With divestitures and modest rate case successes, American Water Works has righted the ship

by Mark Barnett (Analyst at Morningstar)

American Water Works is the largest investor-owned water and wastewater utility in the U.S. 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 attractive 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 the company's revenue is dictated by state and local regulators, profits are effectively capped, diminishing the attractiveness of investments American Water 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. American Water's team has proven to be better regulatory managers than RWE, but all the same we are not bullish on the regulatory environment for water.

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 Works 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 $29 per share from $27 per share after updating our capital expenditure projections, lowering our assumed growth in operating expenses, and lowering our assumed cost of debt in our cost of capital calculation to better reflect markets and comparability with peers.

We expect the company to grow at a fairly strong clip for a regulated utility, increasing EBIT at a 7.5% average annual rate through 2016. We project capital expenditures totaling $4.9 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 should continue to provide some operating margin improvement. We project operating margins to average nearly 33% through 2016. We expect that returns on equity however will be unimpressive, remaining around 8.5%.

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 6% assumed weighted average cost of capital and 8% cost of equity. If we decreased our cost of equity by 50 basis points, our fair value estimate would rise to $32 per share. If we increased it by 50 basis points, our fair value estimate would fall to $25 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 served more than 30 years with PNM Resources PNM in both power and water. Judging by the regulatory successes in 2010 and 2011, Sterba has done a fine job at the tiller so far, though there have been some disappointing cases thus far in 2012. We think management deserves a standard stewardship grade.

The decision to trim debt and divest non-core operations strikes us as prudent, and should allow the company to focus its efforts on improving regulation in its largest segments. However, American Water is likely to continue doing deals, which brings risk of overpaying and expectations of improving returns that don't materialize.

Overview

Financial Health: 

American Water carries a significant amount of debt with a 57% debt/capital ratio at the end of the second quarter of 2012, treating redeemable preferred as debt. Coverage ratios should continue to improve with rate increases, and we expect EBIT/interest coverage will average just below 3 times through 2016. Asset sales are helping the firm deleverage in the near term, with a large divestiture completed in early 2012. We expect the company to continue to be both an active shedder and acquirer of assets.

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.