Lazard Insights

The Value of Water

Summary• At Lazard, sustainable investing does not exist

as a separate discipline. Instead, we regard a company’s management of human and natural capital, alongside its financial management, as a critical component of fundamental security analysis .

• To demonstrate how this aspect of management factors into our analytical approach, we present a brief overview of how it applies to our views of the beverage industry.

• One of the greatest risks to the beverage industry’s margins lies in its management of natural capital. Water scarcity could increase its costs, erode its margins, and disrupt its agricultural supply chains. In addition, growing environmental concerns raise reputational risks.

• Water stress management, particularly operational improvements relating to water efficiency, can reduce vulnerability to climate change and drought, and provide a significant competitive advantage to global beverage competitors.

Lazard Insights is an ongoing series designed to share value-added insights from Lazard’s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author. The original recording can be accessed via www.lazardassetmanagement.com/insights.

Dennis Neveling, CFA, Managing Director, Research Analyst

Sustainability analysis has taken its place alongside financial analysis as an essential component of investment research. As consumers and businesses favor products and services, and governments adopt policies designed to promote the future of our planet and its populations, a company’s environmental impact, its treatment of employees, customers, and the communities where it operates, and its management practices have come to count critically in the valuation of its stock. At Lazard we have been incorporating our views on corporate governance as well as stewardship of human and natural capital into our analysis for over a decade. To ensure our analytical approach is coherent and consistent across our investment platforms, we have developed proprietary materiality mapping frameworks. (Exhibit 1).

Exhibit 1Putting a Value on ESG

Phase 1: MaterialIssues Assessment

- Materiality Mapping Sessions (11 Sectors)

- Identifying key E, S, and G issues for each sector

- Bringing together equity and fixed income perspectives

Phase 2: FrameworkDevelopment

- Developing a framework for material issues

- Determining key quantitative and qualitative metrics

Phase 3: Build a DifferentiatedInvestment View

- Conduct bottom-up research

- Engage with company management

- Gather evidence

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Context Is CrucialMateriality mapping enables Lazard’s investment professionals to contextualize the human and natural capital issues within each economic sector. Consider the “E” in ESG—environmental impact—by way of example. By the very nature of the processes involved, the most conscientious steelmaker will never measure up to a run-of-the-mill soft drink bottler. In fact, they have quite different environmental priorities. For an industry in the materials sector, like steel, energy consumption might constitute the critical environmental variable. For a consumer staple such as beverages the critical dimension might be water usage, as we shall demonstrate in a brief case study. But even within one sector or one industry, we have learned that context is crucial. Companies operating in different geographies may be dealing with entirely different regulatory regimes, they may be producing competitive products with entirely different processes, or one competitor may be facing societal pressures that another may not.

Over the last two years, Lazard’s analysts have completed a systematic materiality mapping exercise to determine the human and natural capital issues that are most relevant to each economic sector and assess the exposure companies within those sectors have to those issues. The ultimate goal is to determine what impact the exposures might have on the company’s financials in the future.

The mapping proceeds from proprietary frameworks that help fit the human and natural capital challenges and opportunities in each sector into financial models and company forecasts. We draw on company reports and alternative data sets, which our fundamental analysts develop in collaboration with our quantitative investment group in many cases because of their complexity. We supplement this quantitative input with site visits and regular dialogue with corporate managements. The ongoing engagement lends our sustainability analysis the timeliness lacking in historical data. The numbers can only tell where a company has been. Engagement gives us an indication of where it is going. Within sectors and across asset classes, the mapping works to guarantee consistency in our views on human and natural capital performance and their influence on stock valuations and bond ratings.

Environmental Concerns Bubble Up in BeveragesThe beverage industry offers a case study of how our materiality mapping frameworks can improve investment decision-making in practice. Begin with the fact that drinks have historically generated high returns (Exhibit 2).

Now consider that this enviable margin relies to a great extent on the availability of an increasingly scarce and widely underpriced resource: clean fresh water. Water accounts for 5% or less of the industry’s cost of goods sold, but the long-range threat to a stable and low-cost water supply extends well beyond the obvious places—the deserts of the Middle East, India, and northern China, shaded in brown—to soft drink bottlers in Texas and vintners in Italy (Exhibit 3).

