If you're an investor in American Water Works (AWK), you have to be pleased with your good fortune lately. Not only has the company been one of the top utility stocks in the country over the past decade, but its performance has also gotten even stronger over the past year. The company had a fantastic 2018, largely ignored the October correction, and is now knocking on the door of fresh all-time highs.
American Water Works is continuing to leave its peers, be it the S&P 500, the utility sector, or other water companies, in particular, farther and farther behind. But can the company's breathtaking outperformance keep up? It's a rather curious case.
How Strong Have American Water Works' Results Been?
Before we get too far into this article, I want to make it clear: the company has delivered excellent results. By all accounts, this looks like an operation with great management and assets. And yet, there's a fair price for everything. It seems increasingly clear that investors are getting ahead of themselves in the case of AWK stock in particular. The easiest place to start is with valuation - earnings are going up, sure, but the valuation ratio is going up in tandem. Note carefully, this is a chart of the stock's P/E ratio, not the stock price:
To be fair to the company, the trailing P/E ratio is closer to 31x at the moment once you back out recent one-time items. Still, you can see this is a company that routinely traded at 17-20x earnings for much of the first half of this decade before Wall Street suddenly became enamored of the stock. Also note that American Water Works IPOed in 2008, we can't look to past cycles to see where it traded on a P/E basis previously.
I'm not necessarily opposed to the idea of paying 20x or 25x earnings for a great company. Better that than 15x earnings for a mediocre firm in many cases. I've even justified paying 27x earnings for Brown-Forman (BF.A) (BF.B) before. But I think 30x earnings for a water utility might be a bridge too far.
Utilities: Capital Intensive Businesses
One of the great things about owning a company like Brown-Forman or other consumer staple companies is that they generate huge profits per dollar of capital invested in the business. I demonstrated this with my recent article on Hershey (HSY), writing that:
It hardly uses any capital due to extreme power in its brands and the wonderful profit margins for chocolate. Last year, Hershey had just $4.6 billion in hard assets (such as factories, machinery, and land) devoted to its business. From that modest capital base, it threw off $7.8 billion in sales and $1.2 billion in after-tax income.
I urge you to compare Hershey's profitability based on the minimal capital it has to employ against other stocks that you own. It's truly remarkable how much profitability, and with such consistency, that Hershey can generate from the North American chocolate business.
Return on invested capital "ROIC" may seem like a concept out in the accounting weeds, but it plays a very important role in future return expectations. A company like Hershey, with minimal capital expenditure needs, can spend most of its profits on share buybacks, dividends, and growth/acquisitions. As its detractors note, Hershey has made a number of questionable acquisitions in recent years. Yet, its stock has crushed the market, in large part because it is a free cash flow machine.
You can look at other companies trading at high P/E ratios, like American Water Works, and find significantly less appealing economics. In contrast to Hershey's $4.6 billion in hard assets, we find $17.1 billion in PP&E over at American Water Works after subtracting depreciation. It used those assets to generate $3.4 billion in revenues in 2018. That's precisely half what Hershey accomplished last year. Thus, American Water uses three times as much capital to produce 50% as much revenue. Its pre-tax income of $820 million also comes in well below Hershey's at $1.2 billion.
This is all logical and doesn't imply that there is anything wrong with American Water Works - the business. A water utility is inherently going to have a ton of infrastructure needed to carry out its operations. However, it's doubtful that American Water Works, in normal conditions, should trade at a far higher P/E ratio than Hershey. Right now American Water is at 28x forward earnings compared to Hershey at 19x. This makes little sense.
Think about it in another way. Given the highly capital intensive nature of American Water Works, they generate little to no free cash flow in most years. Here are the most recent four fiscal years (data from Gurufocus):
- 2014: +$63 million
- 2015: -$72 million
- 2016: -$106 million
- 2017: -$61 million
Here is Hershey's free cash flow, by comparison:
- 2014: +$492 million
- 2015: +$885 million
- 2016: +$714 million
- 2017: +$992 million
There's more to life than accounting earnings. Free cash flow is the direct precursor to things such as dividends and share buybacks that we love. In this case, the market caps here ($18 billion and $23 billion) aren't that different, and their net incomes are in the same ballpark as well. Yet one turns the majority of its pre-tax income into FCF, while the other is basically running even in terms of generating cash.
