2023-07-31 16:18:15 ET
Summary
- American Water Works is a water and wastewater utility company serving over 14 million clients across 14 states.
- AWK's growth strategy focuses on balanced capex targets, value-based strength, and sustainable financial positioning.
- Despite underperformance in the utility industry, AWK outperforms due to superior operational capability and capital efficiency.
American Water Works ( AWK ) is a Camden, New Jersey-based public utility company which specializes in water and wastewater services and infrastructure. The company, servicing residential, commercial, and public facilities, works with over 14 million clients across 14 states as of 2022.
Through these activities, AWK has recorded Q2 revenues of $1.097bn alongside a net income of $280.00mn and an unlevered free cash flow of -$220.00mn.
Introduction
At the core of AWK's growth strategy remains its threefold approach, which emphasizes the balance between accretive capex targets, value-based strength, and sustainable financial positioning.
On a more granular level, AWK seeks to coordinate its capex towards high but stable growth targets, across reinvestment capex- enabling organic geographic and segmented growth, acquisition capex- focusing on penetrating new vertical and geographic markets, and the expansion of AWK's military services group, a fragmented arena which AWK aims to consolidate.
The combined positive earnings effects of AWK's capital expenditures and acquisition strategy, in conjunction with the firm's ongoing rate base strategy and AWK's moderate undervaluation, lead me to rate AWK a 'buy'.
Valuation & Financials
General Overview
In the TTM period, AWK- down 5.51%- has experienced middling performance between the Utilities Select Sector Index (SIXU)- down 8.60%- and the general market, as represented by the S&P500 ( SPY )- up 12.52%.
I believe the utility industry and AWK's simultaneous underperformance is a product of the inverse convexity of utilities with interest rates, with the attractiveness of bonds diminishing the value proposition of similarly acting utilities with lower yields.
Still, AWK manages to outperform the broader utility industry, likely a product of superior operational capability and capital efficiency.
Comparable Companies
Similar to other utility verticals, the water and wastewater industries remain highly fragmented on a geographic basis, though overall operations remain similar. As such, to most accurately represent AWK's value, I sought to compare the company to other multibillion-dollar water utilities. This group includes a Pennsylvania-based Midwest-focused firm, Essential Utilities ( WTRG ), California-based government-centric American States Water ( AWR ), California, Hawaii, New Mexico, and Washington residential water utility, California Water Service Group ( CWT ), and fellow California-based SJW Group ( SJW ).
As demonstrated above, AWK has experienced the second-best quarterly price performance, driven by the third-poorest YoY price action. Despite this, AWK remains undervalued when considering the firm's growth capabilities and balance sheet.
For instance, AWK maintains the lowest PEG ratio of the peer group, alongside the second-highest ROE, second-best ROA, and highest earnings growth in the past 5Y, demonstrating the outsized expansion capabilities of the firm.
This proposition is enhanced by AWK's financial security, with the highest book value per share of peers. Moreover, investors can expect superior returns with the fastest-growing dividend and a balanced payout ratio.
Valuation
According to my discounted cash flow valuation, at its base case, the net present value of AWK is $156.62, meaning, at its current price of $146.94, the stock is undervalued by ~6%.
My model, calculated over 5 years without perpetual growth built-in, assumes a discount rate of 9%, balancing the firm's above-average debt levels and lower equity risk premium. Additionally, in line with the 5Y median revenue growth rate of ~4%, I assume a revenue growth rate of 4%, seeing no obvious catalyst for sudden declines or rises in revenues.
Alpha Spread's multiples-based relative valuation more than corroborates my theory on undervaluation, estimating a base case underpricing of 22%, with fair value being $188.23.
Thus, taking an average of AWK's net present value and relative value, the fair value of AWK is $172.43, meaning the company is undervalued by ~14%.
AWK Sees Primary Growth Through Scale & Inelastic Demand
To form the infrastructure for stable and accretive growth, AWK has dedicated itself to aggressive, acquisition-led scale growth. This has supported 7100 customer connections through 10 acquisitions across 5 states in 2023. Most recently, expanding the firm's wastewater footprint, AWK has completed the acquisitions of Butler Area Sewer Authority in Pennsylvania, onboarding 14,700 customers, and wastewater facilities in Granite City, supporting 26,000 new connections. Ultimately, this expansion strategy has supported stable revenue growth and strong unit economics, with over 1.3mn customer connections in the pipeline.
The said dynamic feeds into AWK's larger rate-base management strategy, expanding the mentioned rate base and enabling capital recovery from capital expenditures through infrastructure surcharges, traditional rate hikes, and so on. I think investors can thus expect a degree of forward margin expansion on the basis of rising rates.
Wall Street Consensus
Analysts echo my positive outlook on the stock, forecasting an average 1Y price target of $159.00, an 8.21% increase.
Even at the minimum projected price, analysts expect a decline of only 5.40%, a relatively safe proposition given a poorer risk-adjusted return climate.
I believe this overall positive view from analysts reflects expectations of restricted forward rate growth as well as a macro stimulus for utility infrastructure.
Risks & Challenges
A High Degree of Regulatory Complexity Leads To Increased Compliance Costs
The utility industry remains one regulated on federal, state, and municipal levels, with augmented complexity for water-related utilities. As such, rising compliance costs or regulatory pressures may lead to compressed profitability and scalability. To sustain margins, AWK may be forced to hike rates or see reduced free cash flow and reduce investor returns.
Climate Variability May Lead to Differentiated Supply/Demand Dynamics
The latter pressures are enhanced by increased regulatory burdens coming from stringent climate and environmental laws. But more so than that, an increasingly variable climate may require greater infrastructure investment and an increased debt burden and lead to poorer capital management.
Conclusion
Looking forward, I believe AWK will continue to benefit from aggressive organic and acquisition-driven growth, scaling on a geographic level and ensuring continued shareholder returns.
For further details see:
American Water Works Sustains Strong Financials And Operations, Trades At Fair Value