Biotech, social media and cryptocurrencies are the usual hotspots for crazy asset prices. This year, though, one of the highest valuations offered in any US acquisition is for the sewer system of a tiny township in Pennsylvania.
This raises questions. Why is an electricity and renewables powerhouse paying a tech-like premium for roughly 8,000 sewer accounts in some patch of Pennsylvania? And why is this township selling its biggest asset in the first place? The answers blend strategy, state privatization laws and small-town politics — and the profits to be made in water.
The US water and wastewater sector is a giant made up of Lilliputians. Of those Americans relying on centralized pipe networks — as opposed to private wells or septic systems — about 85% are hooked up to municipal systems, according to Bluefield Research, a Boston-based water intelligence provider.(2) These can be enormous, like New York City’s, but most are small, like Towamencin’s, or even tinier. This doesn’t leave much market share for private companies. The market cap of the entire listed water utility sector is only about $50 billion, less than one-third that of just one electricity utility: NextEra.
This is one reason why a company such as NextEra would likely be interested. (The company declined to comment). Fragmented industries delivering vital services make rich hunting grounds. Another attraction may relate to credit. NextEra derived 59% of its earnings from regulated utility operations in the 12 months ended in June and 41% from its unregulated business, mostly contracted renewable energy projects. As noted by CreditSights, which calculated the figures, credit rating firms would prefer regulated operations to be at least 60% of earnings, since charging utility bills is akin to collecting taxes. Yet NextEra’s renewables business is growing at about twice the rate of the utility operation, meaning that ratio will continue to deteriorate absent the acquisition of new regulated businesses. NextEra has tried repeatedly — mostly in vain — to buy other large electricity utilities in recent years.
But water is also a regulated monopoly and, with systems that are, on average, a half-century old, an investment opportunity. Americans now spend more on their water rates than on natural gas bills.
Still, given NextEra’s trailing adjusted earnings of $5.3 billion, it would take a lot of Towamencins to make a difference: The town’s wastewater system generates only $2 million a year after expenses. That’s a literal drop in the bucket, especially when you consider the time and effort taken; NextEra has been involved in the township’s sale process for at least 18 months.
And then there’s the political blowback.
Water, whether as fresh supply or treating the waste, is a foundational element of any community. That’s one reason why the current crisis in Jackson, Mississippi, and the many before it attract national attention. Even where such problems don’t exist, people are touchy about tinkering with such a vital service. In Towamencin, opposition centers on cost. Projections published by the township’s administrators show annual wastewater rates for residents more than doubling within five years to more than $1,000 and continuing to rise from there.
The issue isn’t so much that bills are likely to go up — that’s a fact of life with most public infrastructure. By all accounts, though, Towamencin’s wastewater system is in relatively good shape. And the township’s projections show that, if it retained ownership, rates would increase 79% by year 10, below the levels anticipated by all of the private bidders in the chart above (Franconia is a neighboring municipal authority).(3)
Rather, opponents don’t want to have to compensate NextEra for the premium it’s paying.
At almost $14,000 per customer account, NextEra’s bid is close to four times the average for similar deals this year.(4) The company even noted in its bid that it didn’t expect state regulators to allow it to recoup all of that premium. It’s also tough to see how even NextEra could strip much cost out of an operation with only a dozen full-time employees, especially when it lacks other operations in the state over which to spread expenses. By any reasonable measure, NextEra appears to be overpaying.
That’s partly because it can. In most of the US, municipalities thinking about selling their water systems would be forced by state laws to do so at book value. And since these are generally old, depreciated assets, that wouldn’t be worth it. The book value of Towamencin’s sewer system is less than one-sixth NextEra’s bid. However, 13 states have passed laws allowing localities to sell their water assets at fair market value. One of them is Pennsylvania.
These laws are ostensibly helping hands for small towns too poor to pay for system upgrades, allowing them to attract a big upfront payment and offload maintenance to a private operator. Yet Towamencin doesn’t fit that description. As noted earlier, its sewer system is in decent shape. Median household income is a third higher than for the state and the poverty rate, at 3.7%, is lower than for both the state and the county.
One fly in the ointment is debt. While Towamencin’s obligations aren’t that high relative to property values, the 14% of its general budget going to service that debt is troubling, says Matt Fabian, a partner at Municipal Market Analytics Inc.. An optimal level is below 10%. More pertinent, according to Fabian, is the sewer system kicking $2 million into the general fund each year. “Dividends of this type are frowned upon because they show the government keeping sewer rates higher than they should to subsidize other spending,” Fabian said.
That last point chimes with something pointed out to me by Joyce Snyder, the first Democratic candidate elected to Towamencin’s board of supervisors in several decades (she won by 13 votes last year). An opponent of the sale — she was the one dissenting board vote out of five — Snyder claims she only found out NextEra had been selected as the favored bidder when it was announced at a town hall meeting. As for why sell, Snyder said: “It boils down to the fact that the board of supervisors for the past 10 years have not been willing to raise taxes.” The township administration declined to comment for this column. Its own website does confirm that, until an increase in 2021, the real estate tax rate had been flat since at least 2012.
Moreover, the board proposes putting more than $50 million of spare proceeds into a “permanent” reserve, generating interest income. To put that in perspective, the annual budget runs around $16 million. The deal with NextEra isn’t saving Towamencin, which hardly needs saving, but recapitalizing it — and then some. It’s the sort of offer any small township’s administrators might find hard to refuse. They get to fund all sorts of popular projects without the unpopular resort to raising taxes — overtly, that is.
