American Water Works Stock: A Dividend Compounder To Buy Now (NYSE:AWK)

In investing, it’s important to enjoy the journey and to remember the “why” behind it. This is because the phase when investors focus on building wealth (e.g., accumulation) can take a handful of years, even decades to move past.

My reason behind investing is the same as it is for most people. I would like to reach a point where I no longer have to worry about money. Upon reaching financial independence, I still plan on keeping up with my portfolio holdings and sharing my investment research.

I believe this is a pivotal part of my life’s work. However, it will feel even better when I know that my investments have me covered. If I’d like, this could free me up more for philanthropic endeavors.

In my own experience, this September will mark seven years since I began investing. In this time, I have made meaningful progress.

However, I estimate that I likely have almost a decade to go before I will have attained financial independence for myself. God willing, this isn’t even considering the family of my own that I hope to eventually have.

In the meantime, I’m going to keep owning and buying high-quality dividend growth stocks. Since the rate at which my day-to-day expenses increase is steady, I also like to see steady dividend growth rates. After all, passive income growth that can keep up with or surpass my expenses growth will be key to maintaining financial independence.

One stock that I am glad to own is the water utility, American Water Works (NYSE:AWK). When I last covered the company in January with a buy rating, I liked its high-single-digit annual earnings/dividend growth, A-rated balance sheet, and valuation.

Since that time, there have been a few developments that have reinforced my rationale for a buy rating. Just yesterday (May 1), AWK shared first-quarter operating results and announced an 8.1% hike in its quarterly dividend per share to $0.765.

Briefly, the company remains on pace to execute billions of dollars in investments this year. AWK has the financial capacity to keep delivering. Lastly, time and results have arguably made the water utility’s shares more valuable since I last covered it.

Decent Growth Prospects And A Top-Notch Balance Sheet

After the market closed yesterday, AWK shared earnings results for the first quarter ended March 31. The company’s operating revenue climbed by 7.8% year-over-year to top $1 billion during the quarter. For more context, this was nearly $50 million above the analyst consensus per Seeking Alpha.

How did AWK put up such admirable topline growth for a water utility in the first quarter?

The company’s extensive rate case activity as of late is mostly to credit. Since the start of 2024, AWK has obtained $43 million of additional annualized revenue from general rate cases. That includes positive regulatory outcomes in Indiana and West Virginia. The company also secured $55 million of extra annualized revenue from infrastructure surcharges that have been authorized and made effective year to date.

AWK’s diluted EPS grew by 4.4% over the year-ago period to $0.95 for the first quarter. This was $0.03 shy of the analyst consensus according to Seeking Alpha. However, AWK has still beat the analyst consensus for diluted EPS in 15 out of the last 20 quarters.

Thanks to careful cost management, the company’s net profit margin expanded by 20 basis points to 18.3% during the first quarter. Coupled with the uptick in operating revenue, this propelled net income higher by 8.8% to $185 million in the quarter.

In early March 2023, AWK closed on the issuance of 11 million shares to fund part of its capital spending. This pushed the company’s weighted average diluted share count up by 4.8% over the year-ago period. That is why AWK’s diluted EPS growth rate trailed its operating revenue growth rate for the first quarter.

During the first quarter, AWK invested $720 million in capital improvements throughout its network of water infrastructure. This puts the company within striking distance of executing its $3.1 billion in planned investments for this year.

As I alluded to in my previous article, this is part of a broader 10-year plan to invest $34 billion to $38 billion in capital from 2024 through 2033. The supermajority of these investments (68% to 70%) will be used to update AWK’s water infrastructure. The remainder of spending will be split between improving infrastructure resiliency, water quality, system expansion, and operational efficiency. These investments are expected to help the company grow its rate base at 8% to 9% annually for the foreseeable future.

Additionally, progressing rate cases in numerous states, including Pennsylvania, New Jersey, California, Illinois, and Virginia, could drive operating revenue higher in the quarters and years to come. AWK also filed rate cases in Iowa and Tennessee during the quarter.

This is why I believe the FAST Graphs analyst diluted EPS growth consensus for the next few years is reasonable. The current consensus projects that diluted EPS will rise by 7.1% in 2024 to $5.25. Another 8.3% growth to $5.69 is expected for 2025. In 2026, the expectation is that diluted EPS will compound another 7.4% to $6.11.

AWK has the resources at its disposal to make its capital investments happen. In February, the company completed $700 million of 10-year note issuances at 5.15%. Another $700 million of AWK’s 30-year notes were issued at 5.45% for the month.

