Water Utilities Are Poised To Continue Outperforming

Summary

• Recent moves by bond markets and the Federal Reserve, as well as economic uncertainty arising from the Covid-19 virus, indicate a continued environment of low-growth, low-inflation, and low interest rates.
• Water utilities have performed well under the low-growth, low-inflation, low interest rate environment.
• Water utilities are a bond proxy.
• The growth prospects of water utilities, especially through M&A, provide a secular tailwind to the sector.
• Opportunistically add water utilities to your portfolio during times of volatility, with an emphasis on the utilities best positioned to grow via M&A.

Water Utility Investment Thesis

The growing outbreak of Covid-19 virus, or Coronavirus, has thrown a wrench in what had initially appeared to be another year of cruising to double-digit gains. The S&P 500 (SPY) notched a quick 8% over the first month and a half of 2020 before correcting 16% from its 2020 peak. It now sits at $297.46, down almost 8% on the year.

The threat of the Coronavirus has, at a minimum, dented GDP - forecasts for global growth of around 3% now look unsustainable, with a number of august institutions cutting forecasts to the 2%-2.5% range, with the potential for a steeper drop should the virus continue to spread.

The virus is impacting economic activity both directly and indirectly. The direct impact arises from a breakdown in production and trade as workers fall ill, businesses slow or shut to prevent the spread of infection, and the movement of people and labor becomes constricted. Obviously, given the outbreak centered in China, the world’s second largest economy and largest exporter, the ramifications for the global economy could be massive - especially since China exports many mission-critical components.

The uncertainty of the virus adds another wrinkle to the economic threat, as companies defer investment until they get a clearer idea of the economic impact of the virus. Even after the virus has been brought under better control, this hesitancy to invest can instigate a further drop in growth. With growth at a low rate and trending even lower, the Federal Reserve in easing mode, and 10-year Treasuries closing Friday at a record-low 0.71%, it’s not hard to imagine another round of rate-cutting and monetary stimulus to keep the economy from falling into a recession.

In an environment of uncertainty, low-growth, low-inflation, and low interest rates, I see continued outperformance of quality growth and steady dividend payers. One sector that figures to benefit from this scenario are water utilities.

The sector already trades at a substantial premium to the broader market, so this is far from a value play but, under the current market dynamics, they look like a good bet to outperform. Moreover, the recent volatility has offered the chance to get in at more modest valuations. While many of the water utilities have recovered most of their losses, continued volatility is likely to offer future pullbacks, which I would view as chances to accumulate shares, albeit without going all in at once.

In addition to their defensive characteristics, I’d also argue that water utilities have an underappreciated growth story: there is a trend towards consolidation due to the growing costs of treating water, which stem from both increasingly stringent water quality standards and increasingly complex waters requiring treatment. With roughly 50K water utilities in the US, there is a long runway for growth, particularly for larger consolidators such as American Water Works (AWK) and Essential Utilities (WTRG).

Figure 1. Fragmentation of domestic water, electric, and gas utilities.

Lastly, another potential growth vector could come in the form of an infrastructure package from Congress. There always seems to be talk of an infrastructure bill and no action, but with monetary stimulus reaching the bounds of its benefits, it feels more likely than it has in several years that there could be a package. However, from an investing standpoint, I wouldn’t base any decisions on this, but rather view it as a potential avenue for growth that arguably becomes more likely if the economy were to experience a sharp slowdown.

Table 1. Breakdown of the top domestic water utilities

Metric/Utility	AWK	WTRG	AWR	CWT	SJW	MSEX	YORW	ARTNA/B
Price	$141.00	$46.67	$87.78	$54.37	$69.33	$67.21	$48.78	$35.53
Market Cap	$25.5B	$10.4B	3.2B	$2.6B	$2.0B	$1.2B	$636M	$330M
Debt	$8.6B	$2.9B	$481M	$787M	$1.3B	$231M	$94M	$115M
Yield	1.4%	2%	1.4%	1.6%	1.9%	1.6%	1.5%	2.8%
Beta	0.22	0.54	0.06	0.26	0.23	0.36	0.38	0.20
YoY EPS Growth	6.7%	6.1%*	2%	18.5%*	29.7%*	2.6%	18.5%*	11.5%
Forward P/E	33.3	28.3	36.4	31.9	27.4	30.9	41	21.9**

Click to enlarge

All values sourced from Schwab.com. Note: *Designates Non-GAAP projected 2020 earnings as these companies took one-time charges that impacted previous year earnings, sometimes significantly, explaining why in some cases their growth rates look so elevated; **Trailing 12-month PE.

