Contributor C. Cheng asks:
"Interesting that you should mention scarcity of water creating an upside cap on the company's profitability. Now that California is dealing with drought conditions, how do you think this will factor into CWT's performance?"
Our response:
On January 3, 2010 (found here), we posted an Investment Observation on California Water Service (CWT). At that time we said that CWT has a 6-year pattern of trading in a range before breaking out to the upside, price is driven by the dividend with an upside target of $24.145 ($48.29).
Regarding the 6-year cycle, we said the following:
"CWT has had a pattern of trading in a range for approximately 6 years at a time before breaking out to a new and higher trading level. The following are the range in years that CWT traded before obtaining a new high:
- 1976 to 1982
- 1985 to 1993
- 1993 to 1997
- 1997 to 2004
- 2005 to 2011 ???"
Our expectation was that at some point in 2011, CWT would ideally be bought for the pending breakout of the stock price.
The reality of the situation with CWT is that the stock finally broke out of the trading range in January 2013. Again, the 6-year trading range was only the average. However, while investors waited for the stock price to increase there was a sizable dividend being offered at the time. Coincidentally, the price of CWT has peaked at $48.28 on a closing basis as recently as March 25, 2014. This closing price is within $0.01 of our projected high set in 2010.
Our view is that only in hindsight will we know for sure the impact of water scarcity on CWT. However, below is the trend of quarterly earnings since our 2010 posting and it seems to reflect the fact that instead of being able to see higher earnings in the face of scarcity (the rational economic view) we're seeing pre-drought earnings.
What we do know is that the price performance of the CWT has a lot to do with the price paid. Given that CWT currently trades at 25.8x earnings and yields "only" 2.8% (low for a utility), the odds of the stock outperforming in the long-run are slim.
In addition, utility companies generally issue bonds to fund their operations. With interest rates on the rise, their cost of funding will put more pressure on the future earnings. As such, our view on the risk/reward isn't as rosy for CWT.