2015 has been another strong year for the stock of American Water Works (AWK). Year-to-date (through Dec. 18), it is up 11.7% on price and has delivered a 14.5% total return. By comparison, the S&P 500 is down 2.6% on price and down 0.6% on total return. Meanwhile, the Dow Jones Utility Average, of which AWK is now a member, is down 8.1% on price.
This year continues a very long winning streak for AWK’s stock. Over the past five years, the stock is up 136.2% on price, more than twice the 61.4% gain on the S&P 500 and more than three times the DJ Utility Average’s 41.8% gain. During that time, AWK has delivered a 168.6% total return vs. the S&P’s 79.5%. AWK’s compounded average annual total return over that period is 21.9%, much better than the S&P’s 12.4%.
The above chart, courtesy of StockCharts.com, shows the year-to-date performance of AWK stock, which has clearly outperformed the Dow Jones Utility Average (in gold, plotted behind AWK price). It also shows the modest relative outperformance of AWK vs. the Dow Jones U.S. Water Utility Index (top chart section).
Such strong outperformance cannot last forever. At its recent investor day held on Dec. 15, the company acknowledged that it faces a number of challenges in 2016 and beyond. Yet, its forward guidance anticipates annual earnings growth rates of 7%-10%, which is consistent with prior years. If it can deliver, the outperformance will likely continue.
Susan Story, AWK’s CEO, identified the primary challenges as: water supply (especially in California), the ongoing need for infrastructure upgrades, regulatory challenges, cybersecurity concerns and climate change (including more frequent extreme weather events).
Regulated Operations. American Water Works believes that it is well equipped to cope with these challenges, because of the strength of its leadership team and its highly matrixed organization, which includes autonomous local operations supported by functional departments at corporate. Thus, it is very attentive to the needs of local communities, while still enjoying the benefits of economies of scale.
Its operating scale provides opportunities both within its existing operations and in its quest for external expansion. The company sees its geographic diversity – 370 water systems in 16 states – as a key competitive advantage. Its diversity across service offerings, customer relationships and ownership structures gives it the ability to pursue a wider variety of new business opportunities – from full system ownership to joint ventures to public-private partnerships to contract operations, in water and wastewater, on a retail or wholesale basis.
AWK’s annual EPS growth target of 7%-10% for 2016-2020 includes anticipated EPS growth of 5%-8% from regulated operations (including 1%-2% from acquisitions of regulated water and wastewater systems) and 2%-3% from growth in unregulated, market-based operations.
Like most utilities, American Water Works has stepped up its capital spending over the past five years to replace and upgrade its existing infrastructure. It has been replacing 350 miles of pipe per year, which has reduced its companywide pipe infrastructure replacement rate to 125 years. That is about half the national average of nearly 250 years. Even so, it believes that it has much more work to do.
The company has improved its operating and maintenance (O&M) efficiency ratio from 44.2% in 2010 to 35.8% for the latest 12 month period (ended Sept. 30) in 2015. (The O&M efficiency ratio is essentially O&M expense for regulated operations divided by regulated revenues.) That improvement is remarkable and hopefully sustainable. Management has set a “stretch target” for its O&M ratio of 34.0% by 2020, based in part upon investments in technology. A lower O&M ratio allows American Water Works to spend aggressively to upgrade infrastructure while limiting increases in customer rates. For the next several years, AWK expects to incur about $1.1 billion per year in capital expenditures, while capping the increases in monthly bills for most customers at 2.6%.
American Water Works is seeking to grow its regulated operations through acquisitions. The water utility industry remains highly fragmented. 84% of water systems and 98% of wastewater systems are owned by public authorities. Most systems are small, serving only a few hundred customers. AWK sees good opportunities for consolidating the industry, especially in wastewater, even though the pace of consolidation has been slow for decades. Since 2010, five states have enacted legislation supporting system consolidations. Within the company’s operating area, eight of sixteen states have taken steps to streamline the approval process for mergers.
Market-Based Operations. AWK’s unregulated (i.e. market based) business, American Water Enterprises, has delivered compounded annual earnings growth of just under 28% over the past five years. Management sees opportunities to extend that streak. Lines of business in this segment include (1) the operation of water systems on military bases under contract from the U.S. government, (2) homeowner services, such as water and wastewater pipe protection plans and (3) contract services to operate water and wastewater services for municipality. Here, the company’s size is an advantage, because it has experience in all types of contract operations, joint ventures and public-private partnerships. It also has the expertise to handle challenging operating conditions.
