- American Water Works is a stable and profitable water company with high margins and regulated income.
- However, the company's valuation is too high, with a P/E ratio above its 20-year average.
- The company's growth prospects and low dividend yield do not justify the premium price, making it a "HOLD" investment at this time, waiting for the company's valuation to improve.
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I typically invest in one of two sorts of companies. The first sort is a sort of lower-yielding, stable dividend growth company with a good upside annualizing 13-15% on the basis of pure fundamentals, dividend growth, and slow earnings growth. Some reversal might be included if the company has seen rough times and is undervalued. This is a preference for me.
The second type is a higher-yielding or bottom-trading sort of company where the upside is a strong combination of reversal due to that undervaluation, and it has also led to a yield that is significantly above the average for the company in question.
American Water Works (NYSE:AWK), unfortunately, is neither. While I'm happy to look at companies that readers wish for me to dig into, and I do work in the utility and water sector with coverage of peers like York Water (YORW), and even EU companies like Uponor (OTCPK:UPNRY) and invest successfully in them, I do not see American Water Works stock as a worthy investment at this particular point in time.
I'll take a look at this article and show you why that is.
American Water Works - Water is great as a business, but not when it's this expensive
Water is a very solid business idea - providing water to a community. This is a regulated sort of business in most parts of the world, and in most parts of the world, it's also not something that is in any way privatized - though it is what I am writing about today. However, like with electricity, regulation means that the companies involved only get to make a certain profit, and a certain return on their investment, stipulated by a regulatory body that oversees the relevant area for a state or a portion of a country.
In exchange, the business gets more or less guaranteed income and growth. Water is something, together with heat and power, that is the first bill that you pay. If you live in a home and your water is turned off, that's one of the most impactful things that can happen - together with power, heat, and having a home in the first place.
So investing in water as a general sort of idea, is a great business. AWK is actually a bit of a margin leader. The company generates nearly 59% gross margins, 35% operating margins, and over 22% net margin on its revenue, which makes them really a leader in the water sector. It has relatively high debt - but even the 5.5x net debt/EBITDA doesn't bother me because, again, we're talking about a water company. It's going to mean interest cost increases for sure, but the company's income isn't going anywhere.
Unlike other water businesses that mix unregulated service businesses into the mix to provide some growth to the business profile, AWK is over 90% regulated.
As you can see, this makes for a very stable and high profitability earnings profile with plenty of stability. That's also why despite the relatively high debt, the company is actually rated A, even with that 50%+ long-term debt to cap.
However, the issue with this sort of company comes in the form of valuation. AWK, like every other qualitative water company out there, demands an extreme premium for what it provides - essentially "risk-free" growth and earnings as well as dividends. Coming out of an environment of ZIRP where this was essentially impossible to find, the company has been above its 20-year average for over 8 years. This is a very premiumized company, and while it's down from the most extreme of its highs, it's still above a 31.4x P/E.
AWK does have a substantially improved geographical exposure and scale advantage over smaller water players. It's one of the largest water/wastewater companies around, totaling over 53,000 miles of pipe and over 550 plants.
It has exposure to very strong geographies like Texas and California, as well as strong states on the east coast, while also mixing in some lower-income areas and old "coal country", like West Virginia.
Despite a player like this, the heavily fragmented state of the nationwide utility network for water and wastewater makes for an excellent acquisition and consolidation target. Only 16% of the overall network is investor-owned, with 84% of the overall nationwide water network still in public hands. For wastewater, the percentage is 98%.
This is what the company focuses on acquiring and growing. It's always a question of how much CapEx is needed to bring an investment up to par, and how much can the company make, to still provide stable dividends, and earnings while not overcharging customers or getting into a clinch with regulators.
The company has an ambitious CapEx plan, calling for ever-increasing investments mainly focused on things like infrastructure renewal, resiliency investments, water quality investments, and system expansion - though 70% of the planned CapEx is entirely tiered towards renewal because as here in Europe, much of the existing infrastructure for water and wastewater is in dire need of renovation/renewal.
The rate base is how the company makes its money. Its current expectations are for a continued CAGR for the rate base of 8-9%. I believe this is too optimistic. As we've seen in other regulated businesses, when regulators do clamp down, they tend to do so in a way where companies have very little recourse. See Pinnacle West (PNW) for an example. And where we're headed, I believe with inflation and cost increases, we're moving into an environment where people have less money, which will cause political pressure on very basic needs like water, heat, and other utilities - politicians are likely to cave, which influence regulators, which will then lower the company's returns. It's easy - it's just a company, and cutting their rate base CAGR down to 5-7% is still "too high" in many non-investors eyes.
That's why I'd be very careful here, at what valuation and under what assumptions you actually end up buying AWK.
