American Water Works: Inorganic Growth To Propel Stock Price And Dividend

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 |  About: American Water Works Company, Inc. (AWK), Includes: XLU
by: Jeff Williams

Over the past couple of months the Utility Sector (NYSEARCA:XLU) has been quite volatile. Some of the reasons for this uncharacteristic volatility have been the threat of rising interest rates, concerns over future CAPEX spending and some profit taking after a nice sector run. Having stated that, this recent volatility can provide some excellent opportunities, if you wish to invest or add to your investment in the utility sector. American Water Works Co. Inc. (NYSE:AWK) is a utility company worth further investigation.

There are many advantages to adding utilities to your portfolio. Two main advantages include lower volatility and high dividends. So, if the market is getting unpredictable or "frothy," a well picked utility can add some stability to your portfolio while paying a solid dividend. As of August 31, 2013, American Water Works had a market cap of $7.25 billion, a beta of 0.32 and a yield of 2.74%.

American Water Works provides water and wastewater services to residential, commercial and industrial customers mainly in the United States. American Water Works, which is the largest investor-owned water and wastewater utility company in the United States, through its subsidiaries serves an estimated 14 million people throughout 30 States and Ontario, Canada. As the chart below indicates, the majority of American Water Works customers are located in New Jersey, Pennsylvania and Missouri.

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In the course of pursuing the company's inorganic growth strategy, the company periodically acquires water utilities and wastewater utilities by making acquisitions in its existing markets and certain markets in the United States where the company does not currently operate its regulated businesses.

In the section below I will analyze aspects of American Water Works inorganic growth strategy. From this evaluation we will be able to see American Water Works' profitability, debt and capital, and operating efficiency. Based on this information, we will look for strengths and weaknesses that the strategy has produced in the company's fundamentals. This should give us an understanding of how the company has fared over the past few years and will give us an idea of what to expect in the future.

Profitability

Profitability is a class of financial metrics used to assess a business' ability to generate earnings compared with expenses and other relevant costs incurred during a specific period of time. In this section, we will look at four tests of profitability. They are: net income, operating cash flow, return on assets and quality of earnings. From these four metrics, we will establish if the company is making money and gauge the quality of the reported profits.

  • Net income 2010 = $268 million
  • Net income 2011 = $310 million
  • Net income 2012 = $358 million
  • Net income 2013 TTM = $368 million

Over the past three years American Water Works' net profits have increased from $268 million in 2010 to $368 million in 2013 TTM. This represents a 37.31% increase.

  • Operating income 2010 = $748 million
  • Operating income 2011 = $803 million
  • Operating income 2012 = $925 million
  • Operating income 2013 TTM = $901 million

Operating income is the cash generated from the operations of a company, generally defined as revenue less all operating expenses, but calculated through a series of adjustments to net income.

Over the past three years American Water Works operating income has increased from $748 million to $901 million in 2013 TTM. This represents an increase of 20.45%.

ROA - Return On Assets = Net Income/Total Assets

ROA is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment."

  • Net income growth

    • Net income 2010 = $268 million
    • Net income 2011 = $310 million
    • Net income 2012 = $358 million
    • Net income 2013 TTM = $368 million
  • Total asset growth

    • Total assets 2010 = $14.080 billion.
    • Total assets 2011 = $14.776 billion.
    • Total assets 2012 = $14.719 billion.
    • Total assets 2013 TTM = $14.977 billion.
  • ROA - Return on assets

    • Return on assets 2010 = 1.90%.
    • Return on assets 2011 = 2.10%
    • Return on assets 2012 = 2.43%.
    • Return on assets 2013 TTM = 2.46%

Over the past three years American Water Works' ROA has increased from 1.90% in 2010 to 2.46% in 2013 TTM. This indicates that the company is generating more income on its assets than it did in 2010.

ROE - Return on Equity = Net Income / Shareholders' Equity

As shareholders' equity is measured as a firm's total assets minus its total liabilities, ROE reveals the amount of net income returned as a percentage of shareholders' equity. The return on equity measures a company's profitability by revealing how much profit it generates with the amount shareholders have invested.

  • 2010 - $268 million / $4.132 billion = 6.49%
  • 2011 - $310 million / $4.240 billion = 7.31%
  • 2012 - $358 million / $4.445 billion = 8.05%
  • 2013 TTM - $368 million / $4.572 billion = 8.05%

Much like the ROA, the ROE is showing increasing profitability. Since 2010 the ROE has increased from 6.49% to 8.05%. As the ROE has increased over the past four years, this reveals that there has been an increase in how much profit has been generated compared to the amount that shareholders have invested, thus showing an increase in shareholder value.

