WTRG - Essential Utilities: Buy This Cheap Ultra SWAN Dividend Stock

2023-10-06 11:53:06 ET

Summary

• When properly weighted, water and gas utilities like Essential Utilities can fit perfectly into a dividend growth stock portfolio.
• Thanks to its low payout ratio, Essential Utilities’ status as a Dividend Aristocrat is at minimal risk of ending anytime soon.
• Essential Utilities boasts an excellent balance sheet, which is why it enjoys an A credit rating from S&P.
• The water and gas utility appears to be deeply discounted, which makes now a good time to buy with expectations of possibly more downside if interest rates are hiked further.
• Essential Utilities' 3.7% dividend yield, 6% to 8% annual earnings growth consensus, and potential for 4.9% annual valuation multiple expansion make the stock an interesting pick for dividend growth investors.

Short of CDs, the current market environment has left investors with no safe havens to at least somewhat preserve capital. Even arguably the safest stock market sector, utilities, has performed poorly so far in 2023.

BlackRock's iShares U.S. Utilities ETF ( IDU ) has dipped 17% so far in 2023. While I can't guarantee that there won't be further downside ahead, the good news for investors looking to deploy capital now is that this correction in utilities won't last forever. Utilities operating in constructive regulatory environments will likely get approval from regulators to recover higher interest costs through higher utility rates. That is why now is the time to consider buying best-of-breed utilities with favorable regulatory environments.

Essential Utilities ( WTRG ) is one stock that I believe is a best-of-breed utility, though it is down 30% year to date. Since I last covered Essential Utilities in September 2021 , I will dig into what makes the stock a buy for dividend growth investors.

It's often said in this community here on Seeking Alpha that the safest dividend is typically the one that's just been raised. Well, Essential Utilities just raised its dividend by 7% in August ; its 32nd consecutive year of dividend growth. This dividend is handily supported by the company's EPS payout ratio of 64%. Putting this into perspective, that is considerably lower than the 75% safe payout ratio that is the general guideline for the utility industry.

Earning an A credit rating from S&P, Essential Utilities also possesses one of the strongest balance sheets in its industry. Fundamental analysis suggests that this credit rating puts the water and gas utility at a mere 0.66% 30-year bankruptcy risk. In other words, investors have just a 1 in 152 probability of losing all of their capital.

Even if there is more downside ahead, Essential Utilities' current valuation positions investors well for the long term.

• 38% discount to fair value vs. 5% S&P 500 index premium

Essential Utilities' 3.7% yield, 7% growth, and 4.9% annual valuation multiple expansion potential combine for a 15.6% annual total return potential over the next 10 years. Even without any valuation multiple upside, the stock could still top the 10% annual total returns that are expected from the S&P 500 for the next decade.

Essential Utilities Is A Proven Utility

Founded in 1886 as a water and wastewater utility, Essential Utilities is one of the biggest water and natural gas utility service providers in the country. The company serves 5 million people across nine U.S. states. Geographically, about two-thirds of Essential Utilities' customers are located in Pennsylvania. The other third of customers are scattered throughout the likes of Ohio, North Carolina, Texas, and Illinois.

As you'd expect, the company is split into two segments: Regulated Water and Regulated Natural Gas. Each segment made up approximately $1.1 billion in operating revenue or half of the total $2.3 billion in operating revenue that the company generated in 2022 (per page 6 of 406 of Essential Utilities' 10-K filing ).

As established as Essential Utilities is in its industry, there is plenty of room for additional growth. This is because America's aging water and wastewater infrastructure needs to largely be replaced and upgraded, which could be a nearly $750 billion investment opportunity for Essential Utilities. That isn't even considering natural gas infrastructure investment opportunities. This massive addressable market is why the company expects to make $1.1 billion in annual investments between now and 2025. That is why Essential Utilities believes that earnings will grow by between 5% and 7% annually during that time. Analysts expect 6% to 8% annual earnings growth over the long haul from the company.

The utility also has a robust capital structure. Essential Utilities' targeted debt-to-capitalization ratio of 50% to 55% and targeted dividend payout ratio between 60% and 65% leaves it with the flexibility to fund these investments. Along with a constructive regulatory environment in Pennsylvania, this is the rationale for why S&P awards the company with an impressive A credit rating.

More Of The Same Dividend Growth Should Await Shareholders

Like all other utilities, investors tend to buy utilities for reliable income and recession-proof tendencies. After all, everybody needs water, natural gas, and/or electricity, right? However, rising rates have left more risk-averse investors with alternatives that they view as generally more appealing. U.S. 10-year treasury bonds, for example, currently yield 4.7% . This is a full 100 basis points higher than Essential Utilities' 3.7% yield.

But do you know what the utility has that bonds don't have? Attractive dividend growth. Essential Utilities' dividend has compounded at 7% annually over the last five years.

This type of dividend growth should largely continue in the future. Essential Utilities generated $1.77 in diluted EPS in 2022. Compared to the $1.11 in dividends per share paid during that time, this equates to a 62.7% diluted EPS payout ratio. That is almost smack-dab in the middle of Essential Utilities' targeted payout ratio.

Risks To Consider

Essential Utilities is undoubtedly a great business. But even the best of companies face their share of risks.

The company is heavily concentrated in Pennsylvania. This opens it up to a variety of risks that could impact its performance. Natural disasters could halt operations temporarily and weigh on financial results. But more importantly, there is always the chance that regulators could reject Essential Utilities' rate requests. Such an event could hamper the company's long-term growth prospects.

Another risk to the utility is that the banking icon Jamie Dimon thinks interest rates have much further to rise before they can start coming back down again. If this turns out to be the case, utility stocks could further underperform in the near term. Though, this would act as a coiled spring for when rates begin their inevitable descent and utilities recover higher interest rate costs through rate cases (more risks are outlined on pages 22-39 of 406 of Essential Utilities' 10-K filing).

Summary: A Blue-Chip Utility Worth Owning

Essential Utilities' sound operating metrics, exceptional balance sheet, and growth profile make it an Ultra SWAN at this time.

The company's current share price of around $33 suggests that it is deeply undervalued versus the $53 fair value estimate per share. Simply put, Essential Utilities is a buy for investors who realize and are comfortable with the fact that there could be some additional downside ahead. In my view, this is acceptable because nobody should be investing in stocks unless they have at least a five-year time horizon anyway.

Essential Utilities' 3.7% dividend yield and 6% to 8% annual earnings growth alone can perform in line with or a bit ahead of the S&P 500 for the next 10-year period. If or when the utility reverts to its fair value, this could contribute another 4.9% in annual upside over that time.

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