A Water Utility Above The Rest
If you have been following my articles, you will notice that I am attracted to utilities that qualify as "outliers" for various reasons. They could benefit from unique geography, diverse lines of operations, remarkable non-core assets or outsized growth prospects. I have written extensively about water utilities in the past, as I believe that the asset class is one that is attractive and provides investors with a reasonable and safe yield.
Despite these attractive qualities, Water Utilities ( like all other utilities in this current low interest rate environment) are vulnerable to pressure from an influx of investors chasing both security and yield once promised by Treasury bonds. This search for yield can quickly turn to folly however due to the fact that many water utilities are subject to extensive regulation and it is often difficult for them to raise their dividends in order to keep pace with inflation, particularly when it intensifies. Combine this with limited expansion possibilities and high demands for capital expenditure, investors often are threatened by a dangerous situation known as "flight to yield" where prices of assets become disconnected with the reality of their long term returns.
In spite of potential obstructions to growth in this sector, one company, Aqua America (WTR) has been able to continuously grow and prosper by virtue of a unique growth strategy. I believe that this company is extremely well positioned going forward and will benefit considerably due to the highly fragmented nature municipal and local water utilities as well as the solid expansion approach of the company, which has delivered shareholders outsized returns over the past decade.
What Aqua America Does
(Quoted text courtesy of Google Finance)
Aqua America functions as a "holding company for regulated utilities providing water or wastewater services in Pennsylvania, Texas, North Carolina, Ohio, Illinois, New Jersey, New York, Florida, Indiana, Virginia, Maine, and Georgia. During the year ended December 31, 2011, Aqua America's operating subsidiary, Aqua Pennsylvania, Inc. (Aqua), accounted for approximately 56% of its operating revenues. Its other subsidiaries provide services in 11 other states."
In marked contrast to many of the other water utilities which I have written about, Aqua America has both a focus towards growth and a national presence. I believe that this business is extremely well situated to exploit future growth opportunities in the United States as larger portions of our infrastructure become privatized as municipalities become pressured to sell off assets in order to meet near term obligations such as municipal bond and pension liabilities.
As an asset class, water systems are extremely attractive because of their essential nature and relatively predictable cash flows and thus represent ideal sources of growth to a company like Aqua America.
The Numbers on Aqua America
With a market capitalization of $4.17 billion, Aqua America is a company of moderate size however as far as water utilities go, this company is extremely large. Currently priced at $23.60 per share against $8.49 of book value, investors are paying a significant premium for shares of Aqua America. While I believe that a premium is justified by their essential function and predictable cash flows of utilities, I also am of the opinion that investors must be appraised of the fact that this company also enjoys above average growth prospects which I will discuss later in this article.
The company pays both a regular and increasing cash dividend in addition to capitalizing and distributing additional shares of it's stock. The company's dividend currently yields 2.58% at current price levels and has grown significantly, measurably outpacing inflation. What I find surprising is also the fact that the company's payout ratio is relatively low, standing at .44, a number which while low for many regular businesses is extremely low for a regulated utility.
Acquisitions Primed to Drive Future Growth
(Quoted text courtesy of Google Finance)
As seen with the bankruptcy of Detroit and numerous other imperiled municipalities, cities are struggling under the burden of unfunded pensions and other liabilities. This provides the potential for Aqua America to purchase water assets from municipalities which are struggling and to incorporate them into their portfolio of assets, taking advantage of both expansion and leveraging their experience to increase operating efficiency. I believe that over the next several decades this trend of privatization and consolidation will continue, as more municipalities begin to struggle under their obligations, much to the benefit of Aqua America.
Given that the water utility market in the United States is highly fragmented, I believe that Aqua America will have a solid foundation from which to approach acquisitions in the future. In addition, the company is able to leverage the predictable cash flows of water utilities due to their essential nature and long operating history when making purchases going forward. Predictable cash flows of underlying assets coupled with a low interest rate environment is a very good thing in my mind and makes the current environment ideal to conduct acquisitions.
