A Monopoly Fallen on Hard Times - Taking a Chance With Manila Water
Manila Water Co. Inc. (PHS:MWC), a company once sitting at an enviable position as the sole provider of a life-essential resource to a dense urban area with a steadily growing population, has recently roused the ire of the Philippine government, headed by the volatile President Rodrigo Duterte.
The government's crackdown on the Manila-based water provider had a devastating effect on its stock. It collapsed more than 66% this year to ?9.46 Philippine pesos (19 cents) as of Dec. 16, a price not seen since 2007, wiping out more than a decade of gains:
This all started with the well-publicized water shortage earlier this year in Manila. The root cause of the water crisis ultimately traces back to the Philippines water regulator, Metropolitan Waterworks and Sewerage System (MWSS), and its delays on approving new water sources due to pressure from environmentalist and indigenous lobbyist groups. This is not really the fault of the water concessionaries like Manila Water, who have repeatedly warned of a potential water shortage in years past only to have their requests for new sources denied.
Nonetheless, this ended up drawing the Duterte adminstration's attention onto the cushy concessionary contract that Manila Water enjoys.
The contract is essentially a "cost-plus" deal that allowed the water company to charge a wide berth of expenses to the public and have a guaranteed rate of return on all of its capital expenditure. The agreement necessarily favored the water company when it was inked in the mid-1990s in order to attract private money. Back then, the water situation in the Philippines was a mess, with shortages that were far more acute than what was experienced this year. More than 30% of metro Manila had no coverage at all, and water waste (non-revenue water) was higher than 60%. The terms needed to be sweetened in order to attract outside capital and expertise to fix the situation.
Today's government finds the terms "onerous" and wants to get rid of them. That is not to say Manila Water didn't milk the deal for all its worth, from charging back dubious expenses such as sport events to under-investing in capital expenditures such as sewage capabilities and plowing earnings back as capital expenditures instead of paying them out to its government partners. The water company took full advantage of the deal with minimal scrutiny.
This bring us to today. While the water shortage was not necessarily the fault of Manila Water, it directed the government's and the public's attention onto the favorable contract that the company operates on, which triggerred an outcry and a renegotiation.
The renegotiation is looking to be quite one-sided. Despite the company already forgiving the billions of pesos that the arbitration court ruled was owed by the government to the company, MWSS still cancelled an originally agreed extension of the deal to 2037, letting it expire in 2022. Duterte even threatens military take-over of the water assets.
Why would any investor get in under these conditions? Rhetoric aside, I believe they will eventually agree on a watered-down version of the existing contracts with the existing water concessionaries.
MWSS has already indicated that they intend to pursue such terms. To fully renege on the water agreement and its extension will set a bad example and hurt the credibility of the government. They will have difficulty attracting another private operator to provide water if they provide no assurance that any agreement with the government can be relied upon, let alone any other public-private partnerships for future infrastructure projects. Even existing businesses would have to re-evaluate their contracts with the government as a risk factor.
I believe the watered-down deal will remove some of the return guarantees and also implement discipline and restrictions on types of expenses that Manila Water can charge back. The overall effect will be a lowered rate of return and earnings yield.
Manila Water has been earning a long-run return on equity of around 13%. Unsurprisingly, it is currently trading in deep value terrority, at one-third of its book value per share.
With the contract renegotiation debacle, I conservatively estimate that profits will be cut in half to a yield of around 9%, which is still a decent return with a comfortable margin of error in the current evironment where 10-year Philippine government bonds are yielding 4.6%.
The worst case scenario is MWSS decides to go with a different water operator after 2022, but that is a very unlikely outcome. The water company has billions of pesos of debt that are tied to the concessionary agreements, so pulling the rug will bankrupt the company. The regulators themselves are utterly incapable of running the water busines,s as proven in the 90s era, and I also believe any third party will demand similarly "onerous" terms to compensate for the newfound risk in doing business with the Philippine government.
If the more likely scenario of a renegotiated contract comes to fruition, this may be a once-in-a-life-time opportunity to own a regulated monopoly at a signficant discount. Investors with a very high risk appetite may want to take a position at the current price point.
Disclosure: I am long Manila Water.
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This article first appeared on GuruFocus.
