Is American Water Works a Buy?
American Water Works (NYSE: AWK) stock is off to a rotten start in 2018. Shareholders have had to endure a 12% drop through the first two months of the year. While other reputable stocks have suffered similarly poor luck, a fall of this magnitude is very rare for the country's largest publicly traded water utility. In fact, this is just the second time in the last decade that shares have fallen by double-digit percentages in a span of just two months.
That stat alone should get the hamster wheel in your head turning. Couple that with the company's regulated business structure -- which guarantees growth, ample cash flow, and steadily climbing dividend payments -- and you may be wondering: Is American Water Works a buy?
Image source: Getty Images.
By the numbers
American Water Works is a $14.4 billion water utility with an enterprise value of $21.7 billion. The next largest publicly traded peer is Aqua America (NYSE: WTR), which sports a market cap of just $6.2 billion. Both companies own water distribution infrastructure across the United States. There's a little more to it than that, of course.
Water utilities maintain their infrastructure, upgrade it, and expand it over time with the expectation that state regulators will allow them to charge customers slightly higher rates during specific future periods of time. The regulated rate increases are awarded based on capital expenditures made by each company and usually allow for a specific rate of return on investment. Rinse and repeat. This cycle of investment and rate increases is what allows water utilities to enjoy guaranteed (albeit relatively slow) growth.
That's also why water stocks trade at pricey premiums relative to the broader market. American Water Works trades at 27 times trailing earnings, although just 22.8 times future earnings. The recent decline in stock price to start the year actually makes those numbers pretty attractive compared to what investors have had to stomach in recent years. A solid year of earnings growth in 2017 helps, too.
American Water Works managed to grow revenue, adjusted earnings per share, operating cash flow, and cash dividends paid last year compared to 2016 -- although that's almost always the expectation.
Metric | 2017 | 2016 | % Change |
|---|---|---|---|
Revenue | $3.36 billion | $3.30 billion | 1.6% |
Operating income | $1.24 billion | $1.08 billion | 14.8% |
Adjusted EPS | $3.03 | $2.84 | 6.7% |
Operating cash flow | $1.45 billion | $1.29 billion | 12.4% |
Dividends paid | $289 million | $261 million | 10.7% |
Data source: American Water Works.
As you can see, it was a great year for earnings growth. That had a positive impact on cash flow and the amount of earnings distributed to shareholders in the form of a dividend. Things figure to continue getting better.
American Water Works expects to deliver adjusted EPS of $3.22 to $3.32 in 2018. While the low end of the range is slightly below the 7% to 10% annual EPS growth target previously set by management, it may only be a temporary speed bump in the long-term growth trajectory. The company invested an all-time record $1.4 billion in infrastructure in 2017, which bodes well for being awarded future rate increases.
Due to the timing of rate schedules, most of the benefit may not be realized until 2019 or later, but it's on the horizon nonetheless. It's also just a start. The water utility will invest $8 billion to $8.6 billion in infrastructure in the next five years, once again guaranteeing rate increases and growth for the next decade. That's much more capital than peers can deploy in the same span, which proves that when it comes to the heavily regulated water utility business, bigger really is better.
That said, given that most water stocks have dropped to start 2018, do any smaller peers offer decisively better value than American Water Works?
Company | Market Cap | Forward P/E | Price/Sales | EV/EBITDA |
|---|---|---|---|---|
American Water Works | $14.4 billion | 22.8 | 4.3 | 12.5 |
Aqua America | $6.2 billion | 24.3 | 7.7 | 17.6 |
American States Water | $2 billion | 30.4 | 4.5 | 14.7 |
California Water Service Group | $1.9 billion | 28.3 | 2.9 | 12.9 |
Data source: Yahoo! Finance.
The next largest peer, Aqua America, doesn't stack up favorably against American Water Works. Two smaller regional peers, American States Water and California Water Service Group, trade at comparable or better price-to-sales ratios, but as their future earnings valuations show, they're not quite as efficient at turning revenue into profit.
In other words, if you're going to buy a water stock, then look no further than American Water Works.
Is American Water Works a buy?
Considering that nothing is materially wrong with the business, record capital is being invested in infrastructure, and the recent 12% drop in the stock price, I think American Waters Works is a buy right now for investors who understand what they're buying. That is, a somewhat expensive and slow-growing business that doubles as a relative safe-haven investment. It pays a 2% dividend yield right now, and shares have appreciated in price for much of the last 10 years. Long story short, I think the recent pullback is a great buying opportunity for long-term investors.
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Maxx Chatsko has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
