American Water Works: Investing In A Water Utility Giant

Jan.19.12 | About: American Water (AWK)

By Mark Bern, CPA CFA

We gripe when we fill up our cars and SUVs at the pump, paying over $3 per gallon for refined petroleum. But we think nothing of paying $1.50 for a 16-ounce bottle of water. There are 128 ounces in a gallon, or eight 16-ounce bottles. That means we are more than willing to pay $12 per gallon for water, but we get upset with the oil companies for gouging us and making huge profits. Does this make any sense?

Have you ever experienced a drought where you live? I have and it's serious business. The population is growing and there is a finite amount of fresh water in the world and it isn't distributed according to population. "Over 70% of our earth's surface is covered by water ... 97.5% of all water on earth is salt water, leaving only 2.5% as fresh water. Nearly 70% of that fresh water is frozen in the icecaps of Antarctica and Greenland" (source: Human Appropriation of the World's Fresh Water Supply here). We worry about peak oil, but we pay little attention to our own water supply.

Peak oil was supposed to have been here by now, but as the price of crude rises more and more oil becomes available because of improvements in technology and the improved cost/benefit of looking for oil in places that would have been uneconomical at lower prices. Peak oil will come, but it's not here yet. At the same time, water is becoming more scarce simply because it's not always available where it's needed when it's needed.

Companies that provide clean drinking water will inevitably become more valuable as population growth strains the existing system. If you live in Texas or California you are probably aware of the value of clean water since these states have experienced high profile legal battles over water rights; not just recently, but for decades. The Central Texas region depends upon the Highland Lakes for its water supply reservoirs and water flowing into those lakes was about 10% of the average during 2011. (Source: LCRA here). Drought conditions in Georgia got scary this summer as conditions hit the highest drought category as reported by (here). California experienced drought conditions in 2011 as did a total of 14 states in the U.S. (source The New York Times here).

My point is that all the fuss about oil shortages, while real, has caused most investors to ignore the real threat: water shortages. It doesn't matter if we have a flood in one part of the country while drought conditions exist elsewhere. The excess water doesn't help those who are parched because there is no national system to move water to where it is needed. And until there is, and I haven't heard anyone with an idea yet, it is my opinion that publicly traded water companies should represent a solid growth trend for decades.

The water company is not a get rich overnight scheme. It is a get paid while you wait for the appreciation investment. There are a limited number of companies in this area and none are very large. The water market is highly fragmented and mostly run by government entities. You know that can't be a good thing. As local governments search for ways to raise money I expect that water systems could go up for sale. When times get tough it seems to always happen. That means more consolidation in the industry and that is a good thing for a few of the larger players.

My favorite is American Water (NYSE:AWK), the largest investor-owned water and waste-water utility in the U.S. The company provides service in over 30 states and Canada. It also has a non-regulated business which assists municipalities and military bases with maintenance. The company was taken private back in 2001 by German based RWE Group but was divested in an IPO in April 2008. Since that time the company has increased earnings per share and dividends per share in each year. The dividend now yields 2.9% and should continue to increase at an average annual rate of around 10%. I expect total return to also be around 10% per year on average going forward.

The thing that intrigues me about the industry is that the growth potential is nearly unlimited, but the margins remain low enough to restrain that growth. That, of course, is primarily due to regulation. But I suspect that the regulators may become more accommodating as the need to privatize government-owned utilities to raise cash and balance budgets becomes more urgent.

American Water first hit $1 billion in revenue in 1997. Revenue in 2010 exceeded $2.7 billion. It is a steady grower. I'm obviously not the first one to recommend water utilities because money has been flowing steadily into the sector, but I believe that the flow will continue. With the current P/E ratio at 18.4 times trailing twelve month earnings, the company is not a screaming bargain. But I believe that the company will be able to support a forward P/E closer to 20 in the next five years or so because of its consistent growth a low level of risk. How many of us are going to stop taking showers, flushing toilets and drinking water? This is about as recession-proof a business as there is in my opinion. The rate of growth may slow temporarily, but that's a lot better than falling off a cliff.

If you've read my articles before you'll know that I like a bargain. But since it's not priced in bargain territory how do we get a better deal? The price is currently at $32.37 and I feel like if I could get the stock for a price closer to $29 I'd feel much better. So, how could I do that? Let me explain.

I've been following AWK for some time and owned it before RWE Group took it private and made a very tidy profit on top of those dividends over the years. I also watch the options on this company for a little help in lowering the price. It has been tough to find what I want on the yield side but I finally found one that gives me a fair chance to get a good price if the market corrects enough and a decent return on my cash while I wait. Many investors shy away from options and for good reason since about 80% of all options contracts expire worthless. That means that the buyers of those options lose 80% of the time. But flip that over and think about what it means for the sellers: They win 80% of the time. I like those odds and that is why I almost never buy an option except to close an open position that I initiated by selling the option. Confused yet? Let me walk through a simple example using AWK.

The price is $32.37 and I want to pay $29. How do I do that? I "sell" a put option expiring in June 2012 with a strike price of $30 and a premium of $1. This option at this price was available at the close on January 18, 2012, (a few hours before I wrote and submitted this article for publication). By selling the put option I become obligated to purchase 100 shares of the stock for each option I sell at the strike price of $30 if the option is exercised. The option will likely be exercised only if the price of the stock drops below $30 before June 15 (the expiration date of the option contract). If the price of the stock is below the strike price at the close of the market on the expiration date the option contract will be exercised. I get to keep the premium of $1 per share (or $100 per contract) no matter what happens.

If the option is exercised I get the stock at a cost basis of $29 ($30 strike price paid less the premium collected of $1). There is a commission involved, but if you use an online discount broker (which I highly recommend for this type of transaction) it should cost below $10 per contract. When the contract is exercised there is also another fee for executing the exercise and that is usually under $20. So, my actual cost is $29.30 per share, but I can live with that. It's far better than the current price of $32.37. And now my effective yield on the dividend becomes 3.14% because of the lower cost. And I got about a 10% discount from today's price.

Now, what happens if the option does not get exercised? I keep my $90 premium, net of the commission, for a return of 3% in about five months. I should be able to do that again and move my annualized return to 6% and hold it near that level until I get the stock. The market corrects at least 10% once or more nearly every year. If I'm patient enough I'll get the stock below the market price. My eventual price may be higher, but I'll have collected those premiums while I wait and the company will have increased earnings all the time, also becoming more valuable. I either get a 10% discount on a great stock or I earn 6% on my money while I wait. What's not to like?

Of course, you can do better on other stocks, but be careful what you sell puts on. My cardinal rule is to never, ever sell a put option on a stock unless I really want to own the stock. Be safe and prosperous.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.