So how is American Water Works funding its dividend program, along with growth projects, if it isn't generating much free cash flow? Answer: with more debt. Since 2014, long-term debt is up from $5.4 billion to $7.5 billion, and its total liabilities are up from $11.1 billion to $15.0 billion. Again, that's fine, they are a highly regulated water utility with exceptionally stable revenue and profit sources so they can shoulder the load.
But it's hard to look at a company like American Water Works with virtually no free cash flow and think it makes sense to pay a much greater P/E ratio for it than a company who needs very little capex to keep its business growing. And beware that there are limits to how much debt companies can take on before running into trouble. In 2018, for the first time since it started offering sector outlooks, Moody's cut its outlook for utilities from stable to negative citing a "declining financial trend" in the sector. An analyst at Moody's noted that:
For utility holding companies, the consolidated ratio of FFO to debt has been on a steady decline, from 19% in 2013 to 17% at year-end 2017, and we expect it to decline further toward 15% through 2019."
Also, keep in mind that rising interest rates are a negative for utilities in general and American Water Works in particular. American Water Works earns around $600 million in net income per year. Thus, a 1% increase in its interest rate on $7.5 billion in long-term debt ($75/million year) can cause a rather substantial change in its earnings per share.
American Water Works: Mean Reversion Ahead?
Here's an interesting chart. Dating back to 2008, when American Water Works debuted its IPO, here is its performance against numerous other water industry peers along with the S&P 500 (orange line):
In the financial crisis, you can see all the water utilities outperformed the market nicely, as you'd expect. By 2014, however, the S&P caught back up with the industry as a whole, again, matching expectations. The market should outperform utilities in a strong uptrend. Since then, the water stocks have pulled ahead of the market again - albeit to a modest degree. This is likely either due to yield hunting (2016) or more recently a bid for safe-haven stocks.
As you can see, however, American Water Works has been out of step with both the market and its peers since 2011. By 2014, AWK stock was clearly outperforming its peers, and in 2016, the stock went almost exponential. If you buy the stock here, you have to hope there's no reversion to the mean. But with compounded earnings growth of 8%/year over the past five years and analysts also expecting 8%/year over the next five years, earnings will hardly bail you out from the starting 30x trailing P/E ratio.
At 8% earnings growth, in 2023, earnings would hit $4.87/share. That gets you to 20x 2023 earnings for a stock that was consistently trading at 18x earnings earlier this decade. I don't know about you, but I don't want to buy a stock that needs five years of normally-paced earnings growth merely get up to near its normal historical P/E ratio. Put another way, if the market went back to valuing AWK stock at 20x earnings today, the stock would plummet from $97 to $72 - a rather steep haircut for a defensive stock. Additionally, five years of 8%/year dividend growth gets you to just a 2.73% dividend yield if you hold the stock price constant at $97/share. So it's not like the dividend growth is enough to make up for the low starting yield and high starting valuation.
I'd love to hear the contrary argument in the comments. If you own AWK stock, and even better, if you've been buying recently, what am I missing? Is this stock going to trade at 30x P/E on a permanent basis going forward? Does management have some secret sauce that the rest of the water utilities are missing out on?
I will say that this is a fine business. The comments about capital intensity aren't even serious criticism. If the P/E ratio were at 18x here, it wouldn't be a problem. But at 30x earnings, with essentially no free cash flow and a mounting debt load, it's hard to see why this stock is going up so quickly. I don't expect AWK stock to crash or anything - if you buy it now and hold long enough, you'll eventually make money. But you could get a decade of low-single digit total returns while the business' fundamentals slowly catch up to the sizzling stock price.
Disclosure: I am/we are long BF.A,BF.B,HSY. 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.