Aqua America: This Dividend Aristocrat Is A Hold

About: Aqua America, Inc. (WTR)
by: Kody's Dividends

Aqua America is a typical well-run utility, which unsurprisingly makes it a Dividend Aristocrat.

Despite the risks associated with an entry into the gas utility industry, I believe the company will navigate these challenges reasonably well.

Aqua America is about as defensive of an investment as one could find, but it's also 17% overvalued.

Between the 2.2% yield, likely 6-7% earnings growth, and 1.5% valuation multiple contraction, Aqua America is likely to deliver 6.7-7.7% annual total returns over the next decade.

While I absolutely one day want to own this company, I am looking for an entry point around the company's long-term fair value yield of 2.5%.

Image Source: Gurufocus

As a dividend growth investor, I am always watching for high-quality companies in defensive sectors trading at fair value or at a discount to fair value.

While the utility sector is about 8% of my portfolio and accounts for 8% of my dividend income, I find that with the current utility sector PE ratio of 22.4 and Shiller PE ratio of 30.5, the sector is largely overvalued at this time.

One company that I would love to own one day is the water utility and soon-to-be gas utility company with its recent acquisition of Peoples Gas, Aqua America (WTR).

I will detail the overall reasons I would like to own this company which include its dividend safety and growth profile, the resilient nature of Aqua America's business, and its strong management team. We'll then delve into the only factor that is currently discouraging me from initiating a position in the company, which is its valuation. I'll then wrap it up by estimating future total returns from the company's current stock price, which is what I believe justifies my sitting on the sidelines.

A Very Safe And Moderately Fast Growing Dividend

As a dividend growth investor, dividend safety is very important to me because eventually, I'll be relying on dividends to meet the bulk of my expenses.

I will analyze Aqua America's EPS payout ratio, but I won't be analyzing the company's FCF payout ratio because as I've discussed with other utilities I have wrote about, utilities often invest in growth projects. Although these projects typically come with a guaranteed rate of return subject to approval from regulators, these growth projects consume much of a utility's cash flow, which explains why many utilities often actually have negative FCF.

During 2018, Aqua America generated non-GAAP EPS of $1.41, excluding Peoples transaction related expenses while paying dividends per share of $0.847, which equates to an EPS payout ratio of 60%. While this may be a high payout ratio in some industries, for a utility, a 60% payout ratio is conservative and exactly what I like to see.

Assuming an increase in the company's quarterly dividend per share from $0.219 to $0.237, the company is likely to pay out $0.912 in dividends for 2019 compared to the most recent guidance forecasting an adjusted diluted EPS midpoint of $1.475 ($1.45-$1.50), for a payout ratio of 61.8%.

Overall, the company's dividend obligation is very manageable and the company has left itself plenty of room to grow the dividend, even in any inevitable economic downturns.

Image Source: Simply Safe Dividends

It should come as no surprise that Aqua America is awarded a near perfect dividend safety score of 94 from the dividend research firm Simply Safe Dividends.

While we have established that Aqua America's dividend is very safe for the foreseeable future, this is only one component of what I evaluate in a dividend stock. Next, we'll determine what a reasonable dividend growth rate is for Aqua America going forward.

Image Source: Aqua America May 2019 Investor Presentation

As illustrated above, Aqua America has shown a tremendous ability to grow its dividend, with a 5 year DGR of 7.6%. Furthermore, the company has grown its dividend by ~7% annually over the past 20 years.

While the dividend growth of the past doesn't mean anything to newer investors or future investors in the company, I examine this because it can serve as a measure for future expectations, if the overall company fundamentals remain largely unchanged.

When we consider that Nasdaq is forecasting that Aqua America will grow its earnings 6% annually over the next 5 years, I believe that the status quo 7-8% dividend growth of the past will continue in the future.

We'll now examine the underlying reasons why analysts believe it is likely Aqua America will continue to deliver growth resembling that of the past.

A Resilient Business And Strong Management Team

Image Source: Aqua America May 2019 Investor Presentation

As the company's name would suggest, Aqua America is a regulated water utility company that serves approximately 3 million residential water, commercial water, fire protection, industrial water, wastewater, and other water utility customers in Ohio, Texas, North Carolina, Illinois, Pennsylvania, Virginia, Indiana, and New Jersey.

The company boasts an incredibly expansive water infrastructure, with over 13,347 miles of water main, 188 wastewater treatment plants, and 21 water filtration plants.

In addition to the company's vast water infrastructure, the business model is highly durable not only because of the necessary services it provides to its customers, but because over 99% of its revenues in FY 2018 were regulated. Regulated utilities operate similar to monopolies in that they are the only real supplier of utility services in certain geographic areas. In exchange for control of the provision of utility services in these geographic areas, regulated utilities must obtain approval from state and local regulators for its proposed rates.

Image Source: Aqua America 2018 10-K

Geographically, the majority of Aqua America's revenues originate in Pennsylvania, with the rest of the company's revenues being fairly evenly split among the remaining states.

