A Self-Inflicted Swirly?

On Thursday (2/14/13), the Scranton Sewer Authority published a request for qualifications.  They are seeking a valuation on the Sewer Authority so the board can explore a potential sale.

Today, I want to discuss valuation methods.  Because they are not all created the same.

There are three main methods of valuation:

1. Comparable Sale
2. Cost-to-Build
3. Cash Flow

A comparable sale valuation is the most reliable and easiest to perform, but it is not really feasible when you are talking about municipal assets.  Why’s that?  In a word: volume.  There simply aren’t enough regular transactions to review.  In the US, there are about 36,000 municipalities and my research indicates that most publicly owned sewers tend to service 3-5 municipalities.  That means there are about 12,000 – tops – sewer systems in the US.

When you take into account geographic dispersion (i.e. the sparsely populated rural areas that rely on septic tanks and cesspools), that number is likely closer to 7,500.  And it’s not as though you can hop on-line and review listings for sewers.

So, that rules out a “comparable sale” valuation for the SSA.

What about cost-to-build?  That’s tricky because environmental regulations have changed so drastically since Scranton built its sewer system more than 100 years ago.  The cost to build a similar system would likely grossly outpace the actual “sunk cost” incurred by the City.  And then you have questions of efficiency and design: would a modern day system require the same amount of pipe, pumps and stations?  If not, do you still include value of the under-utilized or outdated pipes, pump stations and processing plants that our current system may have?  Because of the difficulty of addressing these issues, a cost-to-build valuation is typically not performed.

That leaves us with a cash flow valuation model.  This is the same type of valuation that Rich and Associates used to value the City’s parking asset.  A cash flow valuation is fairly straightforward.  Here’s a overview:

1. Determine the annual revenue (monthly bill times number of users)
2. Adjust for defaults
3. Apply an annual factor to account for anticipated future rate increases (a.k.a. “revenue growth factor”)
4. Adjust each year’s revenue for the “time value of money” and add up the adjusted annual revenue for a set period (probably 20 years)
5. Profit?

Because you are dealing with a utility, revenue is essentially guaranteed – don’t pay me? I will lien your property – so when it comes to a sale, the sewer authority is less of a company and more of a financial instrument – a purchaser would be buying a stream of future cash flows with a fixed maintenance cost, just like a loan portfolio.  This makes the purchase attractive to companies in low margin industries (such as other utilities!).  They make a profit on volume, not individual customers.  And with about 35,000 users, the SSA certainly has volume.

So what’s the bottom line?  My back-of-the-envelope calculations put the value of the SSA around $75-100 million.  Less an allowance for the EPA requirement to upgrade the treatment plant.  After paying off some debt and splitting proceeds with Dunmore (about an 80/20 split), I think Scranton will pocket somewhere in the neighborhood of $25-35 million – just enough to line the pockets of our Police and Fire unions via the $17,000,000 supreme court judgement and $10,000,000 minimum pension obligation in 2013.  How convenient!

There is one major bright spot in this deal: if the SSA is sold off, it will be regulated as a public utility and will therefore have its rate increases capped at certain levels and subject to review by the PUC.  Does this mean no more 44% single year hikes?  No.  But it does mean more transparency about why they are needed and where the money is going.  That’s always good.

FUN FACT: at the City Council meeting on 2/14/13, Council President Janet Evans stated that a sale of the sewers would allow the cost of upgrades to be spread out over more customers.  This is false.  Sewer users in Syracuse, for instance, would not help defer the cost of upgrades to a system in Scranton.  That’s because sewers are discrete entities – they are not interconnected in the same way highways are.  The only way costs would be spread over more rate payers would be if the new (and EPA required) processing plant was hooked up to multiple sewer systems.  But that can’t happen, because we don’t have any other privately owned sewer operations near Scranton.  Even if Allentown were to “privatize” their sewer, it would not be feasible to ship shit 50+ miles for processing.

FUN FACT #2: I spent three months working on a review of billing practices by a very large Utility during my time in Public Accounting.  When this utility ran new gas lines or electric lines, they carefully tracked the cost of the upgrade and then billed the customers who benefited from the upgrade via a new monthly charge.  There was no cost sharing.  But it’s still cute to see a disabled teacher spout off about how a major organization in a highly regulated industry does business.