Comparing America's 3 Largest Water Utilities

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Includes: AWK, AWR, WTR
by: Joseph Cafariello

Summary

The water utilities industry is expected to underperform the S&P broader market significantly in this quarter and the next, with earnings shrinkage in 2015; dividends are adequate; stocks are stable.

Mean/high targets for the 3 largest U.S. water utilities - American Water Works, Aqua America, and American States Water - range from 5% below to 22% above current prices.

Find out which among AWK, WTR and AWR offers the best stock performance and investment value.

*All data are as of the close of Friday, November 14, 2014. Emphasis is on company fundamentals and financial data rather than commentary.

Investors looking for stock price stability and decent income in this low interest rate environment of the past few years have found utilities quite useful in securing both. Yet such price stability and income generally come at the expense of capital appreciation, since the territorial nature of utilities - while protecting the business they have - does not allow them to expand very easily.

These pros and cons of utilities are clearly illustrated in the graphs below. In the Pro graph, the utilities' price stability was made evident from June 2007 until the market hit bottom on March 9th, 2009, where the Utilities Select Sector SPDR ETF (NYSE: XLU) [blue] lost only 45%, while the broader market S&P 500 index [black] lost 55%.

The three largest U.S. water utilities fared even better, as American Water Works Company, Inc. (NYSE: AWK) [beige] leaked only 19%, Aqua America Inc. (NYSE: WTR) [purple] spilled only 22%, and American States Water Company (NYSE: AWR) [orange] dripped a mere 17%.

Source: BigCharts.com

In the Cons graph, the utilities' inability to capture upward market momentum has been clearly attested to since the recovery began in early 2009. Where the S&P 500 has soared some 200%, the utilities fund XLU has managed to pump out just half as much, some 100%.

Even so, each of the three largest U.S. water utilities performed a little differently, with WTR keeping true to its nature as a slow moving utility by gaining only 85%, AWR proving a little more aggressive than its peers by rising some 130%, while AWK stepped completely out of character by gushing upward some 210%, beating even the broader market itself. (Just don't expect that to happen all that often.)

On an annualized basis, where the S&P 500 index has averaged 35.29% and the XLU has averaged 17.65%, WTR has averaged 15%, AWR has averaged 22.94%, while AWK has averaged 37.06% per year. What is more, each utility averages annual dividend yields of about 2.5% which are not represented by the plot lines.

Source: BigCharts.com

While annual returns ranging from 17.5% to 39.56% (average stock appreciation plus average dividend) would be very attractive during a normal market environment, the past few years have not been a normal market environment. Ultra-low interest rates have forced investors out of low yielding bonds into equities in an effort to capture some more generous upside appreciation, further boosting the equities' bullish momentum. Not only did the Federal Reserve stimulus and low interest rates reduce bond income, they also reduced equity risk, making stocks' low-risk/high-return profile irresistible.

But what will happen to utilities now that the Fed has terminated its monthly bond purchases and turned off the tap of easy money stimulus? And what will happen in a year or two when it begins slowly increasing interest rates?

Sadly, the raising of rates will likely cut into the utilities' profits, as theirs are very capital intensive operations carrying high levels of debt. The three water utilities here compared carry debt loads ranging from 24% to 63% of their market caps, much higher than the broader market average debt load. As interest rates rise, the interest paid when rolling debt forward will increase, creating a drag on profits.

For this reason, the water utilities industry is seen vastly underperforming the broader market S&P 500's average earnings growth rate as tabled below, where green indicates outperformance, while yellow denotes underperformance.

Though growth is expected during the current and next quarters, earnings are seen shrinking in 2015, before returning to growth over the next five years - all the while underperforming the broader market's growth rate.

Zooming-in a little closer, the three largest U.S. companies in the industry are expected to more or less continue their recent performances graphed above, with AWK outgrowing its competitors for the most part from the current quarter on through the next five years.

Interestingly, while AWR's earnings are expected to shrink this quarter, the loss is expected to be reclaimed and then some by next quarter, though the longer term still looks sluggish.

Yet there is more than earnings growth to consider when sizing up a company as a potential investment. How do the three compare against one another in other metrics, and which makes the best investment?

Let's answer that by comparing their company fundamentals using the following format: a) financial comparisons, b) estimates and analyst recommendations, and c) rankings with accompanying data table. As we compare each metric, the best performing company will be shaded green, while the worst performing will be shaded yellow, which will later be tallied for the final ranking.

A) Financial Comparisons

Market Capitalization: While company size does not necessarily imply an advantage and is thus not ranked, it is important as a denominator against which other financial data will be compared for ranking.

Growth: Since revenues and expenses can vary greatly from one season to another, growth is measured on a year-over-year quarterly basis, where Q1 of this year is compared to Q1 of the previous year, for example.

In the most recently reported quarter, AWR posted the greatest revenue growth year-over-year, while WTR delivered the greatest earnings growth. At the lowest growth end of the spectrum sits AWK, quite opposite to the future projections tabled above.

Profitability: A company's margins are important in determining how much profit the company generates from its sales. Operating margin indicates the percentage earned after operating costs, such as labor, materials, and overhead. Profit margin indicates the profit left over after operating costs plus all other costs, including debt, interest, taxes and depreciation.