Image Source: Aqua America 2018 10-K

The company operates in 10 segments and 8 are composed of its water and wastewater regulated utility operations, while the other two segments are not quantitatively significant to be reportable and are composed of Aqua Resources and Aqua Infrastructure. As illustrated above, the Residential Water and Commercial Water segments accounted the vast majority of the company's revenue in 2018, at 73.6%.

Image Source: Aqua America May 2019 Investor Presentation

Aqua America's recent acquisition of Peoples Gas in an all-cash transaction is the first major acquisition of a gas utility by a water provider.

While this is a first time event, it's important to note that this acquisition wasn't conducted for PR purposes.

Aqua America has made a calculated decision to diversify its business into the gas utility industry.

Image Source: Aqua America May 2019 Investor Presentation

The company estimates that the acquisition will be accretive in its first full year, which means that once the transaction closes later this year, the deal will be a positive growth factor for Aqua America in 2020.

While we're on the topic of the deal closing, it's worth mentioning that the deal has been completely financed at this point, and the only necessary regulatory approval that is pending at this point is in Pennsylvania.

Besides the $750 million in recently secured financing, the company expects to issue $2.5 billion in equity to fund the bulk of the transaction, and with shares near an all-time high, that is a brilliant move.

Furthermore, the company will continue to benefit from the acquisition well beyond 2020 as it's expected that the acquisition will grow its rate base at a CAGR of 8-10% in the gas segment, compared to the 7% growth of the water segment. The main focus will continue to be water, as it will account for about 70% of revenues, but this deal provides a nice boost to Aqua America's growth prospects over the long-term.

Image Source: Aqua America May 2019 Investor Presentation

It's also worth mentioning that due to the estimated need for $1 trillion in spending over the next 25 years and municipalities that are under financial pressure, a good portion of the spending to meet America's water infrastructure needs in the years ahead will be executed by companies such as Aqua America. Aqua America has plenty of room to grow as evidenced by the fact that it serves only 1% of the US population in the water segments and 0.1% of the population in the wastewater segment.

It's for this very reason that Aqua America's CEO Chris Franklin believes that there will be a surge in water related deals in the future. We're already starting to see this play out, which is evidenced by the fact that deals related to water utilities in the US have increased from 14 in 2017 to 33 in 2018.

Image Source: Aqua America May 2019 Investor Presentation

The lack of financial resources in many municipalities throughout the states served by Aqua America to maintain their water infrastructure and across the country have caused 6 of the states Aqua America services to enact regulations that are favorable to water and wastewater utilities, such as Aqua America.

Image Source: Aqua America May 2019 Investor Presentation

This fair value legislation allows water utilities to raise customer rates beyond just recouping the cost of the acquisition of a municipality's water infrastructure assets, which is the primary reason for the increased water related deals and the recent surge in municipal transactions. Aqua America did over $130 million in these municipal deals in 2018 and will continue to do even more in the years ahead.

In addition to the favorable terms being provided for water utilities, the company is also fortunate enough to possess a solid management team led by 26 year company veteran and CEO Chris Franklin. The company's COO, Rick Fox has also been with the company for 17 years, and prior to his joining Aqua America, he was in the chemical manufacturing industry for 17 years. These two along with the other executives have spearheaded Aqua America's efforts to enrich its shareholders.

Image Source: Aqua America May 2019 Investor Presentation

Between the increase in base rates, customer growth of 2-3%, the closing of the Peoples acquisition in the weeks and/or months ahead, and the continued need for infrastructure investments to boost the United States' poor water and wastewater infrastructure rating, there are plenty of reasons to be optimistic toward Aqua America's future.

Risks To Consider

While Aqua America is a high-quality company operating in about as defensive of an industry as one can imagine, that doesn't mean the company is immune to risk.

The first risk to consider is that the company's water supply, including that which is provided to its customers, is subject to various contaminants which could result in a disruption of services to its customers, additional costs, and even fines and litigation that could harm the company's reputation and have a detrimental impact on the company's financial results.

The events in Flint, Michigan have brought with them increased scrutiny to the issue of lead and other contaminants in drinking water from home plumbing. While the company has been diligent in its efforts to comply with all laws and regulations pertaining to this matter, new legislation calling for stricter regulations could lead to increased costs for Aqua America. Although the company may be able to pass these costs onto its customers through rate increases, there is no guarantee that the various state regulators would approve such rate increases to cover these costs (Aqua America's most recent 10-K, page 14).

As a regulated utility, it is also worth mentioning that the company's rates charged to customers are subject to regulatory approval. A failure to secure rate increases or a delay in securing rate increases could have a negative impact on the company's financial results (Aqua America's most recent 10-K, page 15).

Yet another risk is that any failure in Aqua America's water or wastewater treatment plants, network of water and wastewater pipes, or water reservoirs, could result in claims for injury or property damage. There may also be the need to shutdown facilities for an extended period of time to conduct necessary repairs, which would also be detrimental to the company's financial results and reputation (Aqua America's most recent 10-K, page 15).

