By Stephen Percoco, CFA From Seeking Alpha

Summary

Cash flow from CWCO’s Caribbean operations funds growth projects in Bali and Mexico.
Yet, the company has been unable to renew operating licenses there.
This raises the risk that CWCO may become overextended and lose its primary source of cash flow in the future.
On March 16, Consolidated Water (NASDAQ:CWCO) reported earnings for the 2014 fourth quarter that were modestly disappointing. Revenues of $15.3 million were flat with the previous year. Earnings per share of $0.07 were also flat, but below the consensus estimate of $0.13. The company recorded an impairment charge of $860 thousand, or $0.06 per share, in the quarter on its share of the Ocean Conversion (BVI) Ltd. (OC-BVI) joint venture. Management had previously hinted that an impairment charge was coming, but the magnitude of the charge may have been a surprise. I did not include an estimate for it in my 2014 fourth-quarter projection of $0.12 per share. Most other analysts apparently did the same.

The stock plunged on the news, falling $1.06 to close at $10.04, down 9.8% on the day. For a few days later, the stock struggled to hold on, drifting down to a low of $9.52, but it has since rebounded back above $12.00 after Janney Capital reinstated coverage with a “buy” rating.

Notwithstanding this recent rally, trading in CWCO has been lackluster since the stock peaked at $16.23 in August 2013. Each of the company’s operations faces challenges that have weighed on investor sentiment. Among these are:

(1) The inability since 2010 of CWCO to renew its operating license in Grand Cayman. My greatest source of concern currently is the lack of progress that CWCO has made in resolving its regulatory status in the Cayman Islands. CWCO’s license was set to expire in July 2010, but the company and the Cayman Islands government have extended the license so far in a series of five one-year agreements. During this five-year period, CWCO and its regulator, the Water Authority of Cayman (WAC), have not even begun formal negotiations on the details of a new regulatory regime. CWCO has fought the imposition of a regulatory model based upon a rate of return on invested capital (RCAM), as proposed by the WAC. The company has long held that RCAM results in a suboptimal outcome for customers (in large part because utilities typically find ways to circumvent the RCAM restrictions that waste customer funds). CWCO has also objected to WAC as its regulator because it is a competitor. Instead, it argues that the government should create a separate agency which would be charged with regulating both CWCO and WAC.

Although these may be valid arguments, the Grand Court of the Cayman Islands ruled in June 2014 that WAC is the appropriate agency to negotiate CWCO’s license renewal. In September 2014, WAC wrote a letter to CWCO saying that it had reviewed CWCO’s arguments against RCAM, but decided to use RCAM nevertheless as the basis for the license renewal. It said that it would send CWCO a draft RCAM license in due course.

In November, CWCO wrote a letter to the government’s Minister of Works, who oversees the Islands’ water supply, and said that it was prepared to accept the RCAM methodology, provided that the government would (1) agree to amend the legislation to appoint a new regulator, (2) appoint a referee in the interim to negotiate and oversee the license negotiations between CWCO and WAC, (3) guarantee CWCO’s exclusivity in the areas that it currently serves and (4) allow CWCO to submit a counterproposal to WAC’s 2010 draft RCAM proposal. CWCO would also agree that its RCAM proposal would continue the practice of having commercial water customers subsidize residential water rates.

While it is admittedly difficult to draw accurate conclusions from two separate events, it appears that the negotiations for a new license agreement have once again come to a halt. It is now more than six months since WAC promised to submit a draft RCAM license “in due course.” CWCO’s November letter seems to focus once again on the process of the negotiations and rejects the Court’s ruling that WAC is the proper entity to represent the government in the renewal of the operating license.

In my view, it is long past the time for negotiating the framework and process of the negotiation. CWCO should now be focused on obtaining its new operating license as quickly as possible. It should enter into negotiations with WAC immediately with only one condition: that the RCAM regulatory formula recognize and preserve the value that CWCO has already created and earned in its Cayman Islands operations. After twenty-five years of operations, the net book value of CWCO’s invested capital in its Cayman operations is likely quite low, so CWCO’s return on capital is probably quite high. As long as water rates paid by commercial and residential customers are reasonable, the negotiated RCAM formula should therefore preserve or “grandfather” the value already inherent in CWCO’s operations. If WAC insists on compromising this value, then CWCO would be justified in petitioning the Court to appoint a new regulator. As long as CWCO keeps the negotiating process from getting off the ground, however, it is placing its shareholders’ investment at great risk, especially if a new economic downturn prompts the government to impose a regulatory formula that is decidedly unfavorable (and unfair) to CWCO’s existing shareholders.

