American Water Works: A Profitable And Stable Utility Trading At A Discount

Investment Thesis

The American Water Works Company, Inc. (NYSE:AWK) is the largest publicly traded water utility in the United States. The utility provides water supply and wastewater management services to customers across the country through their regulated operations as well as servicing some military facilities too.

AWK remains highly profitable and benefits from what I see as a mostly constructive rate-setting landscape. The firm is also very operationally efficient which helps expand their margins and increase shareholder returns.

Current valuations suggest shares of this highly stable utility may be undervalued by up to 10% which is quite uncommon given the almost bond-like returns.

Therefore, I rate AWK stock a buy at the present time and see a very positive long-term value opportunity in shares.

Business Profile

American Water Works is a regulated utility that operates a massive portfolio of water supply and sanitation networks. The firm has over 3.5 million customer connections in the United States and is the only pure-play large-cap water utility in the country.

The utility operates on a massive scale with over 53,700 miles of pipe, 620 water treatment plants, and 175 wastewater treatment facilities present in their regulated utility network. AWK also operates a small military services segment which is a nonregulated business segment.

Multiple small-scale acquisitions from municipalities and other private enterprises have allowed AWK to expand their operations significantly over the last ten years with the firm planning to continue this streak of acquisitions for the foreseeable future.

Through these acquisitions, AWK has built a massive presence in 13 states including California, Pennsylvania, New Jersey, Missouri, and Indiana to name a few.

Susan Hardwick is both the CEO and President of American Water Works and has overseen the continued execution of the firm’s aforementioned growth strategy.

I believe Hardwick is an effective leader for the utility as she exhibits a conservative approach to capital allocation and a real devotion to shareholder returns which I view very positively indeed.

American Water Works Economic Moat

As is the case with most utilities, AWK’s moat is built primarily upon the regulatory text which defines the utility’s right to a return on their investments. I also see the firm’s military service segment as a further booster of their overall moatiness.

The current regulatory landscape permits AWK to charge a premium on their services in order for the company to achieve a sufficient rate of return on their investments.

Historically, the firm has enjoyed a very constructive rate-setting environment which has allowed the utility to charge sufficiently for their water services in order to generate around a 5.5% ROIC.

AWK’s massive scale and acquisitive approach to business has allowed the firm to fundamentally grow their earnings despite the overall rates remaining mostly stable.

The utility often acquires smaller water supply and sanitation systems from private enterprises and municipalities as is the case with their most recent acquisition of Manville wastewater system from the Borough of Manville.

Acquisitions from municipalities are subject to fair market value laws which allow AWK to acquire these assets at an assessed value rather than a historic cost. The states which operate according to these laws basically ensure that the municipality will receive a fair deal for their asset while AWK is able to benefit from an attractive price for said assets.

I really like AWK’s history of acquisitions and believe the utility has a good relationship with regulators which further helps in the closing of sales. A growing portfolio of infrastructural assets also increases the total volume of infrastructural upgrades that must be accomplished which further boosts revenues for the firm.

The relatively small military services segment is the only nonregulated element of the firm’s operations and sees AWK supply water services to twelve army, five air force and one navy base.

While this segment does not benefit from set rates chargeable by the firm, AWK traditionally has contracts lasting about 25-30 years with these military customers with rates still securing solid profitability for the firm.

I believe American Water Works’ regulated utility and military services business generates a wide economic moat for the firm. The company enjoys a fundamentally positive regulatory environment which while sometimes subject to adverse rate-setting policies, continues to allow the firm to generate stable and reliable returns from their enterprise.

Fiscal Analysis

American Water Works continues to generate strong returns with their five-year running ROA, ROE, and ROICs of 3.35%, 12.10% and 5.50% being very healthy indeed. While these returns are lower than some investors may initially want to see, it is important to consider the limit regulations placed on the price utilities such as AWK are allowed to charge for the services.

Nevertheless, the current ROIC of 5.90% is very positive in my opinion, and actually sees AWK outperform industry rivals Essential Utilities, Inc. (WTRG) by around 25bp.

