Pumps and Systems, January 2007
The Water Industry is a $90 to $100 billion collection of businesses engaged in the treatment and delivery of water. This age-old industry has recently become more dynamic due to technological advancements and scarcity. Whether for personal, industrial, or agricultural use (and in each application), water must be clean enough and provided in enough volume to complete each process. While the total water market should grow at close to 5 percent long-term, we believe the infrastructure and equipment segment will grow faster.
The largest component of spending within this industry continues to come from drinking water and wastewater utilities. Capital spending at utilities has grown significantly in recent years. In 2007, utilities expect to spend 14 percent more on capital projects than in 2006, slightly slower than 2006's 20 percent growth rate, but still a relatively quick pace. Table 1 details capital spending across various components.
Table 1.
Aging Infrastructure
The U.S. has had one of the most advanced and reliable water systems in the world for the last century, but these assets are nearing the end of their useful lives. Accordingly, we are beginning a long replacement cycle that should drive spending growth in the U.S. for the next 20 years. The EPA estimates that $277 billion must be spent on the drinking water system alone from 2003 to 2023. Spending on wastewater systems will likely double that amount. Table 2 shows the estimated spending by product type for drinking water systems.
Table 2.
About two-thirds of this spending is expected to go into the replacement of transmission and distribution assets, or pipes. Pipes represent the majority of the assets of any water utility, but utilities have generally not had an asset management plan that regularly replaces pipes. Depending on the material (steel, ductile iron, PVC, etc.), pipe has a useful life of 50-100 years, meaning a utility should replace 1 percent to 2 percent of its pipe each year. According to the Environmental Protection Agency (EPA), the replacement rate was closer to 0.1 percent in 2000, meaning it would take 1,000 years to replace the entire infrastructure. Spending on distribution assets rose at a CAGR of 9.5 percent over the last five years (see Exhibit 1), and the EPA estimates that the replacement rate will continue to rise, which could be another catalyst for driving growth.
Exhibit 1.
Distribution system spending flattened somewhat during 2006, reflecting a slowdown in housing starts and decreased spending on expansion infrastructure. We believe expansion spending will decline as a percentage of total spending as replacement spending picks up. Exhibit 2 shows that housing starts declined to their lowest level in five years, putting significant pressure on distribution spending in 2007.
Exhibit 2.
Despite the drag of a slowing housing market, we believe overall spending on distribution infrastructure will continue to rise due to the repair and replacement market. The residential building frenzy of the last five years has left pent-up demand for water infrastructure, which should be satiated in 2007. We expect overall spending on these hard assets to grow 3 percent to 5 percent for the year.
Scarcity and Efficiency
Water scarcity, or the need for efficient water use, will also drive spending. Scarcity will support an increase in water investments for three main reasons:
- Growing Population - The U.S. population continues to grow while its water supply does not. Population growth increases the strain on water resources, due to greater demand and more pollution, which in turn drives higher spending on water related products.
- Demographic Shifts - Two demographic trends are driving increased investment in water resources. First, some of the fastest growing areas of the country are in water-starved states such as CA, AZ, TX, and FL. Second, the trend towards urbanization means that current systems need to be enlarged and more water needs to reach urban centers.
- Limited Supply - There is a finite supply of clean water, and pollution shrinks that supply. Spending on the reduction of leakage and reusing wastewater is generally cheaper than either importing water or "manufacturing" it by treating seawater.
Regulation
The Environmental Protection Agency and state regulatory bodies continue to drive spending by raising the standards related to drinking water and wastewater quality. While utilities always have to spend on maintaining treatment standards, current spending is augmented by rules such as the EPA's reduction of the acceptable level of arsenic in drinking water to 10-ppb from 50-ppb. When the rule was originally set, it meant that about 4,100 systems would have to take some action to reduce arsenic levels.
As of June 2006, only 1,700 had sufficiently addressed the problem, leaving 2,400 water utilities to continue to evaluate and implement a variety of technologies to solve the problem. Utilities will have to make significant capital expenditures to upgrade their systems to new standards before the EPA gains the ability to take enforcement action in September 2008. 2006 was actually somewhat disappointing, in that fewer arsenic treatment systems were built than were expected. As a result of the 2008 enforcement deadline, 2007 should be a good year for treatment companies.
Consolidation
The water industry should continue to experience significant consolidation in 2007. Large water utilities have been both targets and acquirers: targets of infrastructure and private equity funds, and acquirers of many small systems throughout the country. We believe the pace of consolidation will increase, partially due to the IPO of American Water, which should free it of the capital constraints of its European owners. Consolidation should further increase the rate of capital spending, as privately owned utilities tend to spend more on their systems earlier, both to grow rate base and to provide better services to their customers.
These factors have already driven rapid growth in the water industry. Spending on water and wastewater infrastructure has grown at a compound annual rate of nearly 10 percent for over five years. We believe the last five years were slightly above trend, but that these factors should cause spending growth for water-related products and construction to be in the 6 percent to 9 percent range for at least the next ten years.
Exhibit 3.
Companies that sell treatment products should continue to have the highest growth rate in the industry, but distribution related companies should continue to benefit as well. Beyond this year, growth should moderate somewhat due to the slowdown in residential construction, though increasing replacement of aging infrastructure and adherence to new treatment standards should keep growth in positive territory.