AWK - American Water Works: A Dividend Growth Stock On Sale

2024-01-22 08:00:00 ET

Summary

• As I have discussed repeatedly, water utilities are some of the most reliable dividend payers and growers in the investment universe.
• American Water's operating revenue and diluted EPS grew in the third quarter.
• The company maintains a balance sheet with an A rating from S&P on a stable outlook.
• Shares of American Water appear to be undervalued by 8%.
• The 10-year cumulative total return potential of the water utility is nearly 25% greater than that of the S&P 500.

Readers who have followed my work over the years know that I have an affinity toward water utilities. In my five years on Seeking Alpha, I have covered five water utilities a total of 18 times leading up to this point.

There are quite a few industry characteristics that I find to be appealing. For one, routine access to water is essential to a high quality of life. That's why, no matter the economic environment, customers tend to prioritize paying for water services over most other bills. This tends to support stable and growing dividend payments, which explains how the water utility American States Water ( AWR ) boasts the longest dividend growth streak in America.

An aging water infrastructure also bodes well for the industry overall. Just a couple of years ago, the U.S. Environmental Protection Agency estimated that the U.S. would need to spend more than $744 billion over 20 years to modernize water infrastructure. These heavy required investments should translate into plenty of growth opportunities for water utilities in the years to come.

With that being said, I am going to focus on reexamining American Water Works ( AWK ) today. For the first time since June 2022 , I am going to discuss its fundamentals and valuation to support why I am maintaining my buy rating.

American Water's 2.3% dividend yield isn't exceptionally high, but it is better than the 1.5% yield of the S&P 500 Index ( SP500 ). Even better, the company's dividend should keep growing at a healthy rate in the future.

This is because American Water's 58% EPS payout ratio is much lower than the 75% EPS payout ratio that rating agencies prefer from water utilities. The company's 53% debt-to-capital ratio is also less than the 60% debt-to-capital ratio that rating agencies desire, which suggests it is well-capitalized.

Thus, American Water enjoys an A credit rating from S&P on a stable outlook. This implies that the probability of the water utility defaulting on its debt in the next 30 years is just 0.66%.

Additionally, the risk of American Water cutting its dividend in the next average recession is only 0.5%. Even in a severe recession, the chance of a decrease in the dividend is 2%.

Shares of the water utility also look to be attractively valued at this time. Based on the historical dividend yield and P/E ratio, American Water could command a fair value of $136 a share. Relative to the $125 share price (as of January 19, 2024), that would represent an 8% discount to fair value.

If American Water returned to fair value and met the growth consensus, here are the total returns that it could generate over the coming 10 years:

• 2.3% yield + 8.2% FactSet Research annual growth consensus + 0.8% annual valuation multiple expansion = 11.3% annual total return potential or a 192% 10-year cumulative total return versus the 9.8% annual total return potential of the S&P or a 155% 10-year cumulative total return.

American Water Is "Boring" In A Beautiful Way

Investors who buy water utilities tend to like them for their predictability. They rarely blow the analyst estimates away, but they also rarely miss the analyst consensus by a wide margin. In yet another quarter, American Water delivered on expectations.

The company's operating revenue climbed 7.9% year-over-year to $1.2 billion during the third quarter that ended September 30. That was in line with the analyst consensus for the period. This topline growth was driven by authorized revenue increases from previously completed general rate cases and the recovery of incremental capital and acquisition investments in infrastructure proceedings.

American Water's diluted EPS edged 1.8% higher over the year-ago period to $1.66 in the third quarter. For perspective, that was also what analysts were expecting. Aside from its greater operating revenue base, the company's 8.8% net income growth was fueled by a 20 basis point expansion in net profit margin to 27.7%. Disciplined operation and maintenance expense management was responsible for this margin expansion.

However, American Water's higher net income was mostly offset by the issuance of shares last March . Since there is a lag between when proceeds are collected from share issuances and when investments are made/pay off, this isn't too concerning. Occasional share issuances are simply a part of how water utilities raise capital.

Thanks to an especially promising industry outlook, American Water maintained its 7% to 9% long-term EPS compound annual growth rate. Underpinning this growth, the company anticipates that between 2024 and 2028, it will invest between $16 billion and $17 billion in capital. The vast majority will be to upgrade and expand its existing infrastructure, with the remaining $1.5 billion to $2 billion expected to be dedicated to acquisitions.

American Water plans to fund $12 billion of its capital spending with operating cash flows. The remainder will be split between $7 billion in incremental debt by leveraging its A credit rating with S&P and $1 billion in equity issuances, per slide 13 of American Water's December 2023 Investor Presentation.

Robust Dividend Growth Can Continue

In the last five years, American Water's quarterly dividend per share has cumulatively compounded by 55.5% to the current rate of $0.7075 . Put another way, that's a 9.2% compound annual growth rate.

The company anticipates that it will generate $4.77 in midpoint diluted EPS ($4.72 to $4.82) in 2023. Compared to the $2.7775 in dividends per share that were paid, that equates to a 58.2% diluted EPS payout ratio. That's almost exactly in the middle of the 55% to 60% payout ratio range that American Water targets (target payout ratio range per slide 4 of 33 of American Water's December 2023 Investor Presentation). This should allow the company to grow its dividend in line with earnings moving forward, which is why my base case is for annual dividend growth of around 8%.

Risks To Consider

As the largest regulated water and wastewater utility in the U.S., American Water is most certainly a high-quality water utility. That's not to say that it doesn't have its share of risks, though.

As is the case with any utility, regulatory risk is worth noting for American Water. If any of the company's general rate cases in progress in five jurisdictions have unfavorable outcomes, that could weigh on its growth prospects. That would especially be true in major markets: New Jersey and Pennsylvania accounted for 49.3% of operating revenue in 2022 (page 6 of 306 of American Water's 10-K filing ).

Another general risk is the potential for severe weather events to disrupt service. If this happened, American Water's operating results could be temporarily adversely impacted. Damages resulting from these weather occurrences may also be beyond the scope of the company's insurance coverage, which could hurt its fundamentals.

Summary: A Proven And Discounted Dividend Grower

From my perspective, American Water offers an interesting blend of starting income and growth potential for an investor my age. This is supported by a very secure payout ratio and one of the best growth profiles of any utility.

American Water's valuation isn't dirt-cheap, but nobody should reasonably expect it to be for its overall quality. The company's mix of income, growth, and value is why I am maintaining my buy rating for now.

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