In general, I believe the utilities with a demonstrated history of growth by M&A (American Water Works, Essential Utilities, California Water Service (CWT), and San Jose Water (SJW)) to be the most attractive way to play the sector; at current levels, I believe American Water Works, Essential Utilities, San Jose Water, Artesian Resources (ARTNA, OTCQB:ARTNB) to be the best options. However, my bottom-line recommendation to investors is to opportunistically accumulate shares of whichever companies experience the deepest selloffs during market volatility, ultimately owning a basket of water utilities that, ideally, is weighted towards the ones that regularly drive growth through M&A. Below is an overview of my top four choices at current prices (AWK, WTRG, SJW, ARTNA/B).

Four Water Utilities

American Water Works: American Water Works is the juggernaut of American water utilities. They are 3x larger than their next largest competitor (Essential Utilities), serve 14M people in 46 states and 1 Canadian province (NJ and PA account for ~50% of sales), target 7%-10% CAGR in both EPS and the dividend through 2024, and are at the leading edge of next generation water utility practices, such as operating advanced water quality laboratories and investing in smart infrastructure.

During the post-financial bull market, AWK has consistently traded at a premium to both the S&P 500 and their water utility peers - in other words, it is an expensive play in an expensive sector. However, while I have long admired AWK’s business model, I have more recently come to believe they trade closer to fair value than meets the eye, particularly in the context of a low-growth, low-rate, low-inflation environment. American Water has proven deft at routinely driving high single-digit growth through rate increases, organic customer growth, and M&A, and I envision this pattern continuing for decades given the secular drive towards consolidation, the fragmented nature of the industry, American Water’s ample access to capital markets, and the fact that water will always remain a vital part of life and industry.

AWK has weathered the recent volatility better than their peers and is back to making new highs. As difficult as it is to buy into such an expensive company, I see shares continuing to outperform in this environment. My advice to investors would be to slowly scale in over time, and to prioritize buying AWK shares over other water utilities when the market sells off.

A couple of company-specific risks include: Over-reliance on M&A to drive growth, retirement of longtime CEO Susan Story.

Figure 2. Recent American Water M&A activity

Essential Utilities: Essential Utilities (formerly Aqua America) is the other heavyweight in the water utilities sector. They serve more than three million people in eight states, with Pennsylvania accounting for about 50% of revenue. Like American Water, Essential Utilities is a leader in the next generation model of a water utility (investments in smart infrastructure, advanced water quality laboratories and R&D) and looks poised to continue growing through a combination of M&A, rate increases, and organic customer growth. Essential has grown its dividend by an average CAGR of 7.3% over the past six years and projects EPS growth at a CAGR of 5-7% over the next three years. Essential Utilities is also a Dividend Aristocrat, having raised their dividend for 28 consecutive years.

Essential has been especially active on the M&A front in recent years. In addition to their typical strategy of small, bolt-on acquisitions, Essential also recently signed two large deals. One of these deals was truly transformative, as Essential branched out from water to buy People’s Gas, a natural gas utility serving 662,000 customers in Pennsylvania, Kentucky, and West Virginia, for $4.3B. This deal recently closed. Essential’s other large deal was their agreement to purchase the DELCORA wastewater treatment facility and associated sewers for $276.5M. The deal is pending closing, but should it get the green light to move forward, Essential will have added ~200,000 wastewater customers through this deal alone.

While I am very positive on the DELCORA acquisition, I am less excited about the People’s deal - it takes Essential away from their core competency of water and exposes them to the risks that come with transporting and storing gas. However, I have warmed to the deal over time, as gas is likely to stay cheap and commonly used in the areas where People’s operates, it enabled the company to quickly gain scale through a profitable endeavor, and it may open the door to future water M&A in areas where People’s operates.

For investors interested in Essential Utilities, I would recommend making an account through computershare.com, where dividends can be reinvested at a 5% discount.

Several company-specific risks include: Over-reliance on M&A and trouble integrating/operating the People’s natural gas arm.

Figure 3. Essential Utilities water and gas operations

San Jose Water: In 2019, San Jose Water closed on a transformative deal to merge with Connecticut Water, giving them a foothold in the Northeast (Connecticut and Maine) that counterbalances their historic operations in California and, to a lesser degree, Texas. San Jose Water now earns approximately 60% of its profit from California, 23% from Connecticut, and the remainder split evenly between Texas and Maine (SJW also has a small real estate operation that accounts for ~1% of profits).

After a couple of years of declining profits largely due to charges associated with the merger, San Jose Water expects to return to EPS growth in 2020, recently forecasting a range of $2.25-$2.35. San Jose Water’s dividend has grown by an average of 8.6% over the last seven years, and with a recent 6.7% increase of the quarterly dividend, solid growth looks likely to continue - particularly in the context of SJW streak of 52 consecutive annual dividend raises, giving it the rare distinction of being a Dividend King.