AWK Return on Equity Chart

AWK Return on Equity data by YCharts

Quality Of Earnings

Quality of earnings is the amount of earnings attributable to higher sales or lower costs rather than artificial profits created by accounting anomalies such as inflation of inventory. To ensure there are no artificial profits being processed, the operating cash flow must exceed the net income.

2010

  • Operating income 2010 = $748 million
  • Net income 2010 = $268 million

2011

  • Operating income 2011 = $803 million
  • Net income 2011 = $310 million

2012

  • Operating income 2012 = $925 million
  • Net income 2012 = $358 million

2013 TTM

  • Operating income 2013 TTM = $901 million
  • Net income 2013 TTM = $368 million

Over the past three and a half years, the operating income has been higher than the net income in all years. This indicates that American Water Works is not artificially creating profits by accounting anomalies such as inflation of inventory.

Debt And Capital

The Debt and Capital section establishes if the company is sinking into debt or digging its way out. It will also determine if the company is growing organically or raising cash by selling off stock.

Total Liabilities To Total Assets, Or TL/A ratio

TL/A ratio is a metric used to measure a company's financial risk by determining how much of the company's assets have been financed by debt.

  • Total assets

    • Total assets 2010 = $14.080 billion.
    • Total assets 2011 = $14.776 billion.
    • Total assets 2012 = $14.719 billion.
    • Total assets 2013 TTM = $14.977 billion.
    • Equals an increase of $897 million
  • Total liabilities

    • Total liabilities 2010 = $9.948 billion.
    • Total liabilities 2011 = $10.536 billion.
    • Total liabilities 2012 = $10.274 billion.
    • Total liabilities 2013 TTM = $10.405 billion.
    • Equals an increase of $457 million

Over the past three and a half years, American Water Works' total assets have increased by $897 million, while the total liabilities have increased by $457 million. This indicates that the company's assets have increased more than the liabilities thus adding shareholder value.

Working Capital

Working Capital is a general and quick measure of liquidity of a firm. It represents the margin of safety or cushion available to the creditors. It is an index of the firm's financial stability. It is also an index of technical solvency and an index of the strength of working capital.

Current Ratio = Current assets / Current liabilities

  • Current assets

    • Current assets 2010 = $534 million.
    • Current assets 2011 = $1.398 billion.
    • Current assets 2012 = $499 million.
    • Current assets 2013 TTM = $546 million.
  • Current liabilities

    • Current liabilities 2010 = $775 million
    • Current liabilities 2011 = $1.489 billion
    • Current liabilities 2012 = $995 million
    • Current liabilities 2013 TTM = $1.049 billion
  • Current ratio 2011 = 0.70
  • Current ratio 2012 = 0.94
  • Current ratio 2013 = 0.51
  • Current ratio 2013 TTM = 0.52

Over the past three and a half years, American Water Works' current ratio has been decreasing. The current ratio has decreased from 0.70 in 2010 to 0.52 in 2013 TTM. As the current ratio is under 1, this indicates that American Water Works would not be able to pay off its obligations if they came due at this point.

Operating Efficiency

Operating Efficiency is a market condition that exists when participants can execute transactions and receive services at a price that equates fairly to the actual costs required to provide them. An operationally efficient market allows investors to make transactions that move the market further toward the overall goal of prudent capital allocation without being chiseled down by excessive frictional costs, which would reduce the risk/reward profile of the transaction.

Asset Turnover

The formula for the asset turnover ratio evaluates how well a company is utilizing its assets to produce revenue. The numerator of the asset turnover ratio formula shows revenue found on a company's income statement and the denominator shows total assets, which are found on a company's balance sheet. Total assets should be averaged over the period of time that is being evaluated.

  • Revenue growth

    • Revenue 2010 = $2.555 billion
    • Revenue 2011 = $2.666 billion
    • Revenue 2012 = $2.877 billion
    • Revenue 2013 TTM = $2.873 billion
    • Equals an increase of 12.45%.
  • Total Asset growth

    • Total assets 2010 = $14.080 billion.
    • Total assets 2011 = $14.776 billion.
    • Total assets 2012 = $14.719 billion.
    • Total assets 2013 TTM = $14.977 billion.
    • Equals an increase of 6.37%.

