2023-12-01 08:58:07 ET
Summary
- Next summer, American States Water should be the first company to extend its dividend growth streak to a mind-boggling 70 consecutive years.
- The water utility grew operating revenue and adjusted diluted EPS by double-digits in the third quarter.
- American States Water maintains an A credit rating from S&P on a stable outlook.
- The water utility looks to be priced at a 9% discount to fair value.
- American States Water should at least match the total returns of the S&P 500 in the next 10 years.
When many investors think of Dividend Aristocrats and Dividend Kings, they probably think of the most popular first: These include Procter & Gamble ( PG ), Johnson & Johnson ( JNJ ), and Coca-Cola ( KO ).
However, some equally impressive companies fly under the radar. There could be a variety of reasons behind this fact, but it probably has a lot to do with the fact that the aforementioned companies are consumer-facing with global presences.
Serving California and various U.S. military base installations, American States Water ( AWR ) isn't a household name to most investors. While I don't own the company, it is one that I would at least consider owning. For the first time in two months , let's revisit the company's operating fundamentals and valuation to learn why I like it.
Although its 2.1% dividend yield isn't high relative to other utilities, AWR does provide more starting income than the 1.5% yield of the S&P 500 ( SP500 ). This appears to be relatively secure as well. AWR's 61% EPS payout ratio is well below the 75% EPS payout ratio that rating agencies prefer from water utilities according to Dividend Kings.
The water utility also has a great balance sheet, with a 33% debt-to-capital ratio. For more color, this is just over half of the 60% debt-to-capital ratio that rating agencies want to see from water utilities per Dividend Kings. That suggests AWR is well-capitalized.
Considering these variables, Dividend Kings projects that the risk of the company reducing its payout in the next garden-variety recession at 0.5%. Even in a severe recession, the probability of a dividend cut stands at just 1%.
After years of being overvalued from my perspective, AWR looks to have finally grown into its valuation. This is supported by Dividend Kings' $90 average fair value estimate.
That fair value figure also jives with the $86 fair value that I get from using the following inputs in the dividend discount model: A $1.72 annualized dividend per share, a 10% discount rate, and an 8% annual dividend growth rate.
Averaging these two fair values together, I get an $88 fair value. Relative to its current $80 share price, AWR is trading at a 9% discount to fair value.
If the company returns to this fair value and matches growth expectations, here are the total returns that it could produce through 2033:
- 2.1% yield + a 6% annual earnings growth rate + 0.9% annual valuation multiple expansion = 9% annual total return potential or a cumulative 10-year 137% total return versus the 9% annual total return potential of the S&P 500 or a 137% cumulative total return
A Fundamentally Sound Third Quarter
AWR posted respectable results for the third quarter. The company's $151.7 million in operating revenue during the period was up 12.4% over the year-ago period. This narrowly missed the analyst estimate of $152 million in the quarter. What contributed to AWR's double-digit topline growth?
The catalyst for the company's operating revenue growth was primarily second-year rate increases. AWR filed for these rates in June for its Golden State Water subsidiary, and the California Public Utilities Commission implemented them effective on July 31. These higher rates replaced the previous rates that were in place during the third quarter of 2022.
AWR's adjusted diluted EPS surged 16.4% higher year-over-year to $0.85 for the third quarter. This sizable earnings growth was fueled by a higher operating revenue base for one. Secondly, the 5.6% growth rate in the operating expenses category trailed operating revenue growth. This is what helped the company to expand its non-GAAP profit margin in the quarter. For these reasons, adjusted diluted EPS grew faster than operating revenue during the quarter.
AWR also had some favorable developments in the quarter. First, the company was awarded two contracts by the U.S. government for its American States Utility Services business, according to CEO Robert Sprowls' opening remarks in the earnings call . The first was a Navy contract for the Naval Air Station Patuxent River in Maryland, with an initial $349 million value over 50 years. The other was a new 15-year contract at Joint Base Cape Cod in Massachusetts for $45 million over 15 years. This should keep the contracted services segment growing for the foreseeable future.
AWR also filed a new general rate case in August with CPUC, which will set new rates for the years 2025 through 2027. If ultimately approved, this could also keep solid growth going for the Golden State Water subsidiary.
Finally, AWR's interest coverage ratio was 6.3 in the nine months ended September 30. Given that regulated utilities tend to be relatively stable in terms of earnings, this is a very strong interest coverage ratio. That's probably why S&P awards an A credit rating to AWR on a stable outlook.
Healthy And Steady Dividend Growth Can Be Maintained
AWR's most recent 8.2% dividend increase announced in August will be its 69th consecutive calendar year of dividend growth. I also anticipate that similar dividend growth should be the norm moving forward.
This is because AWR is expected to generate $2.91 in adjusted diluted EPS in 2023. Compared to the $1.655 in dividends per share that will be paid during the year, this is a highly sustainable 56.9% adjusted diluted EPS payout ratio.
Risks To Consider
AWR has all the indications of a well-run water utility, but it still has risks that investors need to be fine with before buying.
Since the company's most recent 10-Q filing mentions no new risks since its previous 10-K filing , I will briefly some risks noted in my prior article.
Aside from its secondary ASUS business, AWR is entirely concentrated in the state of California. This concentration especially exposes the company to general risks like wildfires and earthquakes, which could disrupt operations. It could also hurt AWR financially if losses from such natural disasters are above and beyond its insurance coverage.
Additionally, there is a regulatory risk that CPUC may not approve rate requests that are favorable to AWR. This could materially harm the investment thesis.
Lastly, AWR is viewed by some investors as a low-risk stock. As long as interest rates remain high, this could result in a lack of catalysts for the stock near-term as investors stay with higher-yielding options.
Summary: AWR Is An Undervalued And Underappreciated Business
Thanks to its stable operating fundamentals, excellent balance sheet, and unrivaled dividend growth streak, AWR passes my quality test with flying colors.
The company's discounted valuation further seals the deal. That is why I believe it can at least match the S&P over the next decade. This is particularly attractive because AWR can do that while also possessing the characteristics of one of the more reliable businesses in the investment universe. Thus, I rate shares of the stock a buy right now.
For further details see:
American States Water: America's Most Legendary Dividend Growth Stock Is A Buy