American Water Works: Premium Business Deserves Premium Valuation
American Water Works (AWK) - 2/13/2020
Stock Price: $136.10
Market Cap: $24.5B
Forward P/E: 35.02
Dividend Yield: 1.47%
TSC Core Equity Portfolio Weight: 2%
Price Target: $154
TSC Core Equity Portfolio Weight: 2%
Price Target: $154
Since it's 2008 IPO, shares of American Water Works have appreciated nearly 550%, far outpacing the utility sector by a factor of more than 5X, and outpacing the S&P 500 by more than 3x.
This drastic out-performance has resulted in a sky-high valuation for AWK, which in turn has created a growing choir of skeptics of the stock. But despite the current P/E multiple of 35X, AWK has a lot to give. American Water Works is a growing water utility that has a number of secular trends serving as serious tail winds for the company. From the deteriorating water infrastructure of America, to the rise of ESG investing, American Water Works will continue to demand a premium valuation as it continues to execute its long term vision.
The Growing Privatization Trend in America's Water Industry
America's water infrastructure is in need of serious repair. U.S. municipalities are projected to spend upwards of $300 Billion, to as high as $472 Billion in water pipe replacements and repairs over the next decade.
Fig 2: EPA Estimates U.S. Public Water System 20-year Investment Need
While the average age of America's 1.6 million mile stretch of water pipes if 45, some municipalities still rely on 150 year old pipes, and more than 600 towns and counties utilize 100 year old cast iron pipes that have exceeded their intended lifespan.
The growing need for municipalities to invest in their ageing water system sets up a decades long opportunity for American Water Works. The company's tuck-in investment strategy of acquiring small water and wastewater systems serving 3K to 30K customers within proximity of other AWK plants allows AWK to realize significant synergies and increase base rates.
The municipalities benefit from these acquisitions as well. Besides receiving a lump sum payment, when AWK acquires water treatment plants from municipalities, they commit to making the necessary investments to repair the water system, which can be costly, all while limiting the shock of a massive rate increase since AWK can absorb the costs into its larger utility network. In other words, American Water Works enjoys economies of scale, while a municipality operating a single water and waste water system doesn't.
Adding fuel to the privatization trend fire is fair market value legislation which has been spreading across the country. This legislation has made it easier for municipalities to sell their water systems to utility customers at a higher price given the need for investment by the acquirer, and it enables modest mid-single digit growth in the utility company's rate base. The growing trend of fair market value legislation eases the regulatory environment for water utilities and makes it easier for them to acquire and expand.
The water utility industry is highly fragmented and AWK has the scale to consolidate it, providing a significant total addressable market. AWK has outlined a ten year, $20 - $22 Billion capital investment plan.
The Growing ESG Trend
The company is an ESG darling that will benefit from continued fund flows into ESG funds. The stock is included in 18 different ESG funds, according to ETF.com. The lack of ESG compliant electric and gas utility companies means that equity is scarce for ESG utilities and AWK fits the bill. This scarcity factor is likely a small contributor to AWK's recent share price appreciation, as demand outweighs supply for their equity. If the ESG investing trend continues (likely with millenials starting to get a handle on their investment accounts), AWK will benefit from this for years to come.
ESG funds saw $20B in inflows in 2019, four times as much as the previous year.
AWK not only benefits from fund flows into ESG funds, they also benefit from fund flows into utility funds when interest rates fall. If you think low interest rates are a long term trend that is here to stay, continued flows into utility funds are a given, and AWK will stand to benefit.
A Premium Valuation
American Water Works has projected continued rate base growth of 6% until 2023, long term EPS CAGR of 7% - 10% until 2024, and the company has consistently raised its dividend 10% per year. A dividend payout ratio of 54% suggests plenty of upside ahead for AWK's dividend. AWK is one of two water utilities that has a Moody's credit rating, and its single A credit rating from S&P marks the highest of all water utilities. This provides AWK with cheap capital to fund acquisitions and expand.
You can't ignore the fact that AWK is trading at a forward P/E multiple of 35X clearly reflects a premium valuation to electric and gas utilities (low 20's), as well as water utility peers (avg P/E of 33X). The predictable growth profile of AWK over the next decade supports a premium valuation, but how high? That's for the market to decide. I have no problem buying premium companies at a premium valuation, because the strong execution and share out-performance is likely to persist.
Shares of AWK have been in a well defined rising channel since 2009. The stock is currently pushing up against the upper resistance band and should consolidate sideways to digest recent gains.
Looking at a daily chart, and applying fibonacci analysis to the 2019 high and low, generates technical price targets of $138 and $152, representing potential upside of +1% and +11% from current levels, respectively.
While you have to swallow the premium valuation when investing in AWK, you have two favorable trends at your side. First is the growing privatization of municipality water systems and the adoption of fair market value legislation across the country. AWK's economies of scale make them a prime beneficiary of this trend as they continue to execute a constant stream of tuck-in acquisitions. The second trend is the supply and demand profile for AWK's equity as ESG and dividend yield hungry investors drive fund flows into funds that hold AWK. As these trends continue, so should AWK's share price out-performance.