will be the ultimate impact of this large-scale ownership rearrangement on employees, shareholders and customers?

As we hopefully move beyond the Great Recession, it is still an open question as to what will happen with merger-and-acquisition and investment activity in the water industry more generally. As the credit markets tightened in 2008, more highly leveraged players had a harder time securing financing, and many transactions on the books or in the planning stages fell apart. Many strategic industry buyers decided to sit on their cash and wait for the general economic picture to clarify. As these restrictions have loosened, M&A activity has definitely started to pick up again. Indeed, during 2010 there seemed to be a bit of a pent-up demand that was released. Many observers predicted that 2011 will be a big year for mergers and acquisitions, although as mentioned, there may not be that many ?big deals? left in the water industry. Furthermore, it seems unlikely that we will return to the very high multiples that were being paid for water companies in the mid 2000s; water companies will still be highly sought after, and will attract above-average valuations, but they won’t be trading hands at the stratospheric levels of a few years ago.

Consolidation in the Public Sector

When we talk about industry consolidation, it is usually within the context of the private sector – private companies merging with or buying each other, in the commercial sector of the business. However, with the efficiencies and economies of scale of larger water and wastewater operations continuing to grow, it seems increasingly possible ? indeed necessary ? that consolidation within the public sector, or the municipal utility business, will begin to occur as well. As observers are increasingly pointing out, it just makes too much sense for it not to happen.

Water and wastewater treatment are both very capital-intensive businesses, and there is no doubt that scale
can convey distinct operating, technical and financial advantages. Yet, as we’ve seen, the municipal side of the business is primarily made up of very small local players ? about 90 percent of all municipal drinking water systems are categorized as ?small? or serving fewer than 3,300 people. As regulatory requirements pile up, and as the business becomes more technologically complex and expensive to run, it seems logical that some of these smaller utility operations should find a way to combine forces and take advantage of these scale efficiencies. There has been some consolidation among private investor-owned utilities, but privately owned utility companies only represent a relatively small fraction of the overall infrastructure. A major policy debate is emerging around the challenges and the potential benefits of combining smaller public water and wastewater utility operations.

Trying to combine or merge municipally or governmentally owned systems is far more difficult financially, and is obviously fraught with a whole range of sensitive political and fiscal challenges. However, such mergers or combinations would definitely make good economic and operational sense. Many industry observers believe that we must figure out some politically workable and acceptable means of consolidating small and local water municipal utilities. The alternative, they say, will simply be increasing non-compliance with key regulations, and even bankruptcy, as these small utilities will no longer be able to keep up in an increasingly complex business environment.

There are other broader and more vexing policy questions in terms of this potential consolidation of smaller and local utilities into larger ?super-regional? utilities. How would a consolidation of the public water utility business affect the delivery of water and provision of sewerage services? Would such combinations include other municipal services, such as solid waste and highway management, or would they be restricted to water and wastewater? Could such super-regional utilities privatize themselves, and or even consider floating public stock? Or, would it make sense to facilitate the merger of water and hydro-based power utilities, to more effectively utilize their common resource:? water? Despite all of these unknowns, it seems likely that we will see more consideration of public utility consolidation in coming years.

[EDITOR?S NOTE: This is excerpted from 2011 Water Market Review, a comprehensive and widely read annual report on key trends and developments in the world water market. The report is available free of charge at www.tech-strategy.com.]

Steve Maxwell is Managing Director of TechKNOWLEDGEy Strategic Group (TSG), a Boulder, Colo.-based management consultancy specializing in merger and acquisition advisory services, and strategic planning for the commercial water and environmental industries. Maxwell is author of the annual Water Market Review, and a recently released book titled The Future of Water. He can be reached at (303) 442-4800 or maxwell@tech-strategy.com.

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