Aqua America (WTR) is the nation’s second largest publicly-traded water utility, serving three million people in eight states. It held an analyst meeting at the NYSE on Jan. 14, its first under new CEO Christopher Franklin. He is a 20+ year veteran of the company who served most recently as President and COO of WTR’s Regulated Operations.
Mr. Franklin took over for Nicholas DeBenedictis, who served as Chairman and CEO for 23 years. Mr. DeBenedictis oversaw the company’s expansion from a single market, Philadelphia, to become a multi-state operator. During that time, WTR achieved record earnings for 15 consecutive years, raised its dividend 24 times and increased its market capitalization from $150 million to $4.5 billion. Mr. DeBenedictis continues as non-executive Chairman of Aqua America.
Aqua America was originally known as Philadelphia Suburban. In 1999, it increased its presence in Pennsylvania and expanded into four states (IL, ME, OH and NJ) with the acquisition of Consumers Water Company. That was followed by the acquisition of the regulated water and wastewater operations of AquaSource, Inc. in 2003, which expanded its business to a total of fifteen states. In that acquisition, the company took on the name Aqua America. Other notable WTR acquisitions included North Carolina-based Heater Utilities in 2004 and the Ohio water and wastewater operations of American Water Works in 2012.
Besides these large acquisitions, WTR has routinely acquired small water and wastewater systems, many with fewer than 100 customers. These smaller systems are usually contiguous to its existing operations. In total, the company has completed 300 or so acquisitions over the past quarter century, including sixteen in 2015. Aqua America has gained considerable experience in acquiring and integrating water and wastewater systems over the years.
Although Aqua America has operated in as many as fifteen states, it has acted in recent years to exit smaller markets and concentrate its operations in those states where it has sufficient critical mass to achieve a minimum acceptable level of profitability. The company will consider acquisitions in states outside of its existing territory going forward, if it can quickly gain scale there, but it will give priority to “bolt-on” acquisitions within its existing eight state footprint.
Under new CEO Christopher Franklin, Aqua America plans to capitalize on its core competencies – capital investment efficiency, good working relationships with regulators and operational excellence – to achieve profitable growth.
Capital investment efficiency. In 2013, the EPA estimated that $384 billion was needed to upgrade the nation’s drinking water infrastructure through 2030. Likewise, the American Society of Civil Engineers (ASCE) estimated in its 2013 Infrastructure Report Card that $298 billion was needed to upgrade wastewater infrastructure. If the U.S. gets serious about addressing deficiencies in water and wastewater infrastructure, the water utility industry is set for many years of growth; but the cost to customers of doing so in 10 years or less would almost certainly be prohibitive.
Like most of its peers, Aqua America has invested heavily in recent years to upgrade its own water and wastewater infrastructure. From 2010 to 2014, it spent $323 million annually on average for capital investments. It anticipates spending $325 million in 2015. Over the next three years, from 2016 to 2018, the company plans to spend $367 million annually.
To put this into perspective, Aqua America’s annual capital spending has equaled roughly 10% of the total dollar value of its Sept. 30, 2015 rate base (i.e. the net value of the property upon which it is allowed to earn a rate of return) or about 7%-8% of the net book value of $4.6 billion of property, plant and equipment as reported on its balance sheet.
Besides seeking to enhance the reliability, quality and safety of its water and wastewater systems, Aqua America will commit capital to reduce operating and maintenance costs. It has achieved savings, for example, by reducing the number of water main breaks (per 100 miles of pipe) in its southeastern Pennsylvania operations by half, from 25 in 2000 to about 12 in 2015. (The American Water Works Association (AWWA) considers 25-30 water main breaks per 100 miles of pipe per year to be acceptable.)
The company will invest up to $7 to achieve a $1 reduction in operating and maintenance expenses. For example, it has committed to spend $17 million to develop a new water source to eliminate a take-or-pay contract for 3.5 million gallons of purchased water per day. The anticipated $7.3 million in annual savings equates to a 2.4 to 1 ratio of capital spending-to-savings, well within its 7-to-1 benchmark. WTR uses this 7-to-1 guideline in determining whether to bring costly outside services in-house or undertake other capital projects designed to reduce direct operating expenses.