This demonstrates that the company has access to capital on reasonable terms. For more color, 10-year U.S. Treasuries (US10Y) were priced at a 4.3% yield at the time that AWK completed its offering. 30-year U.S. Treasuries (US30Y) were priced around 4.5% at that time. Thanks to the company’s A credit rating from S&P, AWK issued long-term debt at investment spreads of 100 basis points or less to U.S. Treasuries.

Finally, the company’s interest coverage ratio was 3.4 in the first quarter. Factoring in the predictability of a regulated water utility’s revenue/earnings base, this is a strong interest coverage ratio. The company’s 56% debt-to-capital ratio as of March 31 was also below the 60% that it is targeting and what is considered ideal by rating agencies (unless otherwise sourced or hyperlinked, all details in this subhead were according to AWK’s Q1 2024 Earnings Press Release and AWK’s Q1 2024 Investor Presentation).

Shares May Be Interesting Here

In this elevated rate environment, there isn’t as much demand for a water utility’s stock as usual. This is because investors can secure nearly 5% yields from 10-year U.S. Treasuries. That is harming sentiment toward AWK.

This is why shares of the water utility are exchanging proverbial hands at a current-year P/E ratio of 23.6. This is well below the 10-year normal P/E ratio of 29.

To be fair, such a multiple is probably not the best gauge for fair value any longer. It’s hard to envision interest rates being as low as they have been throughout much of the last 10 years. Even so, when rates settle 150 basis points to 200 basis points lower from the current level, I think a valuation multiple of around 26 could be realistic.

The calendar year 2024 is roughly 35% complete, so 65% of my fair value estimate is driven by the 2024 diluted EPS analyst consensus of $5.25. The other 35% of my fair value is fueled by the 2025 diluted EPS analyst consensus of $5.69. These blend out to a 12-month weighted-average diluted EPS consensus of $5.40.

Applying a valuation multiple of roughly 26, this works out to a fair value per share of $141. Relative to the current $124 share price (as of May 2, 2024), that is equivalent to a 12% discount to fair value. If AWK grows as anticipated and reverts to my fair value multiple, nearly 35% cumulative total returns could transpire between now and the end of 2026.

Expecting More Of The Same Dividend Growth

AWK’s 2.5% forward dividend yield is meaningfully lower than the utilities sector median forward yield of 3.9% per Seeking Alpha’s Quant System. However, this level of yield isn’t unusual for a water utility.

When considering the safety and growth potential of the payout, the company’s current starting income becomes intriguing in my view. That’s because the company’s 58% EPS payout ratio is comfortably less than the 75% that rating agencies prefer from the industry.

Applying the $5.25 diluted EPS midpoint from AWK’s 2024 guidance ($5.20 to $5.30), the payout ratio for 2024 would be 57.2%. This assumes that the $0.765 dividend that was recently declared can be maintained with the three quarterly dividend payments remaining this year. That would work out to $3.0025 in dividends per share being paid this year.

This would be within the 55% to 60% EPS payout ratio that AWK is targeting (slide 6 of 31 of AWK’s Q1 2024 Investor Presentation). That gives the water utility leeway to grow the dividend at least as fast as its high-single-digit annual diluted EPS growth that’s currently anticipated. This is why I’m confident that annual dividend growth of around 8% can persist in the years ahead.

Risks To Consider

AWK is a well-run business, but there are still risks to watch as the quarters and years progress.

In 2023, the company served more than 3.5 million active customers in 14 U.S. states. However, it’s worth noting that AWK’s top five markets of Pennsylvania, New Jersey, Missouri, Illinois, and California comprised 79.4% of total regulated operating revenue in 2023. The other nine states made up just 20.6% of total regulated operating revenue (details sourced from page 6 of 168 of AWK’s 10-K filing).

This exposes AWK to regulatory and operating risks in the top five states and most especially the top two. Pennsylvania and New Jersey alone were almost half of total operating revenue last year. If regulatory outcomes are unfavorable in any major markets, that could be a drag on the company’s growth prospects. If severe enough, such outcomes could also result in a downgrade of AWK’s credit ratings.

Any adverse weather occurrences could interrupt the water and wastewater services that the company provides to customers. At any time, this could hurt AWK’s financial results. If these events were significant enough, the damage inflicted on the company’s infrastructure could be more than its commercial insurance coverage. That could permanently impair AWK’s earnings power.

Summary: A Great Dividend Grower With Respectable Total Return Potential

Accounting for 0.4% of my portfolio weighting, AWK is a smaller holding for me. However, I wouldn’t mind eventually doubling or perhaps even tripling this weighting.

AWK’s 2.5% forward yield and high-single-digit annual diluted EPS growth potential make for an enticing combination. The company’s payout is also secure and should grow at least as fast as earnings. Not to mention the A credit rating from S&P on a stable outlook. Throw in moderate undervaluation and this is enough for me to reiterate my buy rating.