Over the past three and a half years the revenue growth has increased by 12.45% while the assets have increased by 6.37%. This is an indication that the company from a percentage point of view has been more efficient at generating revenue.

Based on the information above we can see that American Water Works has produced strong results over the past three and a half years. Revenues have increased by 5.98%, the ROA and ROE have both signified an increase in profitability while the increase in assets has almost doubled the amount of liabilities. One low point that the analysis reveals is that the company does not have the liquidity it once did. Based on the results above we can see that the company has produced strong results over the past three and a half years.

AWK Revenue TTM Chart

AWK Revenue TTM data by YCharts

Inorganic Growth Strategy

One of the reasons for the company's increasing profitability is management's inorganic growth strategy. This strategy is designed to expand its operations through the acquisition of smaller companies in strategic zones. So far in 2013 the company has closed on seven acquisitions.

August has been a busy month for the company as it has made three major announcements:

Announced on Aug. 30th American Water Works subsidiary Illinois American Water announced the acquisition of the Grafton system for $1.8 million.

On Aug. 29th American Water Works subsidiary Pennsylvania American Water announced it has closed three acquisitions and purchased the assets of water and wastewater systems serving a combined total of approximately 2,100 people. The total transaction amount of the newly acquired systems is approximately $6.9 million.

On Aug. 16th Iowa American Water announced the company's acquisition of the City of Dixon, Iowa's, water system.

Moving Forward

The three examples listed above illustrate the company's goal to expand the regulated business segment through focused acquisitions. Besides acquisitions, the company is also making regulated investments, taking steps to develop and maintain its infrastructure and introduce new services to help drive earnings. As the main focus for the company is the inorganic growth strategy, American Water Works has a fixed long-term earnings growth target in the range of 7% to 10%. These strategic acquisitions are all geared toward achieving this goal.

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Analysts' Estimates

Based on the company's inorganic growth formula, analysts at MSN Money are estimating an EPS for FY 2013 at $2.19 while the EPS is expected to improve into FY 2014 with an increase to $2.38.

Bloomberg Businessweek supports this idea as it expects the company's revenues to be around $3.0 billion for FY 2013 and increase to $3.1 billion for FY 2014.

Dividend

According to the chart below, American Water Works has had a solid history of dividend increases. The company's philosophy is to maintain its dividend payout ratio between 50% - 60% of net income. As earnings are expected to increase between 7% - 10% in the foreseeable future, the history of dividend increases is expected to remain intact.

The 2013 payout ratio, with an estimated EPS of $2.19 and an estimated payout of $1.12 equals a 51% payout ratio. Based on the company's payout ratio philosophy and an estimated EPS of $2.38, I would expect a strong increase in the dividend for 2014. If the company increases its ratio to 55% this would equal a quarterly dividend of $.32 or an increase of 14.3%.

Valuations

Currently, American Water Works stock has a P/B of 1.59, which is inline with the industry average of 1.58, A P/S of 2.53 is above the industry average of 1.99 while a P/CF of 7.82 is slightly above the industry average of 7.62. Even though the ratios are indicating the stock is currently trading at the higher end of the spectrum, a pullback in price from here would indicate value moving forward.

Price Targets

  • Finviz has a price target for American Water Works at $47.37
  • On July 24th, Brean Capital gave the company a "Buy" rating with a target of $53.
  • Barclays reinstated its position with an "Overweight" rating and a target of $45.00.

The above analysis reveals that American Water Works' inorganic growth strategy is driving revenue, profitability and earnings upward. The ratios segment of the analysis reveals that American Water Works' revenue, profitability and earnings have increased over the past three and a half years. Supported by the inorganic growth strategy the company's revenue, profitability and earnings are expected to continue to grow. American Water Works' management has a long-term earnings growth target in the range of 7% to 10%. Based on this target revenue projections for American Water Works are expected to be around $3.0 billion for FY 2013 and increase to $3.1 billion for FY 2014. As this is the case analysts are estimating that American Water Works' EPS for FY 2013 will be $2.19 while the EPS are expected to improve to $2.38 in FY 2014. Based on the company's dividend philosophy of a 50% to 60% payout of earnings, I estimate the dividend should show significant increases over the next few years. As the earnings and dividend payout increase over the next couple of years this should inspire investor interest, raising the stock price thus leading to the price targets in the $45.00 to $53.00 range.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.