Managing Relationships with Regulators. WTR’s capital spending program is supported by a Distribution System Improvement Charge (DSIC), an innovation which it pioneered in 1996. The DSIC allows WTR to raise rates by a certain percentage of its capital spending each year, in advance of submitting a formal rate request to utility regulators. In this way, it receives a quick partial return on its capital investments.
The company must still submit a formal rate increase request to state regulators to make permanent any increases covered by the DSIC charge. If regulators do not approve all of the DSIC, WTR might be required to roll back rates and refund the unapproved portion to customers. To date, such rate rollbacks and refunds have been rare, but they could become more common, if regulators and consumer advocates begin to push back more aggressively against proposed utility rate hikes.
Aqua America does not currently plan to file a rate request in Pennsylvania – its largest and most profitable market – until 2017 or 2018. It last filed a rate case there in 2011. That will be an unusually long time between rate case filings. The company estimates that in the intervening period, it will spend about $1 billion on infrastructure upgrades, which could result in a potential rate increase of 45%.
Despite the expected six or seven year hiatus, a request of that magnitude is almost certain to be pared back. Management did not offer a specific explanation for the delay. However, it did say that the company is earning more than its allowed rate of return on equity (ROE) in Pennsylvania. So if it sought a rate increase now, the Pennsylvania Public Utility Commission might offset a larger portion of the requested increase by recapturing the excess earned ROE.
In the interim, Aqua America expects to be able to achieve a 7.5% increase in revenues from its DSIC plus the equivalent of a 5%-10% (or 7.5% at the midpoint) revenue benefit from a Pennsylvania “repair tax” deduction that allows WTR to deduct certain investments that were previously capitalized for tax purposes. The repair tax deduction was approved by Pennsylvania regulators on a “flow through” basis in 2012. The combination of the DSIC and repair tax benefit would effectively give the company a 15% increase in rates or about a third of the total potential increase of 45% prior to the rate case filing.
By delaying the rate case, Aqua America may be able to make adjustments that would allow it to get more of a rate increase (than it would otherwise get.) For example, it might be able to convince regulators that its allowed ROE should be higher, especially if interest rates are meaningfully higher by that time. It might also argue that it deserves a higher ROE because customers benefit from improved quality, safety and reliability of service as a result of those infrastructure investments. Obviously, if regulators are not willing to compensate Aqua America for this additional investment, the company would have to scale back its infrastructure upgrade program.
Aqua America may be facing additional headwinds on rate increases because it is also generating profitability above its allowed ROE in Texas and at its allowed ROE in Illinois, New Jersey and Ohio. Since the company views its ability to manage its relationships with regulators as a core competency, however, it hopefully will be able to address these potential challenges successfully, as long as the economic environment does not take a turn for the worse.
Pursuing Growth through Acquisitions. Aqua America’s high level of capital expenditures combined with its profitability at or above allowed ROE in five of the eight states in which it operates may make it more difficult to grow earnings from its existing franchises going forward. This may be a primary reason why it is ramping up its acquisition program.
In July, the company hired Dan Schuller as EVP, Strategy and Corporate Development. Mr. Schuller was previously an investment principal at J.P. Morgan Asset Management. In that role, he guided the turnaround and growth strategies of SouthWest Water, which was acquired by JPAM-advised investors in 2010. He was also responsible for managing JPAM’s investment in Summit Utilities, a privately-held, gas distribution utility holding company based in Littleton CO. Clearly, a big part of Mr. Schuller’s mission is to help accelerate Aqua America’s growth and acquisitions will feature prominently in its growth strategy.
Today, 85% of the nation’s population is served by more than 50,000 municipal water and wastewater systems. Many of these systems serve fewer than 500 customers. As many of those systems face increasing financial and service quality challenges, they may become more receptive to selling out to larger, professionally-managed operators. Industry consolidation could help fuel the growth of investor-owned water utilities, like Aqua America.
Yet, the pace of consolidation has been extremely slow. I remember public water utility executives extolling the potential for industry consolidation 20 years ago, when I first started following the sector. Although the need for stepped up infrastructure investment has long been great, most water and wastewater systems have been able to provide acceptable service without making all of those required investments. Municipalities see water and wastewater as essential services that should be controlled locally for the benefit of their constituents. In most cases, they will not sell out unless there is no alternative.
