2023-08-31 17:29:36 ET
Summary
- California Water Service has seen a decline in its valuation and is now trading at a lower multiple compared to other water companies.
- The company's decline in revenue and earnings is primarily due to a decrease in customer usage and increased costs for water treatment.
- CWT faces future challenges, including the need to comply with PFAS regulations and make a significant investment of around $200 million.
Dear readers/followers,
When I last looked at California Water Service ( CWT ), it was after several articles with a "HOLD", going to a "BUY". The company proceeded to go up after my article, only to decline right back down double digits to where we now look at the latest results and give a thesis update.
The water sector is inherently attractive due to how it's structured in the US. It's a "safe" income. The question is how this income and company ought to be valued based on its rate base, the surrounding climate, and the company's fundamentals. Typically, water companies trade at a very high overall premium - just look at York Water ( YORW ), another company I invest in here.
However, this change in funding costs and risk-free rates have impacted not only riskier businesses but also businesses such as water companies, which trade at significantly different multiples compared to what we've seen before.
California Water Service - Much more attractive now than before.
CWT is a water company. This particular company offers water in Dixon, East Los Angeles, Bakersfield, Travis, Stockton, and areas in the vicinity, and has your typical water company holding structure. That means CWT is the holding company of various water utility subsidiaries. CWT, in this case, owns companies like Cal Water, New Mexico Water, Utilities on Hawaii, and the like.
Now, part of the reason the company is down is also the troubles we've seen in Hawaii - but the decline precedes what's going on there in terms of fires. The real decline started all the way back in June, well even before 2Q was reported, which came in during the end of July of 2023.
The reason for the drop was shown, in part, when it came to the 2Q23 report. Operating revenue was down $12.2M which for a water company priding itself on stability, is not a small amount. This came from a $13.8M decrease in billed and unmetered billed revenue, mostly due to a decrease in customer usage.
This is despite an $800,000 decrease in OpEx as well as significant cost decreases for water treatment. The company's costs are well in hand, but mandated water usage (meaning less) is causing lower revenues, and in turn, lower overall profit for the company.
It caused a significant decrease in quarterly EPS, actually down 52.8% on a diluted basis for the quarter YoY, and a 51% decrease in net income. Part of the reason there was also an increase in the interest expenses, around 15%.
Another reason was a delay in the rate case, which impacted the company.
The unrecorded Cali regulatory mechanisms for 2023 resulted in an understatement of reported operating revenue - and it's in this understatement we find much of that missing EPS, depending on how its estimated. Highlights worth noting for the quarter are mostly related to investments and capital improvements in the company's base.
Politically speaking, California has extended the arrearage payment program to aid struggling customers with coverages for delinquent customers for specific periods. This doesn't impact CWT all that much beyond making sure that payments do happen, with a request for those funds at the end of 3Q.
Part of what caused more decline is also likely the estimate that production costs will increase towards 2H23 - and the company has already filed an advice letter to that fact to account for this.
Impacts in earnings and future expected earnings are both clear, but also diversified, in accordance with what we can see here.
YTD results are not a necessarily pleasant read either, echoing many of the trends we see on a quarterly basis. The decrease, mostly due to usage, is down 9.7% on a YTD basis, and revenue is down over $50M on an operating revenue level, with operating expenses down about $16M.
Thus, we're seeing a fair bit of margin compression for the company, for a variety of reasons. YTD EPS has gone negative, and now stands at -$0.23 for the 6-month period, for the most part, due to unbilled revenue and lower usage, but also internet costs and increased production costs.
The cost of capital in this case is decent enough, and Cal Water did approve a rate increase of 4% effective in May of 2023, which is expected to increase revenue by about $20M. As you can see based on results, this is barely enough to really offer upside here, and 4% is of course also less than inflation.
Furthermore, and additionally to what the company needs to do, there is a PFAS regulation update. If this is adopted in its current form, the company will have to invest about $200M in order to simply comply with the regulation.
This will of course impact the company as well, as it would require full compliance by 2026E.
In short, what we have here is a water company that's seeing more margin compression than is typical for a company in this sector. This has caused a decline in valuation to where CWT is now well outside the typical premium range of 30-35x P/E for a company like this. A $200M investment is nothing small for a company with a market cap of under $3B, so this is something to definitely keep an eye on.
The company is in no way in trouble though. With a very low debt of sub-41% to capital, and an upside from what is essentially selling the most important utility, even more so than electricity.
