American Water Works: Fundamentals Are Unattractive, Cash Out Gains

Summary

• Being in the utility industry, AWK was not an exception from the challenging 2022 FY.
• AWK faces sequential dilutions until 2027, which I believe will affect the company's share prices.
• In light of the unattractive fundamentals, it is preferable to cash out gains and hold off on reinvesting until conditions are more favorable.

NicoElNino

Investment Thesis

Through its subsidiaries, American Water Works Company, Inc. (NYSE:AWK) provides water and waste water services in the United States. Being in the utility industry, AWK was not an exception from the challenging 2022 FY. The utility industry was generally awful regarding shareholder returns due to a harsh macroeconomic environment. Although the entire sector performed poorly, it is worth noting that AWK underperformed both the US water utility industry and the entire US market. AWK had a shareholder return of -10.6% compared to -8.2% and -8.8% of the US water utility industry and the US market, respectively.

The performance of the company's shares over the previous year was generally dismal. Its shares fell by roughly 11%, which the company attributes to the challenging macroeconomic environment, particularly the high inflation. I agree that this was a significant element, but the company's share dilution over the previous year played a role.

After this kind of result, the future matters in terms of investment. The stock price has leveled out after a relatively strong upward trajectory over the past five years, suggesting that the market has already overvalued the company. With its year-to-date price performance and forward price-to-earnings ratio of 28.61X, down from 30.27X, I think AWK is headed in the wrong direction. Considering the company's continual share dilutions and weak balance sheet, this PE shrinkage suggests an impending bear trend. In addition, the company is expensive according to relative valuation criteria, and its fundamentals are unappealing; thus, I expect it to continue on a downward trend.

Share Dilutions

Dilution can be detrimental to shareholders because it dilutes their ownership stake and diminishes their say in business affairs. Shareholders may find it more challenging to sell their shares at a price that reflects the company's true value if dilution has occurred. With this context in mind, AWK has diluted its shareholders' ownership during the past year. It plans to raise more capital through stock offerings, which will continue impacting current shareholders and eventually affect the company's share prices.

Over the last year, total shares outstanding have increased by 7.1%, diluting the holdings of existing shareholders. During the company's Q4 2022 call transcript, the CFO said that the company's plan for financing included issuing about $2 billion more equity between 2023 and 2027. This shows that investors should be ready for their shares to be diluted over time.

John Griffith," Moving on to our financing plan. We expect to issue an estimated $2 billion of equity from 2023 through 2027. Consistent with our prior messaging, subject to market conditions, we plan to raise a significant portion of the total planned equity in 2023. The remaining portion of the $2 billion of planned equity not completed in 2023 is expected to be issued near the end of the current five-year plan."

In what appears to be part of this strategic plan's execution, the company raised $1.4905 billion through a Follow-on Stock Offering earlier this month. The price range offered was $135.50, which represented a reduction of $2.0325 per share off the security's $2.0325 per share security price. It is apparent from this offering that the company is issuing its stock at a discount, which adds to the predicaments faced by existing shareholders who may want to sell their current holdings. Additionally, this discount supports my claim that the company's shares are overvalued, and this action will cause the share price of this company to trend downward.

Weak Balance Sheet

With $12.38B in debt and $7.69B in equity, AWK has a debt-to-equity ratio of 161%, which is pretty high. In addition to this balance sheet's precarious state, its liquidity is also low, with $85M in cash and cash equivalents.

Wall Street

The most current annual balance sheet for American Water Works Corporation shows that the company has $2.81b in short-term and $17.28b in long-term obligations. In contrast, it had $85 million in cash and $723.5 million in receivables with a maturity date within the next 12 months. Hence, its liabilities exceed its cash and short-term receivables.

Given that this deficit is large compared to American Water Works Company's sizable market capitalization of US$26.54 billion, shareholders may want to pay close attention to how the company uses debt. Shareholders would undoubtedly see significant dilution if its lenders demanded that it strengthen the balance sheet. It is no surprise that the current share dilution is in play.

