Keeping it Simple
Investing in utilities is an effective and conservative way to approach building a dependable income stream. Though it does not promise vast riches or explosive growth potential, utility investments can represent a critical part of an income oriented investor's portfolio. Artesian Resources (NASDAQ:ARTNA) is a small water utility that I believe offers investors an attractive dividend yield and potential for moderate growth in the coming years. The company offers potable water, wastewater under both regulated and non-regulated agreements in addition to engineering and consulting services.
One of the most basic, yet most under-appreciated commodity resources in the market during the last several decades has been water. Despite the lack of notice given to smaller water utilities by the market, this sector has enjoyed healthy gains (and in my mind, more importantly, protection on the downside) in recent years. In one of my first articles, I discussed the merits of a specialized water utility in the Caribbean offering a healthy dividend, Consolidated Water (NASDAQ:CWCO), which has since appreciated in value significantly. I believe I have found another potential utility in the water sector that qualifies for a long-term hold.
The Numbers on Artesian
This company is tiny, with a market cap slightly north of $200 million. Currently priced at $23.08 per share against $13.58 of book value and $0.4 of cash per share with a PE ratio of 22, investors are paying a premium for the assets of the company. The company currently yields a 3.56% dividend that has a history of being increased regularly. The company's payout ratio is .77 which is relatively high. From a superficial perspective, investors might be put off by both the premium paid for the assets currently held on common shares and the high payout ratio of the company. I am of the opinion that given the essential underlying nature of the asset and its competitive position, which I will discuss later in this article, that a premium can be justified. In addition, a high payout ratio is also justified given the type of basic service provided by the enterprise.
A Strong Position With Growing Regional Exposure
Artesian currently has dominant market share in Delaware - much like certain regulated public utilities including Hawaii Electric (NYSE:HE) and Pacific Gas & Electric- Artesian operates with the sanction of the state of Delaware. Despite the fact that the population of Delaware is one of the smallest in the country, a captive market is a captive market. The company has also conducted acquisitions in recent years, purchasing smaller water companies in addition to water assets from counties, representing the continuation of its expansion strategy into nearby geographic areas.
Another interesting facet about this company is the recent introduction of a service line protection plan, a type of insurance that can save homeowners a significant amount for costly repairs. Begun in 2005, the company offers this type of insurance for an additional $5.50 per month for residential customers. The company has also expanded this coverage to sewer lines, offering protection at $11 per month - if you have been following my articles you will know that I am attracted to insurance companies because of the intrinsically attractive economics of the business. The more customers that opt into these programs, the more efficiently risk will be distributed - something which should translate into another source of revenue- a boon in a regulated utility environment.
Expansion Opportunities into...Delmarva?
Delmarva is a term for a large peninsula on the east coast of the United States. Made up of three states, Delaware, Maryland and Virginia, the peninsula is host to roughly 1,400,000 people. Though the peninsula is primarily comprised of Delaware, Maryland and Virginia both retain counties on this peninsula and provide logical targets for Artesian's expansion. Due to Maryland and Virginia's proximity to the nation's capital and the growth of the United States government apparatus, this region is positioned to enjoy significant growth in population. With population growth there logically comes a higher demand for water utilities.
I believe that investors interested in making a long-term commitment to this company will be rewarded as the Delmarva peninsula becomes more densely populated - a demographic trend that I believe will occur as the region around Washington, DC continues to grow. Given the proximity of the peninsula to the nation's capital and the developed road infrastructure, I believe that real estate on the Delmarva peninsula can be a compelling value proposition as a bedroom community for would-be homebuyers and renters seeking to commute into the capital.
Potential for Acquisition and Acquisition Strategies
Investors can find several water utility companies trading at less than a $1 billion market capitalization. I believe that in the future, regional water utilities will experience a period of consolidation - as they are highly desirable assets by virtue of their essential nature and dependable cash flows. For investors monitoring regional water utilities, the past several months have shown considerable appreciation in the share price of many of these companies. The question then becomes: is this a permanent trend in which value is finally becoming appreciated or simply a function of an investor flight to yield? The jury is still out.
Though I would never purchase shares based upon the hope for acquisitions or merger activity to immediately occur in this sector, I would say that the added potential of a one time significant premium does not hurt the case of investors seeking a stable investment - given the fact that one of the largest players in the sector, Aqua America (NYSE:WTR), has both a wide geographic distribution and a history of acquisitions.
As seen with the unfolding bankruptcy of Detroit - many municipalities are struggling under the burden of unfunded pensions and other liabilities. This provides the potential for Artesian to purchase water assets from nearby municipalities which are struggling and to incorporate them into their service network, taking advantage of both expansion and leveraging their management experience to increase operating efficiency.
Despite the essential nature of the company's product, there are several factors that investors need to account for before they make a purchase.
1. The earnings of the company can be impacted by adverse weather or excess rainfall. While this factor will not be a significant issue for investors making a long-term investment commitment, periods of higher than average rainfall could impact the earnings of the company and reduce demand for its product over a period of one or several years.
2. As a significant portion of the business is regulated, inflation might erode the attractiveness of the company's dividend and impact its pricing power, reducing its capacity to pass enough rate increases onto the consumer to defray its costs. Though the company has a history of increasing its dividend, the inability to increase the dividend at least on par with inflation would make it an inefficient choice for an income-oriented investor.
3. The company has been investing heavily in capital expenditures recently, expending $20 million in 2012, up from $15 million in 2011, as the company executes its growth strategy and acquires or builds out more water infrastructure on the peninsula. If this investment is accompanied by an increase in population as well as increased efficiency of a larger enterprise, the company will see growth. If these factors are not realized, expansion efforts could have the potential to destroy value.
4. Contamination of the water provided by the company could trigger significant regulatory penalties, which could include heavy fines or suspension of operations in addition to civil lawsuits. Due to the proximity of the company to the nation's capital, there is also potential for terrorist activity, though the probability is extremely low.
For investors seeking a stable source of growing income, I believe that Artesian merits further investigation. By virtue of its small size, the company has been overlooked by many larger institutions and while it still provides a healthy and growing dividend yield. Making an informed decision about the risks inherent to the business (including the potential drawbacks of a regulated utility's profits in an inflationary environment and potential over-investment during this most recent capex cycle) and balancing them against the intrinsically attractive characteristics of the sector (dependable cash flows and the vital nature of water).
In the midst of the influx of money into the equity marketplace, I would employ dollar cost averaging as I establish a position in this company in order to mitigate the risk of and to possibly exploit a significant drawdown in price. I also advocate that this investment deserves the right kind of investor - one that cultivates moderate expectations towards growth and seeks to preserve capital.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ARTNA over 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.