Both American Water Works (AWK) and Aqua America (WTR) have made a significant number of acquisitions over the past two decades, but the bulk of their growth (in terms of customers and revenues) has come from acquiring larger, investor-owned utilities (IOUs).
It is striking that more than a decade after Aqua America made the three large acquisitions that expanded its territory from one market, Philadelphia, to eight states and after completing 300 total acquisitions, 70% of its rate base and more than 50% of its water connections still come from its core Philadelphia market. To be sure, Philadelphia remains a great asset and the high density of customer connections within that market gives the company the highest profit margins in its peer group; but achieving comparable density in other markets has proven to be next to impossible.
Despite the slow pace, there are factors that could quicken the pace of consolidation in the coming years. A few states – including three of WTR’s states: Illinois, Indiana and New Jersey – have adopted legislation that should encourage sales and/or mergers of financially distressed or troubled water and wastewater systems. Illinois now permits acquirers to pay fair market value (as opposed to original cost), which may make some municipalities more receptive to a sale.
Even though it has been more than five years since the financial crisis, many municipalities are still not on solid financial ground. The next economic downturn – if and when it comes – will likely present even greater challenges for them. Financially strong investor-owned utilities, like Aqua America, should therefore be well positioned to offer them assistance.
Flint, Michigan. The downside consequences of system neglect and mismanagement are currently being played out in Flint, the birthplace of General Motors, whose economy was decimated 25 years ago after several automobile manufacturing plants closed. (The plight of Flint was the subject of the documentary film, “Roger & Me,” by Michael Moore, who was born and raised there.) Last year, Flint tried to save money by leaving the Detroit water system and drawing water directly from the Flint River. Unfortunately, that water severely corroded Flint’s pipes, contaminating the water at the tap. The EPA and Michigan environmental authorities have declared Flint’s water undrinkable, but it is not clear when and at what cost the system will be fixed. President Obama has signed an emergency declaration making Flint eligible for federal aid.
Although the crisis has not made the front pages everywhere, it is getting increased attention. Municipal officials across the country are undoubtedly paying close attention to what is happening there. The incident will cause local officials to think twice about finding quick and cheap fixes to their water and wastewater budget problems. State regulators will most likely monitor more closely municipalities that are facing financial pressures to avoid similar problems in the future. This could conceivably speed up the transfer of the management and/or ownership of troubled systems to water utilities, like Aqua America.
Other Acquisition Considerations. Besides smaller municipal systems and IOUs, Aqua America will also consider making larger strategic acquisitions that will allow it, for example, to gain critical mass quickly in a new territory (i.e. state) or expand its operating scale meaningfully within an existing territory. There are a few large, publicly-traded water utilities that might meet the company’s criteria for a strategic acquisition.
Although Aqua America’s focus is clearly on acquisitions, it has agreed on occasion to operate water and wastewater systems on a contract basis (e.g. Chicago Heights, IL) and has also pitched municipal systems (e.g. in New Jersey) on the benefits of working collaboratively in public-private partnerships. The company prefers ownership, but it will consider other arrangements, if the returns meet its hurdle rates.
Market-based operations. Besides growing its core regulated business, Aqua America is also pursuing strategic acquisitions in non-regulated or market-based businesses. Currently, market-based operations account for only $35 million or 4% of revenues.
In 2014, WTR acquired Newark, DE-based Tri-State Grouting for $3 million. Tri State specializes in rehabilitating storm and wastewater infrastructure, specifically in cleaning, evaluating and repairing (trenchlessly) storm and wastewater pipes. At the time of acquisition, Tri-State had $6 million of revenues and operated in six Mid-Atlantic states, including Pennsylvania. The acquisition expands Aqua America’s portfolio of services that are related to its core regulated water and wastewater operations. Over time, Tri-State’s services will be expanded to other WTR operating regions.
Also in 2014, Aqua America acquired a water distribution system services and consulting company. Since it did not issue a press release on this acquisition (at least, I did not find one), it was probably a small acquisition. Nevertheless, management views it as noteworthy because of its growth potential.
The company will continue to seek other non-regulated businesses that offer specialized services to the water and wastewater industry. The mandate for these acquisitions falls within Mr. Schuller’s portfolio.
