By Dezhong Xiao and Geoff Gage
We are often asked by investors and water companies where the highest profitability
lies in the global water industry. The water sector is fairly complex, with many attributes
making it less than straightforward to answer this question, including a large number of
private players with limited transparency on their financial performance, and volatility of
company performance from year to year.
Recently we looked at nearly 150 water companies around the world to shed some light on the real profitability landscape for our industry, looking at both EBIT and ROIC indicators over a 5-year period, with more than 1,500 data points in all.
In the following article, we share our analysis and thoughts on 1) profitability by type of company along the value chain, 2) individual company performance, 3) volatility in profitability by value chain position, 4) how profitability and size relate, and 5) how profitability and region of the world relate.
1. Depending on where they play along the value chain, global water companies have different profiles of business profitability.
Utilities have the highest average earnings before interest and taxes (EBIT) at 28%, reflecting their need to reinvest heavily into capital-intensive businesses to maintain operations.
Excluding utilities, chemical and operations/service companies have the highest profitability across the seven value chain positions at 14.4% and 13.5% EBIT, respectively. These asset service-oriented water companies demonstrate better profitability thanks to the recurring nature of revenue that allows them to focus on improving the bottom line, as compared to asset development companies that rely more on projects and project-related one-off product and service sales.
Water equipment and solution businesses have very similar average EBITs of 9.9% and 10.2%, respectively. Design and engineering, procurement, and construction (EPC) firms typically have the lowest average EBITs at 4.9% and 7.3% respectively, reflecting the highly competitive nature of their activities, relatively comparable pricing, and high project risk.
We have also looked at companies serving the residential & commercial water market as a separate category. These are providers of water treatment products such as filters, water coolers, softeners, and related services to households and commercial spaces, that have a stronger business-to-consumer (B2C) business nature as compared to the others. They achieved an average EBIT of 10.5%, similar to solution providers for the municipal and industrial sectors.
2. Besides where a company plays along the value chain, how well it performs as an individual company is equally important, as there is significant variation within a category
We see high variation in profitability of individual companies in all value chain categories apart from design, suggesting clear “winners” and “losers” on profitability within each category.
Utilities have the largest variation in profitability with a wide range from 8-66% EBIT, whereas the profitability band for design firms is much tighter within 4-7%. Solutions (0-28%), operations / service (5-30%) and EPC firms (-17-32%) also show large variation in average EBIT.
There could be many different potential market factors affecting an individual company’s profitability, such as industry vertical, specific water application, customer segment, and geographic region in which the company operates. The main factors vary for different value chain positions as we have learned based on numerous projects that Amane has delivered through the years. Hence, it is important to carefully examine your target market through a tailored study to understand the specific market dynamics for any investment decision.
3. Different value chain positions also show varying degrees of profit volatility over a 5-year period
Standard deviations of each company’s 5 years EBIT% are used to indicate the profit volatility. Among the different groups of companies, the highest volatility is in utilities and solution providers with 4.2-4.3% average standard deviation, as compared to the most stable category of design firms and residential & commercial companies with only 1.1-1.4% standard deviation.
Because of the specialist expertise and know-how required, many solution providers are relatively small in size. As observed across all companies assessed, smaller size companies are more susceptible to business fluctuations (see our later analysis on profitability by company size). However, the high profit volatility for utilities is rather unexpected considering the generally stable nature of the utility business and the large company sizes. The reason behind the volatility is geographical, with the high standard deviation value distorted by a few utilities, all from developing countries. This implies a more challenging management and operation environment for water utilities, likely due to fast-changing social and economic development activities coupled with less mature utility operation in the developing countries.
4. Small companies <50M have lower profits with significant volatility, while larger companies show modest profitability but with better stability
Excluding utilities, as their much higher EBIT% would have skewed the result, the average EBIT profits of the rest of companies improve from -4.7% to 12.2% as the company size increases from <$50 million towards $1 billion annual revenue (Fig.4). Multi-billion revenue companies demonstrate a decline of EBIT% with increasing size. However, this observed pattern is distorted due to the composition of large company categories.
Excluding the above companies (i.e. utilities, design, EPC and Chinese companies), we can still see EBIT profit improvement with increasing size for companies below $1 billion. But different from the previous pattern, the multi-billion revenue companies (L and XL in Fig. 4) achieve marginally higher average profits than medium size companies with increasing size.
On the other hand, the stability of profit shows a clear increase as companies become larger in size for both cases (i.e. the reducing volatility with company size), thanks to the breadth of portfolio, diversified business and matured management in those large companies.
5. Across regions, Chinese companies have higher 5-year median EBITs, but returns on capital are more in line with the other regions
The 20.6% average EBIT achieved by Chinese companies is more than twice as high as the 9.1% from the next highest region, North America (Fig.5a), raising an interesting question – is the largest water market also the most lucrative one? Indeed, stringent local water discharge regulations have driven up the market demand for more advanced water treatment solutions, which typically allow suppliers to make better margin than commoditized solutions. We have also seen many fast-growing Chinese local companies catching up on product and service performance and quality with leading international competitors. However, the much higher EBIT% reported should still be taken with a pinch of salt, as few if any international companies report a much higher profitability for their Chinese business than other regions. Considering that the Chinese water market is still in the development stage, we believe the view shown by ROIC% comparison (Fig.5b) is closer to the market reality with Chinese companies achieving 8.2% return on invested capital (ROIC) on par with their Western peers.
Other Asian markets, on the other hand, are highly fragmented with many low-cost local competitors. The low profitability of non-Chinese Asian companies also reflects the strong competition in this region.
Moving to the west, companies from Europe and North America show remarkably similar performance on both EBIT and ROIC, suggesting similarity between mature markets but also partially due to the fact that many of these companies have significant business presence in both regions.
6. Broadly speaking, residential & commercial, chemical and equipment firms are the most “attractive” in the water value chain considering both EBIT profitability and return on capital
Residential & commercial companies provide the highest ROIC of 11.7% among all categories, indicating a high efficiency of cash generation with invested capital. Although the 10.5% EBIT achieved is only ranked average, considering its low EBIT volatility (Fig. 3), it is reasonable to conclude that the residential & commercial market is one of the best performing water company categories in terms of profitability. This also fits with the growing interest in this particular segment, with a rising number of M&A transactions observed in recent years.
Chemical and equipment providers also demonstrate good profitability with decent ROIC and EBIT performance. Though having the highest EBITs, utilities only provide an average return on invested capital of 7.1% due the nature of a business that requires constant capital investment to drive cash generation.
What will drive the profitability of water companies going forward, especially with the ongoing pandemic that has been changing every aspect of our industry and the world? It is a time of great uncertainty, but we can draw several conclusions based on analysing the most successful water companies and insights from conversations with our clients and other participants in the wider global water industry.
Several key profitability drivers from the pre-COVID world are likely to remain:
Performance-based water treatment and management services, and solutions improving business and operation resilience could be accelerated by the pandemic:
“The residential & commercial market is one of the
best performing water company categories in terms of
profitability…Chemical and equipment providers also
demonstrate good profitability with decent ROIC and