The company's debt to EBITDA ratio is fairly high-5.6-and points to a substantial debt load. Interestingly, it has a 3.5 times interest cover, which is reassuring because it suggests it can responsibly fulfill its debt obligation. Accounting earnings aren't enough for a corporation to pay off debt; it needs free cash flow. So, it is vital that we need to check to see if the EBIT is producing the expected free cash flow. The American Water Works Corporation spent a lot of money over the past three years. Although investors are undoubtedly anticipating a change in that circumstance in due time, it is apparent that this makes its use of debt riskier.

The company's high net debt prompted my hesitation about buying AWK stock to the EBITDA ratio. The firm's subsequent EBIT did not allay my skepticism about free cash flow conversion. Yet, concerns about its ability to increase EBIT are overstated. It is also important to remember that organizations in the Water Utilities market, such as American Water Works Company, regularly employ debt without experiencing any difficulties. When we consider the big picture, it is evident that American Water Works Company's debt levels pose concerns for the company. It could increase profits if things go well, but it also means taking on more debt, which increases the chance of a devastating loss of capital.

Valuation

AWK's valuation metrics are much higher than the industry median; hence the firm is overvalued relative to the industry and receives a grade of F in valuation.

Seeking Alpha

Since the company's fundamentals aren't very appealing, I think this is the best time to sell and wait for a cheaper entry point, around $66 per share, which is what Wall Street estimates as the fair value.

Conclusion

Over the past five years, AWK has seen tremendous growth, leading to an increase in its stock price and an overvaluation of the company. However, the company's growth has stalled, with an 11% drop in value over the past year. The company's fundamentals aren't compelling; therefore, I recommend selling at the current premium price and waiting for a cheaper entry opportunity when the fundamentals turn optimistic.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

Disclaimer: The content of this article is intended solely for educational purposes. The information presented here is not intended as a recommendation to buy or sell any securities. Do your own due diligence and form your own opinion before making any stock trades, or talk to a financial expert. Capital loss is a possibility when investing.

Comments

[High Sharpe]

My metric for overvalued with these guys is this: 10 years ago they generated ttm cash flow ops of 957 million. Now they generate around 1.4 billion. 10 years ago their enterprise value was 13 billion, now its 40+billion. So cash flow ops went up 47% and enterprise value went up 200%, assets basically doubled, but operating cash flow to ev is around 2.7% today vs. 6.9% in 2013, seems a bit stretched. My vote with author

[Big Mountain Jim]

The share count has been going up forever, including over the past 10 years when it had a total return of 330.4% vs. 203.1% for the S&P 500.

When authors talk about growth stalling, they usually refer to things like revenues, earnings, cash flows... Saying growth has stalled because the stock fell 11% seems silly. AWK has greatly outperformed the S&P 500 over the past five and ten years, is tied on a 1 year (total return) basis. It has underperformed over the prior 3 years as the stock was probably ahead of itself and its valuation has been slowly correcting during that period. For dividend growth steady eddies like this with relatively low current yields of ~2-3%, their performance in 2022 wasn't great as their valuations, but not necessarily their operating fundamentals, were hurt by rising interest rates.

When I see you question the growth of this excellent performer over the past 5-10 years, my question for you is what exactly in the fundamental story for American Water Works has changed?

[0xBinder]

@Big Mountain Jim The company ops don't need to move for the valuation to fall. The yield on this is already -3% in real terms and below treasuries - so there is significant growth priced in. If the market starts believing the fed on the long end of the curve, look out below on names like this.

[moseharper]

Ah, yet more comparisons to standard corporate measures for AWK here. They do not work- it is a unique utility that can and does function nationwide. For example, with constant cash flow from monthly receipts from customers, it does not need to maintain huge cash balances. CR and QR ratios do not apply to AWK.
And the same old question- does it pay it's dividend from cash flow or does it borrow it? This has been hashed out several times in the past. Glad to see it is up a respectable amount today.

[sneddons]

Points well taken, but Utility 101 is that Utilities employ a high degree of debt in their capital structure because of the predictable nature of their cash flows and their high fixed asset base (i.e. people need water). The key then becomes if they are managing their debt structure appropriately. If they have a competent CFO we should find most of their debt is termed out in a laddered fashion (debt management 101). Also, in this environment doing a proactive equity raise should be applauded if you have the intermediate and longer term in mind. It also makes sense in their case since they are serial acquirers and can use the cash from the raise to make accretive acquisitions which would be a positive for shareholders.