2023-03-15 14:27:54 ET
Summary
- I was relatively negative on California Water Service Group in my last article, not because it's a bad company but because of the valuation, which I viewed as far too high.
- Since my last "HOLD"-rated article on the company, California Water has underperformed the S&P 500 by a factor of almost 5x, validating my thesis.
- I review California Water for the year 2023, to see if, in the context of water utilities and overall macro, this might become a "BUY."
- I'm changing my rating for California Water Service Group here - with a new price target.
Dear readers/followers,
You know by now that I like water companies and this sort of utility business a great deal - I've invested in several of them, including The York Water Company ( YORW ). Another company I look at often is California Water Service ( CWT ). You see, wherever there is turmoil, there is opportunity. And I see plenty of turmoil on the West Coast these days, which also means that I see plenty of opportunity by investing there.
And investing in a utility at a good price, that's one of the safest ways I can think of to capitalize on such development/risk.
This is the performance of the company based on my latest article , which as you can see was definitely the right stance to have.
Seeking Alpha CWT (Seeking Alpha CWT article)
In this article, I'll see if we can find a positive and working thesis for CWT where we can buy the company and expect a good return.
Let's get going and see what we have.
California Water Service - There might be a potential upside even at a high valuation
So, water services. At this point, if you're a frequent reader of my articles, you should be somewhat familiar with them. If not, well - the company offers water in Dixon, East Los Angeles, Bakersfield, Travis, Stockton, and areas in the vicinity.
CWT has your standard water utility business structure. That means that CWT is actually a holding company with each of the various subsidiaries running somewhat of their own shops under CWT, including Cal Water, New Mexico Water, and many others. The company even has operations in Hawaii. Despite what the name suggests, CWT is actually more diversified than you might expect.
One of the core concepts you have to understand when you invest in water, your yields, and your dividend growth are going to be very low. These companies have low, single-digit yields and they're not usually bumping those yields that quickly. These companies also come at high multiples - usually, over 30x normalized earnings, to reflect the underlying safety and rate-oriented nature of their cash flows, earnings, and revenues, as well as pretty much an unassailable position in its markets.
However, while these companies might have been attractive as safety during times of low-interest rates, the question also becomes what a 1-2% water company at a high valuation might serve in terms of value when you can get 3-5% from a conservative bond or treasury. While the company brings with it the potential for capital appreciation, water companies are in no way immune to the inflation and cost increases that we are currently seeing across various markets and sectors.
CWT's latest set of results does little to change the overall thesis and nature regarding the company, except for a slight rating change. Because, as you might know, water companies are some of the most boring businesses in existence - in a good way.
Full-year results came in mostly positive...
...with somewhat lower net income. The reason for this was due to an $11M unrealized change in the valuation of a retirement plan, and some interest rate expenses - though this number was offset by an increase in the amount of unbilled revenue.
The company is in a bit of a crunch situation, as some rate-oriented businesses are, where the increases in OpEx and costs overall are going up faster than the rate relief/increases are going. This especially seems to be the case in west-coast states, or California, where water is more of an overall issue (lots of droughts and the like).
The company has a record amount of CapEx for the year, much due to significant 4Q22 investments. In the quarter alone, the company spent $105.7M in CapEx, which is an overall increase of 23.8% as things stand here. The EPS bride on a YoY basis gives us a good idea of how these individual impacts go for the company.
One of the primary concerns for a utility in a drought-stricken state like Cali, even with its other exposures, is how the company handles its cost of capital because the future has a lot of investment needs. However, the news from the company insofar as full-year results go was a non-starter, because there is no news. The company says that it's not even clear when a proposed decision will be issued, but the earliest is April 2023, which is a few weeks ahead even of this particular time.
This makes things tricky for the company.
Why? Because CWT cannot determine whether market conditions could affect components in CoC decisions. And that was back in December. We're at a materially deteriorated position now, in terms of lending costs, and given what's been going on in the past few weeks.
This isn't to say that CWT has any sort of major problems - the company's financing program and the cost of debt are actually lower than last adopted.
However, CWT has not made any provisions of reservations for any potential outcome from CPUC, which means there's a potential impact range that includes any sort of customer refund liability associated with the retroactivity in 2022/2023. This makes the associated impacts on the company's capital structure and allowed RoE an unknown factor in this case - and unknown factors are never a good thing when it comes to investing unless you're looking to take advantage of associated volatility.