I expect SJW to continue focusing on ensuring the integration between its SW and NE operations goes smoothly, but with the integration well underway at this point, I’d imagine SJW will turn their attention back to exploring other M&A opportunities sooner rather than later. Management has indicated that recent developments in Texas (fair market legislation and establishment of an infrastructure replacement surcharge) have made the market more attractive from a financial standpoint and can facilitate increased M&A activity. Though San Jose Water could of course pursue M&A anywhere, based on management’s comments, I’m expecting them to focus on Texas for the intermediate future.

A few company-specific risks include: high exposure to California’s regulatory environment, California's propensity to experience natural disaster (earthquakes, droughts, fires, etc.), debt taken on as a part of the merger, and trouble competing in the M&A market against the deeper pockets of AWK and WTRG.

Figure 4. San Jose Water areas served

Artesian Resources: Delaware-based Artesian Resources differs from most of the other domestic utilities in a few ways. For one, it is family-controlled: the founding Taylor family controls the company through the highly illiquid ARTNB shares. As a consequence of the family control, Artesian does not hold conference calls or investor presentations. The 10-K and quarterly earnings releases are essentially the extent of communication with investors. Artesian also differs from the other utilities in its small size, which makes it more challenging to secure the financing required to grow by M&A.

Despite this, I believe Artesian to be worth a close look. While the company is controlled by insiders, I don’t necessarily see this as a bad thing - they own ~11% of Artesian, and are thus invested in the long-term success of the company. Artesian also appears to be well run - they have a long track record of safely and inexpensively treating, transporting, and storing water. They also seem to punch above their weight in operations, as they operate both water and wastewater plants, and recently made a significant investment in a water recharge facility that bolsters their presence in water recycling and aquifer management.

Artesian does make the occasional acquisition, a recent example being their 2018 purchase of the Slaughter Beach Water Company, a small water utility serving Slaughter Beach, a community on the Delaware Bay.

Artesian also stands out due to their heftier dividend and more modest valuation. While I do believe Artesian should trade at a discount to their water utility peers, especially the larger ones most active in M&A, I’m not convinced the discount should be so steep (25%-50%). Artesian’s 2.8% dividend is growing slowly (~3% a year in two 1.5% raise increments), but with solid EPS growth over the past 10 years (up > 50%), a 22-year dividend growth streak, and a durable business model, Artesian should be able to continue growing its revenue, EPS, and dividends for the foreseeable future.

Company-specific risks include: Family control, inability to compete with larger peers for M&A targets, geographic concentration (Delmarva Peninsula), micro-cap.

Figure 5. Artesian Water financials

Risks

This article is meant to make an argument for the continued outperformance of water utilities compared to broader indices. The thesis is predicated on a continued environment of low-growth, low-inflation, and low interest rates. Should any of these conditions change, it would warrant a reassessment of the investment approach. Inflation in particular is one to keep a close eye one. While inflation has been benign for years, the Coronavirus could hurt supply, leading to inflation and interest rate increases.

It is also important to emphasize that, though water utilities are safe haven stocks that often trade as bond proxies, they are not bonds. As the last week showed, these stocks can be prone to sharp swings in either direction, and in times of market turmoil can behave much differently than a bond.

Lastly, to get a better idea of the industry or company-specific risks, I highly recommend visiting the 10-K of any company before investing in the stock and closely looking over the "Risks" section. A few broad risks that apply to the sector are: failure to safely treat and transport water, damage to infrastructure, failure to win rate cases, and a turn in public opinion away from privately-owned water utilities.

Conclusions

As unbelievable of a run as water utilities have had, recent developments in the global economy and markets, most notably the economic fallout from the Coronavirus and subsequent interest rate cut and drop in bond yields, indicate an investing environment where bonds and bond proxies such as water utilities continue to perform well. Moreover, in addition to their defensive characteristics, water utilities are in a position to grow for decades via M&A. I recommend investors take advantage of the jump in volatility to purchase shares of water utilities, with a focus on the larger consolidators (AWK, WTRG, CWT, SJW).

At current prices, I view the best option of the lot to be WTRG - their combination of valuation, growth prospects, and scale make them my top pick, though I'll emphasize once more that investors should be open to investing in the whole sector and opportunistically accumulate what has sold off. Lastly, while everyone’s risk profile is different, I’d also recommend caution in building positions - the fallout from the Coronavirus is impossible to predict at this point, and markets could fall much further than they have already.

Good luck with your investments and thank you for reading.

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Analyst’s Disclosure: I am/we are long ARTNA, AWK, SJW. 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.