There’s no such thing as free money. Doubling water rates within five years may not involve the word “tax”, but that is how it would work, and regressively so given the flat fee structure. In addition, the initial rate freezes baked into the bids look like teaser mortgage rates. While any rate-hikes require approval by state regulators, the latter have already agreed to big increases by private operators who bought wastewater systems in neighboring townships. In addition, it beggars belief that a township could sit on a permanent fund worth three times its annual budget without it ultimately being bled away by pet projects. “People are literally lining up already for the money,” Snyder said, adding that “I’m one of them.”
Local activists, grouped under the banner of Neighbors Opposing Privatization Efforts, or NOPE, are seeking to change the township’s charter to block the sale. State attorneys have filed a protest with the Public Utilities Commission seeking to block NextEra’s application to become a public utility in Pennsylvania — necessary for the deal — because it wants to contract with another company to actually run Towamencin’s sewer. Some other sales have been successfully opposed, such as in neighboring Norristown and, more recently, the proposed $1.1 billion acquisition of Bucks County’s sewer system by Essential Utilities Inc.’s Aqua Pennsylvania, which would have been the largest such privatization to date.
The mismatch between the potential revenue on offer and the trouble and expense taken suggests Towamencin represents something of an experiment for NextEra. It has also bought a scattering of already privatized water and wastewater systems in Texas, collectively with just 2,700 connections. It’s possible the utility sees potential synergies with its energy business, given the large quantities of water used in conventional power plants. There is even the possibility of using heat pumps and heat exchangers to recover heat energy from wastewater for home heating.
Still, building a water business at a scale that would move the needle, municipality by municipality, looks borderline Sisyphean. It seems more likely such deals, if successful, would tee-up an eventual tilt at one of the big private players.
NextEra’s ultimate objectives aside, its outsized bid in the context of spreading fair-market value laws demonstrates the desirability of these assets. Even though Towamencin’s sewer system is in good shape now, it will require expensive upgrades as time goes on and water regulations tighten. These include potentially swapping out chlorine-based disinfection for ultraviolet light technology and dealing with so-called “forever chemicals,” or PFAS: perfluoroalkyl and polyfluoroalkyl substances (see my Bloomberg Opinion colleague Lisa Jarvis’ recent column on these).
The condition of the US wastewater system, with 800,000 miles of public sewer networks and 16,000 treatment plants, is graded just D+ by the American Society of Civil Engineers. Since utilities earn a return by building stuff, the push to privatize more of these systems isn’t going away. Conventional wisdom dictates private hands run things more efficiently than public officials, and that bigger is better with networks. But the rate hikes associated with these deals suggest that, if such efficiencies exist, they aren’t necessarily trickling down to the end of the pipe. A study published in March in the Journal of the World Water Council of the 500 largest community water systems in the US concluded that private ownership correlates with higher water prices, citing “regulatory capture” as a factor in particularly expensive states, including Pennsylvania.
For places like Towamencin, it seems good on paper to take an asset folks barely think about and use it to fund a whole set of public goods. Unlike a private company, however, where taking an offer like NextEra’s is a no brainer, these assets make the township possible and are held in trust for both current and future generations. That question of trust is at the heart of the deal: trust in a new owner; trust in the regulator to actually hold that new owner in check; trust in officials up for election every few years to avoid short-term thinking; and trust in the township as a whole to use its resources, including cash, responsibly. A big check often seals the deal but, in this context, is also its own red flag.More From Other Writers at Bloomberg Opinion:
• Yes, We Can Make Rain. But It Won’t Fix Drought: Amanda Little
• Iowa’s Water Crisis Offers a Glimpse of the Future: Adam Minter
• Lead-Tainted Water Is Worst Infrastructure Failure: Tim O’Brien
(1) As per a screen of mergers and acquisitions conducted on the Bloomberg Terminal’s MA function on September 16, 2022. Includes all deals announced (but not withdrawn or canceled) in 2022 between US targets and acquirers valued at $100 million or more.
(2) Bluefield estimates that, on the wastewater side, 75-80% of the population use centralized systems and, of those, 85% are on a municipal network. On the drinking water side, 90% of the population use centralized systems and 86% of those are on municipal networks.
(3) That would appear to include $36 million of capital projects and running costs rising 5% each year. The township didn’t release a working model or detailed output for its scenario of retaining ownership. However, some assumptions in an FAQ document allow some calculations to be made. After grants and other revenue, about $27 million of capex needs funding; 20% under pay-as-you-go rate increases and the rest from borrowing. Assuming 20-year amortizing bonds at 4.2% (implied by the township’s assumptions), that incremental annual cost is about $2.2 million. Factor in cost inflation and an extra 1,500 accounts by year 10 (the township’s assumption, applied linearly) and the all-in rate rises by $425. That is higher than the township’s estimate of $356, so my crude calculation clearly isn’t fully aligned with their model. However, it would appear to confirm those extra costs are included in the township’s projection and even my crude, higher figure is lower than for the NextEra or American Water projections.
(4) The average amount paid by private buyers of water systems in the first half of 2022 was $3,743 per connection, according to Bluefield Research, a Boston-based water-sector intelligence company. NextEra’s offer for Towamencin’s wastewater system implies $13,815 per connection.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Liam Denning is a Bloomberg Opinion columnist covering energy and commodities. A former investment banker, he was editor of the Wall Street Journal’s Heard on the Street column and a reporter for the Financial Times’s Lex column.
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