However, valuation and estimates are important. And it's here where I say we find our biggest problem if we want to invest in CWT - the company is simply valued in accordance with very good growth estimates in terms of earnings. The recent set of guidance targets, together with the estimates for what the company will have to invest, do not go well with these growth expectations.
Let's see exactly where we can see the problem here.
California Water Service - Some things to like, but valuation is tricky here.
Usually, a decline of over 10% is enough to strengthen my thesis in a company. In this case, it's a bit more complicated than that. The company is estimated to grow its earnings at double-digits for the next three years compared to 2022. However, in light of recent earnings, I put into question the likelihood of such a development.
At the very least, the necessary investment, provided the mandate goes through, will have the very real potential to heavily impact company EPS for the next few years as this is planned and executed - remember, 2026E is when CWT would be forced to be in compliance. Costs, as such, come ahead of such a compliance.
I also discount the company based on the expectation of a further compression based on earnings and costs - this is more general, and something we're seeing globally. People have less money and things cost more - and the sectors where we'll see most of these compressions, as I see it, are in sectors where there are governmental regulators involved and can exercise influence in pricing and trends.
Electricity and Water, as such, are such sectors. The fact that governmental support has been going on here not only in Sweden but in other nations, including the US, speaks to the sentiment held from politics that these are things people "need" to be able to pay for.
Here is the upside based on a much lower growth rate, and a 25x P/E for CWT.
Now, do I think it likely that the company will decline and trade more long-term at around 25x? Hard to say. I would say it's unlikely - but at the same time, we're in trends that we have not seen in a very long time, and that poses challenges that we may never have encountered.
When it comes to any company that trades at a premium and has a 15-20-year history of trading at a premium, I would say the higher the premium is, the more likely it is to impact this. Historical models of valuing these companies may not be accurate for this environment.
This includes every type of company - including things like REITs.
Any valuation premium we find or look at today should be considered with extreme care. And this is especially true with a company that has a static nature and lack of growth in earnings - which water companies have.
So CWT may outperform. But you see that my PT of $56 actually goes well in hand with a longer-term PT representing a 25-26x P/E. So even though the price target may seem high today, based on this decline, in the long term and taking into consideration even a relatively positive rate of earnings growth, it's not that high if we look at where this company or this type of companies typically trade.
S&P Global Valuation estimates come to a range of $48 on the low side to $57 on the high side, with an average of $54/share, around $2 below my target. This is down from $64 less than a year ago, however - so that needs to be considered.
The company is not the best upside on the market today - far from it. But recent trends and the news from the 2Q23 have turned this into one of the more undervalued NA water companies - and for some investors, that is both interesting enough and with enough of an upside to be interesting here.
I've also taken a close look at the options chains, though much like with other water companies, the premiums and the returns available at this price really, in my view, aren't much worth considering compared to investing in the common share or investing in something completely different.
In this case, I do consider CWT to be an attractive "BUY" - but I would also say that it's very possible to get a good, or better upside from many different investments on the market today.
I remain at "BUY" with the following, updated thesis.
Thesis
My thesis for California Water is as follows:
- Water companies are among the greatest in terms of safety, rivaling and exceeding even utilities. I follow many of them and invest in several. I do not yet own CWT, but I'm looking at establishing a position in the company going forward.
- In order to invest in the company, I want a sub-30x P/E on an LTM or blended historical basis or a share price below $56 as things stand. We're currently slightly above 30x but at around $55/share.
- For that reason, I'm a "BUY" here. My current PT for the business is around $56/share normalized.
- Future risks include the impact of necessary investments, which could be above $200M for the company. These trends, combined with inflation and macro, could hamper the company's earnings growth rate. For now, I remain at my target, but I may reduce it in the near future.
Remember, I'm all about:
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Buying undervalued - even if that undervaluation is slight, and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
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If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.
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If the company doesn't go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.
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I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.
Here are my criteria and how the company fulfills them ( italicized ).
- This company is overall qualitative.
- This company is fundamentally safe/conservative & well-run.
- This company pays a well-covered dividend.
- This company is currently cheap.
- This company has a realistic upside based on earnings growth or multiple expansion/reversion.
California Water Service Group has an upside but isn't exactly cheap. Still, if you want a water company, don't want YORW, and want cheaper multiples, California Water Service Group is an option you could look at.
For further details see:
California Water Service: Revisiting After A 10% Drop