AME’s businesses are unregulated, but their performance is similar to AWK’s regulated business in several important ways. They generally provide predictable and stable revenue, but require low levels of capital investment. They add diversity to AWK’s operations, which increases the stability of its overall financial performance. At the same time, AME enhances AWK’s opportunities for new business. For example, AME’s experience in operating a desalination plant in Tampa FL helped shape AWK’s proposal to build a desalination plant in its California-American subsidiary’s operating territory in response to the pressures on water supplies caused by the drought in California.
AME is the largest contract operator of water and wastewater systems for U.S. military bases, with twelve bases currently under contract. It thinks it could add as many as 33 new military base contracts over the next 10 years. Contract terms are typically for 50 years. Revenues are derived from both O&M services and infrastructure upgrades and are not volume-based. Under the typical contract, AME has the ability to adjust prices every two years.
AME also provides service protection contracts for water and sewer lines (from the premises to the mains) to customers in 43 states. This business generates predictable monthly revenues. The company has 780,000 customers and 1.6 million contracts that are renewed annually. From a standing start in 2001, the business now produces more than $1.5 billion in annual revenues. AWK has been seeking additional growth by adding related services, such as protection contracts for in-house plumbing, HVAC and electrical systems. The company often partners with local municipalities and utilities to expand its service territory.
Through its Contract Services Group, AME provides water, wastewater and related services to municipalities and industrial companies. Key clients include Tampa Bay Water, the City of Phoenix, Seattle Public Utilities, Frito-Lay, JBS Swift and Coca-Cola. In total the company has 53 contracts and operates in 17 states. It is an industry leader in emerging technologies, such as desalination and water reuse systems.
Keystone Acquisition. In July, American Water Works acquired Hershey, PA-based Keystone Clearwater Solutions, a provider of water-related services to independent oil & gas producers in the Marcellus and Utica shale regions in Pennsylvania, Ohio and West Virginia. Hydraulic fracturing, the principal drilling and completion technique used by these independent producers, is water dependent. Clearwater believes that it positioned for decades of service to these companies.
Most recently, however, Keystone has been seeing declines of 20%-30% in completion activity, primarily because of constrained takeaway capacity, the plunge in oil and natural gas prices and most recently, the warm winter weather. New pipeline projects expected to come on line over the next three years will help to alleviate the oversupply, which will eventually lead to higher production activity.
Keystone offers a full range of services for shale producers throughout the water management cycle, including sourcing, pipeline transport, storage and reuse. It currently serves 25 active E&P customers. It is the only company in the region that offers a total water management solution and has the technical know-how to tackle complex projects.
Keystone plans to continue to add new customers and expand services to existing customers. Its services may be especially attractive to capital constrained E&P producers who seek turnkey solutions for their water needs.
Although the use of hydraulic fracturing well development technologies has continued to grow, there have been ongoing concerns about potentially harmful environmental effects of the chemically-laced water used in the drilling process. For its part, Keystone management says that it has developed disciplined handling procedures at every step in the process, so it believes that it can manage this risk effectively. American Water Works says that it has structured the acquisition to minimize the risk to the holding company.
Although there have been allegations that hydraulic fracturing has poisoned water supplies in a few areas, the EPA has not deemed the process to be unsafe. E&P producers have refined their operating procedures to guard against environmental mishaps. Still, there is environmental risk in this business.
Despite those risks, this business is appropriate for American Water Works, whose mission is to be the leading full service provider of water and wastewater services in the U.S., as long as the company can generate an acceptable return on investment while managing those risks successfully. (Hopefully, Keystone structures its contracts to share the environmental risks with its E&P customers.)
Keystone is expected to be accretive in 2016. Management has not provide any specific figures. My concern at this time is whether it will be able to price its services to cover the full cost of building and maintaining water systems infrastructure as well as the environmental risks that it will assume.
Guidance for 2016. American Water Works has refined its guidance for 2015 and issued new guidance for 2016 and beyond. It has reaffirmed its guidance range of $2.60-$2.65 per share for 2015 and established new guidance of $2.75-$2.85 for 2016. Its long-term target of 7%-10% annual growth in EPS is now centered upon a historical base of $2.43 per share for 2014.