This strategy of growth and consolidation has been regularly implemented. In 2013, "the Company purchased seven water and wastewater utility systems, including three in Pennsylvania, three in North Carolina and one in Virginia. In November 2013, the Company announced that its Virginia subsidiary has acquired the Blacksburg Country Club wastewater system and treatment plant. In December 2013, the Company announced that its Illinois subsidiary has acquired three water systems and two wastewater systems and its Virginia subsidiary has acquired a water system."
WIllingness to "Reshuffle of Assets" Makes This Company Nimble and Provides Profit Opportunities
I first encountered this company while writing about smaller regional water utilities where several of the companies that I was writing about had dealings with Aqua America and purchased water systems from the company. Eventually, I became very interested about the company that was selling these water systems to these smaller regional water companies and was motivated to find out why.
One of the most interesting things that I noticed about Aqua America was that the company was willing to sell some of it's water utility assets to other smaller utilities that would benefit from regional synergies by virtue of their geographic position. The fact that the company is willing to "trade" on it's portfolio of water assets coupled with it's significant capital expenditures to upgrade the systems it purchases made a lot of sense. Conceptually, this behavior reminds me of an individual who restores classic cars - pocketing a tidy profit once the improvements have been made.
I believe that this type of behavior is extremely practical in the case of water utilities - while revenues from the distribution and management of drinking and wastewater are typically regulated by Public Utility Commissions, the transactions between utility companies buying and selling the systems can provide Aqua America with sources of significant one time profit and the opportunity to improve the asset mix of it's portfolio.
As with any water utility, investors must be appraised of several factors that could significantly impact their investment. While their product is essential, it is important to understand that the shares of these companies have grown popular, significantly raising the risk of overpaying.
Despite the fact that Aqua America's assets are diversified across the United States, it does have a regional concentration of assets - particularly in it's home state of Pennsylvania which accounted for over 50% of it's operating revenues.
The earnings of the company are also vulnerable to factors including severe weather, such as heavy blizzards or cold temperatures causing damage to infrastructure as well as excess rainfall. While this factor will not be a significant issue for investors making a long-term investment commitment, periods of higher than average rainfall could impact the earnings of the company and reduce demand for its product over a period of one or several years.
While the company does have a history of robust dividend increases and is diversified it is important to understand that inflation might erode the attractiveness of the company's dividend when compared to other companies such that operate with a higher degree of pricing power. These inflationary pressures could reduce the ability of the company to pass rate increases to consumers or obtain approval through Public Utility Commissions to defray its costs.
Given the fact that a large portion of the company's growth has been through the acquisition of fragmented assets and that it has benefitted considerably from low interest rates, it is important to be aware of the fact that a rise in interest rates could impede the company's ability to make acquisitions at the pace it has in the past several years. Should interest rates rise, I believe that the growth profile of the company will more resemble that of a "normal" utility - one of slow and steady growth in share price and dividends.
Any form of contamination of the water provided by the company could trigger significant regulatory penalties, which could include heavy fines or suspension of operations in addition to civil lawsuits. In addition, while extremely remote, there is also the possibility of the company's expansion attempts being quashed by regulators or, even more likely, the potential for the assets of the company to be nationalized.
Final Thoughts: One Water Utility to Bind Them
I am of the opinion that investors seeking the safety of water utilities and the ability to harness macroeconomic factors will be extremely intrigued by Aqua America due to it's growth strategy, growing dividend and ability to benefit in the future. Should low interest rates persist, I am of the opinion that the company is well situated to continue its pattern of growth given the highly fragmented nature of water utilities in the United States.
I believe that while investors in the company enjoy a high degree of safety against the potential of permanent capital loss, they have to worry about achieving a good purchase price. Should the shares of Aqua America decline on broader market volatility to the point where the company yields 3%, I will begin purchasing shares using dollar cost averaging to mitigate the risk of paying too high a price for a company which, I hope by now you will agree with me is a well positioned business.