Recent Performance and Outlook. On a rolling 12 month basis through Sept. 30, 2015, WTR’s revenues increased 4.2% to $809 million and EPS from continuing operations was up nearly 6% to $1.26. Given its full year EPS guidance of $1.25-$1.27, management anticipates flat earnings for the 2015 fourth quarter.
4-ish% growth in consolidated revenues is supported mostly by double-digit growth in market-based businesses and estimated 1.9% customer growth in regulated operations, three-quarters of which comes from acquisitions. Earnings have grown faster than revenues, primarily because operating & maintenance expense for existing operations is expected to grow at a slower rate of 2%. WTR’s tax rate has been running at about 10%, a full percentage point lower than last year. The 2015 capital spending budget is $325 million, which will drive rate base growth of 6%-7%.
Management anticipates 2016 EPS of between $1.30 and $1.35. The midpoint of the range, $1.325, translates into earnings growth of 4.3%.
Its 2016 guidance for other metrics is unchanged. Customer growth is expected to be between 1.5% and 2.0%. This includes the usual small acquisitions; but customer growth could be higher, if the pace of acquisitions picks up. The company plans capital expenditures of $350 million in 2016 and about $1.1 billion through 2018. This would sustain 6%-7% annual growth in its rate base. Operating and maintenance expense, exclusive of acquisitions, is expected to rise 1%-2% in 2015.
Valuation. At Friday’s (1/22) closing price of $29.79, WTR is trading at 23.5 times estimated 2015 EPS of $1.27 and 22.4 times projected 2016 EPS of $1.33. The 2015 P/E multiple is equal to the peer group average, while the 2016 P/E is a full point above the peer group average of 21.5. WTR’s dividend yield of 2.4% is below the group average of 2.6% and its price-to-book value ratio of 3.0 times is well above its peers’ 2.2 (primarily, I suspect, due to past acquisitions).
Thus, WTR trades at a slight premium to its peers; but that is not much of a surprise, given that the stock is one of only two water utilities (AWK is the other) with market capitalizations above $2 billion. Institutional investors will often pay a premium for the additional liquidity offered by stocks with larger market capitalizations.
The water utility sector has provided double-digit returns for the past four plus years, performing roughly in line with the market through 2014, but outperforming in 2015. Valuations for the group are on the high end of their historical range. As a result, maintaining this superior performance could be challenging for the sector, especially if the economic environment becomes more difficult.
WTR has likewise delivered double-digit total returns to shareholders over the past four years. Investors have been attracted to its dividend yield (in this low interest rate environment), annual growth of 7.9% in that dividend, modest growth in its EPS and also the non-cyclical nature of its business. Expected earnings growth of 4% in 2016 does not support continued dividend growth of 8%, but WTR’s payout ratio is just under 57%, below the company’s target of 60%-70%; so it could conceivably maintain the faster dividend growth rate for several years before it bumps up against its dividend payout ratio limit.
Although water utility stocks have continued to outperform the broader market during the recent sell-off, they could struggle, given their relatively high valuations, especially if a change in the economic environment prompts state regulators to take a tougher line on rate increases. As already noted, WTR also faces potential headwinds on profit growth because it is earning at or above its allowed return on equity in operations that account for 92% of its rate base.
Operational Excellence is Key. Clearly, Aqua America’s ability to navigate through these potential earnings headwinds depends upon management’s ability to demonstrate its core competencies – capital investment efficiency, managing relationships with regulators and operational excellence – in executing its operating strategies and also its ability to pick up the pace of acquisition activity in both regulated and market-based operations. Management appears to have the right mix of experience and recently-acquired expertise that can help the company improve the performance of its existing franchises and pursue new avenues for growth. Still, the stock’s high current valuation suggests that investors should approach new positions in WTR cautiously.
Some aspects of Aqua America’s operating environment may become more challenging, but there may be a silver lining that opens new avenues for growth. In a tougher economic environment, regulators may be reluctant to endorse high levels of capital spending and resist raising customer water bills. At the same time, however, regulators may help to facilitate the acquisition of cash-strapped municipal water systems by IOUs, like Aqua America.
With its years of experience as a multi-state operator and acquirer of water and wastewater systems and its strong balance sheet, Aqua America and its management team seem well prepared to take on these challenges. Although its stock could face near-term headwinds, it still has the potential to be a superior performer over the long haul.
January 22, 2016
Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1543
Linden, New Jersey 07036