(2) The potential loss of OC-BVI’s operating licenses at Bar Bay, Tortola and Jost Van Dyke in the British Virgin Islands. OC-BVI has what appears to be a complex relationship with the British Virgin Islands that has been shaped by a compensation dispute arising from the government’s decision to revoke OC-BVI’s operating license for the Baughers Bay plant. Although the government assumed the operation of Baughers Bay in 2010, disputes over amounts owed by it to OC-BVI were not settled substantially until 2012 and 2013. Even then, a lingering disagreement over the valuation of the Baughers Bay plant at the time of transfer remains outstanding. During the 2015 first quarter, the government and OC-BVI agreed to appoint an appraiser to resolve this one remaining issue. On top of this, OC-BVI’s license to operate the Bar Bay plant, which was placed into service in 2010 just as the government was taking over Baughers Bay, expires in 2017. OC-BVI has not built a storage reservoir at Bar Bay as required under its licensing agreement because of the ongoing Baughers Bay dispute and the government’s failure to pay its bills on time. OC-BVI also continues to operate a small plant on the island of Jost Van Dyke, whose license expired in 2013. In response to ongoing uncertainty over the Bar Bay license renewal, CWCO recorded impairment charges totaling $1.06 million against the carrying value of its investment in OC-BVI in 2013 and 2014. It will probably record similar charges against the remaining $5.2 million carrying value of this investment over the next few years, unless the license is renewed. CWCO’s valuation of its investment in OC-BVI at the end of 2014 does assume, on a probability-weighted basis, that the license for the Bar Bay plant will be renewed in 2017.

(3) The inability of CWCO to resolve its regulatory status and comply with an order of the Public Utility Commission in Belize. In 2009, CWCO’s operating subsidiary in Belize (CW-Belize) was designated a public utility by the government. The PUC has required CW-Belize to complete several tasks and make some concessions including (A) giving the government an operating manual for its plant and (B) capping its exclusive water supply agreement at 450,000 gallons per day (which is below the plant’s 600,000 gallons per day capacity). Arguments on this order were heard in court in 2012, but the court has not as yet issued a final ruling. CWCO says that an unfavorable ruling could have a material adverse impact on its financial performance.

(4) A slower-than-expected start in Bali. Although construction was completed on a 790,000 gallons per day plant on the island of Bali in 2013, that operation generated only $328,000 in revenues in 2014 and had a negative gross margin. Nearby hotels, which the plant was designed to serve, have balked at committing to long-term contracts at the rates required by CWCO. As long as the local economy remains vibrant, CWCO believes that it will eventually find a sufficient number of buyers for the plant’s output, given the scarcity of water on the island; but it will probably take more time before CWCO’s Bali operations become a meaningful contributor to the company’s overall profitability.

(5) A long, expensive and still risky path to obtain all necessary approvals and begin construction on a proposed 100 million gallons per day desalination plant in Baja California, Mexico. CWCO has achieved several important milestones on the Rosarito project: The government of Baja California has asked the company to develop and submit a detailed proposal. It has partnered with a group of companies that have substantial resources and a successful track record of developing capital projects in Mexico. The company has also obtained a preliminary environmental permit and the proposed site of the plant has been rezoned for industrial use. While this project appears to be well-conceived and well-timed (given the severe drought conditions in California), it will probably take several more years and considerably more investment in order to demonstrate the concept and obtain all necessary regulatory approvals in order to begin construction. The long lead time may therefore place additional strains on CWCO’s resources, as well as the time and attention of management.

In the meantime, CWCO has purchased the land for the proposed project for $18 million and financed part of the purchase with a $10 million demand note secured by its desalination plants in the Cayman Islands. Hopefully, the company will soon obtain longer-term financing under more favorable terms or use the cash available on the balance sheet to pay off the demand loan.

Despite these concerns, I believe that CWCO does have the potential to become a global leader in water desalination, a business that is likely to enjoy superior long-term growth prospects given the world’s growing thirst for water. Over time, CWCO may be able to expand its operations to other parts of the Caribbean and pursue other opportunities for growth in Asia, Africa, the Middle East and parts of Latin and North America. It may also have the opportunity to build more desalination plants on Bali and in Indonesia (once the current plant begins to operate near full capacity). The Rosarito project in Mexico also has excellent potential, given the region’s growing scarcity of water. By itself, Rosarito could double CWCO’s equity market value, once major approvals are obtained and project financing is secured.

Before it can realize this potential, however, CWCO will have to utilize much of the free cash flow currently being generated by its existing operations in the Caribbean to finance these growth projects and avoid becoming overextended. Yet, the company risks losing its primary source of financing because of pending license expirations and the unsettled regulatory environments in Belize and the Cayman Islands. It must therefore seek closure on these license renewals and regulatory rulings as soon as possible.

The title of the article was meant to draw attention to the significant downside risks currently facing shareholders by CWCO’s inability to resolve its licensing renewals and regulatory status in its Caribbean operations. A better course of action for long-term-oriented shareholders, before selling their shares, would be to press management to resolve these outstanding issues without delay.

The analysis in this article was based upon CWCO’s public disclosures, including its financial statements (especially its 2014 10-K), conference calls, and press releases.

Additional disclosure: The author may sell his position in CWCO over the next 72 hours or at a later date.

For more on this story go to: http://seekingalpha.com/article/3072526-sell-consolidated-water
IMAGE: www.cwco.com