The Wall Street Transcript recently interviewed Timothy M. Winter, a Senior Vice President at Jesup & Lamont Securities Corporation, on his outlook for water utilities. Key excerpts follow:
TWST: How has business been in the water utilities space through this economic downturn? I would guess it's not very sensitive.
Mr. Winter: The water utility group is among the least economically sensitive groups or sectors in the market. The bulk of retail sales and revenues are from residential customers who do not experience the economical swings in volume that the industrial or commercial classes do. Water utility bills are low enough that typical residential customers do not change consumption patterns. Roughly 3%-10% of retail revenues are derived from the industrial sector, where volumes sold are directly related to the economy. While industrial water sales have declined, we emphasize that a 10% consumption decline from the industrial customer class, which totals only 5% of retail revenues, doesn't impact the bottom line significantly. So yes, this is probably the most economically resilient group out there.
TWST: Has that resulted in the stocks holding up in this market?
Mr. Winter: There are only 10-12 publicly traded water utilities and the average year-to-date decline is 21%. However, most water utilities did not experience the significant declines in the fourth quarter of 2008. In addition, the largest four water utilities have performed very well year to date. California Water Service (CWT) is up 8%; American Water Works (AWK) is down 15%; American States Water (AWR) is down 7%; Aqua America (WTR) is down 8%. The group continues to trade at healthy multiples of roughly 17 times forward earnings, which, while at the lower end of their historical 15-year range, is still well above both market multiples and utility sector multiples. The electric utilities historically traded in a range of 10 to 17 times forward numbers for the past 15 years, but currently trade 9 times forward numbers, and that's after a little bit of a positive bounce. So yes, the stocks have held up as one would expect.
TWST: Where do we go from here? What's the outlook for the space?
Mr. Winter: I think fundamentally the outlook is as good as it has been in some time. The main drivers of earnings and cash flow for this group will continue to be a) regulatory recognition of infrastructure investment; b), the ability to consolidate the fragmented industry; and c) the ability to profitably privatize municipal water/wastewater systems. On the regulatory front, a big push for infrastructure spending and the environment is coming out of Washington. As a result, water infrastructure spending is publicly understood. We have also seen constructive rate decisions during these harsh economic times. The public continues to want cleaner, safer, higher quality water, and the public is showing that they are willing to pay for it. There is a lot of pipe replacement that needs to be done and other infrastructure work. The publicly traded water utilities continue to be granted a reasonable opportunity to earn on investment. In mid-2008, Aqua America's large Pennsylvania water utility subsidiary was granted a rate increase of over 80% of that requested. Importantly, the allowed ROE was raised to 11%, from 10.6%. In 2008, WTR received rate relief totaling $60 million in additional annual revenue, including $39 million in third quarter increases for Pennsylvania and New Jersey subsidiaries. We highlight that WTR subsidiaries were authorized roughly 81% of the requested $73 million in revenue increases during one of the more challenging economic environments faced in decades. During 2008, AWK was authorized rate increases totaling approximately $206.3 million, including $120 million authorized during the fourth quarter.
In California, which is home to four or five publicly traded water utilities, the regulatory environment continues to get better. A slate of new commissioners has committed to more constructive regulatory policies, including implementation of the California Water Action Plan (CWAP) and has given every indication it will issue more constructive decisions. In mid- to late 2008 several water utilities implemented a revenue-decoupling mechanism and an expanded expense balancing account mechanism. These mechanisms will serve to eliminate earnings volatility associated with swings in consumption and stabilize expenses from changes in supply mix. As a result, we consider future earnings streams to be more predictable with lower risk. I think the water utilities' primary source of earnings growth, which is rate increases, looks good. As far as consolidation goes, 80% of the country is served by municipalities, and the economy has severely weakened municipal budgets across the board. One of the ways that a municipality could improve their budget would be to sell a water or waste water system to a public trading company. They get the funds up front that they can use to fund a pension fund or use for other purposes. At the same time, they get a high quality operator and will have the political protection of the State Public Utility Commission in whatever state they serve to regulate the rates. So because the municipal budgets have weakened, we are seeing anecdotal evidence of more and more municipalities looking at that option.
TWST: What name should investors be looking at?
Mr. Winter: I think American Water Works looks very compelling at these prices. It trades at 12.5 times 2010 numbers and 118% of book value versus the group, which is at 17 times forward numbers and 175% of book, so on a valuation perspective, it's very, very attractive. The fundamentals of AWK are just as strong, and one could argue stronger, than some of the others in the group, given that they are in the process of filing rate increases for the neglected systems from the RWE ownership days. So there is going to be some accelerated earnings growth over the next couple of years. But over the long term, given their size, their expertise, they're going to be one of the biggest consolidators and they're going to be able to exploit the infrastructure needs of the country. So I think that one is very attractive.
TWST: Why the valuation disparity?
Mr. Winter: I think a lot of it has to do with the RWE ownership. They still own more than 51% of the company, they own roughly 60%. There the market knows that RWE is trying to do a secondary to get their ownership below 50%. And as a result, I think every buyside and sellside analyst is using a 15% to 20% discounted multiple until this secondary takes place. So that is one reason. I think the second reason is that because it's a $3 billion market cap name, it has basically fallen on the chair of the electric utility analysts in most places. The electric utility analyst seems to want to focus on other things. They don't quite take the time to understand the unique characteristics of the water industry. And therefore they compare the 12.5 multiple to the 9 multiple on the electric group and say it's expensive, without, I think, a full recognition that the risk is lower and the long-term earnings growth is higher, therefore it should trade at a higher multiple. And if you look, the water utility analysts generally have buy ratings on AWK, while the electric utility analysts generally have hold ratings. And the electric utility analysts, because of the size of the two groups, have a wider audience.
TWST: Is there a second name in the space?
Mr. Winter: Aqua America is a long-time favorite. The CEO is absolutely fantastic. The company's track record is second to none. And they've grown bigger, they've expanded from the Upper Midwest and the Northeast into the Carolinas and Florida and Texas as of recently — when I say recently, I mean the last few years — to continue their long-term strategy, which is to be the best consolidator and the best operator. And I think we have earnings growth returning to their historical 10% per year growth rate that investors enjoyed from about 1992 through 2006 before they had to take some time to digest the strategic acquisitions in the Carolinas, Florida and Texas. Now that those have been digested and the rates look like they're going into effect to recognize those investments, I believe we're going to see their earnings growth continue going forward. So I definitely like Aqua America. That stock has traded as high as 30 to 35 times forward multiples at its peak. And current multiples are, at least on a historical basis, at the low end of their range. We also like American States Water. California has dramatically improved the regulatory environment that they're going to benefit from and we see earnings growing from roughly $1.48 in 2008 to $2 in 2010.
TWST: So good growth there as well, despite being in California?
Mr. Winter: Right. The California regulatory environment improved once Mr. Schwarzenegger became Governor and appointed some new commissioners, and they implemented something known as the California Water Action Plan, which was a set of policies used by the regulators, consumers and companies to address the water issues. That policy is very favorable and it's resulting in constructive regulation that's going to help drive earnings of all of the California water companies. California Water is a very good company. I'd like to see it a little bit cheaper, but it is also going to benefit from this improved environment.