On April 11, Bill Simpson wrote an analysis of American Water Works (NYSE:AWK). In the April 23 IPO, the company raised $1.25 billion by selling 58 million shares, priced at $21.50, below its estimated range of $24-$26 a share. Tuesday the stock closed at $21.07.
The text of Mr. Simpson's original writeup follows:
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American Water Works plans on offering 64 million shares (75.6 million if over-allotment is exercised) at a range of $24-$26. **Note** - All shares in this deal are being sold by insiders. AWK will receive no monies from this ipo. Fact is AWK is heavily leveraged and they most certainly could use ipo monies to pay off debt. However that is not going to occur.
Goldman Sachs, Citi, and Merrill Lynch are lead managing the deal. Co-managing will be nearly every firm on the street other than Bear Stearns. There are thirteen co-managing firms in all.
Post-ipo AWK will have 160 million shares outstanding for a market cap of $4 billion on a pricing of $25.
RWE will own essentially all non-floated AWK shares post ipo, an approximate 60% stake in AWK post-ipo. RWE is the selling shareholder in this deal, selling all 64 million shares, 75.6 million if over-allotment is exercised. RWE, a German operation, is one of Europe’s leading electricity and gas companies and supplies 20 million customers with electricity and 10 million customers with gas in Germany, the United Kingdom and Central and Eastern Europe. RWE purchased the then public American Water Works in early 2003 for $4.6 billion in cash.
This is a classic spin-off ipo as RWE plans on divesting themselves of their 60% stake in AWK as soon as possible (meaning right around that 180 day mark). Expect heavy future overhang here as RWE Aqua will be divesting approximately 90 million more shares of AWK sometime in late 2008.
Note - American Water Works has always toted around substantial debt. As a utility, in this case a water utility, it is common to see substantial debt as cash flows from this type of operation tend to be fairly predictable and not effected by economic cycles. When RWE purchased American Water Works five years ago, AWK had approximately $3.3 billion in debt. The public AWK in 2008 will have $5 billion in debt. It appears that a portion of the increased debt over the past five years has been due to RWE laying debt onto the back of AWK in order to fund payouts to RWE. If we look at the increased debt levels, RWE purchased American Water Works for a total cash and debt-load interest of $7.9 billion. Assuming a pricing of $25, AWK post-ipo will have a total market cap plus debt consideration value of $9 billion.
Personally, I don't care what business one is in, I'm always uncomfortable with a debt to capitalization level in AWK's post-ipo ballpark. $5 billion in debt and an expected initial market cap of $4 billion is a highly leveraged operation. So before we even look at the company, this deal has two serious strikes against it: 1) heavily leveraged with at least a portion of the leverage coming due to cash-out to parent company; 2) future overhang of approximately 90 million shares as RWE plans to completely spin-off their entire ownership of AWK by the end of 2008. I would expect these shares to come in the form of a hefty secondary as RWE is traded in Germany, making a tax free dividend of AWK shares to RWE shareholders unlikely.
All things being equal, the above is enough for me to pass on this ipo right here. Let's take a look at AWK the company to see if something might make me change my mind.
From the prospectus:
'Founded in 1886, American Water Works Company, Inc., which we refer to, together with its subsidiaries, as American Water or the Company, is the largest investor-owned United States water and wastewater utility company, as measured both by operating revenue and population served.'
AWK provides approximately 15.6 million people with drinking water, wastewater and other water-related services in 32 US states and Ontario, Canada. AWK treats and delivers over 1 billion gallons of water daily. AWK's primary water business is regulated as a utility by the Public Utility Commission [PUC]. AWK's regulated business accounts for nearly 90% of overall revenues.
Residential water services account for 61% of revenues. Revenues from Pennsylvania and New Jersey account for approximately 45% of overall revenues.
Sector - In the US water and wastewater utility sector, government owned and operated entities make up the bulk of operators. Government owned systems account for approximately 84% of all United States community water systems and approximately 98% of all United States community wastewater systems. Commercially operated systems such as those run by AWK are in the minority. Overall there are an estimated 53,000 community water systems and approximately 16,000 community wastewater facilities in the United States. A strategy going forward for AWK will be to selectively acquire community based and run water and wastewater systems. For example, in 12/07 AWK signed an agreement to purchase the water system assets of Trenton, NJ.