February 15, 2024, saw AWK publish their Q4 and year-end 2023 earnings with solid top-line growth and great operating efficiency characterizing the year.

Total operating revenues grew a solid 11.31% YoY for American Water Works with the increased revenues being driven primarily by a positive rate-setting environment along with warmer than usual weather increasing demand for retail water.

AWK also closed on 23 new acquisitions during 2023 which came at a price of $589M for the firm. While this rate of acquisitions may sound very high, it is quite normal for American Water Works and is a core element of their business model.

Weather impacts were estimated to contribute an additional $0.13 to total EPS earnings with 2023 weather-normalized EPS of $4.77 increasing a solid 7.19% YoY.

The current regulatory environment also sees American Water Works facing eight new rate cases in Illinois, New Jersey, Pennsylvania, Virginia, West Virginia, California, Indiana, and Kentucky.

Many investors appear to have taken a bearish view towards these ongoing rate cases which admittedly, do present AWK with the possibility of lower margin rates being set.

While it is possible that the regulators could take a tighter approach than in previous years, I fundamentally believe that the utility will continue to benefit from a constructive system which helps guarantee earnings for the firm in exchange for the essential services they provide.

Regardless of the rate cases, AWK continues to excel in operational efficiency with 2023 seeing total operating expenses increased just 8.7% compared to the 11.31% growth in operating revenues.

Such solid cost control came primarily as a result of tightly managed operation and maintenance costs which is impressive in my opinion given how sticky inflation has proven to be.

Net income increased 15% YoY in 2023 thanks to the higher operating income and the comparatively smaller increase in expenses.

Seeking Alpha’s quant assigns American Water Works with a “C-” profitability rating which I believe is excessively pessimistic given their 2023 results. The primary factors that appear to sway the quant away from a higher grade are the poor levered FCF margin and the low asset turnover ratio.

The poor levered FCF margin is understandable given the expenditure on acquisitions in 2023 and therefore does not concern me whatsoever, especially considering it falls in line with the utilities 5Y average.

The asset-heavy business of a utility also lends itself automatically to a low asset turnover ratio and thus this metric also does not present any particular concerns.

AWK’s balance sheet suggests the firm has a solid asset allocation strategy with reasonable leverage and liquidity defining their fiscal profile. The utility has $1.39B in total current assets with total current liabilities amounting to $2.15B.

This imbalance leaves the firm with a quick ratio of 0.49x and a respectable current ratio of 0.65x. Such low short-term liquidity is a standard characteristic of utilities given how capital-intensive their operations are.

Given that AWK’s current leverage ratio is around 3.09x, I am not overly concerned about the low quick and current ratios especially considering the number of transactions the utility made in 2023.

AWK has maintained a ratio in the low threes for the last 10 years and plans to do so for the next ten years.

American Water Works has a total of $11.72B in long-term debts which consist primarily of fixed-rate senior notes. I like the structure of their debt profile and see the concentration of long-duration notes as evidence of a conservative growth strategy.

Indeed, the current maturity profile supports my hypothesis with a great majority of debentures maturing well after 2028.

Moody’s affirms a “Baa1” rating for AWK’s LT issuer rating. Moody’s classifies these “Baa1” ratings as being of “medium investment grade” which once again suggests that AWK has solid fundamental economics underpinning their business operations.

American Water Works’ shareholder rewards are also quite positive with the utility still having the capacity to repurchase up to 5.1. million shares of common stock under a 2015 authorized repurchase program.

While no shares were repurchased in 2023, the utility did continue to pay out a dividend to shareholders.

Seeking Alpha’s excellent dividend tab for AWK tells us that the current FWD yield is 2.40% with an annual expected pay-out of $2.83 and a pay-out ratio of 56.80%.

While the yield absolutely could be larger, I believe management is prioritizing the sustainability of their dividend instead of massive short-term yields. Their 15-year growth streak is impressive given how many acquisitions AWK has executed in this time.

I really like the current situation presently at AWK. Their core operations remain profitable and the firm continues to benefit from a mostly constructive regulatory environment.

This enables the company to generate sufficiently lucrative returns from their enterprise so as to generate a tangible return on invested capital and reward shareholders handsomely.

