The industry continues to be bolstered by strong growth in the residential construction segment—driven by near-full employment, wage improvement, and housing supply shortage. While the residential segment’s growth rate is beginning to decelerate, FMI speculates that the influx of first-time, millennial homebuyers will continue to push demand. Infrastructure construction spend—particularly related to transportation (e.g., airport, mass transit, railroad, water ports) and nonbuilding structure construction (e.g., power, highway, water, sewer)—has also contributed to strong 2018 performance.
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Significant investment across the power, water, and sewer segments is necessitated by the demands of a growing population—the Census Bureau projects that the population will reach ~350 million by 2030.(1) Positive macroeconomic trends also reinforce the need for such investment to support the corresponding growth in commercial and industrial sectors. The demand for utility services (i.e., electric, natural gas, and water) has outpaced current capacity and the aging infrastructure already in place has become increasingly unreliable. Going forward, significant opportunity exists for industry operators specializing in underground pipeline construction services to replace existing infrastructure amidst heightened regulatory scrutiny. During 2017, investor-owned utilities invested ~$50 billion in their transmission and distribution networks.(2) These utilities are in the early stages of multi-decade spending initiatives and are becoming increasingly reliant on third-party construction service providers due to aging utility workforces.
The communication construction segment (up 5 percent year-over-year) is experiencing similar tailwinds. Deloitte estimates that $130 to $150 billion of fiber infrastructure investment will be needed over the next five to seven years to “support broadband competition, rural coverage, and wireless densification.”(3)
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The emergence of 5G wireless technologies marks the next great shift in telecom infrastructure (i.e., from wireline to fiber). Without the far-reaching densification of deep fiber, “carriers will be unable to support the projected four-fold increase in mobile data traffic between 2016 – 2021.”(4) Multi-year initiatives led by telecom service providers will create fiber installation, small cell deployment, and on-going maintenance contract opportunities for those operators with the requisite fiber construction capabilities.
Though there are some that expect an economic pullback within the next year or two, FMI Research projects ongoing growth through the forecast period (4.3 percent annualized growth from 2018 to 2022). That being said, the rate of such growth is expected to decelerate and ultimately plateau around 3 to 4 percent by 2020. In the meantime, contractors and utilities continue to capitalize on low interest rates (still comparatively low despite the end of the Fed’s quantitative easing initiative), taking on additional work to tack on to already record-high backlogs.
During the second quarter of 2018, the Associated Builders and Contractors’ Construction Backlog Indicator expanded to an all-time high of 9.9 months (up 12 percent over Q1) and FMI’s Nonresidential Construction Index remained above fifty for the 26th consecutive quarter (scores above 50 indicate expansion). The impact of the current administration on the construction industry is also worth mentioning. Decreasing regulation and the potential for a trillion-dollar infrastructure plan could have a transformative impact on industry spend in the near future—particularly in the heavy civil and nonbuilding structure construction segments.
Industry Spotlight – Water / Wastewater
The water and wastewater segments will play a critical role in stabilizing utility-related construction through the forecast period. FMI Research projects that both segments, taken together, will grow at an annualized rate of ~4 percent from 2018 to 2022. While water and wastewater construction spend is not expected to rise to the level of industry highs recorded in 2008 (just prior to the residential construction collapse) it is expected to come close by the end of the forecast period. Demand in both segments will be driven by the replacement of aging infrastructure, population growth, residential and utility construction, and state and local government spending. In addition, the opportunity for on-going, lower-margin (but less cyclical) maintenance work will grow as additional capacity is installed. This segment accounted for ~$14 billion in revenues during 2017 (not accounted for in the FMI forecast).(5)
While per capita water consumption is expected to decrease as a result of greater conservation measures taken in response to higher usage rates (approved by Public Utility Commissions to fund infrastructure improvements), any corresponding decrease in water supply demand will be offset by the incremental downstream needs of a growing population and increasing commercial and industrial activity. In addition, the adverse effects of numerous natural disasters—including hurricanes and wildfires—continue to place additional stress on an already-strained water supply.
