Book a Potential 131% on This Overpriced Stock's Slide

The water crisis in Flint, Mich., started nearly two years ago but recently reached a boiling point with massive protests and national media coverage. Corrosion in underground lead service pipes and poor water quality have been blamed for an outbreak of Legionnaires' disease that killed at least 10 people.

The city has issued multiple warnings over the past year, while lawsuits are piling up for everything from civil rights violations to property damage and health risks. One lawsuit even requires all the lead water lines to be replaced at no cost to customers. 

While it's unclear how much the crisis will cost Flint, it highlights a serious issue across the entire country -- one that could cost water utilities hundreds of billions in infrastructure repair.

Water Utility Problems Go Far Beyond Flint

Flint's water problems began in April 2014, when the city decided to switch its water source from Lake Huron to the Flint River to save money. The change was noticeable and residents immediately started complaining about discolored and foul-smelling drinking water. But it wasn't until late last year that the issue caught national media attention and uncovered a problem that extended far beyond Flint.

According to the Environmental Protection Agency (EPA), just nine states are reporting safe levels of lead in their water supply. States must inform the public when the amount of lead in the water supply exceeds a federally regulated allowance. As a result, they may need to replace a massive amount of infrastructure over the coming years.

In a recent study, Fitch Ratings estimated the Flint crisis could force water utilities to replace 6 million lead service lines at a cost of $275 billion. While that's lower than the $385 billion the EPA estimates is needed in infrastructure repair through 2030, the spending could now come over a much shorter time period.

Water utilities haven't yet updated their planned spending budgets, but it may not be long before investors get the bad news. Higher capital investment and maintenance expenses could eat into cash flow and tarnish the bullish investor sentiment the industry currently enjoys.

Aqua America (NYSE: WTR) is the second largest publicly traded water utility in the United States, serving customers in eight states with around 850,000 water connections. Water services account for 88% of the company's total revenue, making it ripe for a fall as spending ramps up.

Free cash flow already turned negative last year on $394 million in capital spending. And operating and maintenance expenses jumped 7% in 2015 to $309 million. As the water infrastructure story develops, I expect the company's cap-ex budget to increase substantially and further detract from free cash flow.

Management currently estimates $1.1 billion in capital spending over the next three years, almost two-thirds of which is expected to be designated for main and service lines, but this number could quickly increase.

Aqua America in Danger of a Quick Drop

Between mid-September and early February, shares of Aqua America advanced more than 30% even as the broader market struggled. The rally came as the company wrapped up 2015 with the aggressive acquisition of 16 water utilities. But the consolidation could soon become a burden to richly priced Aqua America as infrastructure spending needs climb.

With a trailing price-to-earnings (P/E) of 28.1, WTR is trading at a nearly 17% premium to its average earnings multiple of 24.1. Furthermore, of the five largest publicly traded water utilities, Aqua America has the second highest P/E and highest enterprise value (E/V) to revenue ratio.

Water Utilities

While analyst expectations for 5% sales growth and 6.3% earnings growth in 2016 are not out of the question, they may be too high considering the potential for spending to ramp up quickly. Meanwhile, WTR is pricey enough that there is little room for error.

With the need to upgrade the country's utility infrastructure putting a big question mark on cash flow, I see very little upside left in shares. In fact, I anticipate a decline back to the $28.50 area. That's roughly 11% below the current price, but we can leverage that potential move into much bigger profits with a simple put option strategy.

With WTR trading for $31.95 at the time of this writing, we can buy a WTR Jun 30 Put for a limit price of $0.65 per share. That is a put option with a $30 strike price that expires on June 17. Each contract controls 100 shares, costing you $65 per contract.

The trade breaks even at $29.35 per share ($30 strike price minus $0.65 options premium), which is 8% below the current price.

If shares hit my $28.50 target by the June expiration, the option will be worth at least $1.50 ($30 strike price minus $28.50 stock price) for a 131% gain in 79 days. To take advantage of any near-term volatility and weakness in shares, I want to set a good 'til cancelled (GTC) order to sell the option for $1.50. 

So, we're risking as little as $65 for the chance to make a 131% profit in just over 10 weeks. I like those odds. 

But if you're interested in boosting your odds even further, one of my colleagues is sharing a little-known secret that can increase your chances at winning to as high as 90% per trade. 

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