American Water Works is the largest investor-owned water and wastewater utility in the United States. As such, the company enjoys some considerable advantages over its competitors in pursuing the investment opportunities presented by the dismal state of American water infrastructure. Despite its position, we recommend that investors dial back their enthusiasm when considering this investment, as government regulation limits the profits the company can make and creates hurdles to rapid growth.
Much of the U.S. water infrastructure dates back to the Great Depression, and the Environmental Protection Agency estimated in 2007 that it would require about $335 billion to upgrade and repair just community and not-for-profit water systems. With municipalities struggling to finance basic repairs and federal funding unable to bridge the gap, the signs point to massive opportunities for investor-owned businesses.
American Water's size and geographical diversity mean that the firm is better able to capitalize on these opportunities, as it is easier to connect new customers to existing systems and treatment plants than to build new infrastructure. It also helps the company maintain lower rates, as it can balance less profitable operations in one state with more profitable operations in others. This helps with regulatory goodwill but doesn't generally lead to great regulated returns. Continuing economic weakness also weighs on performance, as regulators are more inclined to sacrifice shareholder returns in exchange for political capital.
American Water's regulated businesses occupy local monopoly positions, since it would be prohibitively expensive to reproduce those assets. However, as most of American Water's revenue is dictated by state and local regulators, profits are effectively capped, diminishing the attractiveness of investments the company could make. In our opinion, this is the source of the company's narrow economic moat. Allowed returns are often not achieved, and excess returns are almost never allowed.
An investor must be willing to sacrifice excess returns for stability that is not necessarily guaranteed. In 2003, German conglomerate RWE acquired this company and took it private with dreams of huge growth. It is telling that RWE took only three years to decide to divest its holdings, finding American regulation too onerous. After the initial public offering and three follow-up offerings in 2008 and 2009, RWE no longer holds a stake in the company.
While the company will press ahead with its regulated investments and try to gain some ground with its allowed returns, we think appealing opportunities could lie in nonregulated contract operations. The firm designs, builds, and operates facilities, as well as assuming responsibility for operating and managing existing systems. Given the company's size, expertise, patents, and past successes, we believe this is an area where it could greatly expand its footprint. If it can, this story may get more exciting. The regulated businesses should continue to be a consistent, if unexciting, backbone for profits, and management is committed to paying a steady dividend. The firm has made some sizable divestitures to raise cash, narrowing its focus to a smaller number of states. Still, American Water still has a slog ahead to reach the top tier of regulated investments in our coverage universe.
Valuation
We are increasing our fair value estimate to $27 per share from $26 as American Water has managed O&M and rate activity better than we had forecast. We also incorporate a time-value adjustment. We expect the company to grow at a modest clip, increasing gross margins at an average rate of roughly 5% per year through 2015. We project capital expenditures totaling $4.4 billion during the same period to drive growth, with contributions from minor acquisitions and tuck-ins, given the highly fragmented nature of the industry. Rate cases after years of stay-outs will provide some operating margin improvement. We project operating margins to average nearly 29% through 2015. Returns on equity will be unimpressive but should remain in the 8%-9% range.
One of our key assumptions is high-single-digit average growth in the firm's nonregulated wastewater and contract services segments during the five-year period. We agree with management's assessment that nonregulated design, build, and operate projects as well as operating and maintenance partnerships provide an attractive avenue for growth for which American Water is poised to take advantage. Our fair value estimate is sensitive to our 7.3% assumed weighted average cost of capital, based on a 10% cost of equity. If we decreased our estimated cost of equity by 50 basis points, our fair value estimate would rise to $31 per share. If we increased it by 50 basis points, our fair value estimate would fall to $24 per share.
Risk
American Water Works derives most of its profits from regulated operations. Consequently, the greatest risk it faces is regulation that does not permit the company to earn its allowed return and does not protect it from regulatory lag, which is the time between the incurring and the recovery of costs. A prolonged freeze in the credit markets could force the company to scale back growth expenditures. As acquisitions are a major source of growth for this company, competition with rival regulated utilities is a threat to American Water Works' growth prospects. Municipalities may also resist its overtures, as they did in Trenton in 2010. Its nonregulated businesses are also subject to competition.
Management & Stewardship
American Water Works' senior management has a wealth of experience in dealing with regulation and in the water services industry in particular. Former president and CEO Donald Correll had more than 30 years of experience at water utilities, including 25 years with United Water Resources, and managed to keep the company's house in line despite a difficult period with the RWE debacle. New president and CEO Jeffry Sterba also has a wealth of experience with regulation, having served more than 30 years with PNM Resources PNM, in both power and water. Judging by the regulatory successes in 2010, Sterba has done a fine job at the tiller so far. We like that the average tenure of board members is less than 10 years. The absence of long-term incentives creates a potential conflict of interest between shareholders and management. Current annual incentives are based on short-term financial and operational goals. Furthermore, the firm's newly developed compensation plan should draw skepticism. The plan appears to protect current executive pay by allowing immediate vesting--upon committee approval--in the event that control changes hands. While the use of return metrics is praiseworthy, immediate vesting of options for the executives could dilute future shareholder value.
Overview
Financial Health: American Water carries a significant amount of debt, with a 58% debt/capital ratio at the end of the third quarter of 2011. Coverage ratios should continue to improve with rate increases, and we expect EBIT/interest coverage will average just below 3 times through 2015. Asset sales should help the firm deleverage in the near term, with a large divestiture slated to go through in early 2012.
Profile:
Founded in 1886, American Water Works is the largest investor-owned U.S. water and wastewater utility. It provides water and wastewater services to residential, commercial, and industrial customers, and operates predominantly in regulated markets, which account for nearly 90% of its total revenue. Its nonregulated businesses include wastewater management operations and public/private partnerships.
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