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We are bullish on American Water (NYSE:AWK) because of its attractive top line growth of 11%, low beta of 0.3, cheap valuations, expected long-term EPS growth rate of 7%-10%, decent dividend yield of 2.7%, and expected benefits from the shale gas boom. The company is committed to improving its cost structure.

American Water is the largest investor-owned water utility company. It is serving around 15 million people in over 30 U.S. states and in parts of Canada. It provides water and waste water services to industrial, commercial and residential customers. The company operates in an industry that has strong barriers to entry due to its capital-intensive nature. Business is highly regulated, and is subject to regulations by state and federal governments, as well as the Public Utilities Commission (PUC). Revenues generated by the company are based on the rates determined by the PUC.

American Water reported a strong financial performance for 2Q2012. Revenues for the quarter were $745.6 million, up 11% YoY, beating revenue estimates by approximately 6%. EPS for the quarter were 0.66 cents, up by 57% YoY. The company was able to improve the operating income margin to 36.3% in 2Q2012, from 30.1% in 2Q2011. The O&M efficiency ratio improved over the last 12 months to 41.7% from 45.2%. Growth in the top and bottom lines was mainly driven by improved rates and favorable weather conditions. Going forward, the company will improve on its revenues and earnings due to the warm weather being experienced in the third quarter so far. Capital expenditure in the first half of 2012 was $476 million as compared to $ 391 million in the corresponding period last year. The company also increased its earnings guidance for fiscal year 2012 from $1.9-$2 to $2.12-$2.22 per share. Recent results reflect that the company is on track to achieving its long-term EPS growth goal of 7%-10%.

In 2Q2012, the company resolved court rate cases in Indiana, New York and California, amounting $60.4 million of annualized revenue. Furthermore, the company has requested incremental revenues in Tennessee amounting to $10.6 million. Last week, the Illinois chapter of American Water got a rate adjustment approval from the Illinois Commerce Commission (Pending:ICC) after 11 months of review. The rate adjustment was based on statewide investments in infrastructure of approximately $180 million. This will help the company generate around $17.9 million per annum in additional revenues. Going forward, the company is expected to file four general rate cases in the current fiscal year, and infrastructure surcharge fillings in 4-6 states. Revenue growth in the recent second quarter was highly contingent on the conclusion of rate cases. The resolution of these cases is also expected to expand the company's top line going forward. The company has been working on its growth strategies, according to which it completed its Aqua New York acquisition and sold regulated operations in Ohio. It also closed a public-private partnership contract in Pennsylvania, and expanded its homeowner services' footprint with the New York City contract. Cost structure improvement and efficient use of capital are two of the company's goals. To that end, it is committed to improving O&M efficiency below 40% by 2015, and will invest $900 million in infrastructure.

The company offers a respectable dividend yield of 2.7%. Over the last five years, dividends increased from 20 cents per quarter to 25 cents per quarter. Cash flow from operations improved in the first half of 2012 to $316 million, up 20% YoY. Due to the growth in net income, the management has indicated that it will not be issuing equity in the near future. It has debt-to-equity of 131% and an interest coverage ratio of 2.5x. It has an operating cash flow yield of 13% and free cash flow yield of 4%. Currently, the company holds S&P s BBB+ corporate credit ratings and A-2 commercial paper ratings, and its outlook was revised from stable to positive. If the company is able to get a ratings upgrade in the future, it will help AWK increase investor confidence and lower its borrowing costs.

The recent shale-gas boom and the excessive use of water in hydraulic fracturing bode well for the company's growth potential. The use of water for hydraulic fracturing differs from site-to-site, but around 50,000 to 350,000 gallons of water is required to fracture one site. The company has signed agreements to provide fresh water for fracturing. It also provides services for purifying contaminated water. In the recent second quarter, it signed a portable water pipeline contract for shale-gas development with Rex Energy. Shale-gas drilling is expected to grow sevenfold in the next decade, which will create a wastewater and treatment market worth more than $3 billion per year. This provides an opportunity for the company to tap the growth opportunity.

AWK

Aqua America Inc. (NYSE:WTR)

American States Water Company (NYSE:AWR)

California Water Service Group (NYSE:CWT)

Average

Forward P/E

17x

20x

17.7x

17.5

18.5x

PEG

2.2

3.3

4.5

3.7

3.8x

P/B

1.5x

2.65x

2x

1.75x

2.15x

Source: Yahoo Finance

American Water is expected to grow at a healthy rate of 8% per annum for the next five years. It is currently trading at a discount when compared to its competitors, based on its multiples. It has forward P/E of 17x and P/B of 1.5x, which are below its competitors' averages of 18.5x and 2.15x, respectively. Its PEG of 2.2 reflects its cheap growth, as compared to its competitors.

Source: Buy American Water As It Benefits From Shale Gas Boom