I have invested in regulated businesses for over 10 years, and take it from me, that regulators can surprise you - especially when your regulatory exposure is spread to over 10 states with very different political climates. Arguments like the % of median household income in such cases do not really matter.
It's credit rating, while solid, is probably also due to the company's low payout. The company's current yield is less than 1.95% as I'm writing this article, and this is an extremely tough sell in an environment where I can shove money into a savings account and get a 3.6% risk-free and backed up by the government.
AWK wants you, in essence, to pay a very high (30x+) P/E premium for a single-digit earnings growth profile and a sub-2% yield profile. It's safe, this is true. But the price demanded for that safety is a smidgeon too high for what I consider to be comfortable here.
Also, the impact of increasing financing costs is coming home to roost, albeit slowly.
The company has affirmed its 2023E guidance, but this only shows us more of the negative ongoing impacts from inflation, recent rate cases, financing costs, and other things. it's still an increase, and not a bad one, but the pressure is increasing. The only way for AWK to keep growing as it has is by acquiring more assets. I won't call the company extremely highly leveraged. It's A-rated - it has ample room to move, but I would expect future moves to be somewhat slower and less than historically, even with the 1.3M customers in the company's current pipeline.
Going forward, I would keep very, very close eyes on the outcome of the next set of rate cases and try to gauge the political climes in the company's various operating geographies.
Let's look at the valuation, and let me show you why I really don't think you should go in here.
AWK Valuation - It's not great
Some may forecast AWK at high premia of 30-35x. I'm always careful when I do this, and due to the company's mixed regulatory exposure which is actually not risk-neutral, but a potential risk increase for me, I mark the company down to its 15-year longer-term average. This comes to a range of 25-28x P/E, and I choose 25x P/E here because it's been a long time since we've seen this sort of operating environment, both in rate, inflation, and macro.
At a 25x P/E, the company has no upside - nothing meaningful. Even at a growth rate of 7.45% per year, which is forecasted here, a 25x P/E gives us an annualized RoR thanks to the near-2% yield of no more than 0.25% per year.
This, to me, is nothing I can work with. Even on a 28x P/E basis, it doesn't rise above 4.5% per year. I'd rather put my money in a savings account, where it's literally no risk compared even to this investment.
You'd have to forecast AWK at least at a 30x P/E level to get even a 7.5% return under these circumstances - and by the way, these forecasts include significant dividend growth on a forward basis. And 7.5% also isn't enough for me when many fixed-income investments in the IG spectrum yield 6-8%.
There's an imbalance between risk and reward here, owing to the company's high premium that has not yet normalized. I would be willing to go up as high as $130/share, but at that valuation, I'm still being very positive about where the company might be able to go.
S&P Global has a valuation range starting at $136, above my PT, to 185/share. I'd love to look at the calculations for that $185/share because that would entail either a 35x+ P/E or a double-digit growth rate which just isn't in the company's books, as I see it. 11 analysts follow the company and give it an average PT of $158, which, again, is still too high for my taste.
I will say that analyst conviction for these targets is low. Only 3 analysts have a "BUY", with a combination of 9 at "HOLD", "Underperform" or "SELL", which makes little sense when you look at their various recommendations and ratings. But as we know, this is not an unusual phenomenon among analysts.
Here is my thesis for AWK.
- American Water Works is a great business in the area of water and wastewater. It's one of the largest businesses in the segment in fact, working in a very fragmented market. Regulated businesses tend to be very attractive investment opportunities, but they do require the right valuation to "work".
- This is my introductory article for the water company AWK, and I caution you to go into deeply here - unless you find a thesis that works.
- If they do work, I'm all for buying them and I would go "deep" into such an investment. However, at this particular time, I do not consider the business all that great. Its upside is too limited for a good RoR.
- I consider AWK to be a "HOLD" with an overall conservative Price target of no more than $130/share. At that level, I would be willing to start investing a bit, just like with York Water, but at over $145, this is an absolute no-go for me.
Remember, I'm all about:
- Buying undervalued - even if that undervaluation is slight and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
- If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.
- If the company doesn't go into overvaluation but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.
- I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.
Here are my criteria and how the company fulfills them (italicized).
- This company is overall qualitative.
- This company is fundamentally safe/conservative & well-run.
- This company pays a well-covered dividend.
- This company is currently cheap.
- This company has a realistic upside that is high enough, based on earnings growth or multiple expansion/reversion.
The company is neither cheap nor lacks meaningful conservative upside. I say "HOLD".
This article was written by
Wolf Report is a senior analyst and private portfolio manager with over 10 years generating value ideas in European and North American markets.He is a contributing author for the investing group iREIT on Alpha where in addition to the U.S. market, he covers the markets of Scandinavia, Germany, France, UK, Italy, Spain, Portugal and Eastern Europe in search of reasonably valued stock ideas. Learn more.
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