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Generally speaking, new water and sewer pipeline construction accompanies new residential developments in sprawling metropolitan areas—this is currently the case in Southeast and Southwest regions. In addition, extensions to existing pipeline infrastructure are needed in urban cores where growing populations require more water and generate more waste. Demand for new construction pales in comparison to the opportunity that exists for pipeline owners to repair and replace their aging infrastructure.
Reliability risks associated with aging water and sewer pipeline infrastructure were exacerbated by neglect following the downturn in 2008. State and local governments facing severe budget deficits (as a result of decreasing property tax revenues) were forced to choose between competing objectives (i.e., affordability and quality). In order to stay afloat, municipal water utilities chose to allocate their limited funds toward maintaining the status quo—delaying the inevitable capital-intensive replacement of at-risk infrastructure. The American Water Works Association’s (AWWA) cites the renewal and replacement of water infrastructure as the most important issue faced by the water industry.(6) Its findings suggest that vast majority of underground water pipelines in the US are either nearing or have already surpassed their useful life and that over $1 trillion in investment will be needed through 2035 to adequately address the current state of the country’s water-related infrastructure.(7)
The American Society of Engineers estimates that there are over 240,000 water main breaks across the country each year; according to Deloitte, the direct costs of these breaks has been pegged at ~$2.6 billion per year.(8) In theory, these unforeseen costs are covered by the usage rates charged to residents by their local municipal water utilities.
In the United States, small, municipal water utilities are largely responsible for all costs tied to the maintenance of our water and sewer infrastructure (less than 1 percent of funding comes from federal sources). According to Deloitte, this is problematic given that less than one third of water utilities are able to cover maintenance costs despite accelerating usage rates from population growth.(9) Federal funding to water and wastewater industry has varied historically and, ultimately, failed to keep pace with the level of assistance that has been needed.
The newly-passed Water Infrastructure Act of 2018 provides some much-needed federal support in the near-term. The new law authorizes $3.7 billion for new Army Corps of Engineers projects and $4.4 billion for drinking-water projects. It also reauthorizes the Water Infrastructure Finance and Innovation Act (WIFIA) at $50 million and the Drinking Water State Revolving Fund (DWSR) at ~$4.4 billion. These funds can be utilized for loans, loan guarantees, bond insurance, and project refinancing. While this is certainly a positive development for the industry on its face, it remains a far cry from the influx of capital that organizations like the AWWA believe is needed—especially considering the current administration’s expectation that local water utilities become self-sufficient over time as a result of increasing deregulation.
Given the capital constraints faced by small municipal water utilities, select municipalities have become sellers to large, investor-owned organizations looking to acquire their operations. The water industry is ripe for consolidation. To characterize the water utility space as highly-fragmented is an understatement. There are over 50,000 community drinking water systems in the United States; compare that with 3,300 electric utilities.(10)
Large, private operators of scale are capable of making the capital investment required to upgrade aging infrastructure and better-suited to maintain it, going forward. These investor-owned companies are enticed by the attractive revenue streams from allowable usage rates (which are likely to increase as the costs to treat and distribute water become more transparent to the public) and are realizing incremental margins through the implementation of a variety of system upgrades and service improvements (e.g., asset resilience monitoring, online billing). While acquisition as a solution is logical on its face, communities have always been hesitant to give control of their drinking supply to a third party.
Not only are these private buyers rolling up complementary facility and distribution assets (i.e., water and wastewater) to achieve economies of scale, but they are also evaluating industry-specific self-performing construction companies as acquisition targets. These capabilities enable them to handle infrastructure expansion, rehabilitation, and maintenance in-house. Other rollups focused on providing industry-specific construction and engineering services may look to vertically integrate for the purpose of securing blanket contracts with large utilities and pursuing large, complex design-build projects.
Nick Illuminati is an associate, and Dan Shumate is a director, at FMI Capital Advisors Inc., FMI Corporation’s investment banking subsidiary.
- U.S. Census Bureau
- Edison Electric Institute
- Deloitte, Communications infrastructure upgrade
- Cisco, Visual Networking Index Forecast
- IBIS World
- Deloitte, The aging water infrastructure: Out of sight, out of mind?
- Water Finance and Management, The Outlook for Partnerships and Private Investment: Q&A with NAWC CEO