For our purposes, AWK is a water utility regulated in a very similar fashion to other utilities. Their utility business does provide a predictable and stable cash flow, however the prices AWK can charge for their services are highly regulated and controlled by the PUC.
Capital expenditures - AWK spends a hefty amount on capital expenditures annually as they're required to continue to keep their infrastructure operating on a baseline level. As WK puts it in the prospectus: 'The water and wastewater utility business is capital intensive.' In 2007 AWK spent $759 million on capital expenditures.
Impairment charges - Since being acquired by RWE in 2003, AWK annually has listed hefty impairment charge losses on their earnings statements. This is directly related to the amount of goodwill on AWK's books due to the acquisition. As of 12/31/07 AWK was carrying approximately $2.5 billion of goodwill on the books. Annually AWK re-evaluates their goodwill and any lowered amount gets written down as an impairment charge on the earnings statements. AWK has had impairment charges of $396.3 million in 2005, $227.8 million in 2006 and $509.3 million in 2007. The large impairment charge in 2007 is due to lowered customer demand expectations going forward; their debt being placed on watch for a potential downgrade; the upcoming ipo and RWE's ownership divestiture; and the continued high debt levels expected post-ipo. While these impairments are not cash flow losses, they do heavily impact the GAAP bottom line. I would expect continued hefty impairment loss expenses annually going forward.
Debt is the issue here. Utilities tend to be heavily leveraged and AWK is no exception. Debt post ipo will be approximately $5 billion in debt. A huge drag on this deal is that AWK will not be receiving any of the ipo monies. AWK could really use ipo cash to pay off debt and better position themselves for future acquisitions. However this ipo is nothing more than an exit strategy for parent company RWE. RWE will pocket all the ipo cash.
Dividend - AWK does plan on paying a quarterly dividend of $0.20. At an annualized $0.80, AWK would be yielding 3.2% on a $25 pricing.
Revenues have been rather flat the past three years. Utilities are generally not a growth industry, and again, AWK is no exception. Revenues in 2005 were $2.1 billion, in 2006 $2.1 billion and in 2007 $2.2 billion.
Due to the impairment charges noted above, AWK booked a significant GAAP loss in 2007.
2007 - Revenues were $2.2 billion. Debt servicing expenses totaled nearly 13% of revenues. For a slim margin utility business, this amount of debt servicing expense will kill margins with or without impairment charges. Operating margins (pre debt servicing and impairment charges) were 24%. When plugging in debt servicing and the $509 million impairment charge, losses after tax were $2.13. To get a clearer picture of operations, we'll fold out that $509 million impairment charge. Folding that out, AWK earned a fully taxed $1.00 per share. This latter number of $1 per share in earnings gives us a better picture of AWK's operation and valuation.
2008 - AWK will most likely take another impairment charge in 2008, so we'll see a much lower GAAP number than 'actual' earnings. Until AWK does their own internal assessment in the second half of 2008, we have no way of determining what that impairment charge may be, making GAAP earnings forecasts here next to impossible. We can, however, forecast AWK's business fairly easily as 2008 should look quite similar operationally as 2007. I would expect revenues to once again be in the $2.1 - $2.3 billion range with earnings per share in that $1.00 - $1.10 ballpark.
On a pricing of $25, AWK will be trading approximately 24- 25 X's 2007 and 2008 earnings and will be yielding 3.2%.
A quick look at '08 estimates and yield for AWK's three public competitors:
WTR - 23 X's '08 earnings, yielding 2.6% with $1.3 billion in debt and $2.6 billion market cap.
AWR - 21 X's '08 estimates, yielding 2.7% with $305 million in debt and a $650 million market cap.
CWT - 23 X's '08 estimates yielding 2.9% with $300 million in debt and a $834 million market cap.
Conclusion - For the amount of leverage and the spin-off nature of this ipo creating substantial share overhang, AWK is a pass for me. Valuation seems a bit aggressive for a water utility with substantial leverage. However we should note that on a PE/yield basis, AWK is not coming public out of line with the sector at all. Note though that AWK's balance sheet is a bit more leveraged than the competition. Also we'll be seeing 90-100 million shares coming for sale later in 2008 as RWE completes their divestiture. AWK's leverage and high annual capital expenses here will mute future acquisition related growth. Other than acquisitions, AWK will be hard pressed to substantially increase the bottom line. I just don't see much growth here over the next few years, quite similar to the past 3-4 years actually. 25 X's earnings for 2008 looks to be a bit steep. Not interested in range.