American States Water (NYSE:AWR) is a small-cap utility with a market capitalization of $1.4 billion. AWR consists of 3 subsidiaries: Golden State Water Company (GSWC), Golden State Electric Utility and American States Utility Service (ASUS). The Golden State Water Company, which accounts for 70% of 2014 revenues, serves water throughout California. ASUS provides water to 9 military bases in 7 states; it generated 22% of 2014 revenues. Finally, the electricity arm serves ~25,000 customers in southern California and accounted for 8% of revenues. Given the importance of the GSWC subsidiary, this article will focus on AWR's prospects as a water provider in California.
(Source: American States Water 2014 Annual Report)
On the surface, AWR seems like a great company. For one, it derives over 90% of its revenues from water, a vital good that I am extremely bullish on. Secondly, California accounts for over 13% of the United States' GDP and its population is expected to grow from 38 million today to 60 million by 2050. This robust business activity and population growth are generally a good indication of increased domestic and industrial water demand. Thirdly, management seems very competent. They have steadily grown their business by acquiring water utilities and water rights throughout California, won contracts throughout the US to provide water the military bases and maintained investment grade debt (AA/A+). AWR's superior operations are clear when compared to other American water utilities. In relation to its competitors (WTR, AWK, CTWS, MSEX), AWR generates a better ROA, ROE and ROI.
Finally, and perhaps most impressive, is AWR's performance. Over the last 10 years it has outperformed the S&P 500 (NYSEARCA:SPY) by 52%. It also beat SPY's bear market of 2007-2009 by over 20% (though AWR did fall 40% from peak to trough). Additionally, AWR has the longest dividend growth streak of any publicly traded company in the US - it has grown its dividend, which currently yields 2.3%, for 61 straight years. With a moderate 54% payout ratio and management committing to future raises, this remarkable streak is likely to continue for the foreseeable future.
(Source: Google Finance)
Despite all these positives, due to California's precarious water situation, I don't believe AWR to be a good buy at its current valuation. For the last century, California has over-allocated its water to the point where, without major infrastructure investments, current use is unsustainable. Over the last 55 years, California has burned through over 50 million acre-feet of groundwater, causing land in some areas to subside dozens of feet. This subsidence continues today in many parts of the state at a rate of 1-2 inches a month.
(Source: National Geographic)
California's snowpack levels have been more variable. Yet the excitement for 2016's snowpack, which is coming in at as average year, illustrates just how rough the past several years have been, including last year, when it was only 5% of a normal year. This shattered the previous record of 25%, which was observed in 1925.
Unfortunately, both California's past and future indicate further dryness. Tree ring analysis going back 2 millennia shows California's current drought is well within the historical norms and that it can get much worse. California has been prone to "megadroughts," meaning a drought that lasts longer than 20 years. However, some of these megadroughts lasted for 100-200 years. For better or worse, settlers from the eastern United States arrived in California during a relatively wet period. This suggests that, at the very least, it is reasonable to expect a reversion to a historical mean, which includes more frequent and persistent droughts than Californians are used to, some of which could span over centuries.
Not all is bad for arid Southern California, as scientists predict climate change will have negligible impact on local precipitation. However, Southern California imports most of its water from Northern California and the Colorado River, both of which will likely be drier during the coming century - projections have snowpack in the Sierra Nevada falling by 50-65% and flow in the Colorado decreasing by 5-20%.
So what does this mean for investors in AWR? A good place to start is last year. With snowpack at precariously low levels, California governor Jerry Brown "impose(d) restrictions to achieve a statewide 25% reduction in potable urban water usage". Given that AWR serves cities and towns, this is concerning, as in one day a state mandate ostensibly capped its water sales 25% below the market's demand (AWR reported a 17% drop in sales). Granted, AWR managed to grow EPS by $0.03 in 2015 and the mandate has since expired. Moreover, with healthy snowfall throughout the winter, 2016 should be a better year in terms of volumes. However, it would be dangerous to assume 2015 is an anomaly, especially when past/future weather trends and population growth are taken into account.
While all this sounds very threatening for AWR, its situation isn't dire. For one, it owns substantial water rights (73,330 acre-feet of adjudicated groundwater and 11,335 acre-feet of adjudicated surface water, along with additional unadjudicated groundwater rights). These account for 60% of AWR's water sources, while the other 40% come from the Metropolitan Water District, the US Bureau of Reclamation and the Sacramento Municipality Water District (these agencies get their water from the Sacramento River Basin, snowpack runoff in the Sierra Nevada and the Colorado River).
Even more importantly, AWR has "decoupled" usage from volumes - meaning government policies and water rates are designed to help AWR reach its profitability goals independent of volumes. Decoupling gives AWR a great cushion when it comes to lower volumes, but I question the ability of AWR to maintain the level of decoupling it currently enjoys. The pace of water rate hikes in California has been substantial over the last decade, averaging 6.5% per year (~3x the rate of inflation), as the California government encourages rate hikes as a method to reduce demand. For the time being, there are still opportunities for consumers to use water more efficiently. Yet water is an extremely inelastic good. At some point I imagine voters will decide they've changed their habits enough and that their water bills have risen too high, at which point less utility-friendly policies could begin to take hold. If or when this happens is anyone's guess, but it is an issue that has the potential to affect AWR more than most other utilities. Moreover, California's Supreme Court is currently challenging the legality of rate increases as a method for reducing demand. I personally believe the success of rate hikes in reducing demand means the practice will continue; this said, I certainly don't know what the legal outcome will be and any adverse ruling could thwart AWR's ability to offset volume declines with rate hikes. When the potential of slowing rate hikes is combined with California's projected economic expansion, population growth and the simple fact that California is running out of water, AWR's heavy reliance on decoupling arrangements to replace volume may become a significant problem.
However, AWR does have a number of options to increase volumes and limit its dependence on decoupling. The cheapest and most simple solution is to invest in basic infrastructure, such as pipes, so loss through leakage is limited. AWR is already doing this, which is good, but the potential benefits are limited.
Another possibility is to build out new infrastructure that adds to water supplies. This includes several options, most notably desalination plants or wastewater purification plants. A cheaper route may be to buy water from an already built desalination plant. Similarly, AWR could buy water from farmers. Farms have access to 40% of the state's water (urban accounts for 10%) and were exempt from the statewide reductions due to their senior water rights. Given the high cost of desalination and the public resistance to purified wastewater, I view this as the most likely scenario.
That said, any of these actions would help AWR overcome the lack of water, though they would come at a price. New, sophisticated desalination and water treatment plants cost hundreds of millions or even billions of dollars depending on the size; additionally, getting the permits needed to build these plants in California can be a challenge. Buying bulk water from farmers or already constructed plants would be cheaper than building a new facility, but it would be more expensive than the current prices AWR enjoys. Moreover, AWR wouldn't own the infrastructure, meaning it may need to outbid other utilities to secure water. In this scenario, it also wouldn't be able to amortize the plant or count it as an asset.
In many respects, I actually really like AWR as an investment. It has a stellar record for performance and dividend growth, it was a relatively stable investment during the massive bear market brought on by the financial crisis and its management seems quite competent. That said, with a P/E of 24.6 and a PEG of 6.3, I think it, along with other water utilities, is overpriced. However, what concerns me most is AWR's heavy reliance on decoupling, the future viability of its water supplies in arid California and its ability to grow without making expensive infrastructure investments. For these reasons, I believe AWR should trade at a discount to other domestic water utilities. Until AWR's multiple comes down, I suggest investors interested in water companies look elsewhere.
Disclosure: I/we 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.