Of the anticipated $0.15-$0.20 increase in EPS in 2016, $0.14-$0.18 is expected to come from regulated operations (including $0.02-$0.04 from acquisitions). Market-based businesses are expected to contribute $0.03-$0.04, while corporate and other expenses will reduce EPS by $0.02.
Of course, actual results may differ from expectations in several ways, including weather, the timing and outcome of regulatory proceedings, the timing of upgrades and new contract awards in the market-based business and certain costs associated with Clearwater. The biggest swing factor is weather, which management says could sway earnings by $0.07 up or down.
AWK’s updated capital investment plan anticipates $6.4 billion in capital expenditures from 2016-2020, an increase of $0.4 billion over last year’s 5-year plan. Investments in regulated businesses will account for 95% of total capital spending, including $600 million for acquisitions of regulated companies. The remainder is earmarked for strategic investments. AWK’s capital spending budget for 2016 is $1.3 billion.
AWK’s balance sheet remains strong with a debt-to-total capitalization ratio of 55%. Its debt is rated “A3” by Moody’s and “A” by S&P. I calculate EBITDA coverage of interest expense at about 5.0 times. About $1 billion in debt comes due in 2017 and 2018 (out of a total of $6.4 billion).
Dividends have grown at a compounded annual rate of 9% since 2010. The company’s policy is to maintain its dividend payout ratio at 50%-60% of earnings. I calculate the current payout ratio, based upon trailing 12-month earning at 52%.
Like most of its water utility peers, American Water Works does not generate sufficient cash flow from operations after capital expenditures to cover its dividend payments. In fact, the company currently does not generate any cash flow after capital expenditures and does not anticipate becoming cash flow positive (before dividend payments) until 2018.
Investors assume that this financial model works because most capital expenditures fund projects that will grow earnings; so cash flows after maintenance capital expenditures are believed to be sufficient to cover dividend costs.
Valuation. The table below shows AWK’s valuation metrics. The stock, which reached a new 52-week high last week, is valued essentially in line with peers on both price/earnings and price/book value. Its dividend yield of 2.3% is also roughly in line with peers. However, most water utility stocks have enjoyed strong relative performance in recent years, especially in 2015, and their valuation levels are on the high side and dividend yields are on the low side of their respective historical ranges. Yet, since management’s long-term EPS growth guidance of 7%-10% is above the peer group average of about 5%, a case can be made that the stock is at least modestly undervalued relative to peers at current levels.
Source: Lark Research calculations of data derived from company financial statements and Yahoo! Finance.
If American Water Works can deliver on its long-term EPS growth guidance, the stock should deliver a total return to shareholders of 9%-12% annually, which equates to 7%-10% EPS growth plus the 2.3% dividend yield, assuming no change in its valuation multiple.
The key question is whether the 7%-10% guidance is achievable over the long-term. The company’s EPS growth from regulated businesses is in line with peers. The extra EPS growth comes from acquisitions of regulated businesses and the continuing expansion of market-based businesses. Management’s guidance therefore appears to be realistic.
However, even the 4%-6% growth in earnings from existing regulated businesses may prove to be optimistic over time, because the regulatory environment has been quite accommodative in recent years and the attitudes of regulators toward continued high levels of capital spending could change quickly in the next economic downturn.
Despite the general sentiment that capital spending across all U.S. water and wastewater systems has been woefully inadequate, American Water Works has been able to upgrade a lot of its infrastructure over the past five years. For now, the high level of spending is likely to continue. But in a tougher economic environment, regulators may become much more sensitive about placing additional financial burdens on consumers and businesses. In most cases, regulators have worked with AWK to channel capital spending to those areas where it has been needed most, so future infrastructure upgrades will be less pressing. Consequently, regulators may not worry about cutting back capital spending sharply for even several years, if necessary. In such a scenario, regulated earnings growth of 4%-6% may be difficult to achieve.
Consequently, it is difficult to make a strong case for buying AWK’s stock today. The company’s ability to achieve its targets is probably good for the next year or so, which may lead to continued outperformance in 2016 and perhaps into 2017. But, AWK’s earnings targets may need to be adjusted downward, if economic and financial market conditions become less favorable.
Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1543
Linden, New Jersey 07036