Looking at the industry a bit more closely, by analyzing company reports and comparing subsector benchmarks, reveals that spirits distillers, largely because of their distillation process, are the most intensive users of water and soft-drink bottlers are the most efficient (Exhibit 4).

Exhibit 2Juicy Margins

0

10

20

30

40

ROEEBITDA Margins

32.9

19.1

27.6

14.4

(%)

S&P 500US Beverage Companies

As of 5 May 2020

Source: Lazard, FactSet (2020 estimates)

Exhibit 3A World Hung Out to Dry

As of August 2019

Source: World Resources Institute

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This closer view also has bad news for environmentally conscious fans of craft brewers: scale matters. The optimally sized beverage facility turning out between 250,000 and 500,000 kiloliters of product annually uses 2.5 times less water, 3.8 times less energy, and emits 3.25 times less global warming gases per unit of output than a facility turning out 50,000 kiloliters (Exhibit 5).

Water PressuresExamining these aqueous facts of life through an investment lens would persuade a financial analyst that the greatest risk to those juicy beverage margins lies in the environment itself, whether as a result of climate change, population pressure, or popular perception. And as analysts on the ground, we see mounting evidence that the water risk is far from hypothetical. Surveys of consumers, particularly those in the rising generation, indicate an increasing awareness of resource depletion. Several governments, looking to increase state revenues, are moving toward raising the price of access to local water sources.

Against this macroeconomic backdrop, we arrayed the beverage companies in our coverage universe against a 0–5 scale of “water stress exposure.” (The World Resource Institute developed the scale by combining 10 physical risk factors and three reputational risk factors.) We could find no greater indicator of the global nature of water risk than the fact that four of the five most exposed companies operate in developed markets (Exhibit 6).

We then took a further step, translating water risk into investment risk by plotting a company’s water stress exposure against its EBITDA1 margin. We postulated that the higher a company’s margin, the greater its ability to sustain profits through drought and controversy, and conversely, the lower its margins, the narrower its barrier against water stress, with the combination of relatively low margins and a high score on the scale of water stress equaling an investment risk to consider avoiding (Exhibit 7). In our analysis, beer brewers in the emerging markets and soft drink bottlers in water-short Australia and Spain dominated that unfavored category in the lower right quadrant.

Exhibit 4Water “Proofs”

Water Intensity by Beverage Category

0

10

20

30

40

Soft DrinkBottlers

BreweriesWineriesDistilleries(ex: cooling water)

Distilleries

32.7

10.9

3.9 3.4 1.8

As of 31 December 2018

Source: Company reports, BIER-2018 Benchmark, CDP, WRI.org, Lazard estimates

Exhibit 6H2O Risks

Water Stress Exposure (0–5)

0 1 2 3 4 5Beer-EMCSD-EMCSD-EMBeer-DMBeer-DMCSD-DMBeer-DMCSD-EMCSD-DMCSD-DMCSD-DMCSD-DMCSD-DM

Spirits-DMWine-DMBeer-DM

Spirits-DMSpirits-DM

Beer-DMSpirits-DMSpirits-EM

Beer-EMBeer-EM

Spirits-EMCSD-DMBeer-DM

Spirits-DMCSD-DMBeer-EM

Water Risk

As of December 2018

CSD stands for carbonated soft drink.

Source: Lazard estimates, Company reports, BIER-2018 Benchmark, CDP, WRI.org

Exhibit 5Big Can Be Beautiful Too

Production RangeWater Use Ratio (L/L)

Energy Use Ratio (MJ/L)

Emissions Ratio (g C02e/L)

<50,000 kL 5.65 2.17 158.08

50,000–200,000 kL 2.92 0.74 65.53

200,000–500,000 kL 2.24 0.57 48.64

>500,000 kL 2.31 0.65 53.13

As of 2017

Source: Lazard estimates, Company reports, BIER-2018 Benchmark, CDP, WRI.org

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Finding Value in Water Sustainability Companies taking steps to improve their environmental practices can present investment opportunities equal to or even more attractive than companies that are already at the top of their game. The soft drink subsector offers a case in point. Many publicly traded bottlers report a water intensity ratio, which measures the number of liters of water used to produce a liter of their carbonated product. The number came down slowly but steadily over the most recent five years for which we have figures, starting in 2013. By 2018, the industry average stood at 1.82 (Exhibit 8).