Because of the company's extensive operations in Pennsylvania, it is also worth mentioning that there is concentration risk in the case of Aqua America. Any natural disasters, unfavorable labor conditions from Aqua America's perspective, or economic conditions could ultimately impact the company's financial results (Aqua America's most recent 10-K, page 18).

It's also noteworthy to mention that as a utility, we've discussed that the company is reliant upon a number of sources to fund its various projects at all phases of development. A large part of the Peoples transaction is being funded by the issuance of additional equity. Although the company's price is quite elevated at the present time, it's worth noting that the fickle nature of the equity markets poses a risk to the company. Should the company's share price precipitously drop in a material way for whatever reason, this could cause deals such as Peoples to possibly be dilutive to shareholders rather than accretive.

The final risk is that pending the approval of the Peoples acquisition, there is the possibility that Aqua America may be unable to adequately integrate the company into its operations, thereby harming its financial results (Aqua America's most recent 10-K, page 18). Multi-billion acquisitions are incredibly complex and come with the possibility of failure, which is something investors must take into consideration.

While the risks outlined above are by no means a complete listing of the risks facing Aqua America, I believe these are the most critical risks facing the company. For a more comprehensive listing of the risks facing Aqua America, I would refer interested readers to pages 13-24 of the company's most recent 10-K.

A Wonderful Company Trading At A Moderate Premium

Since we've established that Aqua America is a defensive company that belongs in a DGI portfolio, we'll now discuss the company's current stock price with relation to its fair value.

The first valuation metric I'll use to examine the company is its 13-year median yield. The company's current dividend yield of 2.15% is well below its 13-year median yield of 2.48%. Unless you believe that the company's fundamentals have materially improved in the past few years, this would imply that Aqua America shares are overvalued.

Assuming a reversion to a dividend yield of 2.48% and a fair value of $35.48 a share, this would indicate that the company is trading at a 15.1% premium to fair value and poses 13.1% downside from its current price of $40.84 a share. (as of June 8, 2019).

The next valuation metric we'll examine is the forward PE ratio. Aqua America's current forward PE ratio of 27.5 is above its 5 year average of 23.2, which is yet another metric suggesting shares of Aqua America are currently overvalued.

Assuming a reversion to a forward PE ratio of 23.2 and a fair value of $34.45, this would imply that Aqua America is trading at an 18.5% premium to fair value and poses 15.6% downside from its current price.

Image Source: Investopedia

The final valuation method I'll use to arrive at a fair value for shares of Aqua America is the dividend discount model or DDM.

The first variable of the DDM formula is straightforward as the expected dividend per share is simply referring to the annualized dividend per share of a company, which is currently $0.88 in the case of Aqua America.

The next variable of the formula is the cost of capital equity, which is another term for an investor's required rate of return. While this can vary significantly from one investor to another, I require a rate of return of 10%.

The third and final variable of the formula is the dividend growth rate, which can be difficult to predict because we must take into account several variables, such as whether the company has room to expand its dividend payout ratio, expected earnings per share growth over the long-term, a company's balance sheet strength or lack thereof, and industry fundamentals.

When I take into consideration that Aqua America's payout ratio is ideal as it currently is, I am forecasting that the company's dividend growth will roughly track whatever earnings growth it is able to deliver over the long-term. In the case of Aqua America, I believe a continuation of the trend of 7-8% dividend growth is a reasonable expectation for the future, so I will split the difference at 7.5%.

This gives us a fair value of $35.20 a share, which means that shares of Aqua America are currently trading at a 16.0% premium to fair value and pose 13.8% downside.

When we average the three fair values, we arrive at a fair value of $35.04 a share. This implies that Aqua America shares are trading at a 16.6% premium to fair value and pose 14.2% downside from the current price.

Summary: Now Isn't The Time To Buy This Dividend Aristocrat

As a water and gas utility, Aqua America certainly isn't one of the most exciting dividend growth companies, but the company's safe and reasonably fast growing dividend will continue to steadily enrich its shareholders. As the investing adage goes, boring is beautiful, and Aqua America is by all accounts a fairly boring company.

Despite the added risks associated with the company's recent entry into the gas utility industry and the debt and issuance of $2.5 billion in equity it is taking on from the Peoples Gas deal, I believe that management will continue to steer the company in the right direction, which will ensure the company's dividend continues to grow in the 7% range.

Unfortunately, the company's shares are nearly 17% overvalued and for a utility, one can't afford to overpay and expect satisfactory results. It is for that very reason, I am staying on the sidelines until the price of the company's shares drop to around $35.

Between the starting yield of ~2.2%, earnings growth of 6-7%, and a valuation multiple contraction of 1.5%, it is likely that Aqua America will generate annual total returns of 6.7-7.7% over the next decade. Once the valuation multiple reaches a point where it will likely remain static over the long-term, Aqua America is a company with a very high likelihood of delivering 8.5-9.5% returns over the long-term, which is reasonable enough to justify a small position in the company.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.