American Water Works: Needs Liquidity

Jun.10.08 | About: American Water (AWK)

American Water Works Co., Inc. (NYSE:AWK) has seen very little price movement since its $21.50 IPO in April. Over the past 2 weeks, many brokerage companies which were involved in the pricing of the IPO issued research reports once the quiet period expired. While most of the reports were understandably positive (underwriting firms usually are careful not to offend potential investment banking clients), there were some disturbing issues uncovered.

To begin, a bit of history on the company is in order. In 2003, a German utility company, RWE, purchased American Water Works as it attempted to break into the US water utility market. The plan was to implement cost controls and thereby reduce expenses in order to recognize greater profits. What ended up happening was a mismanagement of the firm resulting in tense relationships with regulators across the country, and a company with significant needs for capital expenditures in order to strengthen the utility’s infrastructure.

In all fairness, RWE was relatively quick in realizing its mistakes and in late 2005 began the process of instituting new management in preparation for a divestiture of the business. It has taken some time to get the company in shape to offer back to the public but the IPO transaction finally took place in April at 21.50 with RWE selling 39% of its position. The remaining 61% of the company is still held by RWE which is under a 180 day restriction before it can sell the remaining position.

Analysts for the most part paint a bullish picture of the company long-term as they expect rate increases to create additional revenue over the next 4 years. The view is likely correct as AWK has lower rates than many of its counterparts. The majority of the issue is simply going before the local municipalities, filing the proper paperwork, attending hearings, and completing the political process. However, JP Morgan noted that it could potentially be a strain on current management to be working with so many municipalities at the same time.

The major negative issue in owning the stock is the concern over capital raising in the future. In order to be competitive, the company must raise several billion dollars over the next 3 to 5 years as it beefs up the infrastructure. Since the company has a fairly high debt to equity ratio, it will have a more difficult time accessing attractive funding from the debt market. It also doesn’t help that the credit rating agencies have downgraded the company’s unsecured debt in the last year. That leaves the most likely scenario of raising equity capital which would dilute current shareholders. If this is done at the same time that RWE is selling its remaining position, it could have a severe effect on the stock price.

Finally, there is the issue of industry consolidation. Typically a fragmented environment where there are numerous takeover candidates leads to higher prices as takeover speculation drives multiples to a premium. AWK, however will likely be on the other side of that coin, making purchases of its own. If it becomes too aggressive and investors believe purchases are being made that dilute current investors, it would likely cause further deterioration of the stock's multiple.

So in conclusion, the stock appears to have enough concerns to warrant staying away from it at this time. My fund has a small short position as I believe the additional stock held for sale by RWE will pressure the price for several months. So while utilities are often a safer place to invest during weak economic periods, it seems AWK may have some issues of its own that cause too much concern.

AWK Notes

Disclosure: Author has a short position in AWK.