Recently, at the Three Part Advisors East Coast IDEAS Conference, I had the opportunity to sit in on the presentations given by two water utility companies, Connecticut Water Service (CTWS) and American States Water (AWR).
Connecticut Water Service entered the state of Maine in 2012 with the acquisition of Aqua America’s subsidiary, Aqua Maine, followed that same year by the acquisition of the Biddeford and Saco Water Company, which serves part of the Maine coastal region south of Portland. In total, CTWS paid $73.3 million for 31,500 Maine customers and $55.1 million of rate base (as of December 31, 2015).
Since the acquisitions, CTWS has been able to push through about $1.8 million of annual rate increases equal to about 8% of roughly-estimated Maine revenues. The company has also been able to reduce costs by integrating and streamlining the operations of the acquired utilities.
Like its water utility peers, CTWS has been pursuing an active program of infrastructure upgrades. Regulators in Connecticut and Maine have facilitated these upgrades by allowing the company to begin to recover its capital costs quickly, increasing rates as costs are incurred without waiting for rate case filings. In Connecticut, these costs are recovered through the Water Infrastructure and Conservation Adjustment (WICA) mechanism; In Maine, through the Water Infrastructure Surcharge (WISC). To encourage conservation, both states also allow CTWS to earn approved rates of return independent of actual water consumption.
CTWS has been pursuing acquisitions and large scale projects within both of its operating regions to grow its rate base. Most recently, it has been selected to serve the University of Connecticut campus in Storrs and the surrounding area by extending a pipeline seven miles from its existing Northern Service Area. In May, it has also agreed to acquire the Heritage Village Water Company, which serves the towns of Southbury, Middlebury and Oxford. HVWC will add 4,700 water customers and 3,000 wastewater customers at a total cost of $20.5 million.
CTWS has been pursuing growth opportunities aggressively, but its overall level of capital expenditures has been closer to cash flow generated from operating activities than many of its peers. Consequently, I believe that it does not bear as high a risk of a precipitous drop in earnings growth, if regulators decide to scale back its infrastructure upgrade programs.
Down the road, CTWS does risk a higher tax rate when the favorable “repair tax” treatment that it has received on infrastructure upgrades runs its course. However, management says that its commitment to replace 1%-2% of its pipe each year will allow it to sustain AWR’s current low tax rate.
CTWS will continue to borrow in 2016 to cover a net deficit after capital expenditures, acquisitions and dividend payments; but it has the debt capacity to do so. Its debt is rated “A” by Standard & Poor’s.
Compared to other water utilities, CTWS has a low risk business model. Except for the expansion into Maine and HVWC, most acquisitions have been smaller tuck-ins. On the unregulated side of the business, the company has stuck mostly to related businesses, such as contract management operations of water & wastewater systems within its geographic territories and insuring customers against water line breaks.
On balance, therefore, CTWS has a solid niche position which should allow it to generate stable revenues and earnings with modest growth potential in the years ahead.
American States Water (AWR) has two subsidiaries that operate in three business segments. Golden State Water Company (GSWC), (80% of 16Q1 revenues), provides water service to 260,000 customers in 75 cities and 10 counties in California. It also distributes electricity to 24,000 customers in several mountain communities through its Bear Valley Electric Service division.
American States Utility Services (ASUS), (20% of revenues) provides water and/or wastewater services under long-term contracts to nine military bases located in Maryland, Virginia, North Carolina, South Carolina and on the Texas-New Mexico border. This is AWR’s growth business. The company is the second largest provider, behind American Water Works, of contract water/wastewater services to U.S. military bases.
The military has just started the process of contracting out water-related services at its military bases. Roughly one-half of water/wastewater systems at U.S. army bases are now operated under contract. The Air Force is just getting started and the Navy has yet to begin the conversion process. The company anticipates that a significant number of water and wastewater contracts serving U.S. military bases will be awarded over the next five years.
ASUS operates these military base systems under 50-year, fixed price contracts. AWR guarantees ASUS’s performance obligations. The contracts are typically subject to price adjustments every three years (after an initial two-year term); but some provide for economic price adjustments annually. There are also provisions for reimbursement for infrastructure upgrades, construction of new facilities, changes in laws and regulations and changes in wages and benefits.
GSWC has been coping with the effects of the drought in California. The U.S. Drought Monitor estimates that nearly 60% of California remains in a severe drought. In 2015, the Governor of California imposed water restrictions on residents and businesses designed to achieve a 25% cut in water usage compared with 2013 levels. Those restrictions have been extended to October 31, 2016.
All but one of GSWC’s water systems meets current conservation standards. In May, the Governor issued a new Executive Order intended to develop permanent water use regulations to prohibit wasteful use and encourage utilities to minimize leaks (in part by replacing aging infrastructure).
Like water utilities in most states, GSWC has benefited from conservation provisions that allow it to maintain its revenues even when water consumption declines. As a result, GSWC’s revenues and operating income have been essentially flat over the past few years, even with the water restrictions imposed because of the drought.
Despite the growth potential of the military water system contract management business, ASUS’s revenues and profits have been somewhat choppy over the past few years. Some of this is due to the timing of reimbursements for infrastructure upgrades. However, both the U.S. military and contract service operators are continuing to find their way in this process. (A more complete picture of the true condition of these water and wastewater systems emerges after they have been under third-party management for a year or two.) As a result, adjustments to both the pricing formulas and capital budgeting plans are ongoing. Management is confident that this will be a low risk, growth business for AWR for years to come.
AWR has generated positive cash flow from operations after capital expenditures over the past few years, but not enough in 2015 to cover the rapid growth in the dividend payout. The company has maintained a strong balance sheet. Its debt is rated A+ by S&P and A2 by Moody’s; so it has the capacity to increase leverage, if necessary.
The increase in dividend payout was the primary catalyst in the stock’s superior performance over the past several years, but the stock has hit a rough patch in 2016, as profitability has leveled off. The company sees this as temporary and believes that it can continue to grow the dividend at a mid-single digit clip over the next several years. Yet, AWR’s dividend payout and anticipated growth in dividends are now in line with peers.
Valuation. Water utility stocks have significantly outperformed the broader equity market since the end of the financial crisis. During this period, they have been among the top performing sectors in the equity market. The stocks have extended their gains in 2016. So far this year, the Dow Jones Water Utility Index is up 28.6%, while some stocks, including AWK, CTWS, CWT and MSEX, are up more than 35%.
I first expressed concerns over water utility stock valuations in December (Income Builder, Bulletin 1438). Valuations have become even more stretched since then. Water utilities used to trade at 3% dividend yields and forward P/E multiples around 20-22. Today, they trade at an average yield of 2.1% and forward multiples of 25-28.
The stock market has bid up the prices of stocks with better than average yields and higher perceived levels of safety this year; but the valuations of many of these stocks are now at historical highs. Although I believe that both CTWS and AWR are of interest on a long-term basis, I would prefer to wait until prices come back down to reasonable levels before buying in.
July 12, 2016
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
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