That's not something we're necessarily looking to do when it comes to CWT.
Take these facts together with the issue of the environment. Not environmentalism, but environmental and meteorological facts related to large parts of the company's operating geographies. All Californian districts are now in "stage 2" drought restrictions, and there is far more risk to this company than to peers like YORW.
To me, this means that CWT cannot and should not hope to command the same sort of premium that YORW does, because it is not of the same fundamental quality and visibility.
The company also has some real issues with COVID-19-related debt, where CWT had to start shutting off customer water for nonpayment. While this is down, this is still there. The fact is that other states are doing a much better job here than California.
So despite an overall decline in the company's share price, this means that I'm unwilling to assign the same sort of premiums to CWT as I am to any of the other companies we're looking at - like YORW, which I am long in.
Let's look at the valuation and where this puts forecasts.
CWT valuation - a tricky case
Now, technically speaking, the company is actually below its 10-year P/E premium, which is something that bears mentioning at the very least. The problem, it isn't as indicative as it might be for some of the company's water peers. The company is at 30.38x normalized here, which is almost fair value for a water company. But the company also, quite often, goes a lot lower. Take a look here.
CWT valuation (F.A.S.T. Graphs)
So, it might be attractive - but also might be expensive. Again, remember, you're getting below 2% in an environment where you can relatively easily make around 3-5% from simple bonds and treasuries. And that is tricky.
I could argue and say that the upside here based on relatively conservative estimates for a water company isn't bad. From a forecast range of 30-34x P/E, we find an upside based on current estimates starting at 10.5%...
CWT Valuation (F.A.S.T. Graphs)
...and going up all the way to 12-13% annually. This is, quite obviously, better than a 3-5% return on a treasury investment or bond placement, if it's even close to what might happen.
My previous price target for CWT called for around $58/share or below a 30x P/E normalized. That is not yet where we are, but we're fairly close to it in terms of multiple, and below it in terms of nominal dollars. At the same time, the forecasts given the uncertainty given CPUC have gone down, so I've adjusted accordingly and this calls for at least $1-$2/share lower in PT, putting the company's share price very close to the PT, with perhaps only a very slight overall upside.
As I see it, anything above a 33-35x P/E is too much here. Even if we consider a 34x P/E on a forward basis for the company, including some reversal and a slight amount of growth, we get barely double digits at 34.4x P/E. There is, simply put, too much of a miss rate in this company from analyst targets - almost 25% on a 2-year basis, or over 40% on a 1-year basis with conservative margins of error.
Still, at most times historically, if you'd gone ahead and bought at this valuation, you'd have eventually come out on top with a decent return.
So I have a hard time sticking to my hold here. It's really a question of how you value the company's next few years of potential and what happens. With the "wrong" sort of response from CPUC and worsening conditions, I can easily see this company trading to 25-29x P/E and staying there for quite a while.
That is usually not a situation I want to find myself in - especially in a highly-valued company like this one.
Understand that I say, you can buy the company here. The analysts following CWT give the company a range of $58 on the low side and $66/share as a high, which means that they don't consider my discounting or the overall discount on the company as valid. That's from 4 analysts, with an average of $61.25, which means that they're significantly above mine, and they have cut theirs by around $3/share since my last article - likely for similar reasons as I cut mine.
Out of 4 analysts, only 1 is at a "BUY" here, so that's somewhat problematic as well if you're a CWT Bull and following these targets. From peer averages, the company is in a sector alongside YORW, American Water Works Company ( AWK ), Essential Utilities ( WTRG ), American States Water Company ( AWR ), and others. The fact is, CWT is undervalued compared to most of these - significantly even going by how the company's revenues are being valued in terms of multiples. Still, I do believe the company has the sort of trajectory you may be happy to be a part of, at the right price.
CWT Forecast (TIKR.com/S&P Global)
I do not see the company having the same downward volatility as a tech or pure growth business - but I do say that there is potential for the company to drop to around 25x P/E, which should imply some taking care here because that's a double-digit downward potential.
In my last article, I called CWT a "BUY" below 30x P/E. That remains my stance at this time. However, given changed forecasts and prices, the company is now about a dollar below my current, updated PT - and I follow my investment and rating rules.
I now rate CWT as a "BUY" - albeit a weak one.
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.
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: The 'Hold' Thesis Pays Off, Looking At 2023 (Upgrade)