Valuation

Seeking Alpha’s Quant calculates a “D-” valuation rating for AWK stock. I disagree with this relative analysis and believe the letter grades assigned to each metric may actually be slightly misleading.

Current P/E GAAP TTM and P/S ratios of 24.09x and 5.37x are both down 27% and 21% respectively from their 5Y averages. The significant drop in valuations has mostly come from investors reacting to a higher-for-longer interest rate environment and the potential damage this may do to the relative returns generated by utilities.

However, I believe this market reaction has been overdone and see the utility’s current P/CF TTM ratio of 12.25x (down 35% from 5Y averages) as evidence that AWK stock has perhaps entered an oversold position given how stable earnings from utilities are.

AWK stock has seen much more volatility over the last five years with a boom during the height of the COVID-19 pandemic being corrected post-2022. Nevertheless, AWK has still outperformed the greater utility sector (as defined by the popular utility sector ETF XLU by 4.5% over the last five years.

Still, long-term shareholders will find it difficult to ignore the poor performance of the utility over the last six months with the greater market rally that has even lifted most utilities by around 7% being unable to reignite American Water Works’ stock.

To gain an objective quantitative perspective of the value present in AWK, we can use The Value Corner’s Intrinsic Valuation Calculation.

By inputting the current share price of $121.50, 2024 estimated EPS of $5.24, a realistic “r” value of 0.08 (8%), and the current Moody’s Seasoned AAA Corporate Bond Yield ratio of 5.03%, I derive a base-case IV of $134.50 per share. This represents a 10% undervaluation in shares.

Using a bear-case CAGR value for r of 0.06 (6%) to reflect a scenario where unconstructive rate-setting limits revenue growth and still generates an IV of $112.50. This suggests just an 8% overvaluation at present prices.

I am reluctant to make any particular forecasts about AWK’s short-term (3-12 months) performance. The potential for any negative or positive catalyst to significantly impact the share price is real and could easily shake investor confidence given the convoluted macroeconomic and political landscape in the U.S.

In the long term (2-10 years), I believe American Water Works will continue to be the leading water supplier in the U.S. and see the firm’s strategy of consistently acquiring small water suppliers as a viable strategy for long-term growth.

AWK Risk Profile

While utilities are generally regarded as having one of the lowest risk profiles of any industry, I must admit that I see American Water Works now facing more threats than perhaps ever before.

An increasingly stringent regulatory environment creates two threats for AWK. Firstly, the increasingly strict requirements for the quality and safety of the utility being provided (in this case, water and wastewater systems) may place a greater fiscal burden on the firm.

Quite simply, if AWK has to invest in new infrastructure to comply with ever-tightening quality regulations it is quite possible that their overall profitability will be eroded.

The threat of a regulatory infraction also presents a massive risk to AWK with Hawaiian Electricity serving as a great example of the damage alleged negligence in utility services provision can do to even the most stable of companies.

Secondly, the potential for unconstructive rate-setting limiting profitability has become a real threat in recent years. Should a state in which AWK operates decide on rates which provide a lower return on capital for the company, a real degradation in both top-line growth and real profitability may occur.

While I see little risk in most states, some such as California present what I believe will be an unconstructive landscape for AWK in the coming years.

These risks also fall into the environmental and governance ESG categories which fundamentally limits my ability to recommend AWK as an ESG conscious pick.

Of course, risk analysis is an inherently subjective matter and I implore you to conduct your own comprehensive research into any and all risks which may accompany this company and its stock should it be of concern to you.

Summary

Overall, I continue to view utilities in general positively and believe American Water Works is a superb example of how profitable and efficient a well-run utility can be.

Their superb operational efficiency helps the utility generate solid returns even from more constrictive rates and illustrates how well-managed the firm really is.

The current valuation also suggests that the utility may finally be trading at what is a real undervaluation. While the uncertainty the ongoing rate cases create does increase the risk associated with an investment at the present time, I still believe the firm makes for an attractive value opportunity.

Therefore, I rate AWK stock a Buy at the present time and believe the utility is well-positioned to continue generating exceptional shareholder returns in the long run.