2023-09-26 04:00:43 ET
Summary
- American States Water's diluted EPS payout ratio should be in the high-50% range in 2023.
- The water utility's operating revenue and diluted EPS both surged higher in the first half of 2023.
- American States Water's financial health is quite strong.
- My inputs into the discounted cash flows model and the dividend discount model suggest the utility is 8% undervalued.
- American States Water is a buy for investors looking to balance dividend growth with capital appreciation.
If you're a dividend growth investor such as myself, you probably highly value reliability from your investments. This is because your bills will consistently rise with each passing year, so you expect your investment holdings to throw off growing passive income to offset this occurrence.
What better way is there to combat inflation than by loading up your stock portfolio with Dividend Kings? No matter what economic event, public health event, or military conflict has transpired over the last 50-plus years, stocks in this exclusive club have delivered dividend growth.
Having hiked its dividend every calendar year for the last 69 years, American States Water ( AWR ) boasts the most established dividend growth streak among the Dividend Kings. As I'll discuss below, the company's fundamentals remain strong. And because of poor stock performance, since I last covered American States Water in April 2022 , I now believe the stock is priced at a buyable valuation for dividend growth investors.
AWR Has The Right Stuff To Reach 70-Plus Consecutive Years of Dividend Growth
You'd think with a dividend growth streak dating back nearly three-quarters of a century, AWR is a boring dividend stock. But the company's 8.2% annual dividend growth rate over the last 10 years is markedly better than the utility sector average annual growth rate of 5.2% during that time. That's why the Seeking Alpha Quant system awards an A grade to AWR for overall dividend growth. In even better news, the company's annual dividend growth rate has accelerated to 9.3% in the past five years. As strange as it may sound, this suggests that AWR's dividend growth streak is only getting started .
The water utility is expected to generate $2.77 in diluted EPS in 2023. Against the $1.655 in dividends per share that are slated to be paid this year, that equates to a 59.7% diluted EPS payout ratio. This is a payout ratio that leaves AWR with an adequate buffer to continue paying its dividend if earnings growth temporarily stalls.
Fortunately, the utility earns a B+ from Seeking Alpha's Quant system for growth when measured against its utility sector peers. That is because it is anticipated that diluted EPS will increase by 14% annually over the next three- to five years. Coupling these healthy earnings growth prospects with a manageable payout ratio is why I am maintaining my long-term annual dividend growth rate forecast of 8%.
The Utility Is Having A Great 2023 Operationally
For a business of its quality, it's not surprising to learn that AWR is off to an excellent start to 2023 through the first half of the year. The water utility's total operating revenue climbed by 37.9% year over year to $318.8 million in the first half of 2023.
AWR's tremendous topline growth was driven by the favorable decision from the California Public Utilities Commission or CPUC in June. This drove $24 million of water operating revenue growth during the first half. Customer base growth and contracts with military base installations fueled the remainder of topline growth.
AWR recorded $1.97 in diluted EPS for the first half of 2023, which was more than double the year-ago period. Thanks to disciplined cost management, the company's operating expenses grew by just 21% during that time - - barely half the operating revenue growth rate. This helped AWR's profit margin to soar from 14.8% in the first half of 2022 to 22.9% in the first half of 2023. That is how the company's diluted EPS growth far outpaced operating revenue growth during the first half.
AWR is also a financially robust business: The company's interest coverage ratio was a whopping 6.9 for the first half of 2023. Such a high interest coverage ratio explains why S&P gives AWR an A credit rating on a stable outlook (details in section sourced from AWR Q2 2023 earnings press release and AWR Q1 2023 earnings press release and AWR Q2 2023 Investor Presentation ).
Risks To Consider
AWR is a remarkable company. Yet, investors need to be aware of its risk profile before investing their hard-earned money into AWR.
As a regulated utility, it's important to realize that the company is at the mercy of regulators and the U.S. government. If the CPUC or the U.S. government were to hand down an adverse decision, AWR's financial profile could be harmed.
Due to environmental regulations aimed at maintaining water quality, the company's operating costs could increase. The costs incurred by AWR to protect the quality of water may or may not be allowed to be recovered by regulators from customers.
Finally, AWR stock could continue to underperform as long as interest rates remain elevated. That is because AWR's 2% dividend yield isn't viewed as attractive by some investors when the risk-free rate (U.S. 10-year treasury) is yielding 4.5% (all risks from risk factors section of AWR's most recent 10-K filing ).
The Stock Has Shifted From Overvalued To Undervalued
It's essential that investors not overpay for shares of AWR. This is because even as a relatively fast-growing utility, the company can only do so much to grow out of a sizable premium valuation. The good news is that with shares down 6% since I last covered the stock (as opposed to the S&P 500 index's 1% decline), AWR looks to be slightly discounted. I will go over two valuation models to support this argument.
The first valuation model that I will use to value AWR's shares is the discounted cash flows or DCF model, which has three inputs.
The first input into the DCF model is the last 12 months of diluted EPS. This amount is $3.21 in the case of AWR.
The second input for the DCF model is growth forecasts. I'll use a 7% annual diluted EPS growth rate for the next five years. I will then assume a deceleration to 6% in the years beyond that timeframe.
The third input into the DCF model is the discount rate, which is simply the required annual total return rate. I'll use 10% for this input.
Factoring in these inputs for the DCF model, I get a fair value of $88.86 a share. That means shares of AWR are trading at a 9.4% discount to fair value and offer a 10.4% upside from the current price of $80.49 a share (as of September 25, 2023).
Investopedia
The other valuation model that I'll utilize to estimate the fair value of AWR's shares is the dividend discount model or DDM. The DDM also is comprised of three inputs.
The first input for the DDM is the annualized dividend per share, which is $1.72 for AWR.
The next input into the DDM is the cost of capital equity. This is another term for the annual total return rate. I will use 10%.
The final input for the DDM is the annual dividend growth rate over the long haul. As noted earlier, I will use 8% for this input.
Plugging these inputs into the DDM, I arrive at a fair value of $86 a share. This implies shares of AWR are priced 6.4% below fair value and could provide a 6.8% capital appreciation from the current share price.
Averaging these two fair values out, I compute a fair value of $87.43 a share. That indicates AWR's shares are trading at a 7.9% discount to fair value and could offer an 8.6% upside from the current share price.
Summary: AWR Is A World-Class Dividend Grower Available At A Discount
AWR stands out among dozens of the most impressive businesses in the world. Better yet, dividend growth doesn't seem to be showing signs of slowing down, either. With a low payout ratio and vigorous growth prospects, such dividend growth should continue for the foreseeable future.
And for the first time since I initiated coverage almost four years ago, AWR looks at long last to be trading below fair value. That makes the stock a buy for dividend growth investors.
For further details see:
American States Water: Time To Finally Buy The Longest-Reigning Dividend King