Hold Till Death Do Us Part: Water Utilities

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Includes: AWK, AWR, WTR
by: Alex Lucken

Summary

Extremely safe and predictable industry.

Current P/E values are much higher than the historical average.

Good options for those who are looking for steady and growing dividend yield with very little long-term risks.

In this series of articles, I will focus on companies that I either own or would like to own in my buy and hold portfolio. The basic idea is to focus on companies that will not only survive but thrive over the long term, rewarding their owners with both capital appreciation and, in most cases, an ever increasing stream of dividends. We will be taking a look at some of the numbers, but mainly these articles are about the reasons behind the success of the company. In this particular article, I will be focusing on water utilities in general as I feel that all of the larger ones are worthy of consideration.

Why go with a water utility?

Before even considering individual companies, let's take a look at the sector as a whole, specifically its strengths in the long run. As you are aware, this is a regulated industry which translates to both safe and predictable earnings at the cost of major upside. Safety is key here, while the share price of companies in this sector have had some more significant swings in the past, their earnings have been relatively stable. Over the long term, that price volatility will even out, and as long as profits keep rising, so will the share price. The other major upsides of this industry are that demand isn't really affected by the economical situation of the area and the fact that there is very little risk of future technology substituting current methods for transporting water from point A to point B. Let's face it, people want running water in their houses no matter what their financial situation is, and until someone figures out a cheaper and more reliable way of transporting water, these companies are a safe bet.

The companies involved

As I said earlier, all of the bigger companies are worth a consideration. This includes American Water Works Company (NYSE:AWK), Aqua America (NYSE:WTR) and American States Water Company (NYSE:AWR).

While these companies are trading at a higher P/E than the average for water utilities (which is 19.90 at the time of writing according to Yahoo Finance), their size makes up for it. Why does size matter? Because in this industry, acquisitions are key to growth. These companies have the capacity to make acquisitions on a constant basis, often resulting in several small acquisitions per company each year. Organic growth is scarce which makes these acquisitions so important. For example, Aqua America had 0.6% organic growth in 2015, but managed its goal of 1.5% to 2% growth in customers due to the 16 acquisitions it did throughout the year. This is a long-term trend as evidenced by the nearly 200 acquisitions the company has made over the past decade. The company's guidance of 1.5% to 2% customer growth for 2016 certainly suggests that the trend will continue.

EPS growth for all three companies has surpassed an average of 10% per year over the past 5 years. American States Water Company takes the crown, with an average of approximately 14% per year increase in EPS, while also being the fastest dividend grower at an average of 11.5% per year followed by American Water Works Company at 9.1% and Aqua America at 7.5%.

You can find a more detailed comparison of the three largest players (AWK, WTR, AWR) in one of my previous articles: Comparing The 3 Largest Water Utilities.

Long-term view

For once, predicting the future with some sort of certainty seems clear. Most, if not all, of these companies will continue on their path of acquiring smaller water and wastewater companies and integrating them into the main company or subsidiaries. This will bring in more customers which, of course, translates to more revenue and more profit. Both AWK and WTR serve as good examples of stable customer growth though acquisitions, let's look at the track record that AWK has. In 2015, it invested $64 million into regulated acquisitions, adding approximately 24,000 customers. On top of that, it acquired Keystone Clearwater Solutions, which provides water services for the oil and gas sector, for $130 million. In 2014, $8.9 million were spent on acquisitions, resulting in 4,500 new customers. In 2013, it was $23.7 million for approximately 30,000 new customers.

In general, the current levels of capital expenditure are quite high; this is mainly related to improving and renewing existing infrastructure. While these improvements certainly drain cash, I see this having a positive effect in the long run as it will improve the reliability of their pipelines. Nonetheless, these improvements do put some pressure on the cash flows.

The companies mentioned above have also been active in share repurchases in the past couple of years. Over the past decade, the amount of outstanding shares has increased, but the past couple of years have been an exception and could be a sign of changing policy from these companies. At the very least, AWK, AWR and WTR have shown that they are willing to take steps to reduce dilution, though AWR did announce on its 2015 report that management does not anticipate a new repurchase program in the near term. I am skeptical about the timing of these companies, but in general, I feel that share repurchases, as long as they lead to a reduced amount of outstanding shares, are a good way to increase shareholder value in the long term.

Conclusion

While these companies are currently trading at historically high valuations, I still feel that they provide the necessary safety and stability for long-term investors. And by long term, I am talking about 5 years at the very minimum. These are boring investments and none of these companies will make you rich overnight, but they should be able to keep rewarding their shareholders with increased earnings and dividends year after year, leading to good results in the long run.

Those of you looking for short-term investments won't find anything interesting in this industry, and even those of us with a long-term view might be better off waiting for the valuations to return closer to their historical averages. However, you won't be losing your money with a buy and hold strategy even at these prices. As I discussed in my earlier article, Aqua America As An Alternative To 10-Year Government Bonds, you could also use the safety provided by the monopolistic nature of water utilities to find an alternative to low yielding bonds.

Disclosure: I am/we are long WTR.

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.