A bottling plant recently brought on line in Texas by the industry’s best-in-class company, which has announced its intention to get close to 1.00, has a ratio between 1.30 and 1.40 by our estimate.

In tandem with decreased water intensity, bottlers have undertaken water replenishment programs, through intensive recycling and returning the fresh water they consume to the local environment. The industry leader in this metric first went to net zero five years ago in its own manufacturing processes. Today, through community projects such as dam and creek restoration, it has actually managed to add more fresh water into the environment than it takes out. It replenishes 155% of the water it uses globally during manufacturing. An environmental approach like this has vital investment implications, in our view. We believe companies that have made proactive investments to conserve the world’s water supply will benefit tangibly in the not-too-distant future as water scarcity becomes an increasingly urgent concern and its mitigation moves up the policy agenda.

Water Conservation Flows UpstreamEven as companies across the industry, in brewing and distilling as well as bottling, are engaging in direct water conservation, a small number have begun to look for ways to reduce water consumption all along their supply chains. Initiatives to engage with the fruit, grain, and sugar cane growers who supply the industry’s agricultural raw materials have been few to date, but sweeping in scope. One global brewer is working with 3,200 farmers to develop drought-resistant grains and implement best water efficiency practices in barley cultivation worldwide. A soft drink bottler is pushing growers’ associations to establish water efficiency standards for cultivating citrus, sugar beets, and sugar cane.

Such initiatives in our view epitomize enlightened self-interest in an era of heightened environmental awareness. They hold the promise of improving the farmer’s lot and conserving an increasingly scarce resource, to be sure. At the same time, they afford the prospect of ensuring reliable supplies through a time of uncertain climate and rising environmental awareness. We expect many more projects will follow these early efforts.

The Key IngredientRegulation, technological innovation, and changing consumer psychology have created a growing demand for sustainable investment products and solutions that go beyond generating above-market returns to benefit the environment and society at large. We believe the key to meeting this twofold objective lies in applying cutting-edge fundamental research to inform investment decisions and identify those companies that can accommodate and adapt to ever-increasing expectations.

As the beverage example shows, sustainability has many profound and far-reaching implications. By providing for the environment in this case, the industry’s leaders are securing their place in a rapidly evolving future—and providing prudent investors with a durable long-term asset.

Exhibit 7Margin Preservers

EBITDA Margins vs. Water Stress Exposure

MostVulnerable

50(%)

Water Risk

40

30

20

10

01 1.5 2 2.5 3

Spirits-EM

Spirits-DMSpirits-DM

Spirits-DMSpirits-DMWine-DM

Spirits-DM

Beer-EM

Beer-DMBeer-DM

Beer-DM

Beer-DM

Beer-DMBeer-DM

Beer-EM

Beer-EM

CSD-DM

CSD-DM

CSD-DM

CSD-DMCSD-DMCSD-DM

CSD-DMCSD-EM

CSD-EM

CSD-EM

Spirits-EM

As of December 2018

CSD stands for carbonated soft drink.

Source: Lazard estimates, Company reports, BIER-2018 Benchmark, CDP, WRI.org

Exhibit 8Drier Goods

Carbonated Soft Drinks Industry - Water Intensity

1.7

1.8

1.9

2.0

201820172016201520142013

Water Stress Exposure

As of 31 December 2018

Source: BIER-2018 Benchmark, CDP, Company reports, LAM estimate, WRI.org

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RD00199

Notes1 EBITDA represents earnings before interest, taxes, depreciation, and amortization.

Important InformationPublished on 28 May 2020.

Mention of these securities should not be considered a recommendation or solicitation to purchase or sell the securities. It should not be assumed that any investment in these securities was, or will prove to be, profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. There is no assurance that any securities referenced herein are currently held in the portfolio or that securities sold have not been repurchased. The securities mentioned may not represent the entire portfolio.

The MSCI Emerging Markets Index is a free-float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. The MSCI Emerging Markets Index consists of 26 emerging markets country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates. The index is unmanaged and has no fees. One cannot invest directly in an index.

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