Of our three contestants, WTR operated with the widest profit and operating margins, while AWR contended with the narrowest.

Management Effectiveness: Shareholders are keenly interested in management's ability to do more with what has been given to it. Management's effectiveness is measured by the returns generated from the assets under its control, and from the equity invested into the company by shareholders.

For their managerial performance, where AWR's management team delivered the greatest returns on assets and WTR's team delivered the greatest returns on equity, WTR balanced itself with the least returns on assets, while AWK's team delivered the least returns on equity.

Earnings Per Share: Of all the metrics measuring a company's income, earnings per share is probably the most meaningful to shareholders, as this represents the value that the company is adding to each share outstanding. Since the number of shares outstanding varies from company to company, I prefer to convert EPS into a percentage of the current stock price to better determine where an investment could gain the most value.

Of the three companies here compared, WTR provides common stockholders with the greatest diluted earnings per share gain as a percentage of its current share price, while AWK's DEPS over stock price is the lowest - although all three are very close to one another.

Share Price Value: Even if a company outperforms its peers on all the above metrics, investors may still shy away from its stock if its price is already trading too high. This is where the stock price relative to forward earnings and company book value come under scrutiny, as well as the stock price relative to earnings relative to earnings growth, known as the PEG ratio. Lower ratios indicate the stock price is currently trading at a cheaper price than its peers, and might thus be a bargain.

Among our three combatants, AWK's stock is cheapest relative to forward earnings, company book value, and 5-year PEG. At the overpriced end of the scale, where AWR's stock is the most overpriced relative to forward earnings and PEG, WTR's is the most overvalued relative to book.

B) Estimates and Analyst Recommendations

Of course, no matter how skilled we perceive ourselves to be at gauging a stock's prospects as an investment, we'd be wise to at least consider what professional analysts and the companies themselves are projecting - including estimated future earnings per share and the growth rate of those earnings, stock price targets, and buy/sell recommendations.

Earnings Estimates: To properly compare estimated future earnings per share across multiple companies, we would need to convert them into a percentage of their stocks' current prices.

Of our three specimens, WTR offers the highest percentage of the current quarter's earnings, while AWR offers it relative to next quarter's earnings, and AWK delivers it for 2015. Meanwhile, AWR offers the lowest percentage of future earnings over current stock price overall.

Earnings Growth: For long-term investors, this metric is one of the most important to consider, as it denotes the percentage by which earnings are expected to grow or shrink as compared to earnings from corresponding periods a year prior.

For earnings growth, AWK is projected to deliver the greatest growth most of the way, while AWR is seen delivering it next quarter - but only after shrinking by almost as much in the current quarter. At the low growth end of the scale, both AWR and WTR alternate the slowest growth placements.

Price Targets: Like earnings estimates above, a company's stock price targets must also be converted into a percentage of its current price to properly compare multiple companies.

For their high, mean and low price targets over the coming 12 months, analysts believe WTR's stock has the greatest upside potential and least downside risk, while AWR's stock has the least upside and greatest downside.

Buy/Sell Recommendations: After all is said and done, perhaps the one gauge that sums it all up are analyst recommendations. These have been converted into the percentage of analysts recommending each level. However, I factor only the strong buy and buy recommendations into the ranking. Hold, underperform and sell recommendations are not ranked since they are determined after determining the winners of the strong buy and buy categories, and would only be negating those winners of their duly earned titles.

Of our three contenders, AWK is best recommended with 8 strong buys and 6 buys representing a combined 87.5% of its 16 analysts, followed by WTR with 3 strong buy and 3 buy recommendations representing 50% of its 12 analysts, and lastly by AWR with 1 strong buy and 0 buy ratings representing 16.67% of its 6 analysts.

C) Rankings

Having crunched all the numbers and compared all the projections, the time has come to tally up the wins and losses and rank our three competitors against one another.

In the table below, you will find all of the data considered above plus a few others not reviewed. Here is where using a company's market cap as a denominator comes into play, as much of the data in the table has been converted into a percentage of market cap for a fair comparison.

The first and last placed companies are shaded. We then add together each company's finishes to determine its overall ranking, with first place finishes counting as merits while last place finishes count as demerits.

And the winners are... AWK and WTR in a tie finish, each ending with a net score of +4. Though if we had to pick one, we'd likely give the decision to AWK for having scored one additional first place merit. AWR, for its part, slipped down the drain into last place with a net score of -9.

Where the Water Utilities industry is expected to underperform the S&P broader market significantly this quarter and next, with earnings shrinkage in 2015 before returning to modest underperformance over the next five years, the three largest U.S. companies in the space are expected to more or less continue along their recent paths, with AWK leading the way close to the broader market's growth, while WTR and AWR trail farther behind in earnings growth that is closer to that of the industry average.

After taking all company fundamentals into account, American Water Works Company pumps out more value for investors, given its lowest stock price ratios, highest EBITDA over market cap, highest percentage of mid-term earnings over current stock price, highest future earnings growth overall, and most analyst strong buy and buy recommendations - narrowly winning the water utilities industry competition by a tie-breaking concession.

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